TN2 Bill Miller and Value Trust

Case 2 Bill Miller and Value Value Trust

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BILL MILLER AND VALUE TRUST Teaching Note

Synopsis and Objectives

Set Set in the the autum utumn n of 2005 2005,, the the case ase reco recou unts nts the the Suggested complementary case in remarka remarkale le !erforma !erformance nce record of Value Trust, Trust, a mutual mutual fund fund investment management and managed " #illiam $% &Bill' Miller ((( at )egg Mason, (nc% The financial performance : #arren =% Buffett, 2005 &Case 1' case descries the in*estment st"le of Miller, +hose record +ith Value Trust had eaten the S- 500 fourteen "ears in a ro+% The tasks for the student are to assess the !erformance of the fund, consider the sources of that succes success, s, and to decid decidee on the susta sustain ina ail ilit it" " of Mill Miller. er.ss !erfor !erforma mance nce%% Consi Consist stent ent +ith +ith the introductor" nature of this case, the anal"sis re/uires no numerical calculations% The instructor  should not e decei*ed, ho+e*er, ecause the asor!tion of the ca!italmarket ackground and the im!lications of the finance conce!ts in the case +ill full" occu!" the no*ice% This case u!dates and re!laces -eter )"nch and the idelit" Magellan und, &4V0666' and The idelit" Magellan und, 1775 &4V1128'% The case is intended for use in the o!ening stages of a finance course% (t !ro*ides a nontechni nontechnical cal introducti introduction on to the 4%S% e/uit" e/uit" markets markets and sets the foundatio foundation n for some asic asic conce!ts in finance% S!ecific teaching o9ecti*es are to: •

Moti*ate a discussion of the conce!t of ca!italmarket efficienc"%

•

(m!art some recent ca!italmarket histor";in !articular, regarding the (nternet ule of  the late 1770s and earl" 2000s, and the market crash of 17' 2 Burton D% Malkiel, eturns from (n*esting in =/uit" Mutual unds, 1761 to 1771,  ournal o! "inan#e 50 &Aune 1775': 5>7E562%

Case 2 Bill Miller and Value Trust

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Students +ho are ne+ to the su9ect of finance ma" also find it useful to refer to one or  more dictionaries of financial terms, such as  $arron%s &i#tionary o! "inan#e and 'n(estment  Terms,8th ed%, " Aohn Fo+nes and Aordan =lliot Doodman &$au!!auge, Ne+ ork: Barron.s =ducational Series, (nc%, 2002', or The )ew *al+ra(e &i#tionary o! Money and "inan#e, ed%  Ne+man, Milgate, and =at+ell &Ne+ ork: Stockton -ress, 1772'%

Hypothetical Teaching Plan

ssuming the case is taught earl" in an introductor" finance course, the teacher.s classroom strateg" can egin +ith the coinfli!!ing e@ercise suggested " Malkiel% ll students are asked to stand u! and to !re!are to fli! a coin% t the first and suse/uent rounds, those +ho get tails are asked to sit do+n% 4suall" cheers and humor accom!an" the final rounds% 1% Guestion for the student +ho +on the cointossing game: The #ase mentions that $urton  Malkiel su++ests this eample- What #on#ept is he tryin+ to illustrate, and how does this eer#ise illustrate it. This /uestion !ro*ides an entr" into the theor" of efficienc", and es!eciall" the arguments of its !ro!onents like Malkiel% 2% What is the e!!i#ient/markets hypothesis. What does it imply !or the per!orman#e o!  mutual !unds. This /uestion uilds on the first /uestion and aims to estalish the null h"!othesis against +hich the !erformance of Bill Miller and Value Trust can e e*aluated% (f students ha*e not encountered the difference et+een strong, semistrong, and +eak forms of efficienc", here +ould e an o!!ortune moment to discuss it% 3% What would Miller say in response to the #laim that his su##ess is lu#k. What is his in(estment style. #ith this /uestion, the discussion turns to the other side of the deate% The instructor can list the descri!tors of Miller.s in*estment st"le on the oard% (n that segment, the instructor can distinguish et+een fundamental and technical anal"sts, and the different kinds of insights the" seek% This segment of the discussion should seek to flesh out +hat acti*e management means, namel", that one looks for !ricing inefficiencies% >%  &oes anythin+ a0out 1alue Trust surprise you. Why. How 0i+ a !a#tor is the !und, or all  o! the e2uity mutual !unds, in the sto#k market today. $ere the discussion turns to the significant role that large institutional in*estors !la" in the e/uit" markets% The ulk of trading takes !lace among institutions;indi*iduals are not significant in setting e/uit" !rices% 5% What does it mean to 0eat the market. How do you de!ine e#ellent per!orman#e. (n this stage of the discussion, the instructor could introduce a notion of the in*estors. o!!ortunit" cost;the ailit" to in*est in an inde@ fund that aims to match the !erformance

