SAM Peters, who recently succeeded legendary value investor Bill Miller as skipper of the famed Legg Mason Value Trust, is ready to prove to sceptics that he can turn things around at Legg Mason Capital Management (LMCM), whose flagship fund has lost much of its shine in recent years.
The appointment of Peters in April heralds a new chapter at LMCM, which is one of the best-known value equity fund houses in the US. It was founded in 1982 by Miller and the late Ernie Kiehne, who passed away in 2010 at age 92. "There was a great cultural legacy that predated Bill, who learnt a lot from Ernie. And I, in turn, also learnt a lot from Bill," says the Baltimore-based Peters, who is also chief investment officer of LMCM, in an interview with Personal Wealth when he was in town recently.
Under the stewardship of Miller, who is currently LMCM's chairman, Value Trust became a household name among US mutual fund investors after beating the Standard & Poor's 500 index for 15 consecutive years from 1991 to 2005. Since then, however, it has been downhill all the way for Value Trust, which has been trailing the S&P 500 every year with the exception of 2009.
While Peters is keen to improve the performance of the US$2.2 billion ($2.8 billion) US big-cap stock fund going forward, the assertive yet self-effacing American says he will never sway from the fund house's unique blend of value investing, which often involves a contrarian approach to stock picking. "Bill and I have a contrarian streak. We just want to get the world right, but a lot of times, getting the world right means going against the crowd. When you think you are framing the world right, you want to have the strength to maintain your convictions," says Peters, who observes that equity fund managers these days are broadening their stock names to "get closer to the index" for fear of underperforming their benchmark.
The 43-year-old is having none of that. "We have around 45 names in Value Trust. You have got to make it count. When we invest, we invest with conviction. Whether it is Apple or other names, you have got to put in big positions. It has got to be meaningful versus the index. That is part of our differentiation." He adds: "In this day and age when there are a lot of headwinds, the pressure to become like everybody else is powerful. "To survive and thrive again, we have to maintain that we are differentiated, value-driven long-term investors — and I need to preserve that. That is my No 1 job and I think I will continue to do a good job there."
For sure, investing in a concentrated portfolio of out-of-favour value stocks could lead to short-term underperformance. But over the longer term, Peters is convinced that his "high-conviction" portfolio will "make a killing" for long-term investors when the US equity market makes a strong comeback.
"There is a flight-to-safety bubble going on now. It is a very pessimistic world and people hate equities, and that will go on for a while. But there is a real long-term opportunity right now [for value stock pickers]. Once investors come back and there are tailwinds in the equity market, I have to make the most for our long-term investors with my stock picks," says the CIO. He is bullish on stocks such as tech gadget maker Apple, US insurer MetLife, global bank JPMorgan Chase & Co, and semiconductor manufacturer Marvell Technology.
Peters, a small-town boy turned big-time fund manager, was hired by LMCM in 2005 from fund house Fidelity, where he had run banking, technology and healthcare equity portfolios since 2000. He was identified as Miller's successor during the global financial crisis in 2008.
"We recognised Sam as a potential portfolio manager for Value Trust when we hired him in 2005, then observed his steady hand during the 2008 financial crisis... Sam's passion for investing, his temperament, competitive nature and his intellectual curiosity will serve our clients well," Miller said in a press statement in late 2010, when he announced Peters as his successor.
"Coming out of the financial crisis in 2008 and the way I conducted myself back then, I think that made a big impression on Bill and the team. We still face a lot of headwinds today, but what people saw in me was emotional stability, which is important for the team. I am not the most extroverted guy in the world but my mood doesn't change much," says Peters, who tells Personal Wealth that flying planes and taking part in sports help him remain calm.
"Flying around in a plane and being focused on what is going on in the air is a very good mental exercise," says Peters, who received his pilot licence at age 15 and flew his first solo flight at 16. "I got my flying licence before I got my driving licence," quips the fund manager who also runs, swims and climbs. "I do triathlons and I like climbing, too. I climbed Mount Kilimanjaro [Africa's highest peak at nearly 5,900m] last year. Doing sports and being physically active help reduce stress at work. It allows me to back up and maintain my temperament. It is a healthy outlet."
Farm boy to fund manager
Peters grew up in a family cattle ranch in Lea County, New Mexico, that his great-great grandfather bought at the turn of the 20th century. Despite helping out at the ranch when he was young, Peters admits that he wasn't much of a cowboy. "My great uncle and his family line were operators of the ranch. These guys, who were like the Marlboro Man, were real cowboys," he says with a big laugh. "My side of the family were more the office folks. We managed a lot of the businesses at the ranch [which was rich in oil and gas reserves]."
In his early teens, Peters was already exposed to the intricacies of money management through the constant interaction with his grandmother. "The ranch was actually pretty productive. Cattle formed a big chunk of [the business], but the oil and gas helped a lot. My family organised it like a business. My grandmother was CEO at that time and I spent a lot of time with her," he recalls.
