But if one is gifted enough to possess the best qualities of investing legends like Ben Graham, Warren Buffett, John Williams and Charlie Munger, then he is bound to be someone very special. Bill Miller is one such brain.
Investment icon Bill Miller says investors should not just buy companies that are cheap statistically but should also look for undervalued companies that can actually earn decent returns and happen to be cheap temporarily for a variety of reasons.
The secret to Miller’s successful run
Miller boasts an impressive investing record of beating the S&P500 for 15 consecutive years . In 2019, his fund Miller Value Partners emerged one of the best performers in the hedge fund history, generating a 119% return. Miller attributes the success of his famous run to a combination of skill and luck.
Revealing the reason behind his success, he says he was lucky to be working at Legg Mason at that time where he got complete freedom to do what he wanted to do on the investment side.
He feels this kind of freedom is virtually unheard of at any large investment firm nowadays.
In terms of skill, he says he and his colleagues constantly tested their investment approach and were open to changes if something worked better. They also paid attention to the academic literature of their investment strategy.
“It’s not about thinking of things as true or false, but as useful or not useful. I don’t let the price of a company’s stock confuse me about a company’s fundamentals. That’s rarely the end of the story,” he said in an interview to a leading financial website.
How philosophy helped Miller in investing career
Miller was always known to be an outside-the-box thinker even in his days as a graduate student at Johns Hopkins University, where he studied philosophy.
He studied philosophy because he found it intrinsically interesting and that later helped him in his professional world too.
“It inculcated critical thinking and analysis that were essential for what I do in the investment business,” Miller says.
Miller first got attracted to the stock market at the age of nine, when he used to look over his father’s shoulder as he read stock quotes in the newspaper.
Miller maintains a simple investment philosophy that hasn’t changed over the years, but keeps on changing his tactics and strategy according to the global investment environment. He has become more careful in dealing with rare events that can inflict permanent loss of capital.
Miller’s investment principles
Miller lists out four investment principles that can help investors generate good returns for a long period of time.
Valuation: Miller says investors should derive the value of an attractive investment opportunity by looking at a combination of fundamentals, strategy, peers, management and capital allocation.
Then, one should compare such assessments of intrinsic value with the current price and invest when he believes the intrinsic value is significantly higher than the current price.
He feels investors should also translate observable market prices into embedded expectations for specific fundamentals and determine whether those expectations are reasonable.
Time Arbitrage: Miller believes investors are increasingly taking a short-term view and trade stocks with a short term time horizon.
One should focus on factors that he believes are central to long-term performance throughout the process as investing with a longer time horizon plays a significant role in achieving a competitive edge over others.
Contrarian: According to Miller, investors should look for opportunities during periods of uncertainty, typically investing in businesses, industries and sectors that are out of favor with current market sentiment.
According to him, there are three sources to gain an edge in the market — informational, analytical and behavioral. Out of these, behavioral is the most enduring, as humans tend to react emotionally, especially during abnormal and volatile times.
So, he feels the greatest investment opportunities lie when markets are in a state of panic.
Non-traditional: Miller believes intellectual curiosity, adaptive thinking and creativity are important parts of an investment process.
He says to stay a step ahead of the investing game investors need to stay current with numerous non-traditional resources, such as academic and literary journals.
He believes incorporating non-traditional inputs into research and process can allow investors to view businesses and situations from perspectives that others may not.
How to earn superior returns
Miller says in order to earn superior returns than other peers, investors need to assess information differently from the way it is embedded in market pricing.
“Whether making an investment or an investment recommendation, unless it is predicated on the difference between what you expect and what the market expects, the outcome will just be noise,” he says.
Investing techniques that contributed to Miller’s success
The reason behind Miller’s phenomenal success is the investing techniques that he has had up his sleeve which include purchasing a security with a significant margin of safety, holding for the long term with low portfolio turnover, and preferring a bottom-up strategy versus trying to predict where the overall market, or specific sectors, may be heading.
“If you have a valuation discipline, then you know that stock prices change more rapidly than business value. As a result, there should be plenty of opportunities to use market volatility and its manic-depressive tendencies to your advantage,” he says.
Miller is of the view that investors should only look towards future earnings and profits as the only information to be derived from past results is how likely they are to be suggestive of forward results.
Exploit market inefficiencies
Miller says there are two inefficiencies that investors can exploit to outperform the market.
The first is related to Mr. Market’s moods which leads to investors overreacting to news, both on the upside and the downside.
The second is with regards to insufficient information to make a sound decision.
Also, he feels investors should look to capitalize on psychological biases that can mislead investors.
These biases include overconfidence, overreaction to short-term developments, aversion to investment losses, a focus on incorrect or irrelevant data, and a herd mentality that causes investors to follow one another, ignoring objectivity and rationality.
Lower average cost of investment
Agreeing with Bernard Baruch, Miller says nobody buys at the bottom and sells at the top except for liars. So, he feels when investors have an opportunity to lower their average cost, they should do so.
Miller feels investors should hope for lower stock prices over the shorter term, because it allows for a lower average cost that’s extremely beneficial when the price rises over the next few years.
When is it the right time to sell
Miller suggests investors to sell only for three primary reasons which are-
1. When a company reaches fair value
2. When they find a better bargain elsewhere and need the capital to invest
3. When their investment thesis has changed or outside factors have caused the investment story to not play out as expected
Invest in companies earning above its cost of capital
Miller says it is not necessary for growth to always create value as a company can grow, but if it doesn’t earn above the cost of capital, that growth destroys value.
He feels in order for growth to create value, a company must earn returns above its cost of capital. According to him, the value of any investment is the present value of future free cash flows and the free cash flow yield is the most useful metric in determining valuation.
“We try to understand the intrinsic value of any business, which is the present value of the future free cash flows. While we use all of the traditional accounting based-valuation metrics, such as ratios of price to earnings, cash flow, free cash flow, book value, private market values, etc, we go well beyond that by trying to assess the long-term free cash flow potential of the business by analyzing such things as its long-term economic model, the quality of the assets, management, and capital allocation record. We also consider a variety of scenarios. Empirically, free cash flow yield is the most useful metric,” he says.
How to estimate a stock’s expected return
Miller is of the view that a company’s free cash flow yield plus growth provides a guide for a stock’s expected return.
“A company with positive free cash flow and a beaten-down share price would have a high free cash flow yield (FCF/Market Cap). Because the stock’s down so far, it’s expected annual returns (should the company maintain positive FCF) would be its cash flow yield plus any additional business growth,” he says.
So Miller advises investors to find companies whose free cash flow yield can beat the market’s hurdle and hold on as long as they are right.
Miller will surely go down as one of the greatest investors to have ever lived as his investment style has stood the test of time and is one from which all value investors can learn a great deal from.
As Miller rightly puts it in his own words, “Anyone can get lucky for a short period of time. But consistent outperformance over long periods is probably evidence of skill.”
(Disclaimer: This article is based on a book by Janet Lowe on Bill Miller ‘The man who beats the S&P’ and his various interviews available on Youtube.)