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Case 2 Bill Miller and Value Trust

of a road e/uit" market inde@% gainst this enchmark, students should e nudged to consider the riskreturn characteristics of an acti*el" managed fund like Value Trust% 8% What is 3e++ Mason, 'n#-. What is its relationship to 1alue Trust. What are 3e++   Mason%s #ore #ompeten#ies. This segment of the discussion turns to consider the economic 9ustification of mutual funds in a +orld of efficient markets% The !ossile 9ustifications include research &that is, the effort to identif" !ricing inefficiencies', goalsetting, monitoring of managers, and con*enience for the in*estor% 6% Would you in(est in 1alue Trust, as o! autumn 4556, +i(en the in!ormation in the #ase. Man" students are attracted " the stock!icking skill &or hot hand' of Value Trust.s Bill Miller% Hther students +ill e im!ressed " the coinfli!!ing e@ercise% The instructor could close the discussion +ith a *ote on the in*estment recommendation, and then discuss the !erformance of Bill Miller and Value Trust since the date of the case% The instructor could use the u!date as a s!ringoard for closing comments on ca!italmarket efficienc"% #e sites for )egg Mason and Morningstar are highl" recommended as sources of  u!dated information% See htt!:II+++%leggmason%com and htt!:II+++%mf%morningstar%com%

Case Analysis

This note assumes that the instructor is familiar +ith the efficientmarkets h"!othesis and the academic research surrounding it% The discussion that follo+s +ill focus on other teaching o!!ortunities in the case discussion% arge institutional investors and the structure of !"S" capital mar#ets

n im!ortant o9ecti*e of the case is to introduce the no*ice to the $iscussion structure of the 4%S% ca!ital markets% )ater, this foundation is useful for the %uestions &' (' ) * student +hen he or she encounters conce!ts founded on ca!italmarket efficienc", in*estor rationalit", and !erfect com!etition% The case con*e"s the role of aritrage dri*en " huge *olumes of mone" &managed " institutional in*estors' that set  !rices in the markets% Sim!le demogra!hics are an im!ortant descri!ti*e element% The ca!ital market can e segmented into the stock, ond, and mone" markets% #ithin the stock market, there are ma9or  segments " t"!e of !la"er: !ension funds, mutual funds, hedge funds, and indi*iduals% The mutualfund segment, in turn, can e roken do+n " in*estment o9ecti*e: gro+th, income, etc% The magnitude of the market &in terms of dollars and !eo!le' and the heterogeneit" of in*estors underscore the difficult" of achie*ing su!erior !erformance consistentl"% The case indicates se*eral im!ortant trends in the ca!ital markets:

Case 2 Bill Miller and Value Trust

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n 11K com!ound a*erage gro+th rate in dollars under management " all mutual funds  et+een 1775 and 2005%

J

7K com!ound a*erage gro+th rate in numer of mutual funds%

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20K of the outstanding stock in all 4%S% com!anies +as o+ned " mutual funds%

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Fomination of trading " lead steers, +hich is reflected in the trading characteristics of  those institutional in*estors, such as higher trading *olumes, igger siLe of trades, and  lock trading%

