Bill Miller: An Investor's Evolution (Part I)
“The conventional wisdom about value investing was wrong.” “We are interested in the underlying economic reality of the business and not how they report."
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In 2001, Bill Miller was under fire. It was a spot the value investor, famous for his market-beating streak, wasn’t used to.
Miller had invested in Amazon in 1999 and shared his conviction publicly in Barron’s. Meanwhile, the magazine had called Bezos “just another middleman” and ran an infamous cover story headlined “Amazon.bomb.” Two years later after Miller’s investment, Amazon stock had cratered to $5.50 from a peak of $107. Had Miller mindlessly thrown his value-investing principles overboard and turned into the last buyer to rush into the dot-com bubble?
From today’s perspective, it’s hard to imagine that the trade of a lifetime, buying more Amazon stock in the middle of the dot-com bust, was controversial and difficult. Miller admitted “we were clearly wrong in buying when we did,” and averaged down. He eventually shifted from Amazon stock to the convertible bonds (which also allowed him to realize a tax loss). He remained steadfast in his belief in the company’s future. “Most people try to maximize the number of times they’re right,” he said. “The real question is how much you make when you’re right.”
Navigating change is difficult, especially in investing where tinkering with your process can look like “style drift” and chasing the latest fashion. I struggle with this myself as it’s difficult to distinguish lasting change from fads.
WCM’s Paul Black wrote that the investment industry "too often worships at the altar of process. Where else are you penalized for growing your knowledge base and making necessary improvements?” Investing in Amazon and other technology companies required for Miller to abandon dogma and endure criticism from friends. It required an independent and open mind as well as conviction to depart from the accepted wisdom or, in this case, the generally accepted accounting principles.
Miller’s embrace of new ideas was the first part of his fascinating journey. The second came when, after fifteen years of beating the market, he invested in imploding housing and financial stocks during the subprime crisis and his career seemed to come to an end. This mistake overshadowed decades of hard work and success.
By the time I moved to the U.S. in 2010, Miller’s reputation had suffered. Movies like The Big Short presented him as a caricature of the investment establishment. However, I found his letters, starting in 1995, to be an invaluable education. I was able to step into his shoes and follow along as he solved the market’s puzzles by incorporating ideas from a variety of disciplines, including his education in philosophy and involvement with the scientists of the Santa Fe Institute who taught him frameworks crucial to understanding the value of novel technology companies.
Miller made a roaring comeback. His journey holds lessons about change: adapting to it, misunderstanding it, and coming back after being buried by it.
In this first of two parts, I’ll focus on Miller’s journey from getting started as an investor to the top of the dotcom bubble.
All quotes in this piece are from Bill Miller, unless otherwise noted.
The case for quality
“We were fortunate that the 1990s were similar to the 1980s. Value investing beat growth in the early 1990s, as it did in the early 1980s. After the Fed began tightening in both decades, value investors who relied on accounting metrics alone, and failed to take into account the drivers to business value, languished.”
Miller, born in 1950, was introduced to the stock market by his father when he was nine years old: "He said, 'If you own this thing, and it goes up, you make 25 cents.'" As a teenager, Miller bought his first investment book (How I Made $2 Million in the Stock Market) and his first stock, RCA. After a stint as an Army intelligence officer, he pursued a doctorate in philosophy at Johns Hopkins University in Baltimore. One of the professors remembered arriving early each morning with Miller “sitting in the faculty library reading The Wall Street Journal.” He encouraged Miller to go into finance.
Miller found work in the finance department of an industrial company while his wife worked as a broker at Legg Mason. Miller routinely picked her up after work and became acquainted with the firm and its people. Miller was hired to join the research department and in 1982 he joined Ernie Kiehne, one of Legg Mason’s veterans, to help set up the Legg Mason Value Trust. In 1990, Miller took over sole management of the fund. (He also managed several other funds and later became CEO and chief investment officer of Legg Mason Funds Management.)
In November 1990, when he took over the fund, “the economy was in recession, stocks were down, banks — our largest industry concentration — were failing, Saddam Hussein occupied Kuwait, and oil had spiked to about $40.00 per barrel,” Miller said, looking back. “It was clearly a terrific time to invest. All of the great investing periods begin when things are terrible and end when they are wonderful.”
Kiehne and Miller started out with a traditional value framework, “based on low price-to-earnings, low price-to-book, or low price-to-sales.” However, their early track record was mixed. The fund underperformed the market in the late 80s and Miller recognized that the strategy delivered “solid long-term results” but also experienced “uncomfortably long droughts.” The 1990 recession was one such drought. “The approach that had been so successful for us from the bottom of the economic cycle in 1982 had serious shortcomings when the economy peaked and began to head down,” he said.
When he took over the fund, Miller performed a deep-dive investigation into its track record, its stock picks, and the academic literature. He found that the “source of excess return had little to do with pure accounting factors such as low p/e or low price-to-cash flow; it had to do with changes in the return on capital.” Unsurprisingly, “low p/e stocks usually had low valuations because they had low returns on capital. If the return on capital didn’t improve, neither did the valuation.” This insight completely changed his perspective on investing, and he concluded that “the conventional wisdom about value investing was wrong.”
