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The last time we spoke to you in October 2007, you were tweaking your overall strategy. You were buying more large-cap US companies, reducing exposure among your top 10 holdings, increasing the total number of stocks you hold, and selling some of your small- to mid-caps to increase returns. How has that strategy worked for you so far?
Miller: Since October 2007, our strategy has changed because the circumstances have changed. One of the significant market developments in the past several months has been a spike in valuation dispersion from one standard deviation below average to almost two standard deviations above average. Therefore, instead of increasing portfolio diversification, an appropriate strategy when valuation spreads are narrow, we believe given the current environment, is to increase portfolio concentration.
The number of portfolio securities has declined from 44 last September to 35 currently, and the combined weight of our 10 largest holdings remains around 50%. We are still finding attractive valuations among large-cap stocks, and much of our recent portfolio trimming has been focused in the small- to mid-cap space. Historically, wide valuation dispersions have favoured valuation-based strategies, and we believe our portfolio is well positioned to take advantage of the current environment.
How has the investment strategy that you adopted over the past months affected the composition of your flagship Legg Mason Value Trust fund?
The most significant change in Value TrustÆs composition is a shift from a 500-basis-point underweight in financials to a 500-basis-point overweight, reflecting the significant investment opportunities we see in that battered sector. Financials are trading near their 1990 trough valuation levels and at relative price-to-book levels which historically have boded well for future returns. The Fed-orchestrated rescue of Bear Stearns likely marked the end of the panic phase of the credit crisis, and we believe the eventual stabilisation of the credit markets will provide the conditions necessary for financial stocks to begin to outperform.
How has the Legg Mason Value Trust fund performed since October last year? How has it performed year-to-date?
The Legg Mason Value Trust has fallen 24.8% since October 31, 2007 and is down 17.3% year-to-date through the end of May. Although we are trailing the S&P500, a performance inflection point came on March 17, with the events surrounding the possible end of the panic phase for the crisis. From March 17 to the beginning of May, the fund rose over 11% while the S&P500 appreciated 8.7%. However, since early May, the spike in oil prices and backup in credit spreads, have hurt our relative performance and we continue to trail the market year-to-date.
We believe that a return to normalcy in the credit markets and a more rational pricing environment for commodities, remain the key to both the equity market and the fundÆs performance. When liquidity returns to the credit markets, spreads should narrow, equities should do well, and we believe the fund will outperform.
The Legg Mason Value Trust fundÆs size is around $12 billion (as of March) compared with $20 billion in October. Has there been a lot of redemptions or does that reflect valuations of the portfolioÆs stocks?
The change in Value TrustÆs asset level since last October reflects the marketÆs decline, our relative underperformance and, to a lesser extent, net redemptions by investors. The outflows have been manageable, particularly given the relatively large market caps of our holdings. Historically, investors have done best by buying the fund during those times when we have been underperforming, not selling. Although this is behaviourally difficult, for long-term oriented investors it has proven to be a profitable strategy.
We noticed that three of your top 10 holdings in October û Google, Sprint Nextel, and Qwest Communications û have been replaced by Yahoo!, Freddie Mac, and General Electric.
The relative weights of our portfolio holdings shift as a result of transactions or price movements, or a combination of the two. The weighting of each stock we own reflects our assessment of its risk-return profile relative to investment alternatives. However, every stock in our portfolio is owned for the same reason: we believe it trades at a substantial discount to its intrinsic business value which is defined as the present value of the future cash flows it will generate for its owners.
Why have you reduced your holdings in the first three stocks?
Google has shown powerful business momentum, is growing rapidly, and continues to gain share in a secularly growing market. Investors bid up its shares by 50% in 2007, prompting us to trim our position in the fourth quarter. Its temporary swoon in early 2008 largely restored its attractive valuation, when its shares traded at only a 20% premium to Coke on next yearÆs earnings despite having a growth rate four times that of Coke.
Ongoing execution challenges at Sprint Nextel pressured its share price and contributed to its fall out of the top ten. The recent sell-off has pushed the stock not only far below our assessment of its intrinsic value, but below our estimate of the liquidation value of its assets. While challenges remain, the present price appears to fully reflect them; what is not discounted is the substantial appreciation potential if new managementÆs turnaround initiatives are even partially successful.
