QUALIPORT
Bill Miller: Consistently Beating The S&P

By Maynard Paton (TMFMayn)
July 22, 2002

By and large, professional fund managers tend to have a poor reputation. However, a few do stand out. Bill Miller is certainly among the industry's upper echelons. After Miller took charge of US mutual fund Legg Mason Value Trust in 1990, it's since recorded a 17.8% annual average return and has beaten the S&P 500 every single year. His methods are explained in the book The Man Who Beats The S&P: Investing With Bill Miller.

What's the secret?

So what's Miller's style?

"Our objective is to find companies where stock prices are depressed because of negative news or events, but where the value of the business is significantly higher than the current stock price. It has been our experience that the market often over-reacts to bad news, and that by looking beyond the next 12 months, we can find stocks that are undervalued... It almost always involves looking at companies that are controversial or out of favour."

The basics are what you'd expect from a market-beating investor: a long-term horizon, low turnover, relatively large portfolio holdings, a focus on value, an indifference to economic predictions and a penchant for business 'moats'.

Miller adopts a 'rigorous' process of qualitative and quantitative analysis to determine the potential value of each business. Some of the qualitative questions include:

*What is the potential profitability of the business model?
*What is the size of the potential market?
*What are the competitive advantages and disadvantages of the company and its products?
*How well has management allocated capital in the past, and what are the capital needs of the business under various scenarios?
*Does the company demonstrate a commitment to shareholders, or will future returns be diluted by such mechanisms as overly generous stock option plans?
*What are the depth, quality, experience and integrity of the management team?

Risk and reward

And what about the quantitative valuation side?

"Our definition of valuation comes right out of the textbooks: a business is worth the present value of its future free cash flows."

Miller's approach appears to be that of a traditional, 'old economy' investor. And indeed, Miller's present holdings includes the likes of General Motors (NYSE: GM), Bank One (NYSE: ONE) Toys R Us (NYSE: TOY), Eastman Kodak (NYSE: EK), Lloyds TSB (LSE: LLOY) and Tyco International (LSE: TYI).

However, what catapulted Miller into the mutual fund spotlight was his liking for technology shares:

"We believe and continue to believe that technology can be analysed on a business basis, that intrinsic value can be estimated, and that using a value approach in the tech sector is a competitive advantage in an area dominated by investors who focus exclusively, or mainly on growth, and often ignored by those who focus on value".

Value managers, Miller once said, "sound like Old Testament prophets". While investors such as Warren Buffet are constantly searching for certainty, Miller, on the other hand, is willing to risk huge losses if the potential reward is rich enough: "Most people try to maximize the number of times they're right. The real question is how much you make when you're right."

Tech

Miller believes that leading tech companies can have predictable 'business franchises' and are also able to be valued through discounted cash flow calculations:

"Look at tech -- Microsoft (Nasdaq: MSFT) has 90% of its market shares; Intel (Nasdaq: INTC) has 90%; Cisco Systems (Nasdaq: CSCO) has 80%. They dominate. This leads to a winner-takes-all situation in most markets. The technology may change, but market positions do not... It is no more difficult to analyse Dell Computer (Nasdaq: DELL) than Alcoa (NYSE: AA) or US Steel (NYSE: X)"

"We project cash flows out anywhere from five to ten years under a variety of scenarios... For new companies, we will use multiple scenarios with different end points, varying growth rates and a range of discount rates to get a sense of the risk/reward under different outcomes".

Such an attitude has led Miller to invest in Dell and AOL (now AOL Time Warner (NYSE: AOL)).

During 1996, Miller bought Dell stock when it traded at less than five times prospective earnings. At that time, investors had fled the sector due to worries over a cyclical downturn and the increasing cutthroat nature of the industry. However, Miller believed Dell's direct, low cost operating model meant it would -- in time -- become one of the industry's leaders:

"Because we analyse businesses, not historic stock P/E patterns, I was surprised to find that Dell was worth four times what we paid for it... based on our analysis of free cash flow and other factors, including a return on capital of 35%. Since then, the company's revenue growth has far exceeded what we projected. And return on capital rose in 18 months from 35% to 229% -- the highest in American industry. Now if it was worth four times the $1 [stock price] we paid, and subsequently became seven times more profitable, you can understand why we kept raising the value of the company".

AOL was another mid-1990s purchase. At the time, many thought it was on the verge of bankruptcy, the company hindered by poor service and questionable accounting. However, Miller realised AOL's fast growing customer base and then 40% market share would create a "network effect" of attracting more users down the line. Customer service was eventually sorted, the money rolled in and the rest is history.

Although Dell and AOL shares are well off their 2000 highs, both generated extremely handsome returns for Miller. Indeed, Miller had been trimming both holdings since 1999, with Dell sold in its entirety earlier this year.

Jungle

However, the jury's still out on Miller's Amazon (Nasdaq: AMZN) purchase. After initially buying the shares at $80 during 1999, Miller has gradually average down his position to $31 per share. The shares now stand at $15. But to Miller, the competitive similarities between Dell and Amazon are striking. Amazon has "incredible economies of scale, which will eventually become apparent. It doesn't have to keep inventory in stores, which is hugely expensive. So its cost of operations is much lower".

"If we're right," Miller declared in April 2001, "we think we'll make 50 times our money over ten years."

So far during 2002, Miller's Value Trust fund is lagging slightly against the market; down 24.3% versus a 22.6% fall for the S&P 500. Amazon could prove to be a real watershed in Miller's investment career. For the moment at least, huge winners like Dell and AOL appear to be the exception rather than the rule.

In addition, a bold prediction in his latest shareholder report, dated April 30th 2002, may cause Miller's market-beating run to soon come to an end: "I believe the attacks on September 11 catalysed a market bottom and that the bear market ended on September 21, 2001".

More: Legg Mason Value Trust | The Man Who Beats The S&P: Investing With Bill Miller | Bill Miller in Fortune magazine