He says there was still a "Great Depression mentality in the West" during his younger days, where townfolk in Western counties such as Lea felt that "Wall Street was crooked, and [so] invested in tangible things". Peters' grandmother, on the other hand, was somewhat a contrarian. She decided to enhance her family wealth through stocks. "My grandmother was a pretty good investor. She thought about equities, and my family was taking the excess money from the ranch and investing it for the company. Intellectually, I was really intrigued by it," says the CIO, who has obviously inherited his grandmother's penchant for the stock market.
Fascinated by what he had witnessed, Peters pursued an economics degree at the College of William & Mary in Virginia, followed by an MBA at The University of Chicago Booth School of Business. "[An MBA] was the gateway to many things," says Peters, who became a financial analyst at independent US investment banking and brokerage firm Eppler, Guerin & Turner Inc after graduation. "Then Fidelity came and picked me up," he adds. Peters joined the fund management house in 1999 as a banking analyst and became a portfolio manager a year later.
"I was a banking analyst and they moved me to technology in 2000 and then to healthcare. At that time, in every sector that I covered, valuations were expensive. When I covered banks, price-to-book ratios were averaging three times. Now, they are below book. When I covered tech, it was when the tech bubble was blown out," jests Peters, who says he "missed the wedding but showed up at the funeral".
At the turn of the 21st century, at the height of the technology stock bubble, semiconductor stocks were trading at 50 to 60 times earnings, he recollects. Likewise, healthcare companies were trading at 30 times earnings. Being an all rounder at Fidelity, running portfolios in financial, technology and healthcare which are the "biggest chunks" of the US market, got Peters the job at LMCM in 2005. He wanted to join the company because of his desire to become a generalist portfolio manager like Miller. "There was an apprenticeship aspect to it, and it takes a long time to become a generalist fund manager and you just keep broadening your knowledge in order to be able to make a better comparison."
The tutelage under Miller, for whom Peters has great respect, took several years. "What I like about Bill is his intellect and he was willing to think for himself. Intellectually, he has a lot of different mental models. It wasn't just about finding the estimates. He was trying to frame things in a logical way [like how scientists do their research.] We used a lot of scientific models like biology and we explored other aspects like literature and philosophy. There was just a broad-ranging intellectual perch with Miller," says Peters, who co-managed Value Trust with his mentor from 2010 until this April.
The preparation for the transition to him running the show had been in place for a few years. "The culture at Legg Mason is to have a smooth transition. We don't do abrupt changes. I joke around that there is 'Legg Mason time', which could take an excruciatingly long time for us to do things. But things have always been gradual and there aren't any big-step function changes."
Changes to Value Trust
Prior to taking full responsibility for Value Trust, Peters had already begun to make gradual changes to it to reflect his views on the markets. More technology and healthcare stocks have been added to the portfolio and the average market cap of invested stocks has also been raised from US$60 billion to US$100 billion (RM185.4 billion to RM309 billion).
"On tech and healthcare, broadly speaking, you have a pretty neat backdrop. There is more than US$2 trillion in cash in the balance sheets of US companies, but most of it is concentrated in healthcare and tech stocks," explains Peters, who foresees more dividend payouts and share buybacks by such companies going forward.
At the same time, the valuations of many tech and healthcare stocks in the US are very cheap, in his view. He says many investors are pricing these equities at zero or very little future growth. "Growth is being greatly discounted and the opportunity to pay no, or very little, growth premium for these businesses is great."
Similarly, cheap valuations are the main reason for the fund to take a greater exposure to mega big-cap stocks, says Peters, who observes that many of them are selling at a discount. "US large caps were probably among the most expensive and overpriced assets some years ago. Valuations have started to come down, earnings have recovered and now, they are selling at a discount."
To be sure, the valuations of some of these stocks have fallen so much that their managements have started to buy back their shares on the open market. "Even though most investors aren't buying stocks, the companies themselves are buying them back at well below their business value. That compounds intrinsic business value per share and captures dividend growth. The dividend payouts are depressing in the US, but these companies are growing their dividends at double-digit rates," he says.
As Peters sees it, many of the big US MNCs have well-run global businesses that generate good cash flow. The other reason to go with very large caps is because that's where a lot of the cash is. "So, any way you look at them, from a risk-adjusted opportunity, it is an incredible pitch. To me, it is like Investing 101." When risk aversion in the global financial market abates, stock investors will come back to these "US$100 billion big boulders" and the upturn in the stocks could be a multi-year trend, he predicts. "At some point, they will start climbing back up the hill. I am not smart enough to tell you when that will happen, but it will happen," says Peters, who adds that his portfolio is gradually becoming more concentrated.
"I am concentrating a little bit more, so the top 10 names have gotten a little bit more concentrated. If I am buying the very high quality, well-capitalised, large-cap tech or healthcare stocks, I have got to make it count." While the high-dividend-yielding companies such as those in the utility space are investors' favourite group of equities at the moment because of their defensive nature, Peters says he will not be pressured to invest in this "expensive" group of stocks.
"I own no utilities, which have had a huge run and done really well, but people are still chasing yields and are still going into utilities. So utilities keep getting re-rated and valuations keep going up. They are better than bonds, but they are expensive compared with other stocks."
