MI366: Bill Miller: The Man Who Beat the Markets 15 Years in a Row w/ Shawn O'Malley

0:00You're listening to TIP. Hey, everybody. Welcome to the Millennial Investing Podcast. I'm your host today, Sean O'Malley. On today's episode, I'll be going through the career and life story of the legendary investor, Bill Miller. Bill Miller is the founder of Miller Value Partners, which manages hundreds of millions of dollars worth of clients' assets. Miller's career has spanned five decades, from serving as an intelligence officer in the US Army in the 1970s to studying philosophy in a PhD program at Johns Hopkins and then beginning his investment career as an analyst at Legg Mason. He has the most unbelievable accomplishment of beating the S &P 500 for 15 consecutive years, with much of his outperformance coming from extreme concentration in big winners.

0:47Miller is the largest single shareholder of Amazon who isn't a member of the Bezos family. And at various points in the last few years, around 80 % of his net worth was held in just two things, Amazon and Bitcoin. I'm always thrilled to learn from iconic investors like Bill Miller. It's a chance to glean actionable knowledge from those who've carved out a name for themselves in this business. With that, I hope you enjoy today's episode covering the life and wisdom of billionaire Bill Miller.

1:25Since 2014, we have been Value Investors' go-to source for studying legendary investors, understanding timeless books, and breaking down great businesses. Now, for your host, Sean O'Malley.

1:47According to his 2002 book, The Winner's Circle, Bill Miller's relationship with investing begins at just 10 years old, inspired by his father's reading of the financial pages of the newspaper. A young Bill Miller became entranced by the idea of trading stocks and earning money without doing any real work. Miller has since been enlightened that investing in stocks is in fact no easy job, but he still was excited by the notion of using stocks to build wealth. Shortly thereafter, he worked with his dad to invest his modest savings in the Radio Corporation of America, also known as RCA. It was the dominant electronics and communications firm in the US for over five decades and created the first nationwide radio network, the national broadcasting company, better known as NBC.

2:36Through the 1970s, RCA was a seemingly unstoppable force in American technology, innovation, and entertainment. In 1960, when Miller first invested, RCA's stock soared, which inspired him to read as many books on the stock market as he possibly could. He soon crossed paths with the works of great value investors like Ben Graham and continued to hold on to his RCA investment while it racked up exceptional returns. By the time he sold the stock a few years later, his investment had grown sixfold and he used the proceeds to buy his first car. Actually, it was a small sports car. That success then set the stage for what became really a lifetime of passion for Miller.

3:16You can easily imagine, though, how fate could have worked out differently. If Miller's first investment as a child hadn't worked out, he could have been disillusioned and his remarkable investment career might have never even happened. But he pushed on earning a degree in economics from Washington and Lee University while expanding his interests into philosophy in a PhD program at Johns Hopkins. The time he spent studying philosophy helped Miller learn how to think outside of the box, and he became gripped in particular by the intellectual movement known as pragmatism, which dates back to the late 1800s.

3:51When not working on his PhD, Miller began investing by using family money to pick stocks with until he gradually expanded into managing money for friends. He soon took to a job at a steel and cement manufacturer, serving as their treasurer and managing the company's investment portfolio. From there, he came in contact with Legg Mason's CEO, which led him to join the firm as its director of research. Just six months later, he helped launch the firm's Legg Mason Value Trust, kickstarting his career as a professional stock picker. Over the next four years, Legg Mason's Value Trust investment results hammered the competition, leaving a relative newcomer with the best performance results in the entire mutual fund industry.

4:34He's since reflected that studying philosophy, pragmatism, and the great thinkers of the past very much laid the groundwork for his successful investing career, where he was both incredibly rational and also not afraid to think for himself and invest in things that scared others. Quoting from the book, The Winner's Circle, Miller viewed pragmatism as a means for looking beyond the obvious, that which was not necessarily true, and seeing the future possibilities from a different perspective than most investors. When Bill took over the fund, he began to depend less on expectations drawn from past series of events or carefully formulated economic or mathematical theories.

5:13Instead, his process weighed the probability of something happening in the future based on the current situation. This break from reliance on backward-looking predictive analytics opened Bill to new places where accurate information might originate. With that said, Miller is a somewhat controversial figure in the value investing community today. While many revere his success, others take issue with classifying him as a value investor in the first place because his approach differs in practice from the two biggest faces of value investing, Warren Buffett and Benjamin Graham. Miller very much follows the same philosophy of these two greats by treating shares of stocks as real slices of ownership in companies, thinking long-term and estimating intrinsic value.

