Legg Mason’s Bill Miller talks with the Opportunist’s Managing Editor Leslie Stone about which market sectors he considers most promising, his stance on the U.S economy and where he sees the Dow and the NASDAQ by the end of the year.
Bill Miller is chairman and chief investment officer of LMM, LLC the advisor to the Legg Mason Opportunity Trust. During his tenure as sole manager of the Legg Mason Value Trust, the fund outperformed its S&P 500 benchmark index for 15 consecutive years. And just recently, the Legg Mason Opportunity Trust that he co-manages was ranked No. 1 in diversified stock funds by the Wall Street Journal. How does he achieve such stellar results? “There is a fair amount of luck involved in anything like that,” he says. “The late paleontologist Stephen Jay Gould wrote a piece on streaks in which he said that any long streak is typically a combination of skill and luck. From a practical standpoint, the environment created here at Legg Mason has helped our management team achieve its winning streak. It is certainly one that has allowed my colleagues and me to focus on long-term investing as opposed to short-term market moves. We are able to abstract away from all the emotions that drive the market day to day and focus on the value. Most places put pressure on people for short-term results. We believe you cannot get good long-term results from short-term thinking. I think our success comes from thinking rationally and abstracting away from short-term behavior in the market.”
Opportunist: The LMM Fund you co-manage with Samantha McLemore continues to seek ‘out of favor stocks.’ You have even gone on record as saying you prefer stocks with imperfections—‘warts … and all that kind of stuff’—as opposed to so-called media-darling stocks. You’ve had pretty good results. What do you see that others don’t?
Bill Miller: We tend to try and assess the underlying value of the business reflected in the stock price. The great value investor Sir John Templeton once told me that most people who are in the markets—and he meant about 90 percent—are outlook and trend investors, meaning they want to know what the outlook for the company is and what the stock trends are. That’s how they decide what they like. Only 10 percent are price and value investors, meaning we try to determine the value of the business and then see what price the market has put on that business.
Opportunist: How do you determine the value of these businesses?
Bill Miller: Well, the value of any business is the present value of the free cash flows it will generate in the future. It takes effort to determine and it’s not a precise number. There is a range, as the future is not knowable to any precise degree, and neither is the future discount rate, but both can be estimated. If the market values a company at $3 billion, for example, and we estimate the present value of the future free cash flows is $6 billion, then the stock is trading at half of what it’s worth. We try to find the gap between the perceived value today and long-term intrinsic value. A big gap is often caused by people’s fears and can be due to macroeconomic issues like credit disruption or rising interest rates or problems in Europe or it can be microeconomic issues involving companies that have problems. Tesla Motors, for example, was a company that people thought was in danger of going out of business, as Fisker Automotive recently did. Then Tesla’s stock went from $30 dollars to $120. The people who figured out at $30 a share it wasn’t going out of business made four times their money. Those paying $120 because the outlook and trends are better left a lot of money on the table. People see problems and think that is a reason not to invest. When we see problems we try to figure out if they are already reflected in the stock price. You pay a very high price for a cheery consensus and what people are excited about.
Opportunist: You were recently quoted in London’s Investment Adviser as saying you had 35 percent of your managed assets in financials. Are you bullish on that sector and, if so, why?
Bill Miller: When I say ‘bullish’ I mean it is mispriced, that people are too pessimistic about the outlook. Although financials have done well this year, we still believe the sector contains many attractive values that the market has not yet recognized, but will over the next few years. The recent rise in interest rates means they can expand their margins. Capital levels are far above what they were only a few years ago. Many of the companies have above average dividends and are buying back stock. Growth rates and dividend yields are above market, and P/E ratios are below market. It’s a combination of cheap valuation and improving externals and an improving economy that should lead them to outperform the market over the next several years.
Opportunist: What are your favorite market sectors?
Bill Miller: Housing is an area we like a lot. We were early into that and it really helped us last year when almost all housing stocks were up 100 percent. Most of those are underperforming today. That’s OK with us, though, because we are in that sector in a long cycle. In a long cycle, the stocks typically start out very cheap, and then go up a lot and fast as people recognize the cycle is turning. Then they pause and go to sleep and consolidate the gains for some months or more. Housing stocks are in that slumber period while the fundamentals of the sector are doing terrifically well. Eventually they will wake up again and continue to perform well. We think housing stocks may be good investments for years to come.
I also like the airlines, which up until recently were uninvestable. The economics of airlines have improved tremendously with the consolidation of the industry that has taken place the past few years. We think they will continue to outperform the market and so we have a big weighting in that sector. We like scattered technology names also and that’s a sector that selectively offers some opportunity.
Opportunist: What are some of your best-performing small-cap stocks?
