Insights from Bill Miller

One of the features of our StockInvestor newsletter is that I routinely publish detailed notes from our visits with management teams and fund managers that are of interest. Late last year, I and several other Morningstar analysts had the pleasure of spending an afternoon with Bill Miller, manager of several of  Legg Mason's  mutual funds, including the flagship Legg Mason Value Trust. Value Trust is, of course, most famous for beating the S&P 500's return for 15 years in a row (a streak that ended in 2006).

Though the streak is extremely impressive, it is worth noting that it is a fluke of statistics. If you look at any other trailing 12-month period other than December-end to December-end, the streak would have been broken long before 2006. Only 72% of the time has the fund beaten the S&P on a rolling trailing 12-month basis, so it's just highly coincidental that the periods of outperformance fell where they did. Like the baseball player who has the uncanny ability to hit a hot streak in October during the playoffs, one might call Miller "Mr. December."

I say this just to put the streak into perspective, not to minimize Miller's accomplishments. I would argue that one year is too short a timeframe to judge an investor's success or failure. And if you look at Miller's long-term performance, it's still worth every bit of admiration. Looking at the performance on a rolling five-year basis, Miller and his team have beaten the S&P 100% of the time with their fund.

Method to the Madness
Miller's thought process is very similar to what we use here at Morningstar. Though he can be considered a "value investor," some traditional "value" investors�those who only buy boring, slow-growth companies at incredibly cheap prices�have heart palpitations when they look at Miller's portfolio. According to Miller, any stock could be a value, as long as it trades at a discount to its intrinsic value. We agree.

Whether that means  America Online  and  Amazon (AMZN) in the late 1990s, or  Google (GOOG) in 2004, or  eBay (EBAY) and  IAC/InterActive (IACI) today, clearly Miller does not worry about the "value" title limiting where he invests. A company's growth rate is merely something to consider in the company valuation process, not a starting or limiting point when making decisions for the portfolios he runs. At the funds, Miller says that every decision they make is valuation-driven, not driven by macro forecasting. Much like with my own decision process in managing the Tortoise and Hare, the premium or discount to estimated intrinsic value is of primary importance.

The problem Miller sees with being forecast-based is that if one is wrong in a forecast, it does not help future decision making. For example, "I think hurricane season will be heavy this year, so I'm going to sell  Berkshire Hathaway (BRK.B)." Whether you are right or wrong in the forecast, your decision process does not improve over time. In other words, you don't learn much (if anything at all) from your mistakes. But if one is valuation based, each mistake has a lesson to be learned that can help hone in on a firm's fair value.

Plus, if you are forecast-based, there is no guarantee you'll make money from your successful macroeconomic forecasts. Miller used the example of  Altria (MO). In the mid-1970s, you could have made the projection that the number of smokers would dramatically decline in the United States. You could have also predicted a ban on advertising for smoking, first in television and later in print. In addition, you could have predicted huge lawsuit losses for the industry in the tens of billions of dollars. Finally, you could have predicted public smoking being outlawed in a large and growing number of jurisdictions.

If you had a crystal ball back then and could see all of these things coming true with perfect clarity over the next 30 years, it probably would have taken a gun to the head to make you invest in Altria knowing what you did. But if you had invested in Altria back in the 1970s, you would have purchased one of the absolute top-performing stocks of the generation. So not only does macro forecasting not improve your process over time, there are simply "too many links in the chain" to turn macro forecasts into actionable, profitable ideas. This discussion with Miller reinforced my thinking that here at StockInvestor, our dual focus on economic moats and valuation is a winning strategy.

One place Miller and I seem to differ is on the importance of company quality. I'm not certain I would ever invest in no-moat  Kodak  or  Sears  today, but Miller clearly sees something in each. I still think focusing on companies with wide moats is prudent�it adds another layer to the margin of safety and puts time on our side. After all, companies creating solid economic profits and earning returns above their cost of capital will tend to increase in intrinsic value over time, while those with no moats will tend to stagnate on this front.

