Bill Miller Interview with GlobeInvestor Magazine

Canada's national newspaper, The Globe & Mail, has launched an investing magazine called Globe Investor. It seems to be tailored for Canadian investors and seems useful. The inaugural magazine cover story is an interview with Bill Miller. As I have remarked before, Bill Miller is an amazing investor because he is one of the few value investors who can analyze technology stocks properly. Here is some of the Q&A that I found interesting:

Q: Buffett or Graham would never dream of Google or Amazon.com at these kind of price-to-earnings ratios.

A: Actually, I disagree with that a little bit. Graham, in congressional testimony in the '50s, was asked about what he looks for when buying a stock and he said, well, stock prices depend on future earnings. And so, to the extent that one could actually make the judgment about future earnings, one would be able to know which prices were attractive.

There's two reasons Buffett doesn't buy [tech stocks]. Number one, he believes that in many cases, with businesses like that, it's very difficult to look five or 10 years down the road with any reasonable degree of accuracy. The second reason is that he believes that many of those businesses change so rapidly that they may be unanalyzable on their own.

While technologies change rapidly-a new microprocessor every 18 months, new networking stuff-technology market shares actually change much more slowly. If you look at Intel's market share, Cisco's market share, Microsoft's market share, and then compare that to Coke's market share or Nike's market share, they're far higher than those consumer products companies that are thought to be much more predictable. You see the same thing in [Internet] search. Once it's settled down, Google's got it locked up, no matter what Microsoft or Yahoo do.

Insightful way of looking at things. I guess what I need to do is to look at the big picture (margins, market share, etc) and see if that can be stable, while the underlying products change rapidly.

Q: At the beginning of the year, you said U.S. stocks were cheap. Do you still feel that way?

A: The answer at the beginning of the year was, "Stocks are really attractive if these bond rates are right. If the economic growth forecast consensus numbers are right, stocks would be 15% to 20% higher." What's happened is that people have changed their views about risk and they're pricing in much more risk in the market than they did before. [Credit] spreads have widened. That lack of availability of credit, based on behaviour, ought to slow the economy very dramatically.

But I think stocks are still very attractive. The Fed will now, because of the risk to the economy, take whatever actions are necessary so that it can try to fulfill its goals of price stability and employment. And the employment one is under severe question. I think that what you're looking at is a Fed funds rate that, based in theory, should be in the threes [between 3% and 4%]. But the underlying global economy looks okay.

I disagree with Bill Miller here. I think the US economy is going to drag down the rest of the world with it. Things look ok for the time being but I am expecting things to worsen.

Q: How much time do you spend thinking about macroeconomic themes, versus analyzing stocks and companies?

A: We don't make forecasts. The core of what we're doing is analyzing businesses. Our analysts are thinking zero about macro unless I tell them to think about macro.

Classic value investing answer: zero time spent on macro trends. However, do note that Bill Miller, like Warren Buffett and others, thinks about industry trends (eg. whether a company's market share will increase) but does not rely on macroeconomic trends (eg. emerging markets are going to demand more microprocessors). (note: I just made up those examples to illustrate the point.)

Q: You're a student of behavioural finance. How can an ordinary investor apply that stuff to their thinking?

A: If you're going to buy individual securities, you have to believe that you're going to earn excess return from doing that, and therefore that the market's wrong about something. I think most people don't even take that step and say, "What do I think-where is the market wrong about this thing?"

Behavioural finance relies on good evidence about how large numbers of people behave under well-defined circumstances. So they have demonstrated beyond a doubt that people are risk-averse-a dollar's worth of loss is twice as painful as a dollar's worth of gain. The second thing we know is that people over-emphasize the most recent information. A few years ago when a couple of German tourists were killed in Miami, attendance at Disney World fell way off, because that was dramatic-even though more people are killed driving to Disney World from Miami.

The point is that when you see events which are dramatic, recent and cause people to lose money, you can be sure that individuals will overreact. And therefore, they typically would provide good opportunities in the market.

Very important point about psychology. I like to imagine that half of investing is analyzing a company and thinking about it, while the other half is mastering psychology. The latter is extremely difficult. A good question for contrarians to keep asking themselves: "What is the market wrong about?" This is something that I think about all the time with Ambac (ABK).

Q: Let's talk about one of your mistakes-Eastman Kodak. [Miller's fund owns nearly 20% of the struggling company.]