Bill Miller: I don’t actually think about stocks in a sense of small or big cap or where people draw that line. This year, our best performing names include Netflix, which we bought at $60 in the fall and is now trading at $250. Netflix had a $3 billion market cap last fall and most people consider that small. Today it has a $14 billion cap, which is mid-cap to lower-end large cap or super mid-cap. Their stock is up 180 percent this year. In the small-cap range it would be MGIC Investment, which insures mortgages. Magic is up 127 percent year to date. Pandora Media, the Internet radio company, had a $1.5 billion cap in the fall and is $3 billion today. Pandora is up 112 percent so far this year. Best Buy was in the smaller cap range and it’s up 150 percent this year.
Opportunist: Some people have said that Best Buy’s days are numbered because it’s basically a showroom for Amazon. Do you agree?
Bill Miller: People got too pessimistic about their same store sales growth and thought that Amazon would crush them. They love to oversimplify things and make up things that comport with the way the stock market acts. Best Buy over the last several years—and even since the financial crisis—got as high as $40. In 2010 the stock was in the mid-forties and by 2012 it was $12. That’s a pretty big decline. Ordinarily, you wouldn’t see that in a retail company with the No. 1 market share in its category unless it was losing money. What was happening was same store sales weren’t growing and earnings were declining slightly, but the company never lost money. Even at $12 it was still earning 20 percent on equity, which is about 30 percent more than an average American company earns. People were saying things about it that didn’t really comport with the underlying reality.
Opportunist: Why were they saying those things?
Bill Miller: Amazon was growing rapidly and Best Buy wasn’t and they were losing market share to Amazon. But that’s a far cry from saying Amazon would put them out of business. When Walmart was in its high growth mode people were saying it would put everybody out of business. We own Amazon in the fund but it didn’t make any sense for Best Buy to be trading so low. We try to figure out where the market is misunderstanding the economic reality to companies.
Opportunist: Are you still a fan of Apple since its downward trend from a $700 per share peak?
Bill Miller: Apple is one of our favorite stocks. We were overweight Apple and then we started cutting back in the fall. When stocks are hitting all time heights and everybody loves them we are more likely than not going to sell. And when they go down to low levels we are going to be buying them. We sold a chunk of Apple in the $650 to $700 range and started buying it back when it was trading in the $427 to $430 range in the first quarter. We have been adding to our Apple position and believe it is worth about $650.
Opportunist: Do you see Tim Cook as the right person to lead Apple’s evolution into new products, or does the company need a new creative mastermind to join him?
Bill Miller: Tim Cook is doing a great job. Steve was more important in the early years, but Apple has always been more than one person. At its current size, market share and global scope it’s difficult for one person to determine its success or failure but it’s a creative company and I think we will see a lot of new products in the coming years.
Opportunist: You had a Top 10-weighting on Bank of America. What’s your take on their future, given their as yet unknown exposure to Countrywide losses and future losses pursuant to the Dept. of Justice’s Consent Decree last year?
Bill Miller: I don’t think the losses of Countrywide are unknown. Bank of America has more than adequately reserved for potential Countrywide losses and litigation risk together. We are seeing that they are releasing reserves on that, which shows me they are over-reserved and that is exactly what we thought would happen. The housing market is improving and housing stocks are the early beneficiaries. Bank of America may be matching the market this year or a little ahead or perhaps a smidge behind this year. We expect Bank of America will be one of the best performing financial stocks within the next 12 months and we find it very attractive.
Opportunist: Do you see the Fed Chairman’s comments on slowing quantitative easing in the third quarter as realistic due to the country’s continued long-term unemployment rate?
Bill Miller: This has been the most transparent Fed in history. But because it’s so transparent the market perversely focuses on minutiae more than usual. The Fed is very consistent and has said we will not see rate increases until unemployment was 6.5 percent and inflation was 2 percent or higher. Core inflation is about 1 percent, which is below their target. The thing about tapering is that it means going from $85 billion a month on purchases to something less. We don’t know what that less number is but it is less. The sort of consensus now is maybe it will begin in September. Recent employment numbers are good and that increases the odds of tapering. If tapering happens then, we will go from injecting the most liquidity into the market in the history of the U.S. to injecting the second most liquidity into the market in the history of the U.S. The Fed isn’t raising rates. The market is sending longer rates higher, thereby steepening the yield curve. That is usually bullish for stocks as long as rates do not go too high. Since the British and Europeans and Japanese are farther away from raising rates than we are, that is also bullish for the U.S. dollar.
Opportunist: There has been a tremendous withdrawal in the past few weeks from bond funds—even Pacific Investment Management Co. (PIMCO), the world’s largest bond investor, reported its worst month in years. Do you see these withdrawals going into equities?
Bill Miller: Eventually. I believe money will continue to flow out of bonds because we just finished the biggest bond market rally in history. Sure, we are seeing money coming out of PIMCO funds, but the fact is interest rates are rising and that will apply pressure. I don’t expect a big bear market in bonds, but the trend in interest rates longer-term is higher.
Opportunist: How will our country’s long-term debt affect the markets?
Bill Miller: I find the debt problem a non-problem. The Congressional Budget Office says our debt-to-GDP ratio is stable for the next five years at worst. I would expect our debt-to-GDP levels would be flat to declining.
