Bill Miller Thinks Outside the Box

Every fund manager aspires to earn returns that beat the fund's benchmark. So a manager that consistently beats the benchmark eventually builds a reputation and gains a following among investors. After a while, a streak of outperformance becomes like a baseball team that makes the playoffs year in and year out.

Well, between 1991 and 2005 -- the same timeframe during which the Atlanta Braves won 14 division titles -- Bill Miller beat the market for 15 consecutive years. But in 2006, both the Braves' and Miller's impressive streaks came to their respective ends, reminding us that nothing lasts forever in baseball or finance.

Before becoming a successful investment manager, Miller graduated from Washington & Lee University and served as an officer in the U.S. Army's Military Intelligence Corps. Today, he's chairman and chief investment officer of Legg Mason's (NYSE:LM) Capital Management division.

Source: Morningstar.

Source: Legg Mason Capital Management.

Contrarian optimism
Several prominent investors, such as PIMCO's Bill Gross, believe that the U.S. needs a wake-up call as it transitions into a "new normal" economy. They believe that riskier investments won't do as well as safer types of assets.

In his most recent quarterly commentary, though, Miller strongly disagrees with that assessment. He argues that while the future is far from certain, markets have lost some perspective due to being blinded by an "inside" view of the current environment, which has resulted in investors being unable (or unwilling) to look at the situation within a historical context.

He illustrates thusly: "In 1933, consumption as percent of GDP was even higher than today, at 83%, and the savings rate was negative. The consumer deleveraged aggressively, pushing consumption as a percent to 73%, while the savings rate rose."

What happened during that deleveraging period? Between 1933 and 1937, unemployment fell, output grew, and the stock market doubled, says Miller.

Flight from equity
Despite the fact that the S&P 500 has been up more than 60% from its March bottom, people are still very much down on stocks, Miller observes. So is everyone right to dump their stocks and replace them with bonds, or are they wearing blinders?

Miller would argue that fleeing from equity could prove to be a bad move. "There have been 14 10-year periods where stock returns have been negative, including this one. In every one of the previous 13, the subsequent 10-year returns have exceeded 10% real, about 50% more than average, and more than double the return of government bonds."

If this trend continues, then stock investors will earn big rewards. However, as Miller points out, investors have been selling stocks and buying bonds with enthusiasm, which means, according to Miller, people are still thinking inside the box.

Rebutting the "new normal"
Miller sends his message of optimism home by citing an example from Legg Mason colleague Michael Mauboussin's new book, Think Twice, which tells the story of Big Brown, the colt who fell one race short of winning the Triple Crown in 2008.

Since the 1950s, only three of the 20 horses to win the first two legs of the Triple Crown managed to complete the trifecta. Big Brown's speed ratings were significantly slower than any of the six most recent Triple Crown contenders, yet most knowledgeable people estimated Big Brown's chances of winning the coveted title at nearly 80%.

You can see how this example applies to investments. The "new normal" pessimists are putting too much emphasis on recent experience, and as Miller argues, "They assume instances are representative of deeper patterns, they give more weight to vivid examples or dramatic outcomes, [and] they place twice the weight on a dollar lost as on a dollar gained." Simply put, instead of focusing on all of the factors that have historically influenced recoveries, pessimists are looking at recent events in isolation.

Who to believe?
The issues at hand are indeed polarizing. But Miller's argument comes with some compelling evidence. He admits that recent earnings growth estimates are out of whack with GDP growth expectations, but he believes that GDP growth will grow and that the earnings surprises we've seen in the recent quarter will most likely continue. If that's true, almost anyone buying stocks now stands to profit.

Miller has a diverse set of holdings, ranging from technology blue chip Cisco Systems (NASDAQ:CSCO) and insurance magnate UnitedHealth Group (NYSE:UNH) to Sears Holdings (NASDAQ:SHLD).

There's certainly no shortage of naysayers to fervently argue against buying stocks right now. Only time will tell which side has the right idea -- and whether Miller will return to his winning ways.

Stay tuned for the next installment in this ongoing series, in which Chris takes a look at how Fidelity's Harry Lange plans to navigate his firm's flagship Magellan Fund.

Further reading:

• Roundtable: Buy This Bank
• The Daily Walk of Shame: Cowards
• Time to Sell and Lock In Your Gains