Value investor Bill Miller has a remarkable track record: He beat the S&P 500 for 15 consecutive years from 1991 to 2005. He is currently chairman and chief investment officer of LMM and the portfolio manager for its Opportunity Equity and Income Opportunity strategies.
Miller has received numerous accolades, including being recognized as the fund manager of the decade by Morningstar in 1999 and the greatest money manager of the 1990s by Money. He was named to Barron's All-Century Investment Team in 1999.
He served as chairman of the Santa Fe Institute from 2005 to 2009 and is a current trustee. The institute is one of the world's leading scientific research laboratories, conducting multi-disciplinary research in complex systems theory.
Motley Fool Analyst John Rotonti recently interviewed Miller about how he thinks about valuation, characteristics of his biggest winners, and why he's involved with a scientific research institute.
John Rotonti: How do you define a high-quality business?
Bill Miller: We define quality similarly to many others. The most important characteristic of a high-quality business is the ability to earn returns above the cost of capital sustainably. The competitive advantage of a business factors into this determination and importantly, how long we expect that competitive advantage to last. We also look at a variety of other characteristics such as free cash flow generation, quality of the balance sheet, quality of management, growth prospects and cyclicality, etc.
Rotonti: How do you define a high-quality management team?
Miller: We aim to understand how management teams make decisions and allocate capital. The best management teams make rational decisions based upon evidence, exhibit independent thinking, and allocate capital with an objective of earning returns above the cost of capital. The best managements show consistency, transparency, and honesty.
Rotonti: How do you define a growth company?
Miller: When we refer to a growth company, we typically refer to growth of revenues. Over the long term, the expectation is that revenue growth will translate into growth in profits and free cash flow. The value of any investment is the present value of future free cash flows, so that is ultimately of the most importance to us. It's important to note that growth does not always create value. A company can grow, but if it doesn't earn above the cost of capital, that growth destroys value. In order for growth to create value, a company must earn returns above its cost of capital.
Rotonti: Please explain how you narrow your investable universe and how large that universe is.
Miller: We use an inherently flexible strategy and are not limited by investment style or asset classes. Since the core of our competitive advantage is in the U.S., the portfolio has always been and our universe is U.S.-centric. We will invest in a non-U.S. name if we find an opportunity compelling enough. So the universe is broad. As contrarian, long-term value investors, we tend to find new ideas in areas of controversy or where fear or misunderstanding exists. The greatest part of narrowing down the universe consists in looking for companies that screen as statistically cheap: those with high free cash flow yields, low valuation ratios, low prices to tangible book value, etc.
Rotonti: Are there any industries you tend to prefer? Or avoid?
Miller: The firm constructs its portfolios from the bottom up and places most of its emphasis on security selection; therefore, sector allocation becomes a product of the overall process and is not typically the main focus when constructing portfolios. We do not consider benchmark sector weightings when building the portfolio.
We look for investments across all industries but tend to prefer those where companies can earn above their cost of capital through a cycle. For this reason, we have had less exposure to energy and materials over the years. We typically avoid slow-growth, capital-intensive industries where the ability to earn free cash flow is difficult. Currently, we have the greatest exposure to technology, financials, airlines, and healthcare.
Overall, our approach is characterized by flexibility. We always want to understand where the biggest gaps between market expectations and embedded intrinsic value exist. Our investments migrate around depending on the opportunity set the market provides.
Rotonti: How do you think about valuation?
Miller: 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. If a company is earning above its cost of capital, free cash flow yield plus growth is a good rough proxy for expected annual return.
Rotonti: For companies with consistently high return on invested capital (ROIC), do you think it's useful to incorporate enterprise value/invested capital as a valuation metric? I have sometimes found that companies that have high ROIC and are trading at lower multiples of invested capital tend to also look attractive using other valuation methodologies.
Miller: If a company can consistently earn high ROICs and you can buy that company close to the amount that's been invested in the business, that is usually a bargain, especially if the company can grow.
Rotonti: Would you rather invest in a company that is reinvesting most or all of its earnings into growth or in one that can both grow and return cash to shareholders through dividends and buybacks?
