One of our favorite investors at The Acquirer’s Multiple – Stock Screener is Bill Miller.
Miller served as the Chairman and Chief Investment Officer of Legg Mason Capital Management and is remembered for beating the S&P 500 Index for 15 straight years when he ran the Legg Mason Value Trust.
One of the best resources for investors are the Legg Mason Shareholder Letters. One of the best letters ever written by Miller was his Q4 2006 letter in which he discussed the end of his 15 year ‘winning streak’ and how too many investors miss the most important aspect of investing by focusing on value or growth. Miller writes, “The question is not growth or value, but where is the best value?” It’s a must read for all investors.
Here’s an excerpt from that letter:
Calendar year 2006 was the first year since I took over sole management of the Legg Mason Value Trust in the late fall of 1990 that the Fund trailed the return of the S&P 500. Those 15 consecutive years of outperformance led to a lot of publicity, commentary, and questions about “the streak,” with comparisons being made to Cal Ripken’s consecutive games played streak, or Joe DiMaggio’s hitting streak, or Greg Maddux’s 17 consecutive years with 15 or more wins, among others. Now that it is over, I thought shareholders might be interested in a few reflections on it, and on what significance, if any, it has.
A common question I’ve gotten is whether I am in some sense relieved that it is over. The answer is no. Active managers are paid to add value over what can be earned at low cost from passive investing, and failure to do that is failure.
We underperformed the S&P 500 in 2006 and did not add value for our clients and shareholders. It is little consolation that most mutual fund managers failed to beat the index in 2006, or that most managers of US large- capitalization stocks fail to outperform in most years, or that under 25% of them can outperform over long periods such as 10 years, or that the next longest streak among active managers going into 2006 – 8 years – also ended this year, or that it is believed that no one else has outperformed for 15 consecutive calendar years.
(1) We are paid to do a job and we didn’t do it this year, which is what the end of the streak means, and I am not at all happy or relieved about that. There was, of course, a lot of luck involved in the streak. It could hardly be otherwise, as the late Stephen Jay Gould pointed out in his analysis of Joe DiMaggio’s 56 game hitting streak. My colleague Michael Mauboussin applied some of Gould’s analysis to investing in Chapter 6 of his book More Than You Know. What are the chances it was 100% luck?
There are two broad ways to look at it, one involving a priori, and the other a posteriori, probabilities. If beating the market was purely random, like tossing a coin, then the odds of 15 consecutive years of beating it would be the same as the odds of tossing heads 15 times in a row: 1 in 215, or 1 in 32,768. Using the actual probabilities of beating the market in each of the years from 1991 to 2005 makes the number 1 in 2.3 million. So there was probably some skill involved. On the other hand, something with odds of 1 in 2.3 million happens to about 130 people per day in the US, so you never know.
Looking at the sources of our outperformance over those 15 years yields some observations that I think are applicable to investing generally. They fall into two broad categories, security analysis and portfolio construction. Analytically, we are value investors and our securities are chosen based on our assessment of intrinsic business value. Intrinsic business value is the present value of the future free cash flows of the business.
I want to stress that is THE definition of value, not MY definition of value. When some look at our portfolio and see high-multiple names such as Google residing there with low-multiple names such as Citigroup, they sometimes ask what my definition of value is, as if multiples of earnings or book value were all that was involved in valuation.
Valuation is inherently uncertain, since it involves the future. As I often remind our analysts, 100% of the information you have about a company represents the past, and 100% of the value depends on the future. There are some things you can say about the future with a probability approaching certainty, such as that Citi will make its next dividend payment, and some that are much iffier, such as that the present value of Google’s free cash flows exceeds
its current $150 billion market value.
Some value investors such as those at Ruane Cunniff have a high epistemic threshold and do exhaustive analysis to create near certainty, or at least very high conviction, about their investments. Others such as Marty Whitman take a credit-driven approach and ground their margin of safety by insisting on strong balance sheets or asset coverage. What unites all value investors is that valuation is the driving force in their analysis.
Trying to figure out the present value of the future free cash flows of a business involves a high degree of estimation error, and is highly sensitive to inputs, which is why we use every valuation methodology known to assess business value, and don’t just do discounted cash flow analysis.
We pay a great deal of attention to factors that historically have correlated with stock outperformance, such as free cash flow yield and significant stock repurchase activity. It all eventually comes down to expectations. Whether a company’s valuation looks low or high, if it is going to outperform, the market will have to revise its expectations upward.
Being valuation driven means that we minimize our exposure to the panoply of social psychological cognitive errors identified by the behavioral finance researchers. I think those are the source of the only enduring anomalies in an otherwise very efficient market, since they cannot be arbitraged away.
What we try to do is to take advantage of errors others make, usually because they are too short-term oriented, or they react to dramatic events, or they overestimate the impact of events, and so on. Usually that involves buying things other people hate, like Kodak, or that they think will never conquer their problems, like Sprint. Sometimes it involves owning things people don’t understand properly, such as Amazon, where investors wrongly believe today’s low operating margins are going to be the norm for years.
It is trying to invest long-term in a short-term world, and being contrarian when conformity is more comfortable, and being willing to court controversy and be wrong, that has helped us outperform. “Don’t you read the papers?” one exasperated client asked us after we bought a stock that was embroiled in scandal. As I also like to remind our analysts, if it’s in the papers, it’s in the price. The market does reflect the available information, as the professors tell us. But just as the funhouse mirrors don’t always accurately reflect your weight, the markets don’t always accurately reflect that information. Usually they are too pessimistic when it is bad, and too optimistic when it is good.
So grounding our security analysis on valuation, and trying to abstract away from the sorts of emotionally driven decisions that may motivate others, are what leads to the stocks that we own, and it is the performance of those stocks that has led to our performance.