5:56Yet, he invests in companies that Buffett and Graham wouldn't. Much of his success has come from investing early in tech companies like Amazon. When investing in companies hoping to be technological disruptors, especially in their early stages, there's just a ton of uncertainty around their future that makes them uninvestable in the eyes of classic value investors. Instead, they usually focus on companies priced relatively cheaply to their tangible assets or earnings power. But as Miller has argued, any stock can be a value stock if it trades at a discount to its intrinsic value. He sees no basis then in categorically dismissing certain types of companies just because they're in an early stage of their life cycle or because they compete in fast-paced competitive technology niches.

6:40Just a reminder on intrinsic value, this refers to the idea that companies have underlying value not perfectly captured by their price in the stock market. While stock prices swing wildly from day to day or week to week, intrinsic value is more of a steady estimation of what shares in company are worth to a long-term investor who sees himself as an owner in the business. There are different ways to calculate intrinsic value, but the simplest explanation is to imagine estimating all of the future cash flows you'll get from a company from now until some judgment day and discount them back to a present value per share today.

7:15The discounting process uses a discount rate meant to reflect the opportunity costs and risks associated with an investment and reduces the value of future cash flows into a more present value. The discount rate used is a subjective decision by the investor, though they usually range from 8 % to 12%. The further into the future a cash flow is expected, the less it would be worth today. And the higher the discount rate used, the lower the intrinsic value because future cash flows are discounted more heavily. So the difference between Miller and more classical value investors lies in this breakdown of intrinsic value.

7:51Speaking very generally, a more classical approach to value investing would focus on companies whose intrinsic valuation derives primarily from the cash flows they'll generate over the next few years or quarters, which carries a greater weighting in a discounted valuation. This doesn't mean that traditional value picks won't produce steady cash flows for a long time. It's just that these companies' valuations today aren't dependent on them having some massive business breakthrough in 10 or 20 years from now. The types of companies that Warren Buffett prefers, for example, have very predictable earnings power like Coca-Cola, American Express, and Apple, whose valuations are driven more by the billions of dollars of profits they'll generate over the next few years than in the distant future.

8:31In that same vein, because there's a lot more uncertainty around these companies' assets and earnings, their value can be calculated using relatively lower discount rates, boosting estimates of intrinsic value that an investor gets by buying their shares. Miller's approach has left more room for conducting intrinsic value assessments of companies that generate most of their value to shareholders in the distant future. Buying Amazon in 1999, as he did, was not a bet on the company's book retailing business at the time, but a multi-decade bet on how its platform could be transformed into America's go-to site for online shopping.

9:06Intrinsic value becomes much harder to predict when you're using higher discount rates and looking out decades into the future, but that hasn't stopped Miller. My goal isn't by any means to convince you that Bill Miller's approach is better than anyone else's, but rather to show you how different stock pickers have started from the same principles and gone in their own directions according to their unique expertise, interests, and personalities. Over the past two months, I've broken down how gurus like Benjamin Graham, Warren Buffett, and Charlie Munger approach investing. And if you aren't familiar with their approaches and haven't listened to those episodes, I'd encourage you to scroll a few episodes back in your podcast feed and check them out.

9:44Now I want to look more closely at Bill Miller's approach and share with you his own words on how his style differs from others. The following is an excerpt from Bill Miller's 2006 letter to clients of his fund. Value investing means really asking what are the best values and not assuming that because something looks expensive that it is, or assuming that because a stock is down in price and trades at low multiples that it is a bargain. Sometimes growth is cheap and value expensive. The only question is not growth or value, but where is the best value? We construct portfolios by using factor diversification.

10:20We own a mix of companies whose fundamental valuation factors differ. We have high PE and low PE, high price to book and low price to book. Most investors tend to be relatively undiversified with respect to these valuation factors, with traditional value investors clustered in low valuations and growth investors in high valuations. It was in the mid-1990s that we began to create portfolios that had greater factor diversification, which became our strength. We own low PE and we own high PE, but we own them for the same reason. We think they are mispriced. We differ from many value investors and being willing to analyze stocks that look expensive to see if they really are.

10:57Most, in fact, are, but some are not. To the extent we get that right, we will benefit shareholders and clients. This approach has worked out pretty well for him. From 1991 to 2005, Miller's fund at Lake Mason beat the S &P 500 index 15 years in a row. His mentee, Michael Mobison, has estimated that there is a 1 in 2.3 million probability of a professional investor going on such an incredible streak. While Miller has mentored stars like Mobison, he was also a mentee at one point. In 1984, Miller visited Fidelity Investments to meet with Peter Lynch, author of the bestselling book One Up on Wall Street and manager of the successful Magellan Fund.

11:38After sharing his portfolio with Lynch, Lynch was impressed by its holdings, but had one question for Miller. What about Fannie Mae? As Miller has since recounted in interviews, he told Lynch that he couldn't quite figure out Fannie Mae. Lynch's response was simple. It's my biggest holding. Want me to explain it to you? And so Lynch apparently goes ahead and and breaks down the whole investment thesis for Miller, telling him that Fannie Mae is a bank without branch costs like its peers, since it's this quasi-governmental organization based only in DC. That also means it can borrow money at just a hair above what the government itself borrows at while having no depositors, eliminating the risk of bank runs.