Miller: We prefer to see companies make these capital-allocation decisions with an objective of maximizing the present value of free cash flows. If a company can invest in its business and earn returns in excess of the cost of capital, it should usually do that. If a company returns cash to shareholders in the form of dividends, that capital earns the market return. If a company buys back stock, the return depends on whether the stock is under-, over- or fairly valued. We typically like to see a management team that makes these decisions rationally and quantitatively. If the return on buying back stock is greater than what a company can earn investing in its business, buying back stock makes sense. Managements tend to be, and should be, optimistic about their business, so we do our own work on whether management projections and assumptions are reasonable.
Rotonti: What common characteristics or patterns do you recognize in some of your biggest winners?
Miller: The major commonality among our biggest winners is a starting point of low expectations. A stock's performance depends on fundamentals relative to expectations. For big winners, the gap between how a company actually performs and how it's expected to perform is the widest. Our biggest winners tend to be companies that continue to compound value over many years as well, like Amazon.
Rotonti: What lessons did you learn or patterns did you recognize from some of your losers?
Miller: We always look for low expectations. With our biggest losers, we thought expectations were too low when in fact they weren't; they were too high. Typically, this happens when business fundamentals deteriorate for one reason or another.
Rotonti: How should value investors try to avoid value traps?
Miller: One change we made a few years ago after an exhaustive review of our performance to understand how we could improve was to sell more quickly when fundamentals deteriorate. Value traps look cheap, but they aren't actually cheap because underlying fundamentals continue to erode over time. Market prices adjust downward as fundamentals deteriorate. Typically, in the short term, especially in this risk-averse market, the negative stock reaction overdoes what is justified by the fundamentals. However, when a company serially disappoints, the intrinsic business value is usually dropping. This is when you can make a big mistake. For this reason, we are quicker to exit on the back of disappointing fundamentals in order to protect against losing a lot of money.
Rotonti: When do you sell? Will you hold a high-quality company that is fairly valued?
Miller: We will generally sell a security when one of the following occurs: (i) the security reaches what we believe is its fair value, defined as the security will not earn an excess risk-adjusted rate of return over our investment time horizon; (ii) a better investment opportunity emerges that offers a higher risk-adjusted expected return; or (iii) the investment case has changed or is no longer applicable (e.g., changes in the macro/regulatory environment, changes in company fundamentals and/or adverse changes in a company's corporate governance policies).
Rotonti: How do you think about portfolio diversification?
Miller: When we build and manage portfolios, we attempt to diversify drivers of value and risks of loss. By focusing on the drivers, we believe we can achieve better diversity than simply replicating a benchmark in terms of sectors and industries or spreading investments into a large number of stocks. In other words, we assess risk (and the factors that may contribute to risk) at the company level but manage it at the portfolio level.
Rotonti: Can you discuss the research process at LMM?
Miller: LMM currently has three portfolio managers and one analyst. Everyone on the investment team is considered a generalist and everyone helps with the research process. Responsibilities are segregated by current investment needs, capabilities, knowledge, and experience. Each person on the investment team typically monitors current portfolio holdings (about 60) and names of interest while working deeply on a handful of names. Given our team is so small, we have constant communication on all our investments and any new ideas. Typically, we agree on investment decisions, but I have ultimate authority to make the call.
Rotonti: Which qualities should great analysts have? What about great portfolio managers? Are they different?
Miller: Here's a little example that illustrates the difference. A typical analyst loves to figure out brain teasers because they are like puzzles that require you to think carefully to figure out a solution. Portfolio managers, on the other hand, will ask: How is this going to make me money?
More seriously, portfolio managers typically cover a broader area whereas analysts go deeper on fewer names. Different people have different evidentiary thresholds, or analysis required before they are comfortable making a bet. Analysts typically require more.
Other than that, there are many overlapping skill sets, obviously. I agree with Buffett that the most important traits of any investor (analyst or portfolio manager) are independent thinking, emotional stability, and a keen understanding of the individual and institutional behavior. Probably the scarcest resource for analysts or portfolio managers is insight, the ability to see what others do not.
Rotonti: Do you meet with management of the companies you are invested in?
Miller: We regularly speak with companies' management teams, both of current and prospective investments. The frequency of contact and which specific members of management we speak with vary by company and situation. It is common for the team to speak with executive level leads, such as the CEO, CFO, and COO, as well as lower-level business managers and investor relations contacts.
