Bill Miller’s Journey (Part II): Lessons of Triumph and Tragedy.

“It is different every time. The relevant analytical exercise is to figure out what the differences are, what it all means, so that one can make sensible investment decisions.”

Nov 28, 2021

This is the second part of my Bill Miller profile. To understand his evolution and style as an investor, check out part I.

In March 2002, in the middle of the dotcom bust, Bill Miller reminisced on the last bear market. “I took over sole management of the fund in November 1990,” he wrote. “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 per barrel. It was clearly a terrific time to invest.”

This past October, Miller remarked that “nothing” worried him because the market spent an “inordinate amount of time worrying,” and time was better expended on making good long-term investment decisions. This was typical of Miller, who liked to assert that “the path of least resistance for the stock market is higher.” Most of the time, he was correct. But between 2002 and 2021 lay the greatest failure of his career. At the point of his most assets under management, the eternal long-term optimist failed to recognize that the ground had shifted beneath his feet.

I’ve been fascinated with Miller’s life and career. He has a lot to teach about investing and navigating an uncertain and changing world. Miller stuck to his principles but evolved his strategy during his run of beating the market 15 years in a row. But he failed to see crucial differences between his past experiences and the housing crisis of the mid-2000s and ended up as one the era’s biggest losers. Through it all, the ups and the downs, Miller generously shared his thoughts, reflections, and frank self assessments in his letters. In this, the second part of a two-part series, I let him mostly speak for himself. If a quote isn’t attributed, it’s his.

In the first part I wrote about Miller’s successful transition from traditional value investing to investing in technology companies. We explored his multi-disciplinary approach and how he was influenced by the science of complexity at the Santa Fe Institute. At the end of the dotcom bubble, Miller recognized a shift in the market and reduced his exposure to technology. Fortunately, his other favorite group, “the long-lagging financials,” had finally “begun to perk up.”

In this piece we’ll explore Miller’s fondness for averaging down, the run-up to the financial crisis, his very public failure, and his rebound.

Sections:

Lowest cost wins.
Being different.
Deadly muscle memory.
Darkest hour.
Comeback.
The lessons.

Disclaimer: I write for entertainment purposes only. This does not constitute an offer to sell or the solicitation of an offer to buy any securities or funds or other investments mentioned. Seek your financial, tax, legal, accounting, or other advisor’s advice before making any investment decisions. Do you own work. I am are not your fiduciary or advisor.

Lowest cost wins.

Buying at a discount to intrinsic value remained the cornerstone of Miller’s investment philosophy. He was looking to capitalize on other investors’ short-term time horizons and behavioral or analytical mistakes. Miller believed that timing the market was futile (though he had just made a call on the technology sector) and was happy to buy a stock as it continued to decline.

“If you want to boil down everything we do, it's this: The guy with the lowest average cost wins.”

“Stock prices change far more rapidly than does intrinsic business value,” Miller said during fiscal year 2000. “That’s because prices reflect recent history, current fundamentals, and reasonably foreseeable prospects, those looking out, say, six to nine months, all filtered through the prism of psychology and emotion.”

“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’re available at discounts to intrinsic value. These 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. One of the most powerful sources of mispricing is the tendency to overweight or over-emphasize current conditions.”

There are numerous examples of out-of-favor stocks that ended up in his portfolio. Miller bought both Dell and AOL in 1996 when the market dumped the shares. That year, he also bought stock in casino operator Circus Circus. The stock fell from the $30s to $12 and Miller “quadrupled his position.” He later added Mirage Resorts and MGM Grand. “The stocks are flat, but the cash flows of gaming companies have been growing,” he explained.

In 1999, he bought shares in McKesson after an accounting scandal. He also added aggressively as shares of Waste Management fell from the $50s to the “low $30s” after yet another accounting scandal. He also invested in two scandal-ridden conglomerates, Tyco and Enron, noting later, “we were right, for example, to buy Tyco under $10 when it was involved in an accounting scandal. We were wrong to buy Enron when it was also involved in such a scandal.”