A: Yeah, we were clearly wrong to buy it when we bought it, which was '99 or 2000, right around that time-and not because we didn't know that film was going away. Before Dan Carp became CEO, and we didn't own any Kodak, people arranged for him to come down and talk to me, not to convince me to buy it but to pick my brain on how the market thought about Kodak, what it thought about the curves of decline in film, that kind of stuff. They clearly understood that they had to change the business model. What I think we underestimated was how difficult that would be culturally. We should have recognized that sooner than we did."

That was then, this is now. Kodak, right now, has made the transition. It's actually doing well, the numbers are coming in better than people thought. Kodak actually told us a couple of weeks ago that they now have the highest number of requests from investors to come visit them, ever. [We] think it's a $45 stock. [At press time it was just below $28.]

I took a cursory look at Kodak a while ago and don't like it. I'm not sure what Bill Miller sees in it. The problem I see is that Kodak doesn't have any competitive advantage. Its brand, which used to be very strong, is slowly eroding.

Q: A lot of investors in Canada are obsessed with mining and energy. Why have you been a skeptic on commodities?

A: Well, we were wrong. There's two things. One of them is the secular case and the other's a cyclical case. Secularly, we have not been fans of commodities, broadly defined. That's because the empirical evidence and theory, both together, would indicate that commodity prices decline in real terms over time.

Extractive companies, by and large, don't earn their cost of capital over the cycle. They can be cyclically attractive-buy them when the cycle's bad and sell them when the cycle peaks---but generally speaking, they tend to be trading vehicles, versus investing vehicles. In trading vehicles, you've got to be right on both sides. We prefer things that we can invest in for five, 10, 15 years and earn large amounts of money.

The question now is, are we at a cyclical peak, or, as the bulls would argue, is it a secular change-that is, energy prices and copper prices and lead prices and wheat prices will now not decline in real terms from here. I think the jury's out on that.

This is probably the most important thing to learn for present investors given the current commodity boom. If you are influenced by value investing, commodities are a dangerous playground. As Bill Miller points out, commodity businesses have low returns on capital and commodity products decline over time. Investors like Warren Buffett have also shied away from commodities.

On top of the reasons that Bill mentioned, Buffett has mentioned how commodity businesses rarely have pricing power. They are generally price takers and customers can easily switch (this totally goes against Buffett and his preference for wide moat companies). Many commodity businesses only gain pricing power through M&A and trying to create a humungous monopolistic organization. Unfortunately for investors, many such mergers are done at high prices (which incidentally benefit bankers and insiders more than shareholders), generally near the peak of a cycle. In contrast, non-commodity businesses can gain pricing power through organic growth.

Of course, none of this means that you can't make a lot of money on comomdities; all that it means is that it is very cyclical and you have to get the cycles right. For what it's worth, I've been bearish on the whole commodity complex since 2006 (and have generally been neutral on gold since that time as well). My bearishness has more to do with my concern of China than commodities themselves (on a side note, China may be entering a correction (FXI is down quite a bit in the last few weeks)).

Q: How do you avoid value traps?

A: We don't, sometimes. But the nature of a value trap is when people confuse the cyclical and the secular. Toys "R" Us was a famous value trap from the last seven years before it finally went private. People would look at historical valuations and say, "Gee, Toys "R" Us always trades at a 15% or 20% premium to the market. It's the dominant toy retailer. So now that it's at the market multiple or a discount, it's attractive."

But with Toys "R" Us, it wasn't cyclical, it was secular. Wal-Mart, Target, people like that were systematically picking off their product array, and video games were taking away some of their demographic. Trying to avoid value traps means trying to understand what's in cyclical decline versus what's in secular decline.

I said the prior point may be the most important but I lied ;) I think this one is probably more useful to contrarians and value investors. Our biggest problem is value traps (aka catching a falling knife). I always think about what Bill said from Buffett's experience with Berkshire Hathaway (the original textile). If you are looking at beaten-down stocks, you need to be absolutely sure that the industry is not in a secular decline.

I am tracking AbitibiBowater (ABH; TSX: ABH), which is a forestry company with primarily newsprint production. I sort of put that on the backburner because it is not clear to me if we are in a secular industry decline. There is no point taking a position in this until the industry bottoms (or shows some growth). Otherwise, I can easily see the newsprint industry going almost down to zero (at least in North America and Europe). The confusing thing, of course, is that the forestry sector is a cyclical business. So it is very difficult to tell if the current suffering is a cyclical downturn or a secular decline.

I think a company like ABH can seperate the contrarians from the value investors. Most value investors would prefer to avoid these companies unless they are sure of its future earnings power. In contrast, contrarians may take a position simply due to strategies like "last survivor" or a reversal of Canadian dollar strength (would significantly boost earnings).