Bill Miller is the manager of Legg Mason Value Trust, where he became famous for beating the S&P 500 fifteen years in a row from 1990 to 2005. Some critics pointed out that doing so was a fluke of the calendar. Any trailing 12-month period besides end-of-December to end-of-December would have broken the winning streak years earlier.
Yet, at the end of 2006, Value Trust had beaten the S&P 500 on a rolling 12-month basis 72 percent of the time. On a rolling five-year basis, it did so 100 percent of the time.
The name of his fund is Value Trust, so you might expect Miller to be a value investor on the hunt for low P/E ratios, low price-to-book ratios, and other mainstays of the typical value investor's toolbox. That he doesn't search for only such characteristics in his companies makes him fascinating, and worth studying.
How does Bill Miller beat the market? Let's see.
Redefine value by looking ahead
It should seem obvious that investing is an exercise in looking ahead, but not everybody approaches it that way. A lot of value investors check a stock's historical data to see if it's currently cheap by comparison.
For instance, if a stock's P/E ratio has averaged 20 for the last 10 years but it's now 15, it's historically cheap. Miller would say, so what? Unless it's cheap compared to what he expects from its future performance, he's not interested. Is there a reason to expect trouble? If so, maybe the lower P/E is justified. If there's a recovery ahead or a reason to believe that cash earnings will grow faster than the market thinks, then perhaps Miller will agree that the company is a bargain. The way he arrives there, however, is by looking ahead.
When you think about that, it helps to explain why Miller sometimes owns stocks that other value investors shun. In the mid-1990s, most value investors were looking at beaten down cyclical stocks of companies that make steel, cement, paper, or aluminum. Those were the classic low P/E, low price-to-book stocks of the time.
Miller, however, loaded up on technology companies like Amazon.com and Dell. He thought their prices were better values when viewed as a starting point to a future of strong growth and high returns on capital. He was right, and more so than even he expected when his tech bargains skyrocketed in the tech mania of the late 1990s. From June 1997 to April 1999, Amazon.com gained 6,600 percent. From early 1995 to early 2000, Dell gained 7,000 percent.
Years later, in an article on the history of value investing, SmartMoney described Miller's holding on to high-flying Dell in 1998 as "a betrayal equivalent to Bob Dylan's going electric."
In November 1999, Barron's ran an article by Miller called "Amazon's Allure: Why a famed value investor likes – yikes! – a stock without earnings." In it, Miller wrote, "It's true that some of the best technology companies have rarely looked attractive on traditional valuation methods, but that speaks more to the weakness of those methods than to the fundamental risk-reward relationships of those businesses. Had we understood valuation better, we would have owned Microsoft and Cisco Systems. Microsoft has gone up about 1 percent per week, on average, since it has been public. Companies don't outperform year in and year out for over a decade unless they were undervalued to begin with."
He then pointed out that you don't find undervaluation by comparing a stock's price with its trailing earnings, book value, or cash flow. Instead, you need to compare its price to the current value of the free cash that the business will create in the future. That's the same way Warren Buffett determines a bargain price.
This approach has remained a hallmark of Miller's style through the years. In a February 2003 interview with Barron's, he used the phrase "valuation illusion" to refer to stocks that look expensive by traditional measurements, but are actually bargains in light of their bright futures. He again spoke of Microsoft's 1 percent per week performance, and added the example of WalMart. "From the day they came public, they looked expensive," he said. "Nonetheless, if you bought WalMart when it went public at an expensive-looking 20 plus times earnings, you would have made returns of many thousand percent on that." Understanding the growth ahead of Microsoft and Wal-Mart would have made clear that they were bargains.
Miller wrote in his fourth-quarter 2006 shareholder letter, "We realized that real value investing means really asking what are the best values, and not assuming that because something looks expensive that it is, or assuming that because a stock is down in price and trades at low multiples that it is a bargain." He pointed out that "value funds tend to have almost all their money in low P/E, low price-to-book or cash flow, and growth funds have the opposite…. The question is not growth or value, but where is the best value?" Stocks with low P/E ratios and value stocks are not necessarily the same thing.
Don't think that his targeting technology was a fluke of the 1990s, either. At a Manhattan conference in May 2005, he told the audience that "the core part of all of those businesses – and by 'all of those,' I mean Google, Yahoo!, Amazon, eBay, and to a lesser extent, IAC/Interactive – is that they require very little marginal capital in order to generate huge amounts of free cash flow. And their ongoing business models can sustain, at the margin, returns on capital north of 100 percent."