Qwest had been a ten-bagger [an investment which is worth 10 times its original purchase price] from its five-year low of mid-2002 to its recent high in May 2007, but has been weak since due to cyclical and competitive concerns. We believe CEO Ed Mueller has a solid plan to grow QwestÆs revenue through digital offerings, leading to a free option in this cashflow-rich stock, whose dividend yield is at a hefty 70% premium to the 10-year Treasury yield.
Why have you increased your holdings in the latter three stocks?
The 60% premium that Microsoft offered in its unsuccessful bid to acquire Yahoo! at $31 per share in the first quarter highlighted why price is not the same thing as value. While the situation is still fluid, it has come to light that Microsoft offered $40 per share for Yahoo! in early 2007. When you consider the fact that Yahoo! has generated over $1 billion in free cash flow since that time, monetized some of its assets through the sale of Alibaba in China, is making money in search and controls a solid Number 2 position behind Google while Microsoft is a distant Number 3 and losing money, it is not hard to understand why Yahoo! found the $31 offer too low. We agree with Yahoo!Æs management that the company is worth considerably more, even as a stand-alone company, than what Microsoft offered.
In dumping shares of Freddie Mac over credit concerns, investors missed the point that Freddie, together with its sister company Fannie Mae, are a solution to, rather than cause of, the credit crisis. The two GSEs now account for 75% of all activities in the secondary mortgage market and have raised their guarantee fees significantly, leading to very high returns on the fresh capital being raised and deployed. Freddie is trading in the low $20s and we believe the company should be well positioned to earn half that price or $10 per share within five years.
The recent earnings miss at General Electric, driven largely by the inability to close several deals at its GE Capital division, presented investors with an opportunity to own one of Corporate AmericaÆs icons with above-market growth and return potentials, a fortress balance sheet, and attractive exposures to infrastructure booms in emerging markets and alternative energy. The company is trading at a discount to the market on a price/earnings basis yet generates returns on invested capital above the market and has a dividend yield and dividend growth rate above that of the market.
What is your assessment of valuations of US shares at the moment?
Equity valuations in general are not demanding, interest rates are low, and corporate balance sheets, especially in the US, are in excellent shape. That sets the stage for what should be an improving environment for investors in stocks and in spread credit products. Our valuation work indicates that the S&P500 Index is currently worth about 17 times earnings versus a current market P/E of about 14.5 times on 2008 consensus estimates, suggesting that the upside return to fair value for US equities is in the high-teens.
What is the appropriate strategy to take when investing in US stocks now, with a long-term investment horizon in mind?
We believe the new market leadership will come from the same place it usually does: the old laggards. The new leadership will be what no one wants to own today, especially large and mega-cap stocks which have lagged the market most of the last five years. We believe that the greatest gains over the next five years will be made in those securities people are panicked about today. We believe the US market offers attractive investment opportunities for long-term investors whose strategy is valuation-driven, patient and contrarian in nature.
What is the greatest challenge you are facing in investing in the US?
The greatest challenge for investing in the US is coming from the global commodity markets. Oil has supplanted credit as the driver for the markets. Through oilÆs impact on US consumer spending and corporate input costs, the recent run-up in oil prices is causing credit spreads to widen, destruction in demand and changes in consumer behaviour. Since oil went above $120 in early May, credit spreads have reversed their improving trend. If commodities break, or even just stop rising, equity markets should do well.
What are the main risks involved in investing in the US and how are you managing those risks?
In investing in the US, as in investing anywhere, the main risk for long-term investors is failing to purchase stocks at sufficient discounts to intrinsic business value. We manage that risk through an investment process which is intensely focused on the fundamental valuation of businesses compared with the market expectations embedded in security prices. The recent market dislocations have actually created opportunities for valuation-driven investors as prices have declined substantially more than business values. Many of our top holdings sell at less than half our assessment of their intrinsic business value, an unusually wide discount.
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