Sunday, November 20, 2011 4 comments ++[ CLICK TO COMMENT ]++

Opinion: Thoughts on Bill Miller's Exit

Although I don't post much these days, I do follow business/investment news and Bill Miller, CIO at Legg Mason Capital Management, will retire from managing the main value fund. Legg Mason grew from a no-name Boston shop to one of the largest mutual funds, largely due to Bill Miller. He had a strong streak back in the 90's but ended up performing poorly, with near-catastrophic bets on financials, over the last 5 years.

A lot of people don't like Bill Miller—some "value investors" don't consider Miller as a true value investor—but I was, and still am, a fan of him. In addition to Marc Faber, Warren Buffett, Charlie Munger, and David Dreman (at least his book), Bill Miller was one of the key investors who influenced me during my "formative" early years. I suspect what influenced me in the last 5 or so years—good as well as bad habits and knowledge—will probably, permanently, shape my future.

Although I was a fan of Miller, I don't think he is as good as the media made him out to be. In my eyes, he is better than the vast majority of mutual fund and hedge fund managers but he isn't a superinvestor like, say, Martin Whitman. I would put Miller in the same league as Bruce Berkowitz. Miller's record will look pretty bad given how he is going out near the bottom (so to speak) but I think he is a better investor than the record will end up indicating.

Miller's Flaws

Making mistakes is part of life but sometimes there are flaws with certain approaches or behaviours. Bill Miller had several flaws that always made me cautious about some of his opinions.

One of the big flaws with Bill Miller is that he is way too optimistic. He is clearly a bull, with a long tail and pointed horns, and will typically do well during bull markets. In contrast, someone like me, is very doom & gloom most of the time, even in real life :(, and will likely underperform during bullish periods (ideally, you want to outperform duing bull and bear markets, so you want to be a chameleon I guess ;) ). The bullish nature of Miller meant that he is vulnerable to severe negative events; in contrast, someone like is vulnerable to severe positive scenarios.

Miller's underperformance in the last 5 or so years is partly due to his bearish commodities call—same as me :(—but this isn't really a flaw. It may be a mistake but even that is not obvious (I'm still not sure if commodities peaked out in 2008). Although being out of commodity businesses hurt, this isn't what killed him.

Miller's tactic did during the financial crisis (i.e. betting heavily as prices were falling) wasn't really a bad tactic. Instead, what killed him was that, like many other so-called value investors, he bet heavily on financials. If Miller had bet on something else—anything!—he probably wouldn't have done as badly. Many non-financials companies bounced back and could live to fight another day. For example, one of Miller's mistakes from the early 2000's, Kodak (EK), was continuously deteriorating but it didn't collapse so fast and go bankrupt so suddenly like financial companies did.

In my view, value investors are highly vulnerable to overloading on financials, mostly because of historically strong underlying fundamentals such as high ROE, massive moats, strong capitalist management, and fairly good capital allocation. So, even now, many value investors like Fancis Chou, Bruce Berkowitz, and Warren Buffett, are betting heavily on financials. It's sort of a vulnerability with value investors. In contrast, if you look at macro-oriented investors, they wouldn't find financials so attractive and many still treat them as risky even though many companies are trading below book value. (Note: I'm not making a bearish call on financials here, although I do wonder about those financial bets, such as the Bank of America bet by Buffett and Berkowitz. Instead, I'm just pointing out what I feel is an inherent flaw with certain investment approaches.)

The other big flaw with Bill Miller was that he was too political. I hate to say it, because I love what he writes and think he is a great thinker, but he is sort of a fake capitalist. What I mean here is Miller's common stance to blame government when something goes wrong, or literally ask for government bailouts of poor investment decisions or misallocation of capital, or blame the messenger. For example, Miller's last fundholder commentary literally makes it sound like S&P should never have been allowed to downgrade USA's long-term government debt ratings. I agree with some of Miller's points—if USA is AA, are you really saying some of those AAA-rated countries in Europe and elsewhere are actually more credit worthy?—but the tone of his article is basically that S&P is an entity that shouldn't be permitted to issue negative calls. A similar stance during the financial crisis, where the government was largely blamed even though most of the mistakes were made by private investors and executives of private banks, probably clouded the reality and probably didn't help his portfolio.

Bill Miller's Influence

If I had to pick one element that Miller was way ahead of the pack on, I would say it's his interpretation of the business characteristics of technology companies. Bill Miller was famous in the value investing community for investing in technology companies. In fact, many so-called value investors never considered Miller as a value investor because of these investments, and more importantly, his explanation for why a tech company was a value investment. I think Miller was way ahead of his time and, at some point, value investors will come around to realizing how Miller was indeed a value investor. The fact that Warren Buffett recently invested in IBM, a technology bellwether, might start to influence some. You are also starting to see some value funds invest in companies like Google—I think it was Sequoia??—which would have been unthinkable even 3 years ago.