12:13So it borrows money at lower rates than other banks, has a fraction of the overhead, and yet invests in the same things that most banks do, like mortgages. Miller tells the story that he still couldn't wrap his head around the opportunity fully until he went back home and read through Fannie Mae's filings for himself for four hours. The market was distracted by a handful of bad loans on its balance sheet, though Miller realized those loans would soon roll off its books. Those bad loans were blinding the market to an otherwise great opportunity. So he calls Lundsch back up and asks if it's really true that Fannie Mae was trading at one times its projected earnings three years into the future, and Lundsch tells him that that's exactly right, and he figured it out, and Miller went on to of 50x the money he invested in Fannie Mae.

12:58I just think it's a really cool story. I'm not sure there is a lesson in it beyond taking the opportunity to learn from those who are more experienced than you whenever really you have a chance. I get goosebumps imagining what that conversation would have actually looked like. Two of the greatest investors in their generation casually talking shop over an opportunity that would turn into a 50 bagger. Let's take a quick break and hear from today's sponsors. Even Einstein had blind spots. That's why modern science is built on the idea of peer review. Investing may be more art than science, but that doesn't make peer feedback any less valuable.

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16:09And for a limited time, you can use code stocks 15 for a 15 % discount at checkout. All right, back to the show. As I was researching Bill Miller, I went back to reread parts of one of my favorite books, Richer, Wiser, Happier by William Green. Green recalls traveling to visit Bill Miller in Baltimore and the days after 9-11 when financial markets were facing their worst week since the Great Depression. While Miller was a decade into what would ultimately become his unprecedented 15-year streak of beating the market, his fund was off some 40 % at the time. The economy was reeling, the internet bubble had popped, and war was brewing in Afghanistan.

16:47Yet, as Green puts it, Miller was still relaxed and cheerful, coolly staking hundreds of millions of dollars into beaten down stocks that subsequently soared. At one point, Green witnessed Miller take a phone call where an analyst informed him that one of their holdings, AES, had been cut in half after reporting terrible earnings, costing the portfolio$15 million. Miller's response was to instantly double his bet. He assumed investors were irrationally overreacting to the recent dismal news. He told Green, quote, investing is a constant process of calculating the odds. It's all probabilities. There is no certainty.

17:22William Green recounts that at this time, his peers ridiculed him for investing$500 million in the profitless retailer Amazon.com, which many expected to go bust. Miller's response was simply to say that Amazon had incredible economies of scale, which will eventually become apparent. And oh, how they did become apparent. As Green wrote at the time, quote, if he's wrong, it will be the most public failure of his career. But if he's right, and Miller still believes he is, the Amazon bet will rank as one of the greatest investment calls of all time. That investment has grown from the split adjusted price of 79 cents at the time Green and Miller met in late 2001 to over$190 per share today.

18:06That is a 243 times return. While Wall Street fretted over the company's negative accounting profits each quarter, Miller kept his eye on the virtuous cycle that Bezos was building, where Amazon's relentless focus on efficiency and cost reduction would generate economies of scale and user loyalty that enabled huge future free cash flows. In 2005, this vision became a bit clearer when Amazon unveiled its signature Amazon Prime service, which included free shipping for$79 a year. As you probably know, in the years since, the offerings included in that bundle have ballooned to include everything from free TV shows and movies to discounts at Whole Foods and Grubhub.

18:47Miller is considered to have seen this vision for Amazon earlier than anyone else on Wall Street and snatched up a 15 % stake in the company. That stake would be reduced not at his own discretion, though, but because of panicked investors fleeing and withdrawing their money from Miller's management, forcing him to sell Amazon shares to meet those redemptions. Just one year after taking over the Mason Lake Value Trust in 1990, Miller's streak of 15 consecutive market-beating years began. Miller remains humble about the streak. He credits the feat to, quote, a large degree of luck and maybe some modicum of skill.

19:24And I define skill as actually just surviving in markets without blowing yourself up. Similar to how Warren Buffett, with the help of Charlie Munger, had his own philosophy change as a value investor by turning to higher quality companies that he could own indefinitely, Miller had his own shift in the early 1990s. He realized that truly great stocks would look astronomically expensive using normal valuation metrics like price to earnings or price to sales, yet their superior long-term earnings potential could still render them bargains today. That insight led him to high growth names in the early days like Dell, AOL, and Amazon, years before the dot-com bubble had really formed.

