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Bill Miller: We had a dreadful second calendar quarter

August 02, 2006

We had a dreadful second calendar quarter. The Value Trust lost 5.67% compared to the market's fall of 1.44%, for the quarter ending June 30, 2006. Our results, as you may know, bounce around quarter-to-quarter and don't correlate terribly closely with those of the major indices, nor should they. Our portfolio does not look like the S&P 500 and should not act like it. Deconstructing near-term results has little predictive value in our opinion; the market is too efficient and the results of long-term investment decisions are only evident long-term. We have been doing this a long time and have been here before (way behind the market), but for those who are newer, or nervous, or whose psychological equilibrium is disturbed by non-linearity, some context might be helpful.

There are four main reasons why the portfolio is currently trailing the S&P 500. The first has to do with our allocation to the Internet names which include Amazon, eBay, Yahoo, Expedia, Interactive and Google. These names started the year at roughly 20% of the portfolio and collectively are responsible for close to 400 basis points of underperformance over the past 6 months. Over the last several years, these companies have exhibited a seasonal pattern of weakness in the first half of the year followed by a period of better second half performance. All of these businesses are doing well and trade at substantial discounts to our assessment of fair value. All have traded off on some degree of angst about company-specific near-term issues.

Yahoo sold off 20% last week because it is delaying implementation of its revised search strategy for a couple of quarters in order to ensure a smooth and successful launch. Amazon traded off 20% this week because of margin compression this and next quarter as it continues to spend heavily on technology and content. EBay is down 40% this year because of concerns about slowing US growth due to their having captured so much of the addressable market so fast (in other words, they are so good, they are bad), because the market is not sure about how the Skype deal will play out, because Google's new check-out product is seen as a competitive threat to PayPal, and so on. Even when one of these companies reports remarkable numbers, as Google did, the prevailing sentiment leads to the stock's selling off on concerns things can't get better.

In our view, these companies represent superior economic franchises with the ability to earn above the cost of capital as far as the eye can see, and the market's myopic, obsessive focus on what is going on for the next three or six months doesn't alter the business value. Price and value are two different things. We estimate the intrinsic business value of Yahoo, Amazon, and eBay at up to more than double the current price, depending on the company, and that is current value, not what the value is likely to be in several years.

The second source of poor performance was due to our exposure to the managed care industry. The three names we own in the portfolio in the managed care group that constituted over 10% of the portfolio as of the end of the quarter are down an average of about 20% since the end of 2005. These companies, United Healthcare, Aetna and Healthnet, have risen close to 300% over the past five years while the market is up a little over 13% over the same time period - and this performance includes the last six months of poor relative returns! After such strong returns, which were due in part to the companies having done the required "beat and raise" quarterly earnings game, investors have gotten hypersensitive to perceived changes in trend. Momentum money has exited these names as the quarterly results have gone from spectacular to merely very good.

The third area where we have not fared well has been in homebuilding, where our exposure is roughly 5% of the portfolio. Here we clearly made a mistake by initiating positions too early. The homebuilders had performed much like the managed care stocks, handily outperforming the market for several years. We were waiting for a significant sell-off to establish positions as we thought the valuations at single digit multiples were too low given the secular advantages of the large builders. When that sell-off occurred late last year, we jumped in, knowing that the news flow would be bad for about 12 months as the super-hot housing market slowed sharply and began to return to normalcy.

We expected (and still do) the path of the US housing stocks to follow that of the United Kingdom and Australia, where a housing slowdown led to a sharp sell-off, followed by a re-establishment of the secular outperformance seen earlier. While the statistics in the space have come in roughly as expected, the stocks have moved down significantly more than we expected. We have witnessed p/e multiples contract from roughly 6-7x a year ago, to, in some extreme cases, 3-5x earnings. Although estimates came down as we expected, multiples contracted on the lower estimates, which we did not expect.

Usually multiples expand as estimates decline in cyclical industries. We did not expect the stocks to decline to book value, or book value adjusted for land inventory value, which has been a traditional buy point, since we thought the market had figured out these companies were far less cyclical with better returns on capital than they were 10 or 20 years ago. We were wrong, hence early, and now the stocks sell around book, and we think the bottom is either in place or within squinting distance. All our companies expect to convert about 100% of earnings next year to free cash flow, and to use a large portion of that to buy back stock, as most are doing now. That is usually a recipe for excellent results. Finally, our continued lack of exposure to energy, which was the second best performing sector for the six months, hindered our performance during the period. This is another area we were clearly wrong about (isn't hindsight useful?). The call is much harder from here, with only scattered Stone Age tribes in the Amazon, the comatose, or newly arrived aliens from Alpha Centauri, unaware that energy stocks are a one way ticket to outperformance due to demand from China and India, the location of reserves in unstable areas, the lack of investment in new refining capacity, the rate of depletion, the dwindling ability to locate giant new fields, and so on. The only good thing about not owning energy is that disgruntled shareholders or clients who like our general strategy but think we are obtuse on this subject can create their own personal version of the fund by buying whatever energy exposure they think appropriate, thus creating an investment product that optimizes their utility function.

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