Bill Miller is iconic in investing circles.
In the movie The Big Short, fund manager Bruce Miller is believed to have been based on his character. Remember the scene where Bruce cockily defends his bet on crippled investment bank Bear Stearns even as the stock plummets?
Miller’s funds in real life suffered a blow because of the downfall of Bear Stearns and American International Group (AIG). He shared no apocalyptic outlook and was indefatigable in his stance that the financial and housing sectors couldn’t fall more than they already did. Consequently, the Legg Mason Value Trust fund’s performance was abysmal in 2008 and for the 5-year period ended December 31, 2010, the fund finished last among 1,187 U.S. large-cap equity funds. (source)
But he is not just a connoisseur of Wall Street carnage. His most frequently cited accomplishment is the 15-year winning streak from 1991 to 2005, during which the Legg Mason Value Trust fund outperformed the S&P 500 each calendar year. The odds of an outperformance every single year for that many years are astronomically low. When Fortune described him as “one of the greatest investors of our time”, it noted that his record put him in the same league as Peter Lynch, George Soros, even Warren Buffett.
In 1999, Morningstar named him Portfolio Manager of the Decade.
What made Miller have such an amazing run?
It’s no stretch of imagination to say that Miller follows an eclectic value investing strategy. He evolved his strategy to not just buy companies that were cheap statistically but looked for undervalued companies that could actually earn decent returns and happened to be cheap temporarily for a variety of reasons.
Naturally, the legion of value investors scoffed because his portfolio also sported pricey growth picks like America Online, Dell Computers, Nextel Communications, Amazon, eBay and Google.
In a post that appeared in The Wall Street Journal he explained the thought process behind his selection of such stocks with the example of Amazon.
- Investors overemphasize the near-term valuations of Amazon because they overlook the businesses' long-term dynamics and do not estimate the long-term business value.
- Amazon generates huge amounts of free cash flow.
- The company continues to successfully enter into new product categories and geographies.
- Amazon is a low-cost provider of services that also has the highest customer-satisfaction ratings.
- Amazon is thought about as a retailer because it sells products like a retailer. But retail is the business they're in, it's not their business model. They're in the retail business with a model similar to Dell -- direct-to-customer purveyors of goods. You can look at Dell to gauge the trajectory Amazon is on.
- If the company traces roughly the same growth as Dell and you look at its current valuation, it should outperform the market by a factor of at least two.
- We think Amazon will have a sales growth of 25% or higher in the near term and that over the longer term 15% revenue growth isn't an egregious estimate for a company in this early stage of its life cycle
(The above statements were made way back in 2005)
His modus operandi was to look for stocks where the market is missing a significant source of value and hunt for companies that are able to generate sustainably strong returns on invested capital. In other words, value stocks of companies with high profitability. He kept an eye on factors that historically have correlated with stock outperformance, such as free cash flow yield and significant stock repurchase activity.
How did he arrive at value?
It was a question he was often asked since high multiple (Google) and low multiple (Citigroup) names co-inhabited in his portfolio. He countered this question with another: Are multiples of earnings or book value all that is involved in valuation?
According to him, too much time is spent thinking about businesses via simple-minded, short-term factors like current earnings acceleration or deceleration, or the day’s P/E or P/B multiple. As a result, investors react to this information and sell stocks which seem expensive. The biggest opportunity is really thinking out longer term.
Value investors choose securities based on their assessment of intrinsic value, which is the present value of the future free cash flows of the business. But valuation is inherently uncertain because all the information (100%) you have about a company represents the past, and all of the value (100%) depends on the future.
Since trying to figure out the present value of the future free cash flows of a business involves a high degree of estimation error and is highly sensitive to inputs, he employed various valuation methodologies known to assess business value and did not restrict himself to just discounted cash flow analysis.
The question is not growth or value, but ‘where is the best value’?
Bridget Hughes, director of research at Morningstar, told the Washington Post that Miller “had a flexible definition of value,” and his commitment to tech stocks in the 1990s and early 2000s “were not considered value stocks back then.”
Miller was of the opinion that one can simultaneously buy low PE and high PE stocks if both are mispriced. In the mid-1990s, cyclical stocks such as Steel, Cement, Paper Aluminum were being bought by classic low PE and low PB parameters. But tech stocks were also selling at very cheap prices; Dell Computers at 5x earnings and Cisco at 15x earnings.
His judgement to buy the latter, which suggested ratiocination rather than intuition, proved extremely beneficial (he offloaded them in the tech mania of 1998 and 1999). Why own a cyclical company that struggles to earn its cost of capital when you could get a real growth company that earned high returns on capital for about the same price, he reasoned. Granted, tech was not predictable in the way Coke, for example, was. But Miller had learned about path dependence and lock in, which meant that while technology changes rapidly, technology market shares often don’t, so they were much more predictable than they looked.
The lesson to walk away with: Value investing is asking what is the best value; 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.