Miller invested in distressed telecom names such as Qwest Communications, Nextel, and fiber provider Corning. Nextel had tumbled from $80 to $9; Corning had dropped from $100 to $10. Money Magazine called his fund the “scariest portfolio ever,” which Miller reprinted in his letter with some pride. Journalists didn’t understand that the fear in his names made them such attractive contrarian bets. Nextel became his largest portfolio holding and Legg Mason became the largest outside owner of Amazon with a 16% stake. Another internet name was Barry Diller’s IAC, with stakes in Expedia and Hotels.com and what Miller called “Warren Buffett-type characteristics” of “high free cash flow, a strong balance sheet, and businesses that arbitrage the economics of various industries.”

Miller later wrote that “factor diversification” had been a key reason for his winning streak. He defined it as owning “a mix of companies whose fundamental valuation factors differ.” The winners and losers of fiscal year 2001 illustrate this. While most of his tech names sold off, old economy stocks in healthcare, gaming, and financial services did well.

Being Different.

In 2005, Legg Mason gained additional distribution power by combining its wealth management division with Smith Barney. That was also the last year of Miller’s market-beating streak which he called “a fortunate accident of the calendar.” I doubt anybody would be surprised to learn that this year, at the tail-end of fantastic performance, saw the final increase in AUM (the Value Trust is now part of ClearBridge).

Miller laid out his view of the fund’s differentiation for his new investors. It boiled down to variant perception, a diversification in mispricing, averaging down, and his long-term time horizon.

“The most important question in investing is what is discounted, or put slightly differently, what are the expectations embedded in the valuation?”

“Systematic outperformance requires variant perception: One must believe something different from what the market believes, and one must be right. … The market is either wrong about how important something is, or wrong about when that something occurs, or both.”

“Our portfolio contains a mix of businesses, some of which we believe are cyclically mispriced, and some of which we believe are secularly mispriced. The former are often called value stocks, the latter growth stocks, not helpfully in either instance”

“We average down relentlessly. Two things seem pretty clear to me: First, no one can consistently buy at the low or sell at the high (except liars, as Bernard Baruch said), and second, lowest average cost wins. … Someone once asked me how I knew when we were wrong to do that. When we can no longer get a quote, was my answer.”

“We practice the Taoist wei wu wei, the “doing not doing” as regards our portfolio, otherwise known as creative non-action. We are mostly inert when it comes to shuffling the portfolio around, with turnover that has averaged in the 15% to 20% range, implying holding periods of more than five years.”

Miller had also increased his fund’s concentration and wrote in 2004 about his belief that “portfolio concentration, a careful attention to value, and a long-term investment horizon” were critical to investment success and meant that “we have to think and act like owners, not like renters.”

Deadly muscle memory.

I’m writing this section in the spirit of learning and not to point out a well-documented mistake. I’m interested in understanding how the mistake came about. Miller was by no means unaware of the problems in the housing market. On the contrary, he’d always been a keen observer of the macro environment and paid careful attention to the financial services sector.

The mid-2000s bull market was driven by commodities, particularly energy, and emerging markets. Miller did not participate and defended his lack of exposure multiple times.

“We have mostly avoided oil and other extractive industries for many years, believing that these sectors faced a combination of headwinds – slow unit growth, declining prices in real terms, capital intensity, environmental and political issues are some examples – that made long-term investment problematic, despite the occasional opportunity for sharp cyclical moves upward.

“We preferred, and still do, businesses that consistently earn above the cost of capital, have managements that understand shareholder value, are the beneficiaries of secular trends, and which, most importantly, are available at prices below our assessment of intrinsic business value.”

Instead, Miller found success in opportunities like Google’s IPO. He sensed that many investors would abstain due to its unusual Dutch-auction format, in which bidders risked getting stuck with more shares than they wanted. Miller noted the negative news flow ahead of the deal, about “how the founders were arrogant and inexperienced, how the dual class share structure smacked of bad corporate governance, how the company would not provide enough information about its business.” Needless to say, buying Google at the IPO was the right decision.

In 2005, the homebuilding sector stood out to Miller, “trading at 5 or 6x earnings due to the incessant drumbeat about a housing bubble.” His thesis was that the U.S. housing market would undergo a correction followed by a “return to normalcy,” like in the U.K. and Australia. Homebuilders would experience a sharp sell-off followed by a return to secular outperformance. When that sell-off occurred in 2005, he invested.