Opportunist: How will rising interest rates—currently slightly above 4 percent on mortgages—affect housing and the stocks of homebuilders?
Bill Miller: Rising interest rates will affect the pricing of housing stocks—not the housing market—with moderately slower traffic in the short run. Housing affordability is about the best it has ever been, so the housing market itself will not be affected. We would need interest rates above 6 percent, assuming housing prices continue to rise. They are rising 10 percent year over year, so let’s call it rising 6 percent to 7 percent over the next few years. If you can borrow money at 4 percent and use it to buy an asset that is going up faster in price, you will do that all day long. So I see no real negative impact there.
Opportunist: What do you enjoy most about your work?
Bill Miller: It’s endlessly fascinating. The economy and the capital markets are among the most complex systems, so there’s always something for the intellectually curious to learn. You can study it all your life and still know little about it. The capital markets are driven by human behavior and practically everything that happens in the world—from a scientific, social or economic standpoint—can have an affect on them. Whether in high school, graduate school, or working full-time it was always a hobby for me to read the financial news and related books. I was fortunate to be able to turn an avocation into a vocation, which is something not many people get to do.
Opportunist: Where should young investors put money to save for a down payment on a home? And what is a good investment strategy for their retirement 30 years down the road?
Bill Miller: Saving for a home should just be done via savings accounts or other short-term instruments mostly. Stocks are the asset of choice for retirement 30 years down the road. The father of value investing, Benjamin Graham, said to never have more than 75 percent of your assets in common stocks. Right now, equities are the best-positioned asset class. Somebody with a 30-year horizon can take a much broader approach. I would put 25 percent in non-equities, emerging markets and high yield bonds.
Opportunist: Where do you see the Dow and the NASDAQ at the end of the year?
Bill Miller: Nobody can really call the market in the short run. The path of least resistance for stocks is higher, in my opinion, so the market could go up 5 percent during the second half of the year and send the Dow and the NASDAQ up 20 percent for the year. That is not unreasonable given the market’s current level, growth and interest rates. I think 20 percent for the whole year is a good, solid number.
Opportunist: As a fund manager and investor, what’s your greatest fear in the markets right now?
Bill Miller: Well, I think you’re always concerned about what you don’t know. Certainly what the British economist John Maynard Keynes regarded as unquantifiable, irreducible uncertainty is different from risk. That is the distinction people miss when they talk about risk management. They are really talking about uncertainty management. For example, if you’re insuring a car or a house you kind of know how many people will be in accidents, how many people will choke on a piece of meat or how many will be struck by lightning in any given year. You know approximately how many people will be involved but, of course, you don’t know who will be. I am more concerned about irreducible uncertainty. Let’s say we have a nuclear terrorist incident or some kind of severe weather that would disrupt crops globally, or even the unrest we are seeing in the Middle East—those are examples of irreducible uncertainty. Policy mistakes on the part of government, whether Israel is attacking Iran and bad regulation that disrupts the economy are all things that I am concerned about.
Opportunist: Do you believe America’s manufacturing base will ever be restored?
Bill Miller: The U.S. manufacturing base is actually reviving right now. It’s funny—and I’m not questioning the question; I’m questioning the broad talk about the manufacturing base being hollowed out for 20 years—that I have never been asked whether our agricultural base is ever coming back. In 1890 it was 97 percent; today it’s 3 percent. However, by my estimation, the ability to produce all of your food domestically is more important than the ability to produce shoes. We import all kinds of food but nobody is concerned about that. Is it really more important to have products manufactured here in the United States vs. Canada, Mexico or China? If manufacturers can make a profit here in the United States that’s great. If manufacturers aren’t making profits domestically, they should make their goods elsewhere. Manufacturing was 50 percent in the 1950s and yet the U.S. economy is much better off today. Our input costs for manufacturing are relatively low and our industrializing and robotics especially are making us a very productive labor force. If we can augment our efforts with automation, then manufacturing in the United States will find it increasingly attractive to keep plants here. It is more costly to move goods from China to the United States than it is from Peoria to Chicago, so manufacturing is likely to start growing again as a percent of our GDP. So, I think the outlook is actually very bright.
Opportunist: Where do you stand on the U.S. economy?
Bill Miller: The U.S. economy is very resilient. If we look back to the beginning of the year when people were worried about the fiscal cliff, payroll taxes and sequestration, we see that all those things have come and gone and the stock market is up 16 percent, growth estimates are higher and jobs numbers are well above expectation. Bonds yields are historically low and likely to gradually rise. I believe the economy will get stronger as the year goes on. The consensus is pointing to probably 2 percent to 2.5 percent—maybe even 3 percent—and the U.S. economy is certainly looking better than the rest of the world.
Leslie Stone is an award-winning writer/editor with more than two decades of experience covering business, finance and lifestyle issues for newspapers, magazines and online publications. Originally from Virginia, she currently resides in Florida. Follow her on Twitter at @les7989.