Bill Miller is a melting pot of value investing icons There’s no better description than from Janet Lowe (emphasis mine):
“Like the purist Graham, Miller ignores the fickle moods of the infamous Mr. Market. Like value icon Buffett, Miller looks for franchise value. This is one of the characteristics he likes about Amazon.com. Like John Burr Williams, Miller is willing to forecast when he runs the numbers. At the same time, he believes that numbers aren’t enough to tell you everything you need to know before dialing up your brokerage firm and placing an order to buy a stock. Like Charlie Munger, Miller looks for investment ideas everywhere.”
A combination of Ben Graham, Warren Buffett, John Williams, and Charlie Munger makes for one hell of an investor.
In 2019 Bill Miller turned in one of the best performances in hedge fund history. His fund, Miller Value Partners, generated a 119.50% return. That’s not a typo. This, of course, crushed any benchmark by orders of magnitude. It’s easy to get caught up in recent data, but it wasn’t too long ago Miller’s fund saw declines of over 70% in an 18-month span. Talk about a wild ride.
But at the end of the day, Bill Miller will go down as one of the greatest value investors to have ever live. Bill doesn’t call himself a value investor. And it’s perhaps for that reason why he’s so successful. After all, Bill is the only investor to beat the S&P 500 fifteen consecutive years.
Over the course of this piece, we’ll dive into Bill’s strategy, how he looks at new ideas. His thoughts on margin of safety and intrinsic business value.
The amount of content written, produced and recorded on Miller is astounding. The goal of this piece is to strip everything down. Curate the first principle ideas that make Miller one of value investing’s sharpest practitioners. Then, provide ideas on how to use such ideas in our own process.
There’s three things that distinguish Miller as one of the greatest:
Laser focus on free cash flow
Disregard for Investing Labels
Buying at low expectation inflection points and holding on
Before we can discuss what makes Miller one of the best, we should understand the basics of his investment approach.
Miller’s Investment Process
Bill lays out his approach on his website, which you can find here. The process boils down to five principles:
Some of these things aren’t specific to Miller’s style. Valuation is standard across the board. But remember, Miller doesn’t refer to himself as a value investor. This is why the last two principles make sense (from Miller’s site, emphasis mine):
Nontraditional: “Intellectual curiosity, adaptive thinking and creativity are important parts of our investment process. Our team stays current with numerous nontraditional resources, such as academic and literary journals in the sciences. We have also been involved in the Santa Fe Institute for more than 20 years and recently became involved with the London Mathematical Laboratory. Incorporating nontraditional inputs into our research and process allows us to view businesses and situations from perspectives that others may not.”
Flexibility – “Constraints almost always, by definition, impede solutions to optimization problems. Our strategies are characterized by their unconstrained formats, and each attempts to maximize the long-term risk-adjusted returns for our investors through its primary objective.”
We’ll touch on these in more detail later. Let’s pivot to the foundation of Miller’s investment philosophy: ruthless focus on free cash flow.
It’s Free Cash Flow That Matters
Miller succinctly articulates his views on valuation in a 2016 interview with John Rotoni of Motley Fool (emphasis mine):
“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.”
Miller later remarks that free cash flow yield is the most useful metric in determining valuation, saying (emphasis mine):
“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.”
According to Miller, a company’s free cash flow yield plus growth provides a guidepost for a stock’s expected return. This makes intuitive sense. 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.
What would this look like in your investment process? A quick screen of companies that return at least 6% free cash flow yield. It’s a large list depending on other variables, but it’s a Miller-esque starting point.
At the end of the day, Miller’s goal is simple: Find companies whose free cash flow yield can beat the market’s hurdle of 6%-8% and hold on as long as you’re right.
But that’s not the only reason Miller’s reaped significant profits.
Label Adherence Doesn’t Provide Excess Returns
One of Bill Miller’s greatest qualities is his refusal to conform to investing labels. Many Miller critics try and poke holes in Miller’s success. Saying things like, “he’s not a real value investor.” It’s these types of comments that make true value investors cringe.
Miller doesn’t care if a company trades at 10x P/E or 100x P/E. At the end of the day all he cares about is the future cash flows of the business — and if he can buy those future cash flows for less than they’ll be worth. He lays it out in the book “The Man Who Beats The S&P” saying (emphasis mine):
“Our definition of value comes directly from the finance textbooks, which define value for any investment as the present value of the future free cash flows of that investment. You will not find value defined in terms of low P/E [price-to-earnings] or low price–to–cash flow in the finance literature. What you find is that practicing investors use those metrics as a proxy for potential bargain-priced stocks. Sometimes they are and sometimes they aren’t.”
Here’s the important part of this quote: “Sometimes they are and sometimes they aren’t.” Metrics like P/E and P/FCF should be guideposts for further research, not the end-all-be-all of investment decision-making.
