COUNTERPOINT: WHERE WERE YOU, JIM, WHEN AOL WAS $15?

jim: Legg Mason Value Trust, the fund I run, may be the offender that set you off, since we are in the Investor’s Business Daily value index, and have Dell and America Online as our largest two positions. (We don’t own Lucent or Microsoft, however.)

Of course, in l996 when we were buying Dell at $4 — trading at six times earnings with a 40% return on capital — no one thought we were being heretical. And when we were loading up on AOL at $15 in late ’96, people just thought we were nuts to be buying something that was probably going out of business due to either the Internet (Forrester Research), or MSN (the Microsoft-is-God crowd) or their own incompetence (the press, etc).

The issue of course is how can they be valued now, with price-earnings and price-book value ratios in the stratosphere?

Part of the answer has to do with general investment strategy. With money managers turning their portfolios north of 100% a year in a frenetic chase to find something that works, our glacial 11% turnover is anomalous. Finding good businesses at cheap prices, taking a big position and then holding for years used to be sensible investing. In a speculative market, long-term investing is rare, but it’s what we do. We see no reason to sell a good business just because the stock price has gone up a lot, or because some amount of time has passed.

The better answer is that price and value are two different and independent variables. As Warren Buffett has often pointed out, there is no theoretical difference between value and growth; the value of any investment is the present value of the future free-cash flows of the business.

Value and growth do not carve the world at the joints; the terms are mainly used by consultants to allow them to carve up for clients the world of money managers. They represent characteristics of stocks, not of businesses. As Charlie Munger once said, the distinction is “twaddle.”

With the market beating 91% of surviving managers since the beginning of 1982, it looks pretty efficient to me. Since computer power is not a scarce resource, and databases are not in short supply, accounting-based stock factors (price-earnings, price-book, price-cash flow, etc.) that the computer can identify and back-test are unlikely to lead to robust outperformance. Any combination of stock factors that appears to hold the key to outperformance will be quickly arbitraged away. There is no algorithmic way to outperform.

Any portfolio that outperforms over any length of time does so because it contains mispriced securities. The market was wrong about the future of that aggregate. We look directly for mispricings by comparing what the market says a company is worth with what we believe it is worth using a multifactor methodology that starts with the accounting-based stuff and moves through PMV (private market value) analysis, LBO (leveraged buyout) analysis and DCF (discounted cash flow — actually a multi-scenario DCF, since point forecasts are useless).

Valuation is a dynamic, not a static, process. When we first valued AOL it was trading in the mid-teens; we believed the business was worth $30 or so. We now value the business at $110 on the low end to $175 based on what we think is a conservative DCF. If we are right about the long-term economic model, the number could be much higher.

No one complains when we are loaded with General Motors or Chase Manhattan — good, old easy-to-understand values — or when we’re buying perpetual dogs like Toys ‘R’ Us, or Western Digital in the midst of massive losses. It’s the Dells and AOLs people object to. And what they seem to object to most is that we didn’t sell, say, Dell at $8, like the other value guys did, because historically PC stocks traded between 6 and 12 times earnings, so when Dell hit 12 times it must no longer be value.

We are delighted when people use simple-minded accounting-based metrics, align them on a linear scale and then use that to make buy and sell decisions. It’s much easier than actually doing the work to figure out what the business is worth. And it enables us to generate better results for our clients by doing more thorough analysis.

We own GM and AOL for the same reason: The market is wrong about the price because both companies trade at discounts to the intrinsic value of the underlying business.

Best regards,

Bill

Bill Miller is president of Legg Mason Fund Adviser Inc. in Baltimore. This article also was first published in TheStreet.com.