In early 2006, with a 5% allocation to homebuilders, he noted that “housing data is rolling over, which is likely to put some pressure on consumer spending, as well.” Already he admitted to making “a mistake by initiating positions too early.”

“We were wrong, hence early,” he noted in 2006, “and now the stocks sell around book, and we think the bottom is either in place or within squinting distance.”

According to the Wall Street Journal, he also met incoming Federal Reserve Chairman Ben Bernanke. Miller recounted being told that the Fed’s job was to “prevent the worst case from happening,” though a spokeswoman for Bernanke commented that he didn’t recall the meeting.

In 2007, Miller noted the headlines about “the worst housing market since the early 1990s.” The 1990s had been a fabulous time to buy distressed assets. “Had you bought housing stocks during that previous period of duress,” Miller said, “you would have made many times your money and handily outperformed the market over the subsequent decade.”

Miller dug in on his variant perception on housing. The bad news, he concluded, had already been discounted in the price. As he told his analysts, “If it’s in the papers, it’s in the price.”

“The very poor housing fundamentals, now exacerbated by a subprime loan collapse and the continuing upward repricing of adjustable-rate mortgages made in the past few years, show no signs of improvement. But the market looks forward, and by the time those signs are tangible and evident, the stocks will likely be a lot higher.”

Miller was keenly aware of the difficulty of distinguishing between being early and being wrong. Based on the experience in the U.K. and Australia, he expected the correction in housing to be over. But it was just getting started.

In the summer of 2007, two Bear Stearns hedge funds that were invested in subprime mortgages imploded. The crisis was now in full swing and shares in financial stocks started their nosedive.

In late 2007, Miller’s portfolio company Countrywide Financial started selling off on bankruptcy fears. Miller commented on the highly volatile trading as “driven by emotion – first fear, then relief – and was hardly the result of a careful analysis of Countrywide’s long-term business value.” He added: “Fear dominates the pricing of housing stocks, of mortgage-related securities, of financials.”

It was exactly the kind of emotional trading that a long-term value investor would typically take advantage of. Miller bought shares in AIG, Wachovia, Washington Mutual, Bear Stearns, and Freddie Mac.

I was struck by the fact that Miller and his team were very aware of the macro picture. They tracked the data and watched the housing market falter. Unlike the contrarians betting against mortgage-backed securities and banks, however, Miller didn’t see a systemic crisis. His focus was on the value in these “mis-priced cyclicals” that had treated him well in previous crises.

Miller recognized a “reappraisal of risk in the credit markets,” which spread from subprime to other areas including “corporate credit, namely high-yield bonds and loans to finance buyouts.” He correctly concluded that this was not a crisis like the 1987 crash or in 1998 with LTCM, which had been “confined to Wall Street.” This crisis, he realized, extended “to Main Street and to the value of the biggest asset of most consumers, their house.”

But he still compared it to prior instances in which he had successfully averaged down. During the 2002 bear market, his holding “AES traded under $1. It will generate over $1 of free cash flow this year and is up 20 times from the lows of 2002. Yet fear set its price, as it did those of Nextel, Tyco, Corning, Amazon, and a host of other companies at that time.”

And just like in 2002, he recalled the moment when he took over sole management of the fund during the savings-and-loan crisis in 1990. That year had been “a time of panic due to a housing-market recession, soaring oil prices, banks and financials collapsing.” Miller had taken “advantage of the values then offered” and bet heavily on American Express, Freddie Mac, and struggling banks. It was, he noted, “a pretty good period of excess returns.”

Angelo Mozilo and his doomed mortgage machine

When Countrywide agreed to be acquired by Bank of America in January 2008, Legg Mason was its largest shareholder with 11.8% ownership. Miller was “surprised by the decision to sell the company at close to a seven-year low in the stock price” and bought more stock.

In February 2008, shortly before Bear Stearns was taken over by JPMorgan, Miller again mentioned this analogy.

“It’s not an accident that our last period of poor performance was 1989 and 1990. The past two years are a lot like 1989 and 1990, and I think there’s a reasonable probability the next few years will look like what followed those years.”

