Markets

Nir Kaissar is a Bloomberg Gadfly columnist covering the markets. He is the founder of Unison Advisors, an asset management firm. He has worked as a lawyer at Sullivan & Cromwell and a consultant at Ernst & Young.

Bill Miller’s 30-year tenure as manager of the Legg Mason Value Trust is one of the most celebrated runs by a mutual fund manager in investing history, and for good reason. From May 1982 to April 2012, the Value Trust outpaced the S&P 500 Index by an average of 1.3 percent annually (including dividends). And the Value Trust famously beat the S&P 500 for 15 consecutive years from 1991 to 2005.

But there’s a catch. As one of Miller’s former colleagues puts it, the downside of Miller’s approach is the potential for “big mistakes.”

The Value Trust declined 55 percent in 2008, while the S&P 500 declined 37 percent that year. This was no fluke – the Value Trust’s standard deviation was 23 percent higher than that of the S&P 500 during the Miller era -- which means investors had to have the stomachs for enduring very bumpy rides when they traveled with Miller.

Beware the Bump
With his new fund, Miller is attempting to smooth the bumps encountered during his tenure at the Value Trust.
SOURCE: Bloomberg

Well, Miller is now fixing to smooth out those bumps, according to my Bloomberg News colleagues. He's launching a new hedge fund that will attempt to dodge extreme market movements using a physicist-designed model that calculates the “probability of seismic activity.”

Oy, that sounds complicated.

According to Morningstar, Miller’s modus operandi at the Value Trust was to look for “stocks where the market is missing a significant source of value” and hunt for companies “able to generate sustainably strong returns on invested capital.” In other words, Miller invests in value stocks of companies with high profitability, which is the classic Ben Graham approach, of course.

We have good data on simple value and profitability strategies courtesy of financial researchers Eugene Fama and Ken French. The value strategy selects the cheapest 20 percent of U.S. stocks by price-to-book ratios, and the profitability strategy selects the most profitable 20 percent of U.S. stocks by return-on-equity.

It turns out that a 50-50 blend of the value and profitability strategies would have gone a long way to achieving Miller’s current objective.

The value-profitability strategy would have returned 14.1 percent annually from May 1982 to April 2012, as compared to the Value Trust’s return of 12.8 percent over the same period. Granted, the value-profitability strategy does not reflect fees and expenses, which would reduce the return, but an excess average return of 1.3 percent annually on a value-profitability strategy leaves plenty of room for a reasonable management fee and other expenses.

Keep It Simple
How a hybrid value-profitability strategy would have fared relative to the Value Trust during the Miller era.
SOURCE: Bloomberg
Annualized returns and standard deviations expressed as a percentage; Sharpe Ratio as a ratio.

Here’s the kicker, folks: The value-profitability strategy would have also smoothed the bumps that kept jostling Miller's investors during those same years.

The value-profitability strategy would have had a standard deviation of 15.6 percent, whereas the Value Trust had a standard deviation of 19.1 percent. The value-profitability strategy’s lower standard deviation isn’t just theoretical hocus-pocus –- it would have eased the pain when it mattered most. When the Value Trust tumbled 55 percent in 2008, the value-profitability strategy would have declined 32 percent that year –- nearly half the decline suffered by the Value Trust.

The objective of Miller’s new fund is to beat the S&P 500 with less volatility. The Sharpe Ratio is a common measure of risk-adjusted returns, and a higher Sharpe Ratio indicates a better return-for-risk tradeoff. The value-profitability strategy would have had a Sharpe Ratio of 0.61, while the S&P 500 had a Sharpe Ratio of 0.45, and the Value Trust had a Sharp Ratio of 0.44 -- meaning that the return-for-risk tradeoff would have been nearly 40 percent better for the value-profitability strategy.  

All of this reminds me of folksy adages about the virtues of simplicity when it comes to shrewd investing, such as:

  • The best strategies are the simplest strategies.
  • The best strategies can fit on an index card.
  • Don’t invest in a strategy you don’t understand.

The central wisdom in all of these investing guidelines is that consistency is likely to be the most important element of success. It's crucial to stick with a simple, easy to understand strategy over time, especially when the road gets bumpy.

I have no doubt that Miller understands every nuance of the earthquake-predicting model he’s chosen for his new fund. But maybe he doesn’t need complicated models to get where he wants to go. Maybe he just needs to keep it simple.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

To contact the author of this story:
Nir Kaissar in New York at nkaissar1@bloomberg.net

To contact the editor responsible for this story:
Timothy L. O'Brien at tobrien46@bloomberg.net