His portfolio of low-multiple stocks had performed well after a recession because “the return on capital of the cyclicals expanded more rapidly than that of the growth names.” However, over the course of a cycle “all the classic cyclicals,” industries like “paper, steel, aluminum, chemicals,” were “poor businesses” as they were “unable to earn their cost of capital through an economic cycle.” Going forward, “they might be good trades,” but they were bad investments.
Instead, Miller would combine “statistical cheapness with an analytical view about when a company’s return on capital would begin to improve.” That would eliminate companies “that looked cheap” but could not “systematically improve their return on capital.” In other words, he pledged to avoid value traps.
This first pivot is not uncommon among value investors and mirrors Warren Buffett’s evolution from Ben Graham-style investing to a focus on quality companies. It also highlighted to me the long feedback cycles in investing. Miller later remarked: “It was in the late 1990s that we benefited from what we learned from our mistakes of the late 1980s.”
The value of technology
“What the wise do in the beginning, fools do in the end.” — Warren Buffett
In early 2000, Miller wrote to his shareholders: “Much of the excess returns earned by Value Trust shareholders in the past several years has been due to our being early in investing in great businesses such as AOL, Dell, and Nokia.”
The next step of Miller’s learning journey started with his first visit to the Santa Fe Institute in 1992 at the invitation of Citibank Chairman John Reed. Founded in 1984, this scientific think tank focused on the study of complex systems. The institute attracted a number of prominent investors over time and Miller served as chairman from 2005 to 2009.
A key insight came from economist Brian Arthur, who taught Miller about “path dependence and lock-in.” Leading companies often defended their market share even though the underlying technologies changed quickly. "Although technology changes reasonably rapidly,” Miller argued, “it doesn't follow that such change is random or unpredictable.” He started by investing in blue chip IBM in 1993. IBM was cheap and had a business model that would “support high returns on assets or equity with significant free cash flow generation.”
During a market correction in 1996, Miller looked at cyclical stocks like steel, cement, and paper companies, which were cheap and “down and acting badly, just the sort of thing we tend to like.” However, he decided to pass and instead invested in several technology companies. Dell Computer was selling at “about 5x earnings,” and he bought it together with Finnish mobile-phone leader Nokia. He also invested in AOL “when people thought it was going bankrupt.”
The book, At Home in the Universe by Stuart Kauffman, a researcher at the Santa Fe Institute, became Miller’s inspiration for the AOL investment. Drawing on the ideas of self-organizing complexity and network effects, Miller saw enormous potential in AOL, which he viewed as possibly becoming the organizing entity capturing the rapidly emerging market for internet access.
Miller was now convinced that technology companies had “the ability to create substantial, long-lasting shareholder wealth." Value investors simply couldn’t choose to ignore the sector.
"If technology is difficult, it is not incomprehensible. Investors who rule out the largest sector of the market, and the most important driver of economic growth and progress, because it takes work to figure it out have little to cavil about when others get the rewards."
In addition, technology companies disrupted other industries, which would leave ignorant investors to “bad investment decisions by not understanding the risks.”
However, young and unprofitable technology companies presented a unique valuation challenge. Miller believed that GAAP failed to capture the intrinsic value being created. “It is true that some of the best technology companies have rarely looked attractive on traditional valuation methods,” Miller acknowledged, “but that speaks more to the weakness of those methods than to the fundamental risk-reward relationships of those businesses.” Traditional analytical tools, like multiples of profitability or cash flow, were useful because there was historical data to support them. This wasn’t the case for young technology companies.
Miller was ready to discard what he called “the accounting stuff” if necessary: “We are interested in the underlying economic reality of the business and not how they report what is going on. I think a lot of the issues that people have raised are bogus. Go back to AOL [now AOL Time Warner] back in 1996, when we were buying that. Everybody was concerned because they were capitalizing the cost of acquiring subscribers instead of expensing it. The costs were what they were, it didn’t really matter how they were accounting for it. They were spending money to acquire subscribers. We understood the underlying principles.”
Value was not defined by a low current multiple but was the present value of future free cash flows. While investors used multiples as proxies for bargains, Miller mused that “sometimes they are and sometimes they aren’t.” Even though some of the stocks he bought were owned by growth investors and derided by value colleagues, he didn’t see himself as drifting in style towards a growth philosophy. Instead, he discarded what he felt were antiquated tools and recognized a new breed of companies whose value creation was obscured by accounting. Returns in technology were driven by the power laws: a few winners captured outsize returns by dominating their markets.
Of course, he wasn’t right about everything. While AOL later merged with Time Warner in a deal that defined its era, it didn’t become a global monopoly for internet access. Instead, it experienced a rapid decline among broadband internet adoption.
Career trades: Dell, AOL, Amazon
Dell, AOL, and Amazon were key examples of Miller’s new style. Dell and AOL started out as typical contrarian investments, but Miller held on to them even as they regained the market’s favor because they kept growing. Amazon, on the other hand, became a litmus test for Miller, who started building his position near the peak of dot-com euphoria.
