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A good year for the rises


Legg Mason’s Bill Miller beat the S&P 500 for 15 straight years to 2005 but his Value Trust subsequently suffered a rare spell of severe underperformance.

After a tough 2006-08, returns were back to form last year and the team is currently bullish on value opportunities throughout the market.

Mary Chris Gay, who works alongside Miller at Legg Mason Capital Management, says the firm is valuation-driven, valuing businesses extensively and investing for the long term.

“While this process will beat a momentum strategy 80 per cent of the time, there are periods when it is difficult for value managers to out-perform,” she adds. “This is often at the most extreme downturn periods when all
that matters is the macro side and we suffered badly from 2006-2008. But we are contrarian investors and that means having the courage that your convictions are grounded in fundamentals when headlines claim you are wrong.”

Gay says Miller’s long period of annual outperformance was often a fortunate accident of the calendar but investors came to expect this consist – ency as part of his process.

“We have always been about maximising risk-adjusted returns over the long term and this short-term focus runs contrary to our approach of
holding stocks for several years,” she adds.

Over Miller’s long track record, he has only suffered two spells of underperformance, the 2006-08 period and three years in the late 1980s. Gay says both were in the midst of financial asset crises, with the savings and loan situation troubling markets in the earlier years.

“After both spells, we re-evaluated our process to identify mistakes, revising our valuation method in the 1990s to factor in return on invested
capital in addition to classic value indicators like low priceearnings ratios and price-tobook ratios,” she adds. “More recently, we underperformed first through lack of exposure to global cyclicals and then underestimating the severity of the crisis and failing to go defensive enough. With policy decisions now so important, we are spending more time in Washington to keep on top of upcoming changes to areas
like financials and healthcare.”

After a tough three years, Legg Mason’s funds – includ – ing the UK-domiciled US equity – has a better 2009 and Gay says the market remains
very cheap. “After a poor decade for equities, money is understandably continuing to flow into bonds but people are again investing as they
wish they had,” she adds.

“After 10 years in the wilderness, high-quality US large caps are cheap compared with bonds, with a company like IBM showing record earnings and growing its dividend by 25 per cent per year but still on just 12 times earnings.

Apart from technology, financials is another key weighing, at around a quarter of the portfolio, and the sector’s rally last year played a large role in Legg Mason’s overall performance.

Gay acknowledges uncertainty over future regulation but notes price-to-book ratios at lowest-ever levels.

“What gets discussed in pol – icy terms is not always passed and meanwhile, you have a company like Goldman Sachs offering 32 per cent return on equity trading at seven times earnings,” she adds.

“More generally, the shadow system has disappeared, banks can currently borrow at nothing and lend at higher multiples and non-performing
assets are expected to peak this year.”

On the macro side, Gay says the major surprise in 2010 may be stronger data than currently being discounted.

“In our view, the consensus for economic and possibly profits growth for 2010 is too low,” she adds.

“Corporate profits’ growth is expected to be 25 per cent in 2010, with over 80 per cent of companies beating expectations in the third quarter of
last year. History and data show GDP ought to be 7 per cent to 10 per cent if corporate profits grow 25 per cent while current predictions are in the 2.5-3 per cent range.”

Elsewhere, she points to inventories still being rebuilt and while the Government will withdraw some liquidity, it still has 70 per cent of the
stimulus package to spend.

Broadly, the group believes names trading at low valuations will be winners this year while companies where prices already discount midcycle earnings, largely materials and industrial cyclicals, may fare less well.

“Our view is that 2010 will be a good year for stocks, with low inflation, good economic growth, ample liquidity, rising corporate profits, attractive
valuations, and continued investor scepticism combining to move the market higher, perhaps substantially so,” adds Gay.


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