The Comeback Kids: The Interviews

Legg Mason Value Trust (LMVTX)

SMARTMONEY: Crazy ride? How do you describe 2008?

MILLER: Dreadful, a disaster. When my streak was going on, people would ask: “Won’t it be a relief when it’s over?” And I said: “No, it won’t be a relief. How would it be a relief if we underperform?” We underperformed by far more than we thought we would abstractly. There was a lot of disappointment from clients because no matter what you told them, expectations were too high. Everyone expected I would underperform eventually, but they didn’t expect to see these types of declines.

SM: The fund had always been lauded for its thoughtful analysis and thorough research. How did you make mistakes like buying Bear Stearns before its collapse or Freddie Mac before its bailout?

MILLER: Take Bear. You never had a case before where an investment bank had failed and had a run on it that didn’t have a legal problem or rogue trader. After Bear, we realized we were not being cautious enough about the depth of the crisis so we sold Washington Mutual and Wachovia and thought we were moving up the quality spectrum by buying AIG (AIG) and Freddie (FRE). We were not naïve about the depth of the housing crisis. We were prepared to take losses if we were wrong on that. But we weren’t prepared for the government to come wipe us out preemptively; there was no funding crisis.

SM: So what were the lessons?

MILLER: There was a significant thing we missed in this. We do probabilistic scenarios and try to have robust tactics and strategies to deal with them. At the grossest level, I didn’t have in our planning scenario a credible chance of another Great Depression. I figured everything post-World War II is fair game—and that’s a lot: Inflation going from 0 to 10 percent, crashes, Watergate, oil embargo, banking problems... A client said, “You should have had a wider range.” Obviously, but in retrospect, how wide? Should I plan for civil war or return to slavery? You have to draw the line somewhere and I drew it at the Depression and that was, as it turned out, wrong.

SM: So now what?

MILLER: All the strategies we have to deal with these events is based on there being a liquidity-driven crisis, like in 1987, 1994 or even 2002 debt deflation scare where the Fed cuts rates and grows its balance sheet to solve the problem. In that crisis, what you do is what we’ve always done: When the injection comes you have three to six months to get invested, typically in the areas of the market that has been the source of the problem. And it works great. But this was not a liquidity-driven crisis but an asset-collateral driven crisis, with housing prices dropping and then stock prices dropping. In this crisis, liquidity injections offer only temporary relief and the problem is not solved until policies are adopted. Had we understood the difference we would have gotten defensive very fast, which is what we will do the next time—it probably is not going to be in my lifetime but it may be in yours.

SM: What else have you learned?

MILLER: We also did poorly coming into this period because we didn’t have energy, materials or industrials. We have tweaked the process so now if we have a group in the bottom decile of its historical valuation—or it gets as cheap as energy did in 2003—whether or not we think the industry can earn more than its cost of capital, we will have exposure to it. It’s for the same reason you diversify.

SM: We have had this amazing rally so now what? If you look at your portfolio, are these the companies that are going to help you recoup your losses?

MILLER: It all depends on valuation. The difference between now and 2003 is that back then lower-quality stuff led, followed by a rebound in “quality” but the top of that spectrum—names like General Electric (GE) and Cisco (CSCO)—didn’t do well in the next couple years because they were richly priced. Now, that top end of the high-quality spectrum is very cheap. That is where the values are shaping up.

SM: What’s your take on health care?

MILLER: There’s an emerging opportunity there. We have good exposure with the managed care operators, and Medtronic (MDT) and Amgen (AMGN), but there are broader areas opening up. Device companies like Stryker (SYK) and Zimmer (ZMH) are under consideration for us. And I think in smaller biotech there are strong opportunities coming as soon as reform outlines are clear. I think there will be a huge merger and acquisitions wave.

SM: The Value Trust portfolio is more diversified in terms of sectors but what about holding more names?

MILLER: We owned a lot more names in Opportunity Trust than Value Trust and it did worse. We used to own 100 to 150 names so concentration is not part of our philosophy. It flows from where the opportunities are. If I’m looking at three companies all in different industries that are all trading at 10 and I think they are worth 20, it pays to own all three. But if I think the last one is worth 100 it pays to concentrate in that one.

SM: What preoccupies you now?

MILLER: The traction the recovery will get. I’m concerned about any thing that would be a shock to aggregate demand –pandemic, terrorists, Fed policy.

SM: Aren’t those always the risks?

MILLER: Well, no it’s much worse now. People are talking about the deficit and the need for an exit strategy because otherwise we’re going to have inflation. The best protection against inflation will be a strong economy. Pressure to exit too fast is a real risk, as is bad accounting policies.

SM: What about rebuilding assets or your record?

MILLER: Assets follow performance.

SM: Do you feel vindicated after this year’s gains?

MILLER: Relief is a much better word. I’m pleased that the shareholders who stuck with us are recovering at a faster rate than others...and I hope that continues.