Bill Miller 4Q 2007 Commentary

Bill Miller published the 4th quarter commentary and it is always an interesting read. He is having a tough couple of years and he says it is somewhat similar to 1989 and 1990. Here are some excerpts...

Are we in 1990?

The past two years are a lot like 1989 and
1990, and I think there is a reasonable probability
the next few years will look like what followed
those years.

The late 1980s saw a merger boom similar to what
we have experienced the past few years and a
housing boom as well. In 1989, though, the merger
boom came to a halt with the failure of the buyout
of United Airlines to be completed. The buyout
boom had been fueled by financial innovation.
Then it was so-called junk bonds..Now it is subprime loans
repackaged into structured financial products...

By 1990, housing was in freefall, the savings and
loans were going bankrupt (as the mortgage companies
did in 2007), financial stocks were collapsing,
oil prices were soaring in 1990 due to a war in
the Middle East, the economy tipped over into
recession, and the government had to create the
Resolution Trust Corporation to stop the hemorrhaging
in the real estate finance markets. Eerily
similar to today, the situation began to stabilize
when Citibank got financing from investors from
the Middle East.

He seems to think the current period is similar to the 1990 period. That thought has also run through my mind but given the unprecedented run-up in house prices, I'm not sure how likely the the future will resemble anything like the early 90's. The housing recovery may take a lot longer than in 1990 and this can hurt financial and real-estate stocks for much longer. But the argument in favour of a quick recovery is the fact that the correction in real-estate-related assets have been very steep.

I think the market is in for a period of what the Greeks
refer to as enantiodromia, the tendency of things to
swing to the other side. This is not a forecast, but rather
a reflection on valuation.

All of the poorest performing parts of the market,
housing, financials, and the consumer sector—with the
exception of consumer staples—are at valuation levels
last seen in late 1990 and early 1991, an exceptionally
propitious time to have bought them. The rest of the
market is not expensive, but valuations cannot compare
to those in these depressed sectors.

Bonds, on the other hand, specifically government
bonds...are very
expensive...The 10-year Treasury trades at almost 30x
earnings, compared to about 14 times for the S&P 500.
The two-year Treasury yields under 2%, and is thus
valued at over 50x earnings!...

Even more compelling are
financials, where you can get dividend yields about double
that of Treasuries, which only adds to their allure, with
them trading at price-to-book value ratios last seen at the
last big bottom in financials.

I share Bill Miller's view that US stocks are neither expensive nor cheap, and the beaten-down sectors like financials and consumer discretionary (especially anything to do with real estate) seem to have low valuations. The big risk for investors (especially foreign ones) is the potential for further US$ decline.

I tend to go for risky stuff (maybe I should change this strategy) but one can find relatively cheap stuff in the struggling sectors. There are companies that can easily go bankrupt; and there are others who are unlikely to go bankrupt. For example, some financial industries like bond insurers (eg. ABK, MBI) and mortgage lenders (eg. CFC) are risky, but large money center banks (eg. BAC, C) or investment banks (eg. MER) are safer. Similarly, homebuilders (eg. PHM) are risky but building material suppliers (eg. USG) are safer. Some of the established retailers like Home Depot and Sears may battle their way through any economic problems but the smaller, niche, players are risky. I'm not recommending any of these (simply giving some examples) and none of this means that you won't lose money one way or another. However it does mean that buying an established financial company with a decent dividend yield and long-term history seems attractive.

I think enantiodromia has already begun. What took us
into this malaise will be what takes us out. Housing stocks
peaked in the summer of 2005 and were the first group to
start down. Now housing stocks are one of the few areas
in the market that are up for the year. They were among
the best performing groups in 1991, and could repeat that
this year. Financials appear to have bottomed, and the
consumer space will get relief from lower interest rates.
Oil prices have come down, and oil and oil service stocks
are underperforming in the early going.

Clearly a bullish comment on the beaten-down sectors. I'm not sure if this is a bit too early...

Investors seem to be obsessed just now over the question
of whether we will go into recession or not, a particularly
pointless inquiry. The stocks that perform poorly entering
a recession are already trading at recession levels. If
we go into recession, we will come out of it. In any case,
we have had only two recessions in the past 25 years, and
they totaled 17 months. As long-term investors, we position
portfolios for the 95% of the time the economy is
growing, not the unforecastable 5% when it is not.

I believe equity valuations in general are attractive now,
and I believe they are compelling in those areas of the
market that have performed poorly over the past few
years. Traders and those with short attention spans may
still be fearful, but long-term investors should be well
rewarded by taking advantage of the opportunities in
today’s stock market.

Needless to say, doing anything now is definitely a big call and could make the difference between a disaster or huge success. Even if you are a long-term or medium-term investor, housing is scary because the run-up in prices and the demand was unprecedented in modern US history. The fact anything heavily tied to housing is cyclical multiplies the damage from a mistake.

