It's been nearly six months since Bill Miller, whom we Fools consider one of America's greatest money managers
, underperformed the market for the first time during his leadership of the Legg Mason Value Trust
(LMVTX). But 15 out of 16 ain't bad, especially considering that the vast majority of money managers fail to beat
the Standard & Poor's 500 over time.
So how has Miller beaten the market on such a consistent basis? I looked for the answer in the only book I've found that's dedicated solely to investigating his investment philosophy: Janet Lowe's The Man Who Beats the S&P. As it turns out, Miller is just another run-of-the-mill value investor, but he's managed to apply value-investing fundamentals to companies where most traditional value investors fear to tread.
Lowe's book was published in 2002, when the market was just working through the excesses of the dot-com era, so it tends to be overly focused on what was then considered the "New Economy," which Miller openly embraced until valuations grew exceedingly wacky. However, insight into the inner workings of Miller's investment philosophy is what drove me to the book, and that part doesn't disappoint. Better yet, Miller's approach to investing has remained relatively static during his tenure at Legg Mason. Therefore, there's plenty to offer interested investors who are searching for current opportunities.
"Catapulting" value investing into the 21st century
Back in 2002, Value Trust managed $11.8 billion and had beaten the market over an 11-year period. But contrary to what most investors might believe, outperformance didn't happen in every calendar year. In fact, Value Trust underperformed four out of five years in the late 1980s. Lowe explains how this could have happened: Miller "fully expects to be wrong a certain number of times, but he expects to be so spectacularly right enough times that he will achieve a high level of performance" in the long run. In other words, Miller is willing to underperform over shorter time frames, but he expects the short-term lags to eventually yield to the long-term outperformance he has so far achieved.
Miller refers to this approach as time arbitrage. He laments "the inability of people to understand long-term investing" that's crucial for the time-arbitrage method to work. He also can't understand the obsession with categorizing investing as "value" or "growth," or the grid with which mutual-fund rating firms such as Morningstar (Nasdaq: MORN ) try to squeeze managers into a style box.
But as with most value investors, Miller looks to buy companies trading at a significant discount to their intrinsic value, or true value, if it were known for certain what their future free cash flows would be. He differs from the value-investing crowd, however, in that he "will look for value anywhere" he can, be it new-economy firms such as Amazon (Nasdaq: AMZN ) or Google (Nasdaq: GOOG ) , or turnaround plays such as Tyco (NYSE: TYC ) (before the recent breakup of the firm) or Qwest Communications (NYSE: Q ) . These firms are current-day holdings that remain true to where Miller tends to look for opportunity.
Lowe cites other well-known value-investing techniques in Miller's management arsenal, including 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. He finds it small-f foolish to try to forecast gross domestic product accurately, since the process is highly uncertain and "subject to large error."
Miller's successful stocks include the following features:
- Those trading at low valuations and well off their highs because of a problem, "perceived or real," that turns out to be temporary.
- Those whose companies are industry leaders with "franchise value." For instance, Wal-Mart (NYSE: WMT ) has high franchise value because of its low-cost advantage and its service orientation, by way of providing what customers demand.
- Those whose companies "have management who actually care about shareholder value."
- Those with "fundamental economic value" that allows them to post returns on invested capital well in excess of their cost of capital.
You either get it, or you don't
As an investor, Miller quickly found that the concept of value investing made sense, and he suggests that individuals either understand it or they don't. In a recent interview with Miller, Money magazine writer Jason Zweig explained that the approach takes a certain temperament -- one that comes naturally to Miller, Warren Buffett and Berkshire Hathaway, and Benjamin Graham. Simply put, these investors buy when the market is reaching new lows and look to sell when it hits new highs or becomes overly optimistic.
In Miller's words, "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. Miller also stresses that future earnings and profits are what matter, since "there are flaws using the backward-looking stuff." The only information to be gleaned from past results is how likely they are to be indicative of forward results.
Lowe cites two inefficiencies that investors such as Miller exploit to outperform the market. The first relates to Mr. Market's moodiness -- namely, overreaction to news, both on the upside and the downside. The second is in regard to insufficient "information to make a sound decision." In addition, Miller looks to capitalize on psychological biases that can trip up investors, including 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
Win with the lowest average cost
It's pointed out that Miller frequently cites Bernard Baruch, who stated that nobody buys at the bottom and sells at the top except for liars. Because this is the case, when investors have an opportunity to lower their average cost, they should do so. In fact, 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 ensuing three years, or longer.
When to sell
The book notes that Miller is motivated to sell for three primary reasons: When a company reaches fair value, when he finds a better bargain elsewhere and needs the capital to invest, and when his investment thesis has changed or outside factors have caused the investment story to not play out as expected.
The Foolish bottom line
The book pretty much sums up Miller's thoughts on investing and the key reasons his portfolio has beaten the market over the long term. For further insight, be sure to check out a presentation he made last year in Chicago, or the more recent Money magazine interview.
For related Foolishness:
Berkshire Hathaway and Wal-Mart areInside Value recommendations. Berkshire Hathaway is also aMotley Fool Stock Advisor selection, as are Yahoo! and Amazon.com. You can check out any of our newsletters with a 30-day free trial.
Fool contributor Ryan Fuhrmann has no financial interest in any company mentioned here. Feel free to email him with feedback or to discuss any companies mentioned further. The Fool has an ironclad disclosure policy.