Bill Miller Writes About the End of “The Streak”

If you have read about my investment philosophy on peridotcapital.com you will see that I refer to Bill Miller (manager of Legg Mason Value Trust) in comparing my value strategy to others that are more well known than myself. Miller looks at the market differently than most, and I use many of the same techniques when I manage money, so he is an excellent person to read about if you want to get a better idea of what Peridot Capital is all about.

A logical question would be “If Bill Miller is so good, why should I invest with you instead of him?” If you look at Miller’s performance in recent years, it pales in comparison with his longer term track record. The reason is quite simple; as Miller as gotten more and more publicity, money has poured into his fund.

He now manages billions of dollars, and as a result, is very limited in the stocks he can buy for his fund. Since Miller prefers very concentrated portfolios, he is now limited to investing in very big companies. With a smaller universe from which to choose his investments, Miller’s margin of outperformance is narrowing with each passing year (see chart).

As you may have heard, 2006 was the first year since Miller took over the fund in 1990 that Legg Mason Value Trust failed to beat the S&P 500 index. Although “The Streak” is now over (it is the longest streak by a mutual fund on record), Miller’s overall investment philosophies remain very relevant. For managers who don’t have the task of investing tens of billions of dollars, continuing to invest according to a contrarian investment strategy will prove very profitable.

Fortunately, for those who aren’t familiar with Bill Miller, he writes quarterly letters that are made available to the public, regardless of whether you own shares of his fund or not. In his latest, Miller discusses the end of “The Streak” and other important value investing concepts.

While I would no longer recommend investors buy shares in his fund for the reasons mentioned, I definitely suggest that those interested in contrarian value investing in general, or Peridot Capital more specifically, should read his quarterly letters. You may access his latest letter here.

If Your Broker Sells Mutual Funds, Run, Do Not Walk, To The Nearest Exit

In a perfect world, stock brokers would actually earn their money. If they recommend individual stocks to their clients, those stocks would do better than the ones chimpanzees choose by throwing darts at the Wall Street Journal stock tables. If they recommend mutual funds to their clients, those mutual funds would be above-average performers. After all, if you have thousands of options and a professional helping you choose from them, you should be able to tell the good from the bad.

Ah, but the world is far from perfect. Research has shown that sell side investment recommendations provide investors with more volatility and lower returns than a broad market index. In addition, a study done by a trio of college professors from the Harvard Business School and the University of Oregon shows that between 1996 and 2002 brokers who sold mutual funds actually cost their clients billions of dollars. This conclusion was reached by comparing returns for two groups of funds, those that brokers sold and those that individuals picked on their own.

If we take a step back and think about brokers who sell mutual funds, and how they are compensated, we can understand why they might not provide the best advice to their clients. Brokers get paid to sell certain funds. Those funds are not chosen based on how good they are, but rather on which fund companies give kickbacks to the brokers selling them. So, if brokers are getting paid to sell “Fund X” and that decision has nothing to do with how good Fund X is (but because Fund X is throwing money at the broker), there is little reason to think Fund X would be any better than alternatives such as “Fund Y” or “Fund Z.” As a result, logical minds might conclude that mutual funds sold by brokers will perform no better and no worse than the average mutual fund. If performance is not a yardstick that is being given any attention, how well the fund does in the future will be pretty much a coin flip.

Interestingly, the aforementioned study (which tracked more than 4,000 mutual funds over a seven year period) showed that broker-sold funds actually do far worse than average. How striking were the results? Very striking indeed. Investors working on their own to pick mutual funds earned an average return of 6.6% per year. Investors who used a broker and bought the funds they recommended earned 2.9% annually. The public outperformed supposedly “knowledgeable” brokers by more than 100 percent. To make matters worse, the people working with brokers actually lost money after factoring in inflation and taxes.

If you are using a broker and are invested in mutual funds that they recommended to you, you might want to take a close look at your results and make sure your broker is working for you, not the mutual fund company subsidizing their paycheck.

Customers Name Edward Jones Best Full Service Firm

From the Associated Press:

“A survey by J.D. Power and Associates found that brokerage Edward Jones was consumers’ choice as the best full-service investment adviser for a second straight year.

J.D. Power, a marketing firm that’s part of The McGraw-Hill Cos., asked investors to evaluate full-service brokers on seven criteria, including competitiveness of portfolio, account set-up and offerings, commissions and fees and account statements. More than 5,000 investors responded, the company said.

