Systematic Relative Strength

Bill Miller at Legg Mason Value Trust had one of the longest mutual fund outperformance streaks in history, 15 years through 2005. His record may end up like Joe DiMaggio’s longstanding consecutive game hits record—never equalled and rarely even approached. Yet even superstar fund managers may occasionally have feet of clay. According to a Bloomberg article, his fund has had a rough time with Eastman Kodak:

Legg Mason Capital Management Value Trust (LMVTX), run by Miller since 1982, disclosed in a semi-annual report last week that the fund sold 18.2 million Kodak shares late last year and during this year’s first quarter for about $3.89 each on average. The fund realized a $551 million loss through the divestiture, according to the report.

Miller, 61, began loading up on Kodak shares in 2000 and, by the end of 2005, his firm owned as much as 25 percent of the Rochester, New York, company. Value Trust, one of several Legg Mason funds and accounts to hold Kodak stock, kept the bulk of its stake for more than a decade, only to sell after the film company had lost more than 90 percent of its market value.

Source: www.photographymonthly.com

One of the challenges that value investors must take on is the value trap. A value trap is a stock that looks cheap, but turns out to be cheap for a reason. EK didn’t necessarily hold Bill Miller back; he had quite a number of years of market outperformance with Kodak included in the portfolio. Other selections did pan out and more than offset the problem stocks. The problem with value traps is psychological. The Bloomberg article goes on:

“Part of it was just this mentality that this was just a temporary setback and Kodak would be able to get quickly back on track,” said Bridget Hughes, an analyst at Morningstar Inc., a Chicago-based stock and fund research firm. “It was not only a mistake, it was also causing a lot of client angst.”

I put the psychological problem in bold. It drives clients crazy to see a big loser in the portfolio quarter after quarter, year after year. Even when buying cheap stocks is obviously part of the investment philosophy and when patience is required to get good returns, clients sometimes struggle with it.

Portfolio management using a systematic relative strength process has different strengths and weaknesses. Clients are less likely to see a big loser sitting in the portfolio quarter after quarter, but are more likely to see more numerous transactions that result in small or moderate losses. I suspect clients are no happier about a string of small losses, but they often seem to be able to let it go. On the plus side, when using relative strength, most of the big winners will be retained in the portfolio for an extended time.

No investment approach is perfect, and every investment methodology will have its fair share of mistakes. Still, clients choose to stick with some investment managers and bail on others, even when their long-run performance is comparable. The client’s choice is often made primarily on the basis of emotion—sometimes just how they feel about how things are going. All other things being equal, why would you elect to have your big losers show up on client statements for an extended period of time?