When an attendee asked why he liked the very expensive Google in particular, Miller replied, "What's not to like? It's got huge profit margins. It grows very rapidly. The management has executed brilliantly. And it sits exactly in the nexus of where all of the long-term trends are going in media…. What Google is doing is using the old media network television model – which is, 'We will deliver content to you, the viewer, and because it's ad-supported, you don't have to pay for the content at all.' And what Google is doing is using that model to start to deliver actual content…. I mean actual products like Gmail – and maybe an operating system and maybe applications."
The key to getting bargains is looking ahead, not looking back. Miller participated in an event called "Conversation with a Money Master" at the 50th anniversary Financial Analysts Seminar hosted by the CFA Society of Chicago in July 2006, and the transcript appeared in the August 2006 edition of Outstanding Investor Digest. About looking ahead instead of back, Miller told the moderator, "So they say, 'Oh, Toys "R" Us historic multiple was X. And now it's 8X-and so there's an opportunity here.' Or, 'Look at what the pharmaceutical companies did for the last 50 years. And now they're cheap compared to that. So now they're a good value.' The problem is that in most value traps, the fundamental economics of the business have deteriorated, and the market's gradually marking down the valuation of those to reflect the fundamental economic deterioration. So what we've always tried to focus on is, in essence, what the future return on capital will be, not what the past return on capital has been. What's our best guess at the future return on capital and how the management can allocate that capital in a competitive situation that is dynamic so we can avoid, in essence, those value traps?"
He ends up owning some of this and some of that, with the only common theme being good value by his definition. His stocks look wildly different to onlookers because they sport measurements at opposite ends of the spectrum. Are they value stocks or growth stocks? It doesn't matter. They're stocks bought at bargain prices compared to what their futures hold.
Miller wrote in his fourth-quarter 2006 shareholder letter, "When some look at our portfolio and see high-multiple names such as Google residing there with low-multiple names such as Citigroup, they sometimes ask what my definition of value is, as if multiples of earnings or book value were all that was involved in valuation. Valuation is inherently uncertain, since it involves the future. As I often remind our analysts, 100 percent of the information you have about a company represents the past, and 100 percent of the value depends on the future."
Future free cash flow on sale
If forced to distill his definition of a bargain stock down to a single measurement, Miller would likely choose a cheap present value of future free cash flow. To him, that factor has it all. It trumps low P/E ratios, low price-to-book ratios, low everything else. If you can buy future free cash flow at a cheap price, you found yourself a bargain.
Let's see if we can understand why he takes this approach.
Net income is the money left after a company pays its bills, taxes, interest expenses, and such. Free cash flow is the money left after a company uses its net income for capital expenditures, known as CAPEX, which is buying new equipment, buildings, or land to improve its business. So, free cash flow is what's left when there are no more expenses. Everything is paid and there's just a pile of cash in a bank account that's free for other uses. The regular stream of such cash into the account is the flow.
Miller told Barron's in February, 2003, "One of the most important metrics we focus on is free cash flow – the ability to generate it and what it yields: that is, free cash flow per share divided by the stock price. Kodak at $30 and an expected $3.70 of free cash flow this year is yielding 12 percent on free cash flow."
On the same amount of free cash flow, a cheap stock has a higher yield than an expensive stock. For example, if Kodak had $3.70 of free cash flow per share but a share price of just $20, its free cash flow yield would have been an even more impressive 19 percent. That's just 3.70 divided by 20 to get .19, or 19 percent. With a share price of $50, Kodak's free cash flow yield would have been a less attractive 7 percent.
Miller explained to Barron 's in April 2001, "By the time a catalyst is evident, the stock price has already moved. For us, the main catalyst is a cheap stock price. The key to our process is trying to buy things at discounts to intrinsic business value, which, from a theoretical standpoint, is the present value of the future free cash flows. . . . We are looking for things that are statistically cheap…. Ideally, what we want is a company that is a leader in its industry, that has the capability of earning above-average returns on capital for the long term, a company that has tremendous long-term economics and those economics are either currently obscured by macroeconomic factors, industry factors, company-specific factors, or just the immaturity of the business."
Do what is unpopular
It should be clear by now that Miller has achieved his successes by doing things differently, going against the crowd. In investing, such a maverick is called contrarian. He invests in a way that's contrary to what most others do. He thinks differently, he looks different places, he reaches different conclusions, and he achieves better performance.
A true contrarian
The funny thing about contrarianism is that so many people claim to embrace it. By definition, that can't be. Almost all value fund managers say they're looking for bargains "that others miss" as they merrily build a portfolio of the same stocks that others found. Miller is not one of them. He's a true contrarian, to the extent that he sometimes finds himself disagreeing with the findings of his own analysis. He says that "most fund managers own what they like to own. We own what we hate to own."