Edward Jones, the investment brokerage network of The Jones Financial Companies based in Des Peres, Mo., was rated No. 1 with a score of 808 out of 1,000, J.D. Power said. The other firms in the top five and their scores were Raymond James Financial Inc. of St. Petersburg, Fla., 800; A.G. Edwards & Sons Inc. of St. Louis, 778; LPL Financial Services operated by Linsco/Private Ledger Corp. based in San Diego, 775; and The Vanguard Group Inc. of Malvern, Pa., 775.”

I found this study pretty interesting. Jones is headquartered right in my backyard and a closer look at the results of the survey are confusing to me. I am well aware that Edward Jones has below-average stock recommendations (their Model Portfolio has lagged the S&P 500 since it was created in 1992) and their commissions are fairly high as well, being a full-service brokerage.

Why then did they score so high? Evidently, their customers care much more about the overall experience with Jones and their personal brokers than they do about actually doing well in the market. Portfolio performance and fees associated with their investments made up only 33% of their overall rating of the company. Shouldn’t those two factors be some of the most important?

Jones surely gets kudos for providing a positive client experience, but I wonder if such happiness is luring customers into thinking they are actually doing well with their investments.

Lagging Fidelity Fund Seeks to Change Benchmark

In the latest example of how mutual fund companies couldn’t care less about their long suffering shareholders, consider Fidelity’s recent announcement that it will be recommending its Blue Chip Growth Fund (FBGRX) change its benchmark from the S&P 500 index to the Russell 1000 Growth index.

As soon as I read about the proposal I knew a little research would yield some interesting findings. Sure enough, the Fidelity Blue Chip Growth fund has trailed the S&P 500 for six straight years.

In the real world such pitiful performance would result in the manager of the fund getting fired. But who are we kidding? The mutual fund world is nothing like the real world. Fund managers hardly ever get canned, even though 80 percent of them fail to beat their benchmark. So what does Fidelity decide is the proper course of action? Well of course, change the benchmark!

You guessed it, the Russell 1000 Growth index has lagged the S&P 500 over the last five years, so the switch will make it look like Fidelity Blue Chip Growth has done better than it actually has. Interestingly, the fund has also lagged the Russell 1000 Growth index over the last five years, just not by as wide a margin as it has the S&P 500.

Alright, so maybe you’re thinking I’m being a little too cynical here. Maybe the Russell 1000 Growth index really is a better benchmark for this particular fund, based on the companies it invests in, and therefore such a change can be adequately defended. I admitted that was a possibility, so I did a little more digging. If Fidelity Blue Chip Growth is really quite different from the S&P 500 index, I’ll be happy to get off their backs.

The top five largest holdings of the Fidelity fund are Microsoft, GE, Johnson & Johnson, AIG, and Intel. Sounds like the S&P 500 to me. What did I find when I peaked at the Vanguard Index 500 fund (VFINX), the largest S&P 500 index fund in the country? GE is the fund’s 2nd largest holding, followed by Microsoft at #3, Johnson & Johnson at #5, AIG at #8, and Intel at #10.

Let me throw one more statistic out there that I find too amazing to ignore. In case it was just the largest holdings of Fidelity Blue Chip Growth that overlapped almost exactly with the S&P 500, I decided to look at the market cap of the fund’s average holding versus the average market cap of the S&P 500 index fund. Guess what? They’re exactly the same… $46.9 billion versus $47.1 billion!

And yet Fidelity is trying to get away with saying they think the S&P 500 isn’t a good benchmark for the fund? Investors should not tolerate this. Unfortunately though, most of them probably have no idea it’s even going on. Fortunately, that’s one of the purposes of this blog.

Rising Commissions? Since When?

I had to double check to make sure what I heard over the weekend was correct. A.G. Edwards (AGE), a St. Louis based firm with 7,000 brokers nationwide, is planning to raise their commissions by 5 percent beginning on March 15th. In addition, their postage and handling fee is jumping 10 percent to $5.50 per transaction. Yes, that is correct. The company will charge customers $5.50 to mail them each trade confirmation. BrownCo actually only charges $5 to make a trade, so you can see how out of whack these fees really are.

Amazingly, full service brokers continue to thrive, even when they are ripping off millions of investors. AG Edwards stands to bring in an estimated $50 million in incremental revenue from the price hike, as they generate $1 billion per year in commissions (40 percent of total sales). Now I understand investors take comfort in having a personal broker with whom to work with, but at what point does one think twice about paying these astronomical fees? After all, it costs next to nothing to execute trade, which is why discounters can charge less than $10 and still make a lot of money.