On Potential Countrywide Financial Takeover

Legg Mason Capital Management (LMCM) is the largest
shareholder of Countrywide Financial (CFC), holding
about 11.8% of the company’s shares outstanding as of
December 31, 2007.

We were quite surprised by the decision to sell the
company at close to a seven-year low in the stock price,
and agreeing to a bid that amounts to only 30% of book
value and under 3x consensus earnings for 2009. What
makes the decision puzzling is that the company was seeing
solid deposit growth, has no apparent capital
problems, was not forced by the regulators to seek a
merger partner, and is in sufficiently sound condition to
have declared its regular quarterly dividend at the end of
January. Subsequent to the decision to sell, the Federal
Reserve cut interest rates sharply. The reduction in rates
is quite beneficial to CFC by reducing its costs of deposits,
and by setting off a wave of refinancings that should
significantly increase its loan production.

I was surprised with the Countrywide decision as well. No doubt mortgage lenders have run into massive problems, with many declaring bankruptcy. However, except for some wild, unsubtantiated, rumours of imminent bankruptcy, CFC seemed to be strong enough to survive the downturn. I don't have a position in CFC and haven't followed it closely enough, but the deal looked to me as if insiders were looking for an exit strategy more than anything. Whatever the case may be, it is up to the shareholders to accept or reject the deal. It looks like Bill Miller is adding to his position:

We petitioned the Office of Thrift Supervision for
permission to increase our holdings in CFC to up to 25%
of the shares outstanding. That permission was granted
on January 18, and we (LMCM) have increased our holdings
to about 86 million shares, representing 14.9% of the
company’s shares outstanding...

We have asked CFC’s Board to eliminate the poison pill
(or at the least provide us with an exemption from it) as it
plainly is unnecessary since the company has already
agreed to be acquired by BAC. Eliminating it would
allow us to acquire additional shares, should we decide to
do so.

We have asked other companies to allow us to exceed pill
thresholds, and those requests have been routinely
granted, as we are long-term patient shareholders, not
activists or acquirers. We fully expect CFC’s Board to do
the same.

Bill Miller views the takeover as offering CFC shareholders a put option on their company:

It is important to understand that CFC’s Board has effectively
negotiated a put option contract with BAC. Shareholders
now have the right to put the company to BAC
for 0.1822 shares of that company. They may elect not to
do so, in which case the company will remain independent.

Given the turmoil in the mortgage and credit markets, and
the failure of hundreds of mortgage originators, some of
whom were public, this provides protection to CFC
owners from a worst-case outcome should the housing,
mortgage, and economic situation worsen dramatically.
On the other hand, should the actions of the Federal
Reserve and the economic stimulus package lead to a
gradually improving situation, CFC owners can turn down
the deal, should they believe that is in their best interests.

I don't think Bill Miller is hedging his position (i.e. not shorting BAC stock as risk arbitrage players would) so this is basically a bullish bet on housing. I suspect Miller will be happy to own BAC shares if CFC accepts the buyout so this looks attractive to him.


On Potential Yahoo! Takeover

LMCM is YHOO’s second-largest shareholder,
owning over 80 million shares. Subsequent to the
deal being announced, we have met with Steve Ballmer,
MSFT’s CEO, and spoken with Jerry Yang, CEO of
YHOO...

That said, we think it will be hard for
YHOO to come up with alternatives that deliver more
value than MSFT will ultimately be willing to pay.

I don't follow these companies well enough to have a strong opinion. My feeling is that Yahoo is struggling but it has a strong brand and display advertising. Their problem is that they are having a hard time monetizing their strong brand. To make matters worse, Yahoo is good at display advertising but what is popular with customers is context-sensitive text advertising. The problem with these tech companies is that even though they have huge barriers to entry (online mass advertising is locked up between the three, Google, Yahoo, and MSN), their valuations are high. Yahoo's TTM and forward P/Es are 63 and 54, respectively (growth companies should technically not have depressed earnings). It's awefully hard to satisfy the required growth rates for such high valuations even if you are one of the top 3.

It has been reported that MSFT has been
discussing a combination with YHOO for well over a
year, and that it had been prepared to pay over $40 per
share previously. We have no way of knowing whether
those reports are accurate or not.

Our own valuation work puts the value of YHOO in the
range of those reported numbers, though, and we think
MSFT will need to enhance its offer if it wants to
complete a deal. YHOO shares were recently trading at a
four-year low, and the stock averaged above the current
offer price for all of 2004.

I feel like Bill Miller is a bit too optimistic here. Yes, Microsoft is being opportunistic by offering a price off the 52 week low. But Yahoo doesn't seem to have anything going for it. I also don't think Microsoft needs this deal as much as some make it out to be. There are major integration risks if Microsoft buys Yahoo. Unlike prior purchases, Yahoo is massive and there is room for big culture conflicts, not to mention issues with technology integration issues. Lastly, with such a high valuation being placed on Yahoo by the market, I'm not sure how easy it will be for Microsoft to satisfy market expectations in the future.