And though Miller talked down the usefulness of macroeconomic forecasts, he had no shortage of predictions to make himself. Among them were the following:

• The dollar is in fine shape. As long as the "net worth" of the country grows more in any given period than the trade deficit in that period, the situation is sustainable and one does not need to worry.
• Since the Fed has paused in raising rates, it signals that the Fed thinks the economy is neither too hot nor too cold--it's just right.
• Since the interest-rate increases stopped over the summer, the market has been in a strong rally. One might view today similarly to 1995, when we were four to five years beyond the last recession, interest rates stopped increasing, and the market was in the early stages of a record run. He thinks 2007 will be a good year.
• The economic cycles as our parents knew them are probably a thing of the past. Over the past 25 years, the economy has only spent 15 months in recession. Instead of whiplashing between boom and bust, it may be more helpful to think of the economy today as cycling between fast (but not as fast as previous booms) growth at peaks and slow growth (but still growth) near the troughs.

I also had to laugh at the names Miller mentioned during the meeting: chatting economics with Ben Bernanke, discussing the housing market with Charlie Munger, phone calls with Steve Wynn on casinos, talking computer servers with Jeff Bezos, and so on. There is no doubt that being able to draw on the insight of the top minds in the world is part of Miller's advantage as an investor.

Seeing Patterns
One of the more interesting insights concerning how to look at stocks came when Miller explained how he and his staff like to use what he called "equivalent economic models." This means you take a young company and then look at a more mature company with a similar business model to see how the future might play out for the young company.

Two examples Miller used were to consider Amazon today and compare it with where  Dell  was in the early 1990s. Another example that came up in conversation was examining eBay in terms of where  Microsoft (MSFT) was 20 years ago. Obviously, the growth rates, profitability, and life cycles aren't going to be exactly the same between the young and mature companies, but I liked the idea of using history as a way to think about the future economic possibilities for any given company.

Seeing patterns and similarities is part of what drew me to  MasterCard (MA) earlier this year. The story was quite similar to what we had experienced with  Chicago Mercantile Exchange (CME) in the Hare Portfolio. At their public offerings, both companies had risks. For CME, it was the threat of European exchanges entering the market; for MasterCard, it was antitrust lawsuits. But thankfully, having the market overly focused on these risks created buying opportunities.

Other similarities include how both CME and MasterCard were transforming from nominally profitable co-ops run for the strategic business benefit of their owners to profit-focused entities. Both companies had very wide moats due to the network effect, had continued strong growth nearly guaranteed, and had copious amounts of operating leverage built into their business models. Combine all these, and you have a recipe for explosive profit growth. CME's earnings over the past year are fully triple what they were in 2003, and we are in the very early innings with MasterCard.

Dot Com Redux
Getting back to Miller, we also asked him what he thought the absolute best businesses were in terms of quality and competitive advantage, and he said Internet companies. (Is it any wonder some "value" purists consider Miller an outcast?). He pointed to the fact that the Internet seems to obey the power law of distribution. To boil power law down in this case: There are millions of Web sites, but only a small handful that have millions of customers.

Part of the reason, Miller explained, is that there is an enormous difference between barriers to entry and barriers to success on the Internet. Anyone with a couple thousand dollars can start a business on the Internet, but gaining the number of customers needed to be successful is a great challenge. Plus, Internet businesses that do beat the odds tend to be easily scalable with very high returns on incremental investment, which is another way of saying there is a great deal of potential operating leverage. Amazon, Google,  Yahoo , IAC/InterActive, and eBay are all top 20 holdings in Miller's Value Trust fund, while  Expedia (EXPE) is also part of the portfolio.

I wholeheartedly agree with Miller's assessment of Internet businesses here, which is why we have a number of them on the Bellwether Watchlist and/or in the Hare Portfolio. And while I have some trepidation about the valuation of Google at the moment, I do find Hare holdings IAC and eBay to be among the more attractive stocks in the portfolio today.

In all, meeting with Miller was a great experience, and taking the time to learn from successful investors is always a fruitful endeavor.

This article originally appeared in the December issue of StockInvestor.