In 1996, Miller bought Dell and “took advantage of the panic surrounding a feared slowdown in personal computer demand.” Miller saw that the direct sales model let the company earn much higher returns on capital than its competition. Dell shares quickly recovered and by 1998, Miller remarked that he was frequently asked about when he was going to sell. “We sell when a company's share price has reached fair value,” he responded. “We sell to replace an existing holding with a better bargain, and we sell when our original investment case is no longer applicable.”
Dell’s intrinsic value had grown quickly. Miller believed it could be the “Wal-Mart of the PC industry,” with a “sustainable competitive advantage” which the market did not understand. He held on and pushed back against critics who pointed out its high multiple.
“Dell trades at over 40x next year's earnings, Gateway at under 20x. Is Gateway cheaper than Dell? If Dell earns over 200% on each dollar of invested capital, as it does, isn't it worth more than Gateway, which earns 40%? How much more? If it's 5x as profitable, is it worth 5x as much? If its price/earnings ratio is only 2x that of Gateway, is it then a bargain? This is not meant to suggest an answer, just to note that businesses have different values and those values are hardly captured by a single number on a linear scale such as price/earnings ratios. We are delighted, though, when people persist in thinking price/earnings ratios tell most of the story about value, since it gives us an opportunity to make better investment decisions by doing a more thorough job of analysis.”
As I mentioned, Miller’s investment in AOL was quite controversial and he remarked that “people were telling us that it was a massively stupid thing to do.” But the company’s dominant market share, “relatively small capital investment needed,” and high expected future profitability made it attractive. Instead of looking at a P/E ratio, his team looked at subscriber economics and underwrote margin expansion and lower future capital investment. He applied Brian Arthur’s model of increasing returns, “the tendency for that which is ahead to get further ahead, for that which loses advantage to lose further advantage.” In the new internet economy, the winners would keep winning without requiring increased investment or running into physical constraints. That meant, Miller wrote, that their “economics get better as they grow, as opposed to the decreasing returns that classical economists believe most businesses encounter.”
Miller was comfortable with both stocks becoming large positions in the portfolio. From March 1996 to September 1998, they accounted for the majority of the fund’s gains, according to the New York Times. He explained with an analogy:
“The Chicago Bulls have five sources of points operating at any one time, but Michael Jordan's play usually determines their results. Should they trade him for a rookie so they won't be so dependent on him? If he does poorly, in all likelihood, so will they. When will they replace him? Probably when they determine he can no longer produce the results given what they are paying for him. That same criterion is helpful in thinking about stocks.”
Miller’s decision to invest in Amazon followed a meeting with company executives at the Santa Fe Institute. He could draw on two case studies to understand the company’s potential: Fannie Mae and Dell.
In the 1980s, Miller had met Peter Lynch who explained to him the business model of government-backed mortgage company Fannie Mae. Fannie was a bank without branches, with lower cost of capital due to the government guarantee, and invested in the same assets as other banks. Thanks to a lower cost model, returns would vastly outperform traditional banks.
Dell operated without stores, collected cash immediately from customers, and paid suppliers later on, resulting in a negative cash conversion cycle. Customers and suppliers were financing the company’s growth. Miller saw that Amazon had similar advantages and bet on its capital efficiency, noting that it “generated its first $600 million in sales on just $28 million in capital.”
He demonstrated the degree to which the market misunderstood at a 2000 Grant’s Interest Rate Observer conference when he asked attendees to guess Amazon’s cumulative cash burn since inception. Guesses ranged from $200 million to $4 billion, compared to the correct answer of $62 million.
Lastly, Miller believed that preconceived notions kept people from seeing the “long-term reality” of the internet, and therefore investing in Amazon which "symbolizes all that people hate about the Internet: a young man like Bezos making a billion dollars, these companies losing vast amounts of money.” What he called preconceived notions I’d call envy and resentment.
The flexible optimist
By the end of the dotcom bubble, Miller was on an epic streak of beating the market. While his investment philosophy was bottom-up, he was a keen observer of macro conditions “not because we try to predict the economy or the market,” but to understand the “economic forces operating at any given time and what the valuation of various asset classes is implying about the future.”
Miller remained bullish in 1998, after the Russian default and the implosion of Long Term Capital Management. "All important activity in complex adaptive systems begins at the margin," he said. He saw improvement in areas that had led the market into crisis – stocks and economies that had been at the center of the Asian Financial Crisis – and concluded that the worst was over.
In 2000, he sensed a regime shift as the average money manager piled into technology stocks. Miller reduced his exposure, remarking that the future of “prominent technology companies” was now “well recognized and well discounted by the market.” While he still bought Amazon, he shifted back to value stocks.
“The Federal Reserve was raising interest rates, oil prices were rising, and real rates were close to record levels,” he said. “These warning signs were ignored or dismissed as unimportant. Consistent with our beliefs at the time, we significantly reduced our holdings of technology stocks in the first and second calendar quarters of 2000, moving the money into the depressed financial sector, and into such unpopular names as Waste Management, Toys ‘‘R’’ Us, and McKesson, the large drug distributor.”
Well, that’s it for this first piece. In Part Two I will look at one of Miller’s great strengths, how it led to disaster, and how philosophy helped him recover.
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