Miller: IBM the Most Remarkably Mispriced Name in the Market

Bridget Hughes: Hi. I'm Bridget Hughes. I'm one of the mutual fund analysts at Morningstar. And I am here at the 2010 Morningstar Investment Conference, talking with Bill Miller of Legg Mason Capital Management. Bill Miller runs both the Legg Mason Capital Management Value Trust, as well as Legg Mason Capital Management Opportunity Trust.

Thanks, Bill, for joining us.

Bill Miller: Happy to be here.

Hughes: Thank you. I wanted to ask you to go a little bit deeper into the behavioral edge that you've talked about before that the portfolio managers at Legg Mason Capital Management bring to the portfolios.

And just more specifically is it a data-driven exercise? Is it more intuitive? And then secondarily does it apply more at the portfolio level, does it take you away from that stock-by-stock analysis or can you take the behavioral ideas to each individual company?

Miller: Okay. Well, part of the reason that we focus on behavioral edge in addition to the information edge and the analytic edge, those are the three basic edges you can have is, it's the most enduring, because there is a lot of evidence, psychological evidence, socio-psychological evidence, historical evidence that large numbers of people behave in certain predictable ways under well defined conditions. And since human nature doesn't change or mainly changed over hundreds or thousands of years, you can pretty much count on that when you see those sorts of conditions developing.

So, that's the kind of thing that works both at the macro level in the portfolio and at the micro level in the portfolio. It's partly data-driven. I would say, it's more judgmental than intuitive, because you are really trying to make a judgment about how far that's, how much that's working in any given instance. So I will give you two examples, one macro and one micro.

Right now in the overall market, you are looking at a market, which is at the same level it was 12 years ago, just after the Long-Term Capital Management crisis. Very predictably as the market goes lower, in this correction we are down about 14%, bearishness goes higher. That's sort of counterintuitive, since the lower stock prices go, the higher the future rate of return, and the higher the stock prices go the lower the future rate of return.

So, if you ought to get more bullish if prices go lower, but they don't, that's a very predictable thing. So we use that and put that in historical context to tell us how aggressive we should be in the overall market, because as people get more pessimistic, as the market's lower, we want to get more optimistic and more bullish. So that's a macro example of that.

At the micro level, there is a very pertinent one right now, the oil spill in the Gulf. So that's caused a huge amount of panic on the part of investors with respect to BP, Transocean, Anadarko and some other companies that have been involved in it. And all those companies have been sold off extremely harshly, despite there being very different underlying data-driven conditions. So BP is responsible for the spill. Anadarko is responsible for part of the spill under certain conditions, and Transocean is responsible for none of the spill and is indemnified by BP, but as a week or so ago Transocean was actually off more than BP was.

So, that's a perfect example I think of people using their emotions and not their judgments, and not an analysis of the situation. So, quite apart from whether any of those companies is attractive, the behavioral aspects of that are very clear in terms of people fleeing uncertainty, fleeing potential loss and people hating headline risk and dramatic negative events.

Hughes: So, we've also talked in the past year or so about the portfolio of Value Trust specifically, sort of, migrating up the market-cap ladder and the quality ladder, that there were good valuations there. You have written about it and talked about it as a gradual shift. I am just curious if the valuations are there why the gradual shift, does it have to do with this behavioral idea?

Miller: It does partly, and its also the fact that in this kind of market there are large numbers of really good values and so from our standpoint – and you've seen the smaller- and mid-cap names perform better than the large-cap names, and it's a residue of this long history of large-cap underperforming and the small-cap names being in a 10-year cycle.

But within that context the names that would be smaller in our portfolio on a market-cap thing, still probably decent market caps, are equal to or somewhat cheaper than the mega-cap. So, we are waiting for a crossover period where the mega-caps get significantly cheaper. Some of the mega-caps are, and in fact many of the mega-caps are very cheap, and we are looking always at pairing off certain kinds of names against other larger-cap names.

But, I guess, it's more of an idea that, if you think our five or 10 years, it's going to be hard for the mega-caps not to beat almost everything else. If you look at the next five months or year, it's sort of a toss-up. So, there is no urgency right now. If they got a lot cheaper, if they continue to underperform, then we would accelerate that move.

Hughes: Can you really get those high-quality franchise names much cheaper than they are? I mean are you ever going to get them at a 40% discount?

Miller: Well, I don't think they are going to get a much cheaper than they are today on a relative basis, moderately so, but not necessarily, dramatically so, but the ones that are the cheapest, we've already got them. There are other ones that are sort of sitting out there on the cusp, names like Wal-Mart, for example, that are very cheap historically. It's hard to see how you don't earn double-digit returns on Wal-Mart, but there are other retailers that are just as cheap or cheaper, like JC Penney, right now. So, Wal-Mart a little bit better quality, JC Penney cheaper, and that's kind of the trade-off that we are looking at.

Hughes: So, as we look at maybe some more of those names, as you look at the portfolio today, who is the up-and-comer, what's your favorite idea?

Miller: Well, I guess, the name that I find the most remarkably mis-priced name in the market is IBM. And the reason for that is that IBM I think is representative of what you can get in mega-cap in the U.S. And the reason I use IBM is, it's been around a 100 years. So, it's not like Google, which is relatively new or companies that you don't have a lot of data. You have a 100 years of data on IBM. You have data on how the markets' valued and how it's behaved in various economic conditions.

Moreover, IBM is followed by everybody that follows big-cap tech. So, there is a large numbers of people looking at it and trying to figure it out. Maybe, most interestingly, IBM is one of the most transparent companies in the market. They tell you their long-term goals, they tell you their long-term expectations with respect to earnings per share, free cash flow, operating margins, dividend policy. And then they tell you the short-term, too, they gave you – they have already upped their guidance twice this year.

So, if you think about that the long history, the large numbers of people looking at it, and the company being very open, you would expect that if anything is going to be properly priced in the market, it's going to be IBM. You should be able to earn excess return by buying IBM in the marketplace today. Yet, if you look at their results over the past five years, what you see is IBM has doubled their operating earnings per share in the last five years. The dividend has grown over 20% a year over the last five years. They've bought back stock and shrunk the shares outstanding every year.

This year, they will have record earnings and record operating margins again. They had that two years ago actually during the worst recession since the Great Depression. So, if they can navigate through that kind of an environment, when the economy has been arguably as difficult as it's ever been, when the economy gets better, as is doing right now, they should do even better, which is why they have increased guidance twice this year.

Yet, you can buy IBM today at around 10.5 times this year's earnings and around 9.8 times next year's earnings, the lowest multiple it's ever traded at, with returns on capital in the 25% to 30% range.

If you run it through any valuation model, it will show that it's 30% to 50% underpriced. Yet, nobody seems to care about it. In fact, when I mentioned it to other investors, they are like, 'I haven't looked at IBM in a long time.' So, I think that's the – it's sort of like Poe's Purloined Letter, it's hidden in plain sight.

Hughes: Well, Bill, thank you very much for your time.

Miller: Thank you. Thanks, Bridget.