We believe that understanding management's priorities, objectives, and decision-making criteria, along with other pertinent topics, can result in better investment decisions. Developing long-term relationships with management can be a crucial source of investment insight and context. Furthermore, investment professionals have been trained by BIA, Business Intelligence Advisors (former CIA professionals), on effective interviewing techniques and how to identify misleading information.
Rotonti: Do you have any performance metrics that you prefer management compensation be based on?
Miller: We always want management incentives to be as closely aligned with long-term owners as possible. We favor compensation related to how shareholders do over the long term. We also think it's important to incorporate return-on-capital metrics into compensation packages, rather than pure market share, margins or growth, which can all provide incentives to destroy business value in certain circumstances.
Rotonti: What is LMM's behavioral edge?
Miller: We think there are three sources of edge in markets — informational, analytical, and behavioral. The most enduring of these three is behavioral, as humans tend to react emotionally, especially during abnormal and volatile times. As a result, we tend to see the greatest investment opportunities when markets are in a state of panic.
The securities we typically analyze are those that reflect the behavioral anomalies arising from largely emotional reactions to events. In the broadest sense, those securities reflect low expectations of future value creation, usually arising from either macroeconomic or microeconomic events or fears. Our research efforts are oriented toward determining whether a large gap exists between those low embedded expectations and the likely intrinsic value of the security. The ideal security is one that exhibits what Sir John Templeton referred to as "the point of maximum pessimism."
We believe our long-term orientation, active stock selection, and focus on behavioral inefficiencies in the market provide us with durable and sustainable advantages. In addition, innovation and adaptation are key aspects of the culture. For the market broadly, the recent trends are toward shorter investing time horizons and less active stock selection, which gives us confidence in our competitive advantages of long-term, actively managed investing. The average holding period for mutual funds is now down to just six months, compared to our time horizon of three to five years. We believe that the one constant in the markets is the behaviors of groups of people and the advantages provided by a focus of behavior inefficiencies. The broad features of human behavior have not changed, and social psychologists have mapped pretty well how large numbers of people behave under various conditions. We try to arbitrage between perception and reality in behavior.
Rotonti: What goes on at the Santa Fe Institute, and what you have learned from your time there?
Miller: I have been involved with the Santa Fe Institute, one of the world's leading scientific research institutions, since the early '90s. The Santa Fe Institute's research focus is on complex adaptive systems such as the stock market, the economy, cultures, the immune system, evolution, and so on. Our involvement gives us the opportunity to sit down with Nobel Prize winners in physics and economics, and with historians, biologists, and computer scientists to get a broad look at the issues on which they are working. It also provides a diversity of perspective the firm has found valuable as it thinks about the investment landscape. Investing is an idea business, so having access to diverse and leading-edge ideas provides great insight.
Rotonti: Would you be willing to share your quick investment thesis on Apple and Gilead Sciences?
Miller: We've owned Apple (NASDAQ: AAPL) for a number of years. We've cut it back and added to it at various points. Overall, we believe what's misunderstood about Apple is the power of its brand. The market values Apple as a computer hardware company. We believe Apple is a powerful consumer brand similar to Nike or Coca-Cola or Hermes, which typically trade at twice the valuation accorded Apple. The Apple brand encompasses a broad global ecosystem with tremendous brand loyalty. Repurchase rates of Apple products are typically well over 90% even though other products are cheaper or may have features Apple lacks. Currently, the stock is pricing in zero growth while possessing the strongest balance sheet in world history. We bought the long-term call options back in 2013 when the stock pulled back on growth and margin concerns between iPhone launches. We thought you could make 5 times on the options back then, and we did as the stock more than doubled over the next 18 months. We are in a similar period now. The returns aren't quite as attractive, but you can still triple your money if the stock goes back to its 52-week high in the next 18 months.
Gilead (NASDAQ: GILD) is another company we've owned for a number of years. It's currently trading at under 7 times what it will earn this year as people fear the current earnings run rate isn't sustainable as its Hepatitis C drug totally cures people. We think Gilead will be able to maintain earnings around this level. The company has allocated capital fabulously in the past with some great acquisitions. I met with the new CEO recently and he was very impressive.