“The late 1980s saw a merger boom similar to what we’ve experienced the past few years, and a housing boom as well. In 1989, though, the merger boom came to a halt with the failure of the buyout of United Airlines to be completed.”
“By 1990, housing was in freefall, the savings and loans were going bankrupt (as the mortgage companies did in 2007), financial stocks were collapsing, oil prices were soaring in 1990 due to a war in the Middle East, the economy tipped over into recession, and the government had to create the Resolution Trust Corporation to stop the hemorrhaging in the real estate finance markets. Eerily similar to today, the situation began to stabilize when Citibank got financing from investors from the Middle East.”

But whereas buying distressed financials had been the right call in 1990, it now proved to be a deadly mistake. While Miller was trying to look through the recession, the crisis was still unfolding and investors were uncovering one over-levered balance sheet loaded with bad assets after another.

At a conference on Friday, March 14, Miller discussed buying more Bear Stearns at $30. It was taken over by JPMorgan that weekend for $2 (eventually raised to $10). Miller and his team had failed to recognize “the severity of this liquidity crisis,” as he later told the Journal. “I was naive,” he admitted.

Recognizing the risk of further bank runs, Miller sold Wachovia and Washington Mutual. But he was still a big holder of other failing financials, such as Freddie Mac and AIG. Miller interpreted the collapse of Bear Stearns as the possible end of the “panic phase of the credit cycle.” Far from it. The unfolding crisis was unlike any market Miller had navigated.

“Is it obvious financials should be bought now, having reached the most oversold levels since the 1987 crash, and the lowest valuations since the last great buying opportunity in 1990 and 1991? Or is it obvious they should be avoided, since the credit problems are in the papers every day and write-offs and provisioning will likely continue into 2009?”

“This is the only market I’ve seen where you could just read the headlines in the papers, react to them, and make an excess return,” Miller wrote in mid-2008. “I’ve used the mantra to our analysts that if it’s in the papers, it’s in the price — which used to be correct. Indeed, in the past two years, you didn’t need to know anything except to sell what the headlines were negative about (anything related to real estate, the consumer, or finance) and buy anything that was going up and that everybody liked (energy, materials, industrials).” The market’s time horizon was collapsing.

John Hempton said that Miller “recklessly” averaged down. Since an investor doesn’t know whether they’re making a mistake ahead of time, the right question to ask is “under what circumstances are you wrong” and “how would you tell?” “When you put it that way,” Hempton wrote, “it becomes obvious that you must not average down (much) on highly levered business models.” Averaging down would likely occur before the mistake was revealed — and the damage to shareholders of a highly levered business could be irreversible.

Unfortunately for Miller, averaging down was a core tenet of his philosophy. Having had success in prior crises provided the deadliest of muscle memories. Despite his attention to the macro, he was not able to identify the dramatic change in conditions that had taken place. The playbook of prior decades had gone out the window. And by averaging down in failing value traps he reduced the “factor concentration” that had served him well.

Fund manager Christopher Davis recalled telling Miller that one of his goals was “to just be right more than I’m wrong.” Miller countered with, “What matters is how much you make when you're right. If you're wrong nine times out of 10 and your stocks go to zero — but the 10th one goes up 20 times — you’ll be just fine.”

What may sound good in theory had become reality. Some of Miller’s picks were racing towards zero. And there was no 20-bagger to offset them.

Darkest hour.

Miller called the decision to let Lehman Brothers go bankrupt “a mistake of historic proportions.”

“The authorities and we were too late to recognize the scope and seriousness of the unfolding crisis,” he said, “and too late to take the appropriate action.”

According to Richer, Wiser, Happier, the Value Trust lost 55% in the calendar year and the Opportunity Trust 65%. Miller’s net worth declined even more as he had gone through a divorce and used margin debt. The Journal called his downfall the “Stock Picker’s Defeat.”

His empire at Legg Mason was crumbling under a wave of redemptions which forced him to sell even high-quality companies like his beloved Amazon, despite calling January 2009 “the best time to buy quality in my investing career. He also had to let go of employees.

“Laying off all those people was horrible,” he said. “That was the worst part of it: losing money for clients, and people losing their jobs because I screwed up.”