The lack of "bond proxies" such as the high-dividend-yielding utility and telecoms stocks has weighed down the performance of Value Trust this year — it has turned in half the gains achieved by the S&P 500. At the same time, big exposure to out-of-favour US financial stocks such as Metlife and JPMorgan Chase & Co has also dragged down the fund's returns.
"From a stock-level perspective, financials have been prolonged [underperformers] for us, but I still think they have one of the better long-term valuation opportunities. The key question for me is whether the investment case is flawed. If it isn't, and there is still an opportunity, you have got to be disciplined about your investment case," says Peters, who is willing to wait for two to four years for the market to realise the true value of a cheap stock.
On individual stocks, Peters is bullish on Apple in the tech space. While many investors would consider it as a growth stock, he regards it as a classic value name that is priced for no growth by the market over the long term.
Despite its share price surging more than 50% this year, Apple is still a cheap tech counter at 12 times price-to-earnings ratio, says Peters. He points out that its growth prospects aren't properly discounted by the market. "It had US$110 billion in cash last quarter and generated US$2 billion a week on free cash flow. The amazing thing is that it still trades at 12 times earnings. On current fundamentals, there is no way you can make an argument that it doesn't have a cheap valuation. For people who say it is mispriced and overvalued, well, that is a bad argument."
A good argument for Apple's detractors is that the hardware company could be made obsolete should a competitor come up with a better product. "Yes, Motorola got killed by Nokia's handsets. Then, Nokia got killed by Research In Motion's and Apple's smartphones, and RIM eventually got destroyed by Apple. But unlike a normal hardware company that could see a very quick decline in its economics and products, it seems less likely with Apple," he argues. Peters adds that unlike other handset makers, Apple with its innovative operating systems and iTunes, has "many hooks on people" who view its range of gadgets as more of a platform than mere products.
At its current share price, Peters say the market sees little or no growth for Apple over the next 10 years. "I can basically easily assign zero value beyond 10 years and come up with Apple's share price. I understand people's concern, but Apple is a value stock that is selling way below our estimated business value for what it is." He also considers the gadget maker a great China consumption play.
Other stocks that are way trading below their intrinsic value are MetLife and JPMorgan Chase, says the CIO, who points out that MetLife came out of the 2008 financial crisis with a better business model. "The company bought the international insurance business from AIG that gave it a growth outlet." After the crisis, many savers and investors who were burnt by derivatives turned to good old-fashioned insurance-linked savings and investment vehicles, he observes. "Unlike investment banks where you can question their business models, life insurance companies like MetLife probably have more demand today than before. As the developing world gets richer, people want to secure their financial future for their family."
The challenge for MetLife is a persistently low interest-rate environment, which could hurt its investment income. "Yet, in this environment, where there is huge headwind against MetLife, it is earning around 10% on equities while trading at 60% to book value. That is insane," he asserts. Shares of MetLife, which will be very sensitive to the future direction of interest rates, are currently regarded as "anti-bond" investments, say Peters. "I can't tell you when the value is going to get realised. But at some point, as the rate normalises and you have a better business model and good returns on equities, MetLife is going to work for us. When interest rates go up, it is going to be re-rated."
As for JPMorgan & Chase, which recently reported multi-billion dollars in losses due to a hedging bet that went wrong, Peters says the trading debacle has caused its share price to fall back to levels near its net tangible book value. Given the negative publicity that has surrounded the bank recently, a lot of the bad news has been discounted by the recent fall in its shares. Over the long term, the higher collateral value of its mortgage-related assets, on the back of a recovering US housing market and more merger and acquisition deals globally, will benefit the bank and shore up its earnings and profitability, he reckons, adding that its earnings are currently closer to trough levels. "Will there be a permanent loss of capital in this stock? My answer is no."
Semiconductor manufacturer Marvell Technology is another value stock that Peters likes. The company, which is trading at US$10.50, currently has US$4 in net cash per share, he says. It also earns more than its cost of capital and its free cash flow yield is around 10%, he estimates. "It recently initiated its first dividend, yielding around 2.5%. On top of that, it is buying back around 8% of the company's shares a year. Investors are also discounting no growth for the company," adds the fund manager, who still believes there is an investment case for the company. His fund is also heavily invested in other value stock names such as eBay, General Electric, Philip Morris International, Pfizer, Chevron, Lowe's Cos and Ford Motors.
"You take active bets and you wait for the long term. I will be patient as long as I see a mispricing in an investment case, and we will wait for things to play out," says Peters, who isn't afraid to sell out of stocks when "an investment case is blown".
"When we are wrong, we want to catch the mistakes early," he adds. Peters has been disposing of "value traps" such as energy company Hess, BlackBerry-maker RIM and Bank of America in recent times. While Peters makes no promise that the fund will start to outperform its benchmark soon, he is confident that with the recent changes made to the portfolio, Value Trust will start regaining some of its lustre over the longer term, especially if large-cap US stocks start to make a comeback. "We are well-positioned for that. You have got to have the strength to hold on to your convictions."
Local fund investors who have faith in Peters' ability to turn Value Trust's fortunes around could consider investing in the Singapore-registered Legg Mason Value Fund, which mirrors the strategies of the US-domiciled fund.
This story appeared in The Edge Singapore on July 23, 2012.