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Investment Strategy

Man behind the streak

The odds of beating the S&P 500 Index for 15 years running has been pegged 2.3 million to one. Bill Miller is the one

Globe Investor Magazine, Nov. 21, 2007

NEVER, EVER TELL BILL MILLER HE'S a legend of Wall Street. He doesn't want to hear the word, think about it, or talk about it. "I am well aware, having been in the business a long time, that those sorts of labels can change very rapidly-from 'legend' to 'has-been,'" he says.

Miller became an investing world celebrity as the architect of one of Wall Street's most impressive streaks. For 15 straight years, his Legg Mason Value Trust outperformed the Standard & Poor's 500 Index. The year the streak began, President George H.W. Bush went to war with Iraq. When it finally ended, in 2006, the U.S. was once again led by a Bush and fighting in Iraq. In between, the world saw the death of the Soviet Union, the Mexican tequila crisis, the collapse of Barings Bank and Long Term Capital Management, Monica Lewinsky, the Asian flu, AOL Time Warner, the tech bubble, 9/11, the tech bust, the birth of Google and the end of Enron.

During those years, Miller didn't always make money-but he always beat the S&P. Michael Mauboussin, Legg Mason's chief investment strategist, has calculated the odds against Miller's feat at 1 to 2.3 million. Others have likened it to Joe DiMaggio's 56-game hitting streak for the New York Yankees in 1941-a comparison Miller, a passionate baseball fan, can appreciate. In fact, he thinks investors can learn a few things from the way baseball's best general managers shop for undervalued players, and once persuaded Oakland Athletics GM Billy Beane-chief protagonist of the Michael Lewis book Moneyball-to speak at a Legg Mason investment conference. "What the Moneyball guys are trying to identify is mispricings" in the market for baseball players, he says. "What am I paying for what I am getting?"

Click to enlarge Of course, that's the question Miller asks in the stock market, but he brings to the investment business a breadth of intellectual curiosity that's rare. One minute he's talking about the mathematical stupidity of the sacrifice bunt; the next, he's recounting a discussion he had with U.S. Federal Reserve chairman Ben Bernanke about short-term bonds and interest rates; then, he's expounding on theories of crowd psychology and explaining how to bet profitably at the horse track. The same curiosity led him to get involved with the board of the Santa Fe Institute, a think tank that taught him new theories about the evolution of technology.

That, in turn, helped make Miller a rare figure: a self-described value investor who buys expensive technology stocks like Google and Amazon.com. The Legg Mason Value Trust is one of the largest shareholders in both companies, and the Google investment is classic Miller, displaying his penchant for contrarianism, eclectic thinking and deep re--search. "When Google became public in August of '04, the press was all about, 'Don't buy this, it's like '99, it's hyped, it's this, it's that, it's got these kids running it who don't know what they're doing,'" he says.

Unmoved, Miller assembled a "SWAT team" of analysts to pull the company apart and concluded that, far from being another overpriced Internet stock, it was a tremendous bargain at the offering price of $85 (U.S.). "Google this year will earn, what? About $20 (U.S.) a share? If one understood the market and Google's economic model, and how that market share was likely to persist and even grow, that made it an easy call. We bought all we could get on the IPO. But most other people wouldn't do the work."

More recently, Miller has run into headwinds. His fund is underperforming the S&P 500 again this year and redemptions have been heavy. But his strategy hasn't changed and you can only wonder how long it is before his more recent value picks recover and he's back on top again. Lately, he has turned his attention toward financial stocks, which were hurt by the crisis in subprime mortgages and the credit market squeeze. His fund holds large ownership stakes in JPMorgan Chase and Citigroup; both stocks, as bellwethers of Wall Street, dropped through the summer swoon. But Miller likes the sector: "If I'm looking at financials right now, I'm looking at them trading at the lowest valuations they have in many years. Everybody's hating them."

On a September visit to Toronto, where he manages money for Canadian investors through the CI Value Trust, Miller discussed why tech is good, commodities are overrated and how you can profit from human nature.