According to the Journal, Miller put on 40 pounds and couldn’t sleep for more than a few hours. “There’s only so much pain I can take, and I drew the line there,” he told William Green.

Miller returned to philosophy and especially the stoics. After “getting crushed in the market, no one wants to hear about what you think. You’re really forced to look internally and confront your mistakes and see if you can do better. And it’s good for the ego.”

Miller sold his yacht, reinvested the money, and bought calls in Amazon in his personal account. He stepped down from the Value Trust in 2012 andleft Legg Mason in 2016. The Opportunity Trust, whose AUM had declined to $780 million, became part of his new firm Miller Value Partners.

So where is he today?

The Opportunities Trust has done well since the financial crisis. And Miller has invested in another asset that required novel thinking: Bitcoin. Institutional Investor reported that Miller’s hedge fund vehicle took a 5% position in the cryptocurrency at the beginning of 2017.

“I’m not a Bitcoin bull, but an observer,” Miller said. “It’s a fascinating technological experiment that might fail and be worth zero. But if not — and so far, it hasn’t — there’s the right tail-to-return distribution.”

The lessons.

The lessons of Bill Miller’s early journey were straightforward: Don’t get stuck on dogma. Don’t mistake the map for reality and look beyond accounting at the company’s economic model.

“It’s not about thinking of things as true or false, but as useful or not useful,” he said. “I don’t let the price of a company’s stock confuse me about a company’s fundamentals. That’s rarely the end of the story.”

“I didn’t have my own information on Amazon. My view was just that people were looking at it incorrectly.”

In a recent conversation, Miller related his “amended” definition of value investing. Rather than finding “businesses at a discount to what they're currently worth," he was looking to buy them “at a discount to what you believe they’ll be worth with a sufficient margin of safety.”

Be open-minded, curious, and collect wisdom from different disciplines:

“His main characteristic is curiosity,” Brian Arthur said about Miller. “He just exudes the impression that he’s a very decent guy. He’ll walk into a room and just stand there quietly observing the people. He’s interested in everything, everybody.”

The past two decades are more difficult to figure out. Miller’s tragedy was embedded in a process that had led him to the peak. I wonder if he could’ve avoided the overconfidence that came with tremendous success. And perhaps the end of his long winning streak created an urge to regain his spot at the top with a bold and successful bet.

His story contains a warning against overconfidence and becoming too concentrated in a bold thematic bet, especially if it has significant downside risk.

His journey is a cautionary tale to never let down your guard, to never believe you’ve figured out the game. The moment of our greatest success can lead us straight into the abyss of defeat.

“I’m much more sensitive to risk and being wrong than I was before,” Miller said “It’s an admission that I didn’t think I could be as catastrophically wrong as I was.”

It’s easy to point out that he drew the wrong historical analogy. But it’s hard to withstand the temptation to find meaning in patterns from the past. It’s always different this time, but we don’t know in which way. And we intuitively look to history for guidance (see also comparisons of 1987 to 1929; and see Paul Tudor Jones and the Japanese bubble for a trader’s perspective on working with analogies).

Miller’s journey shows us the need to become resilient. Structural weaknesses silently compound and become exposed in times of stress. Miller faced redemptions due to the mutual fund’s daily liquidity provision. He also dealt with divorce, a hostile market, margin debt in his personal account, and public humiliation. I can’t imagine the amount of stress that weighed on him. If the ability to make good decisions and take risk is impaired by poor health, a lack of sleep, anxiety, and depression, how does one make the bets necessary to emerge from the depth of crisis?

In the end, Miller’s journey shows us that comebacks are possible. That there is a life after failure and humiliation. Though that’s a small consolation for investors who piled into his fund at the top only to redeem at the bottom.

In 2009, Miller reflected on the time of his market-beating streak, when people asked him why he didn’t quit while ahead. “That would have been a really smart thing to have done.”

It may have been the smart thing to do. But a paradox of great investors and entrepreneurs seems to be that their passion and competitive spirit makes it near impossible to quit the game. They hold on and keep playing, sometimes for too long.

“I've been on the top and I’ve been on the bottom,” Miller said a few years ago. “And the top is better.”

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