IFA's Quote of the Week - 45 (Peter Cohan)


Step 5 - Manager Pickers


"Why didn't I just throw my money out of the window - and light it on fire?"

-Peter Cohan, management consultant and venture-capital investor who owns shares of Legg Mason Value Trust, "The Stock Picker's Defeat", The Wall Street Journal December 11, 2008




Play Eugene Fama Jr. Video


Oh, How the Mighty Fall

Most elementary school children are taught the important tale of Icarus, the boy whose father made him a set of wings of wax and feathers to fly away from the island of Crete where the two had been imprisoned by an evil king. Icarus's father cautioned him that he must fly in a straight path and not fly too close to the sun. Icarus obeyed his father's admonition at first, but as he became overcome by the giddiness of the flight, he diverted from his path and flew too close to the sun. Icarus's wax wings melted and the feathers flew away, leaving him desperately flapping his arms as he fell into the sea to drown.

A modern-day depiction of this legendary myth is the harsh reality of the rise and fall of storied fund manager Bill Miller.

As manager of the Legg Mason Value Trust, Miller enjoyed the distinction of being the only fund manager who beat the S&P 500 Index for the 15 consecutive years from 1991 through 2005. Miller was heralded by ratings services and media who put the fund manager on a pedestal, encouraging new money to flood to the lucky manager and making a much bigger fund.

A year ago, Miller's fund had swelled to $16.5 billion as investors clamored to get their share of Miller's unprecedented streak, likely unaware that the fund was badly benchmarked and carried greater risk than the S&P 500.

Miller made a practice of buying just a handful of companies (less than 40 stocks), often in distress and risky. Some of Miller's former picks include Freddie Mac when, in the 1980's, it was under siege and seemingly threatened with bankruptcy. Miller took an aggressive position in the mortgage company; a bet that yielded a return of 50 times his original investment, giving the appearance of certain genius and prompted Morningstar to name Miller "Fund Manager of the Decade" and bestowing its highest five-star rating on Miller's fund.

The chart below shows how the next decade played out for investors who thought past performance was a reliable predictor of future returns. Despite the fact that Miller's fund carried about 40% more risk than the S&P 500 Index, and about 30% higher risk than IFA's Index Portfolio 100, his fund failed to deliver the higher expected returns that should have accompanied the higher risk he took over the ten-year period from December 1999 to November 2008. Investors would have been better off ignoring Morningstar's accolades and buying the benchmark S&P 500 Index which earned an average annualized return that was 3% higher than that of the "fund manager of the decade". Even more compelling, had an investor purchased a globally diversified all-equity IFA Index Portfolio 100, they would have earned an average annualized return that was 5% above the S&P 500 Index and 9.26% above Miller and with less risk than Legg Mason Value Trust.



Miller's underperformance was the result of concentrated investments among highly correlated stocks. This approach was an inefficient use of risk. In contrast, IFA's equity Index Portfolios invest across as many as 15 different asset classes that invest in about 17,000 companies in 40 different countries. As for IFA's Large Value Index (LV), a single asset class allocation for IFA's Index Portfolios, this Index invests in about 250 U.S. companies with a high book-to-market ratio (BtM). Fundamentally important, the BtM sort for IFA's LV Index excludes firms with negative or zero book values. In assessing value, additional factors such as price to cash flow or price to earning ratios may be considered, as well as economic conditions and developments in the issuer's industry. In other words, Miller's strategy of reaching for the falling knife would likely have been avoided by this important rule of construction that governs IFA's Indexes. (Watch Gene Fama Jr.'s video explanation.)

Of Flying High and Falling Fast

Miller's strategy was to "place big bets on stocks other investors feared," according to an article in The Wall Street Journal  titled "The Stock Picker's Defeat".

According to the article, written by Tom Lauricella, "Mr. Miller was in his element a year ago when troubles in the housing market began infecting financial markets. Working from his well-worn playbook, he snapped up American International Group Inc., Wachovia Corp., Bear Stearns Cos. and Freddie Mac. As the shares continued to fall, he argued that investors were overreacting. He kept buying."

Lauricella continued, "What he saw as an opportunity turned into the biggest market crash since the Great Depression. Many Value Trust holdings were more or less wiped out. After 15 years of placing savvy bets against the herd, Mr. Miller had been trampled by it."

By his own admission, Miller admits, "The thing I didn't do, from Day One, was properly assess the severity of this liquidity crisis...I was naive."

In an interview with Lauricella, Miller continues, "Every decision to buy anything has been wrong...It's been awful."

With massive losses and a steady stream of redemptions from individuals and state pension plans alike, Miller's fund is now valued at about $4 billion, less than a quarter of its value just a year ago. According to the article, which cites Morningstar data, "Value Trust's investors have lost 58% of their money over the past year, 20 percentage points worse than the decline on the Standard & Poor's 500 stock index."

Such massive losses have completely wiped out Legg Mason Value Trust's long-term record, and now the Fund Manager of the Decade's track record rests "among the worst-performing in its class for the last one-, three-, five- and 10-year periods, according to Morningstar", says the Journal.

Early lessons such as the tale of Icarus impart important truisms that should not be brushed aside, especially when it comes to investing your capital. Basic, but important lessons can stave off the sort of misery that comes with losing assets by ignoring common sense. Fundamental lessons like, "you don't get something for nothing... there's no such thing as a free lunch... if something is too good to be true, it probably is... and the higher you fly, the harder you fall..." apply to investing as they do to other aspects of life. So, make sure you apply them when it comes to entrusting your hard-earned capital. After all, those who fail to learn from history are destined to repeat it.