All this goes back to GAAP accounting standards. In his interview on The Investors Podcast. Miller discusses this notion of GAAP accounting. Spoiler, he’s not a GAAP purist (emphasis mine):
“If you earn above your cost of capital then growth equals value creation. We did a regression of over 200 variables to see what was correlated with AMZN’s stock price. And it was gross profit dollars. Makes perfect sense because gross profits after COGs, because all that went to investments where the company would earn well above the cost of capital over the long term. Uses example/comparison of John Malone in the cable biz. The guy never reported a profit over 30yrs but you made 900x your money if you invested with him because he created a lot of value but that doesn’t show up in normal GAAP accounting.”
This is why Miller’s comfortable investing in software/technology companies. Old-school value investors focused on net income, Miller focused on the cash flow.
Where do we see such non-GAAP centric ideas today? Software-as-a-Service is a big one. But it goes beyond the SaaS circle. Any business that invests capital today to grow tomorrow won’t look good under GAAP accounting. Short-term profits are exchanged for long-term shareholder value creation. At whose expense? Mr. Market’s short-term bias.
Such companies won’t appear in traditional value investing screens. That’s why it’s important to use metrics like P/E and P/FCF as guides, not absolutes. A perfect example of the dangers of relying on pure quantitative metrics is newspapers. Here’s Miller’s explanation on why buying cheap stocks doesn’t always work (emphasis mine):
“[Value traps happen’] when you get down toward the lower end of these valuations, value people find them attractive. The trap comes in when there’s a secular change, where the fundamental economics of the business are changing or the industry is changing, and the market is slowly incorporating that into the stock price. So that would be the case over the last several years with newspapers. They are a good example of where historical valuation metrics aren’t working.”
An investor focused on sticking to MorningStar’s definition of value wouldn’t be able to invest in technology or software companies. They’d invest in low P/B newspaper-type stocks. Value traps. Miller doesn’t care about labels. He cares about the future cash flows of a business. As it should be. I’ll leave this section with this quote from Miller:
“‘Growth’ and ‘value’ are labels that people use to try to categorize things. If you look at Morningstar’s investment-style grid, we have migrated through the whole spectrum. Yet this fund has invested the same way for 15 years.”
Buy Low (Expectations) and Hold On (For A Long Time)
The final characteristic of Miller’s success is his ability to buy companies at points of low expectations. Maybe it’s one of those Baader-Meinhof phenomenons, but after reading Expectations Investing by Michael Moubouisson I can’t help but see this idea everywhere.
The concept is simple. You buy stocks when the share price implies low expectations of future business performance. If you’re thinking about a reverse DCF, you’re pretty much there. The goal is to use Mr. Market’s price as information about expectations. Does the current stock price imply high or low expectations? What would the company need to do over the next three, five or seven years to justify the current price?
In Miller’s case, he’s looking for low expectation situations (emphasis mine):
“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.”
Low expectations is Miller’s starting point. By being patient, he’s able to take advantage of such low expectation points. When he sees an idea, he buys knowing it’ll continue to drop:
“Lowest average cost wins. It’s rare for us to pay up for anything, and it’s common for us that if the stock goes lower after we buy it — and it always does — we will buy more of it. If we’re not buying more of it, then we’ll be selling it, because it doesn’t make any sense to hold onto a declining position without putting more money into it or changing the weighting in the portfolio.”
If he’s right, he makes a killing. If he’s wrong, his winners make up for the losers. One of Miller’s analysts, Mark Niemann explains this concept (emphasis mine):
“If Miller is investing in four companies, three of them might go to zero. But if the fourth went to 6 times its current price, Miller could end up with a 50 percent return, or a total return on his portfolio that would beat the market. In fact, an analysis of Miller’s portfolio performance would show that he sometimes has a lower frequency of correct picks than other managers do, although his return remains high.”
The above scenario can only happen if you do two things:
Buy stocks at points of very low expectations
Hold on longer than others
Not only does Miller buy at low expectation prices, he generally holds positions for over five years. Portfolio turnover averages around 20%, much lower than the 100% turnover average for most managers.
Why is this important?
Two words: Time arbitrage.
If you can look out further than other investors, you can create an edge. As Joel Greenblatt says (about Miller):
“Legg Mason’s Bill Miller calls it time arbitrage. That means looking further out than anybody else does. All of these companies have short-term problems, and potentially some of them have long-term problems. But everyone knows what the problems are.”
Markets are discounting machines. The short-term is already embedded in the price of the stock. In other words, the only advantage you have as an investor is an ability to look far enough into the future and see a different outcome than the one Mr. Market’s expecting. One way or another it comes back to expectations, as Miller explains:
“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.”
It Boils Down To Three Advantages
Miller’s ability to compound capital is nothing short of spectacular. From the valleys of 70% drawdowns to the peaks of 119.50% annual gains. Miller’s investment style stands the test of time and is one we value investors can learn a great deal from.
As we’ve discussed, Miller’s success boils down to three things:
Ruthless focus on free cash flow
Disregard for investing labels
Buying at low expectations and holding for a long time
Miller consolidates these ideas into three factors: time arbitrage, knowing your competitive edge, and intellectual curiosity.
Are you willing to look further out than most investors? Do you know your edge in the markets? Are you curious about all types of businesses?
If you answered yes to each of those questions, you’re thinking like a value investing legend.