The statistics have shown that analysts aren’t good stock pickers (sell-side research generates the investment ideas brokers in turn recommend to their clients) and the majority of mutual funds lag the market, so the buy side isn’t that great either. Meanwhile, discount brokers now offer all kinds of stock research reports, the same research high-priced brokers are using.


Why then are investors content to pay a 2 percent commission to full service brokers? Think about it this way. Let’s say you hold your average stock for a year. If you are paying 2% when you buy it and another 2% when you sell it, you’re 4% behind the market’s return assuming your stock picks are average performers.

With valuations where they are today in the U.S. stock market, the S&P 500 is likely to only average a mid-to-high single digit annual return for the rest of the decade at least. So, a full service brokerage customer is going to make about 4% per year net of commissions if the market returns 8% per year. Mutual funds will return about 7% in such a scenario, but transaction fees and loads could take that number even lower. No wonder index funds have become so popular. Compared with actively managed mutual funds and full service brokers, they are often a better option.

This current state of the investment advisory industry is exactly why I started Peridot Capital Management. The average mutual fund investor is going to underperform. The average stock broker is going to underperform. Investors who pick their own stocks often buy what they know and like, paying no attention to valuation. In doing so, they buy overpriced blue chips stocks that have done wonderfully over the last twenty years, and as a result, are set to underperform.

Unless you can earn above-average returns on your own, index funds are the best option of the four most common investment options, but by definition you can not outperform by owning them.

The answer, at least in my eyes, is pretty simple; investing with superior independent research from a personal investment manager, who is not working on commission, through an online discount brokerage account. Hence Peridot Capital was born.

Is Merrill Lynch Serious?

Merrill Lynch (MER) is changing the name of its mutual fund group to Princeton Portfolio Research and Management later this year. Now this might seem strange on the surface, just because as far as name recognition and brand awareness go, I would think investors would choose to invest with Merrill over Princeton. Maybe that’s just me.

The part of this story that really got a laugh out of me was Merrill Lynch’s reasoning for making the change. In essence they think a new brand will make it easier for them to gain market share in the retail mutual fund business. Their concern is that brokers and financial advisors with other major firms have avoided offering Merrill Lynch funds because they see it as giving business to their competition.

That seems like a very valid concern. I can’t see many Morgan Stanley and Goldman Sachs brokers trying to sell Merrill funds to their clients. But isn’t it hilarious that they think changing the name will help this problem? Do they think retail brokers are just going to start blindly recommending this new fund family without looking into them at all?

So they’ll do a little research to find out exactly who these “Princeton” folks are, and they’ll learn, if they haven’t heard already, that it’s the old Merrill Lynch fund family. And we’re back to square one.

Side notes:

Amazon (AMZN) is getting hit by $4 today after earnings. As much as I like Legg Mason’s Bill Miller, I really don’t know what he likes about this stock. All I see is a perennial 40+ forward P/E, decent but not overly impressive sales growth, and very low margins (not much better than Borders and Barnes and Noble as was once predicted).

OccuLogix (RHEO) is down more than $9 in the pre-market, to $3 per share. The only reason I even know about this company is because I recall Cramer pumping it on his Mad Money show. Evidently their product showed no difference versus placebo. How he can suggest to average investors that they buy something this speculative on national television is beyond me. Maybe a 75% haircut in a single day will help viewers understand what he is doing. I still have not exactly figured out his motivation (and/or conflicts of interest) in pumping the small caps he does, but I suspect the answer is not comforting.

Legg Mason’s Miller Understands the Game

Bill Miller, manager of Legg Mason Value Trust (LMVTX), has done something that no other fund manager can claim. Since taking over sole management of the fund, he has beaten the market each and every year, for 15 straight years. Is he just lucky like some efficient market supporters would claim? Or does he know something that others don’t?

The answer is neither. Markets are not completely efficient. All they do is incorporate the consensus view of investors and use that to arrive at a prevailing market price. The conventional wisdom is collected in an efficient manner, but such wisdom is wrong more than it is right. Every quarter when public companies report their earnings, about 70 percent will either miss or exceed the consensus estimate.

Miller’s most recent letter to shareholders outlines his strategy. His ideas will seem reasonable, logical, perhaps even obvious to many. However, when we look across Wall Street we see very few who put them into practice. Which begs the question, why?