GLOBE INVESTOR: When did you realize that investing would become your life's work?
BILL MILLER: I first got interested in it when I was nine years old and saw my father reading the paper, the financial pages, which as you know look different from the comics or the sports section. And I said, "What is this?" and he said, "The stock market. It's where you buy and sell pieces of companies." And I said, "What do you mean? Show me." He pointed out a stock and said, "See this? It says up one quarter. If you owned a share of that yesterday, that means today you had 25 cents more than you had yesterday." I'd probably been out mowing the grass for two hours to make a quarter. I was immediately captivated by the idea of making money without doing any work.

Do you remember the first stock that you bought?
It was RCA-'64 or '65, I think it was. I got the money for it from umpiring baseball games and stuff like that. I think I doubled my money in 18 months. When I was 16, I sold the stock and took the $300 that I think I made and bought a car with it. Had I reinvested that $300 in the market continuously, I'd have a lot more money. So, that was a really expensive used car that I bought.

Who's your philosophical idol as an investor?
Ben Graham [author of The Intelligent Investor and Warren Buffett's mentor] and Buffett were the first two people who inspired me. I was naturally taken with the approach that they described about looking for undervalued assets. That always struck me as the most sensible way to invest. And certainly I'd say Buffett today is still somebody that I and everybody else pays a lot of attention to.

Buffett or Graham would never dream of Google or Amazon.com at these kind of price-to-earnings ratios.
Actually, I disagree with that a little bit. Graham, in congressional testimony in the '50s, was asked about what he looks for when buying a stock and he said, well, stock prices depend on future earnings. And so, to the extent that one could actually make the judgment about future earnings, one would be able to know which prices were attractive.

There's two reasons Buffett doesn't buy [tech stocks]. Number one, he believes that in many cases, with businesses like that, it's very difficult to look five or 10 years down the road with any reasonable degree of accuracy. The second reason is that he believes that many of those businesses change so rapidly that they may be unanalyzable on their own.

While technologies change rapidly-a new microprocessor every 18 months, new networking stuff-technology market shares actually change much more slowly. If you look at Intel's market share, Cisco's market share, Microsoft's market share, and then compare that to Coke's market share or Nike's market share, they're far higher than those consumer products companies that are thought to be much more predictable. You see the same thing in [Internet] search. Once it's settled down, Google's got it locked up, no matter what Microsoft or Yahoo do.

You were a believer in Google from the beginning, even though there was all that negative publicity right before the IPO and the company had to drop the price.

That was great. We loved that. The lower the price, the more attractive it was. It still seems to me one of those things that I find startling that people don't understand-lower prices mean better values, other things being equal. People always flip out when their stocks go down. Well, if your analysis was roughly right before, it's got to be better now than it was then.

At the beginning of the year, you said U.S. stocks were cheap. Do you still feel that way?
The answer at the beginning of the year was, "Stocks are really attractive if these bond rates are right. If the economic growth forecast consensus numbers are right, stocks would be 15% to 20% higher." What's happened is that people have changed their views about risk and they're pricing in much more risk in the market than they did before. [Credit] spreads have widened. That lack of availability of credit, based on behaviour, ought to slow the economy very dramatically.

But I think stocks are still very attractive. The Fed will now, because of the risk to the economy, take whatever actions are necessary so that it can try to fulfill its goals of price stability and employment. And the employment one is under severe question. I think that what you're looking at is a Fed funds rate that, based in theory, should be in the threes [between 3% and 4%]. But the underlying global economy looks okay.

How much time do you spend thinking about macroeconomic themes, versus analyzing stocks and companies?
We don't make forecasts. The core of what we're doing is analyzing businesses. Our analysts are thinking zero about macro unless I tell them to think about macro.

You're a student of behavioural finance. How can an ordinary investor apply that stuff to their thinking?
If you're going to buy individual securities, you have to believe that you're going to earn excess return from doing that, and therefore that the market's wrong about something. I think most people don't even take that step and say, "What do I think-where is the market wrong about this thing?"