Most investors focus too much on the short term, react to dramatic events, and overestimate the importance of widely covered news stories. Miller tries to take advantage of that by finding stocks that have been oversold by mistaken investors. That's why he frequently owns stocks that he and others both hate, like Kodak when people thought it couldn't survive digital photography, and Amazon.com when people thought its low operating margins would last forever.
Miller wrote in his fourth-quarter 2006 shareholder letter, "It is trying to invest long-term in a short-term world, and being contrarian when conformity is more comfortable, and being willing to court controversy and be wrong, that has helped us outperform. `Don't you read the papers?' one exasperated client asked us after we bought a stock that was embroiled in scandal. As I also like to remind our analysts, if it's in the papers, it's in the price."
He says that there are three types of competitive advantages: analytical, informational, and behavioral. You have an analytical advantage when you take the same information that others have, but process it differently and reach different conclusions than they reach. With Miller, this is most evident in the way he redefines value, as shown above. He wrote in his third-quarter 2006 shareholder letter, "The most important question in markets is always, what is discounted? What does the market expect, as reflected in prices, and how do my expectations differ?"
You have an informational advantage when you know some-thing important that others don't. Such information is hard to know because inside information is illegal and regulators are strict. There are, however, legal types of informational advantages such as what you can observe that others haven't, the time you take to contact people that others won't, and lucky breaks like overhearing the president of a pharmaceutical company make a cell phone call from an airport about receiving FDA approval on a new drug. Don't laugh. It happens. Stay alert.
You have a behavioral advantage when you understand human behavior better than others and can use that understanding to exploit stock price movements. This advantage is the most interesting to Miller because it lasts. He wrote in his September 2006 shareholder letter, "Until large numbers of people are able to alter their psychology (don't hold your breath), there is money to be made from prospect theory."
This is not the place for an in-depth look at behavioral finance, but it's a good place for a glance at prospect theory. It shows that we hate losses twice as much as we love gains. A 1979 study by Daniel Kahneman and Amos Tversky showed this in an interesting way when they set out to find why people are attracted to both insurance and gambling, two seemingly opposite financial ideas. Subjects were told to choose between these two prospects:
Prospect 1: A 100 percent chance of losing $3,000
Prospect 2: An 80 percent chance of losing $4,000, but a 20 percent chance of losing nothing
Which would you choose? In the study, 92 percent of subjects chose prospect 2. The chance of losing nothing, even though it was improbable, was compelling enough to risk losing more. Prospect 1, however, is likely to lose less.
Next, subjects were told to choose between these two options:
Prospect 1: A 100 percent chance of gaining $3,000
Prospect 2: An 80 percent chance of gaining $4,000, but a 20 percent chance of gaining nothing
Which would you choose? In the study, 80 percent of subjects chose prospect 1. The guarantee of gaining something was more appealing than the probability of gaining more. Prospect 2, however, is likely to gain more.
People hate risk when it threatens gains, but they love risk when it could prevent losses. We're odd creatures, so intent on averting loss that we're willing to risk losing even more to do so. We are not bold enough when the odds favor gaining, and we are too timid around even small levels of risk. That, in abbreviated form, is what Kahneman and Tversky found and what is called prospect theory. It's one tenet of behavioral finance that Miller finds useful.
He wrote in his September 2006 shareholder letter that "people are too risk averse and therefore systematically misprice risky assets more often than not…. Loss is painful, on average twice as painful as gain is pleasurable in matters financial. That is, people on average need about a 2 to 1 payoff on an even odds bet to take the bet. But even a modest advantage yields big gains over time, which is why casinos make so much money. People get more bullish as prices go up, and more bearish as they go down. They overweight recent trends relative to their long-term significance, and their emotions give greater weight to events the more dramatic they are, often out of all proportion to the probability of their occurrence. All of these features of how our beliefs affect our behavior are actionable if they are systematically incorporated into an investment process."
Another of Miller's favorite ideas from behavioral finance is called myopic loss aversion. Richard Thaler at the University of Chicago used it to explain the equity premium puzzle. Stocks have returned about 7 percent per year after inflation while bonds have returned less than 1 percent. The puzzle's question is, if stocks return more than bonds over the long term, why would any long-term investor choose to own bonds? Because, Thaler explained, most investors are "myopic" in that they focus on the short term. Combine that with our inherent aversion to loss, and you understand why people own investments that don't perform well in the long term because they are steadier in the short term. The short-term steadiness gives the illusion of safety but over the long haul runs a higher risk of not earning enough.
