Q&A with William Miller – Chairman & CIO of Legg Mason Capital Management

If there were a Hall of Fame for mutual fund managers, William "Bill" Miller, chairman and chief investment officer of Legg Mason Capital Management, would be one of the first inductees. He began as co-manager of the Legg Mason Value Trust from its inception in 1982 and, in 1990, took the reins as lead manager for the fund. Starting in 1991, he beat the Standard & Poor's 500 Index for 15 consecutive years – the only equity fund manager to have done so. In amassing that record, he earned numerous accolades. Business Week called him one of the "Heroes of Value Investors," putting him in the pantheon with Warren Buffett and Benjamin Graham. Barron's named him to its "All-Century Investment Team." Of course, accolades can be a curse for an investment manager, too. Expectations are high, and the bear markets can be merciless on even the best of investors. Jeff Applegate, Morgan Stanley Smith Barney's chief investment officer, spoke with Miller on his views of the market outlook.

Applegate: Bill, please share with us your broad market outlook.

Miller: I think we're in the early stages of a bull market. The operative question that nobody knows the answer to is this: Are we in a secular bull market, such as we saw coming off of 1982, that's going to last for 10, 15 or maybe even more years? Or is it a cyclical bull market? Or is it just a bull episode in a continuing bear market? I think that we're looking, at the least, at the kind of market we had from 2003 to 2007–a multi-year bull episode. Now, when that bull episode ended, we had the bear market that we think ended in a bottoming process that ran from last fall to this spring. And, in the post-war period, when we've had very bad periods–with the market down 20% to 30%–the market has always been up more than 20% the following year. That's what I would expect for 2009.

Applegate: How long do you think a multi-year bull market might last?

Miller: If you look at the last 10 years, the US equity market is down the most it has ever been for a 10-year period. That point alone would tend to auger for a secular bull market – meaning over the next 10 years, you should get above-average returns. The way those returns are made is in bursts, typically from periods of pessimism. We’ve already seen one of those bursts off the bottom that we made on March 9. This speaks to an important thing, which is that as prices go lower, stocks become more attractive. Lower prices equal higher future rates of return; higher prices equal lower future rates of return. We’ve always tried to take advantage of periods of distress in the market to make our portfolios better and stronger for the long term.

Applegate: Do you see other big investors positioning themselves for an equity bull market?

Miller: If you look at endowments, foundations and the like, virtually all of them are underweight equities relative to their long-term investment policy and goals. And the reason is because they’ve been so battered in equities over the past year and a half. That leaves investors overweight the assets that have done the best, like government bonds and other low-risk assets, and underweight the riskier assets like equities. Now is the time for people, even those who are fairly conservative investors, to begin to move out on the risk curve.

Applegate: The immense fiscal and monetary policy stimulus here and abroad has a fair number of people worried that we're going to have big inflation. Back in the 1970s, rising inflation severely compressed the market's price/earnings multiple. Given your bullish view on equities, are we to assume that you don't think inflation is a threat?

Miller: If we have an inflation problem, it will be years down the road. And I don't mean one or two years. I mean five years down the road. Part of what's happening now is that we're seeing a rise in energy and many other commodity prices. Part of it is the emerging markets move. And part of it is the inflation play that has a lot of hedge funds buying gold. But the difficulty with that is that I don’t think people thought through the transmission mechanism for inflation. Go back to the Great Depression, when we had deflation. We had huge deficits then. We then went into World War II, with the deficit as a percent of GDP having gone from roughly 13% or 14% to 40%, and still we had no inflation until the 1970s.

Applegate: But there are other ways in which we can get inflation.

Miller: We've never had inflation before without unemployment rates down in the 4% range or thereabouts—4% to 5% and capacity utilization in the 80% range. Unemployment right now is pushing 9% and rising. Labor has no bargaining power, and capacity utilization is below 70%. There’s huge excess capacity to be absorbed before we can have any inflation. So, the first signs of inflation would likely happen when we get the unemployment rate down, say under 6%, and capacity utilization is, at a minimum, 10 percentage points higher. That is a long way off.

Applegate: Let's talk about you managing your portfolios. You have fairly significant weights in a few sectors, such as technology and financials. Can you give us a brief overview of why you're overweight those sectors?

Miller: It all has to do with valuation. For example, in technology we're significantly overweight for the first time since 1995. We were very fortunate in the late 1990s to do very well in that period because, unlike a lot of other value managers, we bought technology when it was cheap, in the mid 1990s, and then got out of it in 1999 and 2000 when it was expensive. We got in again last year because technology became extremely cheap relative to the market. Free cash flow yields in technology were the highest they'd ever been, relative to the market. What's surprising about the opportunity that was created in technology is that investor fears were about the financial system, house prices, debt and balance sheets. That's ironic since technology companies, by and large, had great balance sheets, huge free cash flows and tons of cash. That created a significant opportunity, which persists right now.

Applegate: And financials?

Miller: Last year financials did very poorly for most people and disastrously for us. But the financial sector was the source of our systemic problems, and you can't get rid of those problems unless the financial sector gets healthier. As Fed Chairman Ben Bernanke has said many times, we have to have a smoothly functioning financial sector if the economy's going to grow. The risk up until about a month or so ago was that the banks would be nationalized as a way to get them back to health. Now it's pretty clear that's not going to happen. The banks are raising tons of capital in the market from private sources, which will give them significant excess capital over the next couple of years. All of that creates an enormous opportunity in banks. There's an opportunity to make four or five times your money in a three-year period.

----------------------------------------------------------------------------------------------------------------------------------------------------------- The interview was first published in the June issue of Citi Private Bank's 'The View'.

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