Behavioural finance relies on good evidence about how large numbers of people behave under well-defined circumstances. So they have demonstrated beyond a doubt that people are risk-averse-a dollar's worth of loss is twice as painful as a dollar's worth of gain. The second thing we know is that people over-emphasize the most recent information. A few years ago when a couple of German tourists were killed in Miami, attendance at Disney World fell way off, because that was dramatic-even though more people are killed driving to Disney World from Miami.

The point is that when you see events which are dramatic, recent and cause people to lose money, you can be sure that individuals will overreact. And therefore, they typically would provide good opportunities in the market.

Let's talk about one of your mistakes-Eastman Kodak. [Miller's fund owns nearly 20% of the struggling company.]
Yeah, we were clearly wrong to buy it when we bought it, which was '99 or 2000, right around that time-and not because we didn't know that film was going away. Before Dan Carp became CEO, and we didn't own any Kodak, people arranged for him to come down and talk to me, not to convince me to buy it but to pick my brain on how the market thought about Kodak, what it thought about the curves of decline in film, that kind of stuff. They clearly understood that they had to change the business model. What I think we underestimated was how difficult that would be culturally. We should have recognized that sooner than we did."

That was then, this is now. Kodak, right now, has made the transition. It's actually doing well, the numbers are coming in better than people thought. Kodak actually told us a couple of weeks ago that they now have the highest number of requests from investors to come visit them, ever. [We] think it's a $45 stock. [At press time it was just below $28.]

A lot of investors in Canada are obsessed with mining and energy. Why have you been a skeptic on commodities?
Well, we were wrong. There's two things. One of them is the secular case and the other's a cyclical case. Secularly, we have not been fans of commodities, broadly defined. That's because the empirical evidence and theory, both together, would indicate that commodity prices decline in real terms over time.

Extractive companies, by and large, don't earn their cost of capital over the cycle. They can be cyclically attractive-buy them when the cycle's bad and sell them when the cycle peaks---but generally speaking, they tend to be trading vehicles, versus investing vehicles. In trading vehicles, you've got to be right on both sides. We prefer things that we can invest in for five, 10, 15 years and earn large amounts of money.

The question now is, are we at a cyclical peak, or, as the bulls would argue, is it a secular change-that is, energy prices and copper prices and lead prices and wheat prices will now not decline in real terms from here. I think the jury's out on that.

You're still a skeptic on the peak-oil theory?
I'm not a skeptic on the fact that ultimately, production of oil and gas will peak and will go down. I'm a decided skeptic on the notion that we're close to that. This is one of those things you have in energy markets, certainly, and in gold, certainly where you have people who are believers. And they'll get an idea like Hubbert's peak in their heads and then any evidence which is against it, they'll throw out and any evidence which supports it, they are in favour of it.

Cambridge Energy Research just published another field-by-field analysis globally, where they're still making the point that production is going to keep increasing, and you're probably at the earliest 10 years away from a peak.

Do you ever think about Canada as an investment destination?
We're mainly domestic U.S. investors. There are Canadian companies that we look at. We're obviously aware of what the Canadian economy is doing, what the major Canadian products are, how the currency is trading, relative to other stuff, but we don't have any resources dedicated to Canada, per se.

How do you avoid value traps?
We don't, sometimes. But the nature of a value trap is when people confuse the cyclical and the secular. Toys "R" Us was a famous value trap from the last seven years before it finally went private. People would look at historical valuations and say, "Gee, Toys "R" Us always trades at a 15% or 20% premium to the market. It's the dominant toy retailer. So now that it's at the market multiple or a discount, it's attractive."

But with Toys "R" Us, it wasn't cyclical, it was secular. Wal-Mart, Target, people like that were systematically picking off their product array, and video games were taking away some of their demographic. Trying to avoid value traps means trying to understand what's in cyclical decline versus what's in secular decline.

How do you feel about the end of the streak?
I'm not happy about it. I wish it was still going on. It's a lot easier to answer questions about, "How do you feel about the 15th year of outperforming the market?" versus "How do you feel about underperforming the market for another year?" You know, as painful as it is to underperform the market, there's no money manager in history that's figured out how not to do that sometimes.

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