In his N-30D filing for the period ending March 1995, Miller wrote:
The more short-term-oriented one is (the more "myopic"), the greater one's willingness to react to the risk of loss… . Since one's perception of the risk of stocks is a function of how often you look at your portfolio, the more aware you are of what's going on, the more likely you are to do the wrong thing. "Where ignorance is bliss, 'tis folly to be wise," said the bard, who understood myopic loss aversion centuries before the professors got hold of it. Suppose you buy a stock on Monday, and on Tuesday, while you are engrossed in the O.J. Simpson trial, it drops due to bad news. On Wednesday, though, it recovers to close higher than your purchase price. If you had been glued to CNBC on Tuesday when the news hit, and had observed the stock falling, you may have been prompted to act on the news, especially if the stock was reacting to it. If you missed the news until Wednesday, when the stock had recovered, you are much less likely to sell it then, even though the fundamentals are the same as the day before. That is myopic loss aversion at work. Put differently, you are not worried that IBM dropped overnight in Tokyo while you slept, if it closed up two points today in New York. You are worried if it drops today in New York though it's set to rise two points in Tokyo tonight while you sleep… . For most investors, Thaler thinks, the appropriate advice is "Don't just do something, sit there." Our investment approach in the Value Trust has been to use the myopic loss aversion exhibited by others to our share-holders' long-term benefit. We try to buy companies whose shares trade at large discounts to our assessment of their economic value. Bargain prices do not occur when the consensus is cheery, the news is good, and investors are optimistic. Our research efforts are usually directed at precisely the area of the market that the news media tells you has the least promising out-look … and we are typically selling those stocks that you are reading have the greatest opportunity for near-term gain.
Miller believes in what he calls factor diversification. He owns high P/E stocks alongside low P/E stocks, and considers that to be a strength because "we own them for the same reason: We think they are mispriced." Sometimes growth factors are favored, other times value factors are favored. By owning stocks in each factor group, he smoothens his portfolio's fluctuations. He doesn't think there's an inherent advantage in either concentrated or diversified portfolios. It depends on what you're considering. He wrote in his fourth-quarter 2006 shareholder letter, "If I am considering buying three $10 stocks, two of which I think are worth $15, and the third worth $50, then I will buy the one worth $50, since my expected rate of return would be diminished by splitting the money among the three. But if I think all are worth $15, then I should buy all three, since my risk is then lowered by spreading it around."
Because he researches his companies carefully and trusts his analysis, Miller's a believer in buying more when the price drops. He doesn't usually buy all at once, and he's said that after the first buy he hopes the stock starts going down a lot, and right away because he doesn't want it to drop two years later. If it drops immediately, he can begin lowering the average price he pays per share.
Perhaps his most famous example is Kodak. He began buying Kodak in the $50s in 2000 after it had fallen from over $90 in 1997. It kept falling and he kept buying, driving his average price down to the $30s by November 2005, when he told Fortune, "Stocks bottom when results bottom, and we believe that Kodak's results are bottoming now." That leads to his famous quote, "Lowest average cost wins." He told Barron 's in February 2003, "It's rare for us to pay up for anything, and it's common for us that if the stock goes lower after we buy it – and it always does – we will buy more of it."
What you should retain from Miller
Bill Miller finds bargains by comparing a stock's current price with its future prospects. He does not look at only historical data to see whether it's cheap based on its past. This sets him apart from traditional value investors. He is contrarian, often going against the crowd to buy what is hated because it is misunderstood or because others are unable to see through their fear of loss to a great opportunity. Other key points:
- Look forward, not back. Don't just compare a stock's current valuation with its past valuation. The past does not determine the future. Look ahead at its future prospects to see if it's cheap compared to those.
- He says, "The question is not growth or value, but where is the best value?" If traditional growth stocks are cheap, buy them. If traditional value stocks are cheap, buy them.
- Cheap doesn't necessarily mean bargain. It could mean worthless or, in stock jargon, value trap. In many cases, a stock's dropping price is just the market noticing its deteriorated prospects. It might be cheap compared to its past for a reason, and that's why you must look ahead. He tells his analysts, "100 percent of the value depends on the future."
- Use the present value of future free cash flow to determine whether a stock is a bargain.
- Be contrarian by looking at the long term in a short-term world.
- Prospect theory shows that people hate losing more than they love winning. That makes them too risk averse so they "over-weight recent trends relative to their long-term significance" and give greater weight to dramatic events "often out of all proportion to the probability of their occurrence." Use these tendencies to find bargains.
- Myopic loss aversion afflicts most investors, making them focus on the short term. However, a lot of short-term information is irrelevant in the long term. If you've bought solid companies, the best advice is often "Don't just do something, sit there."
- If you must do something, though, buy a good value as it gets even cheaper. Miller hopes that stocks he's started buying drop quickly and dramatically, so he has a chance to buy additional shares at lower prices. "Lowest average cost wins," he says.
(by J. Kelly)