Bill Miller wasn't as good of an investor as superinvestors  like Martin Whitman or Walter Schloss. So, his technology picks, even if the justification turned out to be correct, were questionable investments. If anything, Miller had a good grasp of the business characteristics of the company but his valuation skills were weak. He often paid ridiculous valuations for technology companies. He was one of the first (public) investors in companies like Amazon and Google and he was correct in his business analysis. But capitalizing on the valuation of those firms—the so-called margin of safety, or how cheap an asset is—was questionable.

So what did Miller say about technology companies that was influential?

Well, the most prominent thing I learned from Miller is that technology companies, at least the strong ones, may have products that keep changing but the market share is more stable. Many investors in the past looked at technology companies and thought almost none of them had any moat because the products keep changing. But, Miller argued that you will notice that, even though Intel keeps introducing a new product every 4 or 5 years, its market share has been more stable. I don't know if Miller was the first one to come up with it but I heard it from him first.

Miller was also one of the few to identify the possibility of huge moats with Internet service companies. I believe Bill Miller was the first big-name value investor to invest in Amazon and Google. His initial investment in Amazon, in 1999, was a mistake, but he hung on and added to it, because he understood its business potential. Similarly, when Google had its IPO, I recall Miller saying it was cheap whereas many, including me, thought Google was wildly overvalued at its IPO price.

In addition to the development of a big moat using network effects, Bill Miller was one of the first ones that made me think about how building out the Internet infrastructure will create a moat that will be hard to dislodge. I vaguely remember an interview Miller had with Jeff Bezos of Amazon, back in 2003 or 2004(?), and the feeling I got from Miller was that building out the Internet infrastructure was a huge advantage. At that time, Amazon was posting losses I believe, yet Miller suggested that the approach of spending huge sums to build out the infrastructure was appropriate. Miller said that once the infrastructure is built out, capital spending will drop and free cash flow will rise significantly. So the profitability was artificially lower than what it really was. The Amazon bears at that time were arguing the company was going bankrupt because its profitability was weak. In the end, Miller's view was actually what transpired with Amazon during the 2004 to 2007 period. Too bad I never took any of his advice to heart.

I have been investigating Netflix lately and I think a lot of Miller's thoughts with respect to Amazon and Google (note: I'm solely looking at Netflix's streaming and not its DVD business). Although Netflix will serve more of a niche market and has different characteristics, it is building out "infrastructure" and spending huge sums on acquiring streaming content. Is this like a baby Amazon?

Unlike many value investors, I have always felt that the technology sector shouldn't be ignored. On top of it being very large—almost 1/3 of the economy—it is one of the areas with strong returns on equity (assuming you can buy them cheaply). I was quite surprised to see Warren Buffett take a big stake in IBM recently (particularly because it is mostly a service company these days; software and hardware moats are probably easier to examine than software service moats) but it sort of re-affirms my view that it is a sector that shouldn't ignored (unless it is outside your circle of competence or interest).

Parting Words

Bill Miller ends his investment career on a sour note but this shouldn't be too surprising because he is a concentrated investor who likes to swing for the fences. The problem with this approach is that if you slack off and losing your skills, you will end up with amateur-like strikeouts. This is indeed what happened with Miller.

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4 Response to Opinion: Thoughts on Bill Miller's Exit

November 21, 2011 at 10:17 PM

Good post. One thing that I didn't realize was that Bill Miller actually underperformed for the first 9 years of his career, losing money while the market nearly doubled.

In fact, at no point in his career, even after outperforming for 15 years or whatever, had he cumulatively outperformed the S&P over his entire career. Then, of course, came the financial crisis and his total performance ends up horrendous:

November 21, 2011 at 11:47 PM

Hi McMath,

I posted a similar response at the site you cited as well:

Bill Miller's record isn't as bad as the chart you linked implies. I think the starting point you picked appears to impact the results.

If you look at the Morningstar chart of LMVTX total return since 1982, you'll see that Miller significantly outperformed (until the disastrous bets during the financial crisis).

If the Morningstar chart is correct--I'm not sure if it includes expenses--Miller still ends up beating the S&P 500 over his career.

Sivaram Velauthapillai
November 21, 2011 at 11:48 PM

The maximum chart link should be this:

Sorry about the pasting that other chart.

Sivaram Velauthapillai
November 21, 2011 at 11:50 PM

grr... here is a shorter link

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