(ncreasing li/uidit" in the market, increasing in*estor demand for mutual funds, segmentation of the market " mutual funds, s+itching among funds " in*estors, increasing *olatilit", and increasing attem!ts to time the s+ings in the market;man" of those are elie*ed to e indicators of hot mone" in the stock market% nother im!ortant descri!ti*e element is recent ca!italmarket histor", es!eciall" the stock  market ule of the late 1770s and earl" 2000s, and the market crash of 17 "ears in a ro+% The encomiums /uoted on the first !age of the case &off the charts, su!erhuman, and mortal genius' suggest that Miller had a hot hand, the in*estmentmanagement e/ui*alent of a  asketall !la"er.s ailit" to score re!eatedl"% The statistics from case =@hiits 1 and 5 are im!ressi*e% Value Trust eat the S- 500 and the ussell 1000 indices on a*erage for the !ast 1, 3, 5, 10, and 15 "ears% Since its ince!tion, Value Trust had etter a*erage annual returns than all other e/uit" finds in the )egg Mason fund famil"% Dro+th of Value Trust.s net assets o*er the 177>E2005 !eriod +as a com!ound rate of  28K &*ersus 11K for the S- 500, and an inflation rate of aout 3K'% et Miller +as ale to achie*e such stellar and consistent returns +ith relati*el" little trading: Value Trust.s turno*er rate had not sur!assed 30K since 1772, and had een as lo+ as >K in 200>% Morningstar ga*e Value Trust its to! fi*estar rating% T+o other statistics from case =@hiit 1 in*ite caution, ho+e*er% irst, true to Miller.s strateg" of choosing stocks that are trading chea!l" relati*e to their intrinsic *alue, Value Trust.s  !ortfolio at March 2005 included the stocks of a numer of firms that +ere undergoing ma9or  turnarounds or restructurings, such as T"co (nternational and =astmanIodak% Concurrentl", Value Trust also had relati*el" large !ositions in a numer of highfliers in the (nternet sector, such as eBa" and maLon%com% Both of those in*estment areas +ere highl" *olatile, !erha!s indicating that Value Trust +as achie*ing its high returns " taking highrisk gamles% The fund.s eta of  1%31, ho+e*er, suggests that the fund.s risk +as not e@cessi*el" high% Second, as the commentar" in Morningstar indicates, the siLe of Value Trust is not "et a ma9or concern, ut +e.re kee!ing an e"e on the matter% The larger a fund ecomes, the harder it ma" e for the fund manager to adhere to his initial strateg" ecause that fund ma" ha*e alread" ma@imiLed its !ositions most likel" to sho+ strong !ositi*e returns% (n addition, as a fund gets larger it starts acting like an inde@ fund, +hich is re!resentati*e of the market at large% Value Trust has not /uite !assed that threshold, ut its gro+ing siLe +ill in*ite concerns aout the sustainailit" of Miller.s record%

$iscussion %uestion .

Case 2 Bill Miller and Value Trust

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+iller and /alue Trust,s core competencies $iscussion %uestion 1

(f time !ermits, the instructor can in*ite students to reflect on the sources of e@cellent  !erformance in mone" management% T+o general grou!s of thoughts +ill emerge: J  'n!ormation and speed to market : )egg Mason &and Bill Miller, himself' em!lo"s a large staff of anal"sts and su!!lements its +ork +ith the insights of other anal"sts outside the firm% Moreo*er, !ortfolio managers such as Miller !lace great +eight on !ersonal research  ;*isits, inter*ie+s, and the like% This is su!!lemented " a tendenc" to mo*e /uickl" u!on learning ne+ information% J  Reputation: T"!icall", siLe denotes !o+er in the market!lace% et +hile Value Trust is not the largest e/uit" mutual fund, Bill Miller.s consistent record of success !ro*ides him +ith great market influence other market !artici!ants !a" close attention to his actions ecause of his re!utation% Some students +ill claim that this influence ma" gi*e Miller the  argaining !o+er +ith +hich to s/ueeLe rokers for ne+ ideas and ad*antageous !rices, and generall" to lead andIor to mani!ulate the market% The information argument is consistent +ith market efficienc";the entre!reneur, +ho first e@!loits the insights that the rest of the market does not ha*e +ill generall" earn su!ernormal  !rofits% The re!utation argument is deatale% #hile Miller ma" ha*e certain influence, his actions are still small relati*e to the entire stock market% -ast success has ne*er een a guarantee of  e@cellent future !erformance% The case, ho+e*er, does not !ro*ide the data needed to gain closure on the deate aout the *alue of Miller.s legendar" re!utation% +ar#et efficiency and the anomaly of e0cellent performance $iscussion %uestion 2

Bill Miller.s a!!arent success +ith Value Trust seems to !resent an anomal" to the theor" of ca!italmarket efficienc"% The instructor can use this to moti*ate a deate aout efficienc"%  No*ices ma" e /uite read" to emrace the conce!t of efficienc" &es!eciall" +ith the instructor  standing in front of them, or if the" ha*e 9ust finished reading aout the theor" in te@tooks or  other readings'% The instructor ma" need to !la" the de*il.s ad*ocate on the ehalf of Miller in order to stimulate deate%  ke" insight to emerge from such a deate must e that efficienc" is assured onl" if there are in*estors +ho seek to aritrage information as"mmetries in the ca!ital markets% (n other +ords, the e@istence of Bill Miller is no mark of market inefficienc"%