Found this late this evening. Good night.
The Fine Art of Value Investing
By Fred W. Frailey
Legg Mason Value's William Miller buys undervalued
stocks, but his biggest holdings are highfliers America
Online and Dell Computer. Why?
William Miller occupies unique ground among fund managers. Legg Mason
Value Trust, which he runs, has outpaced Standard & Poor's 500-stock
portfolio each and every year since he became its sole manager in November
1990--an eight-year record of consistent overachievement that no other fund
manager in America can claim. Then again, there may be no other fund
manager with quite the same approach to undervalued stocks.
Like many other value investors, Miller buys stocks when they trade at a
substantial discount to what they would fetch in a takeover. And like some
professional investors, he bypasses popular signposts of value, such as
price-earnings and price-to-book ratios, in favor of more sophisticated
analysis.
The result, however, is not what you'd expect. Legg Mason Value looks and
acts as if it holds pricey growth stocks rather than undervalued issues. Its two
biggest holdings, accounting for almost 20% of assets, are America Online
and Dell Computer, which recently sported P/E ratios of 377 and 72,
respectively, on trailing 12-month earnings. You call this value investing? Bill
Miller does, as he explains in this interview, conducted in his office
overlooking downtown Baltimore.
Kiplinger's: Your fund has "value" in its name, and yet it behaves
like a growth fund--Morningstar even calls it one. Do you attribute
this to the growth stocks you hold?
Miller: I attribute it to the inability of people to understand long-term
investing. "Growth" and "value" are labels that people use to try to categorize
things. If you look at Morningstar's investment-style grid, we have migrated
through the whole spectrum. Yet this fund has invested the same way for 15
years.
And that way is . . .
We buy businesses that sell at large discounts to our assessment of their
underlying value. So the question is, where are the best values in the market?
Are they among companies that are growing, companies that are shrinking or
companies that are cyclical? We own a lot of technology stocks because we
think the best relative values are in that sector.
Even though the price-earnings ratios of these tech stocks are soaring
in the stratosphere?
P/E ratios by themselves are irrelevant. They capture one factor in a stock
and often have little to do with underlying values. Let me explain my
approach this way: Somebody said to me six months ago, how could I own
Dell Computer and not Gateway because Gateway is a much better value? I
said, what do you mean? Well, he said, Gateway trades at 12 times earnings
and Dell trades at 35 times earnings, so Gateway is obviously a better value.
So I replied that I had two businesses for him to invest in. In one he could
earn a 200% return on his investment. In the other he could earn 40%.
Which would he choose? Why, business number one, of course, he said--it's
five times as profitable. I said, you just described the difference between Dell
and Gateway. Dell earns 200% on its capital and Gateway 40%, yet Dell
trades at only three times the P/E ratio of Gateway.
You helped start Value Trust in 1982 and took over from senior
manager Ernie Kiehne in late 1990. Are you investing money the
same way Kiehne did?
Why did you buy Dell and AOL? Those are stocks you never find in a
value investor's portfolio.
AOL never, but lots of value investors bought Dell when it traded at six times
earnings. If you look at historical valuations of personal-computer stocks,
their prices used to bounce between six and 12 times earnings. When Dell fell
to a P/E of six, value investors moved in. When it rose to 12, value investors
sold.
Why didn't you sell Dell then?
Because we analyze businesses, not historic stock-trading patterns. I was
surprised to find that Dell was worth four times what we paid for it--that is,
when we bought it for $2, adjusted for subsequent stock splits, I figured its
real value at $8, based on our analysis of free cash flow and other factors,
including a return on capital of 35%. Since then, the company's revenue
growth has far exceeded what we projected. And return on capital rose in 18
months from 35% to 229%--the highest in American industry. Now if it was
worth four times the $2 we paid, and subsequently became seven times more
profitable, you can understand why we kept raising the value of the company.
We estimate its value in the low to mid $80s, versus its current price of $75.
And America Online--how do you assign a value to a stock like that?
America Online consists of a couple of different businesses. One business is
subscriptions--the monthly fee that its users pay. There are lots of other
subscription businesses, from newspapers to pest control, and you can look
and see what such companies trade for. You can also put a value on those
subscribers. AOL has six million subscribers; they pay x dollars a month, and
their average time as members is y. We make some assumptions based on
the current average life of a subscription and whether it is increasing or
decreasing and thereby value the subscribers.
AOL is also in the advertising business. How are other ad businesses valued?
And it is in the electronic-commerce business. You can figure out what that
part of the company is worth. And now it will own Netscape, which itself is
in several lines of business.
So what do you think America Online is worth?
Right now, without adding in whatever value Netscape adds, AOL is worth
roughly $135 a share. In ten years it may become a $300-billion company in
market capitalization, versus $70 billion today. It remains a core holding,
even though we are not buying more shares. The stock may be ahead of itself
now, but the company remains a long-term value.
Top ten holdings
Ten largest holdings of Legg Mason Value as of December 31, 1998.
Median market capitalization of the portfolio's 48 stocks: $14 billion:
1. America Online
2. Dell Computer
3. Chase Manhattan
4. Berkshire Hathaway
5. Compaq Computer
6. Fannie Mae
7. IBM
8. Citigroup
9. MCI WorldCom
10. Storage Technology Corp.
Minimum initial investment: $1,000 |