20:01Again, this flexibility stems from Miller's refusal to classify the world into either growth or value stocks, no matter how popular that is to do. To understand these promising companies, Miller relied heavily on scenario analysis, working to envision what might happen to a business in a variety of different situations. Each scenario offers up a different valuation for the company, and the more scenarios in Miller's analysis that converge on the same target price range, the higher confidence he has in that projected valuation. In a letter to his clients, Miller writes the following. Growth is an input into the calculation of value.

20:37Companies that grow are usually more valuable than companies that don't. If a company earns below its cost of capital, though, then the faster it grows, the less it's worth. Companies that earn returns on capital above their cost of capital create value. Those that earn below it destroy value. What we try to do is find companies whose economic models support returns on capital above the cost of capital so that they create value at a rate greater than the mere addition to capital that occurs through the retention of earnings in the business. Such companies usually are recognized by the market and valued appropriately, but sometimes they are available at discounts to intrinsic value.

21:14These discounts can arise for many reasons. The most common are macroeconomic change, problems with the company or its industry, or the immaturity of the business. In each case, the long-term economics of the business are obscured by factors or events that prove to be temporary. These temporary factors produce the mispricings that eventually lead to excess returns. If you're not familiar with the term cost of capital, it's a more advanced idea, but to summarize it briefly, a company's cost of capital refers to its mix of debt and equity to finance its operations. It's a single weighted number accounting for the cost of money raised from issuing debt or selling equity versus the split between debt and equity in the firm's capital structure.

21:57If the cost of equity is 10 % and the cost to borrow with debt is 5%, while the company's capital structure has a 50-50 mix of debt and equity, then the cost of capital would be 7.5%, the weighted average of 5 % and 10%. To make Miller's point again, this company would create value for investors if it earns more than 7.5 % per year above its cost of capital and destroys value for shareholders if it earns less than 7.5%. Miller's strategy focuses on finding companies that earn more than their cost of capital and then waiting for opportunities to buy up shares at discounted prices. Sometimes that's for a temporary reason like panic in markets after 9-11, and other times it's because of a more lasting misunderstanding like Wall Street failing to see what Jeff Bezos was building in the late 90s and early 2000s.

22:44The extra wrinkle on top of earning above their cost of capital is that this must be done throughout an entire economic cycle. Miller isn't particularly interested in cyclical companies that are very profitable in some periods and unprofitable in others. Miller is also not afraid to change his mind about companies and their prospects to earn returns above their cost of capital. For years in the 1980s, Toys R Us was quite popular with other value investors due to its attractive appearances on paper, like having low price earnings and low price to book ratios. Yet Miller stayed away after concluding the company's low price was well deserved.

23:20That changed in the early 1990s when the toy company began fixing its underlying problems. Aging stores were given makeovers while it stopped expanding into new sites and focused on making existing ones more profitable. It also recognized that it had managed its inventory inefficiently and the company could cut inventory by$500 million, providing it with massive amounts of cash to buy back stock with. Those changes were enough for Miller to rewrite his outlook on Toys R Us to earn returns above its cost of capital, and he began investing in the company as the stock doubled over the next few years.

23:55Of course, Miller is not without losses. His fund was hammered in 2008 during the financial crisis after he bet big on Citi and AIG. A Wall Street Journal article from December 2008 on Bill Miller begins by saying, Bill Miller spent nearly two decades building his reputation as the era's greatest mutual fund manager. Then, over the past year, he destroyed it. When concerns about the housing market and financial system began to infect the stock market, Miller used his familiar playbook of buying up beaten down names during times of excessive fear. Among his bets were Citi and AIG. Miller also snapped up shares in Wachovia, Bear Stearns, and Freddie Mac.

24:36Bill Miller was early though. And rather than buying at the bottom, he loaded up before the next leg of the crash. On the Friday before Bear Stearns crashed over the weekend, Miller had bragged that he grabbed shares at just north of$30 per share, with the stock down from a recent high of$154. As the Wall Street Journal puts it in that same article, quote, After 15 years of placing savvy bets against the herd, Mr. Miller had been trampled by it. The lesson, at least in the case of names like Bear Stearns, was that stocks may look tantalizingly cheap, though sometimes that's for good reason. He's quoted as saying that the thing I didn't do from day one was properly assess the severity of this liquidity crisis.

25:18From 2007 to 2008, between losses and redemptions, Miller's value fund lost over$12 billion in assets under management, with a return that was roughly 20 percentage points worse than the S &P 500. As Lake Mason's star talent, even though Miller oversaw a small fraction of Lake Mason's$840 billion in assets at the time, its reputation was tied to Miller's success, and thus the company's stock fell 75 % in 2008. Things got bleak for Miller. Clinging to a July 2008 statement from former Treasury Secretary Hank Paulson that Freddie Mac would continue in its current form without being nationalized, Miller insisted on continuing to own Freddie Mac despite his colleagues arguing against it.