People ask me all the time what my philosophy is, my approach to investing. These are the concepts investors must grasp to be good at what they do, before you even begin to look at an industry or a specific company’s stock. Many individual investors choose to buy what they know, what they like. Many financial advisers at your big name retail brokerages recommend them as well. That can end very badly, for many of the reasons expressed below. These are excerpts from the letter.

“Unfortunately, when we purchase companies we believe are mispriced, it is often difficult to determine when the market will agree with us and close the discount to intrinsic value. Our goal is to construct portfolios that have the potential to outperform the market over an investment time horizon of 3-5 years without assuming undue risk. If we achieve that goal, we believe we will be doing our job, whether we beat the market each and every year or not.”

“The most common error in investing is confusing business fundamentals with investment merit. A company that is doing terrifically well, that has great management and returns on capital, and great products and prospects, may be a terrible investment if the expecations embedded in the current valaution are in excess of those fundamentals. A company with poor business fundamentals, a mediocore management, and indifferent prospects may be a great investment if the market is even more pessimistic about the business than is warranted. The most important question in investing is what is discounted, or put slightly differently, what are the expectations embedded in the valuation?”

“Systematic outperformance requires variant perception: one must believe something different from what the market believes, and one must be right. This usually involves weighting publically available information differently from the market, either as to its magnitude or its duration. More simply, the market is either wrong about how important something is, or wrong about when that something occurs, or both.”

Index Funds Lag for 7th Straight Year

Vanguard did a good job of convincing people to buy into their S&P 500 index fund, but was that advice wise? Jack Bogle, the company’s founder and most outspoken advocate, seems to make a decent case for Vanguard.

After getting crushed by their technology stock centric portfolios from 2000 through 2002 (The Nasdaq fell 80%), investors should just move what’s left of their nest egg into index funds. After all, few actively mutual managed funds can consistently beat the overall market indices. Why pay 1.5% per year for a lackluster managed fund when you get pay 90% less for Vanguard Index 500?

Not only do we hear this logic all the time, but millions of people have adopted the strategy. What do they have to show for it? Not much, according to Lipper, a leading tracker of mutual fund perfomance. For the 7th straight year actively managed U.S. stock mutual funds beat the S&P 500 index funds that have been marketed so heavily since the bubble burst.

So far this decade the S&P 500 has averaged a return of 0.2 percent per year. Actively managed frunds have returned 3.5% annually for their investors during the same time period. Some people may be surprised to learn this, but is it really that shocking? If active managers can’t beat a 0.2% return, that would be pretty pathetic. Still, annual gains that barely outpace inflation are certainly nothing that active mutual fund owners should feel all that happy with, so don’t think these funds are all of the sudden your best way to make good money.

The index fund argument completely ignores the entire point of investing; to buy low and sell high. To do so, investors must purchase attractively priced stocks, wait until they trade closer to fair value, and sell them. Then the process repeats itself. How does owning every stock in the country via an index fund accomplish this feat? By definition, it won’t. You’ll own undervalued stocks, fairly valued stocks, and overvalued stocks. Basically, you’re just crossing your fingers and hoping the stock market goes up. Too bad the bull market ended six years ago.

I don’t know about all of you, but banking your retirement on the hope that the market will go up is a risky proposition. Getting superior returns from index funds will solely depend on whether or not you happen to own them during bull markets or not. Unfortunately for investors, the greatest bull market in history ended in 1999. Pretty ironic considering that actively managed funds have outperformed the S&P 500 each and every year since, you guessed it, 1999.

H&R Block Financial Advisors’ Top Picks for 2006

Thought maybe readers would find this list helpful. Not that I think H&R Block Financial Advisors are great stock pickers, but maybe some of these fit criteria that you look for in a stock.

Comcast (CMCSA) Consumer Disc.
Int’l Speedway (ISCA) Consumer Disc.
CVS Corp (CVS) Consumer Staples
Pepsi Bottling (PBG) Consumer Staples
United Natural Foods (UNFI) Consumer Staples
Global Santa Fe (GSF) Energy
Schlumberger (SLB) Energy
Capital One (COF) Financials
Wachovia (WB) Financials
Neurocrine (NBIX) Health Care
Stryker (SYK) Health Care
Teva (TEVA) Health Care
3M (MMM) Industrials
URS (URS) Industrials
Dell (DELL) Technology
Intel (INTC) Technology
Micron (MU) Technology
Verizon (VZ) Telecom
FPL Group (FPL) Utilities

Full disclosure: Peridot owns shares of Capital One