Mutual fund manager Bill Miller doesn’t act much like a typically cautious, value-focused stock investor. Sure, he considers whether a stock is priced far below what he thinks it’s worth. But unlike most value investors, that doesn’t stop him from exploring some high-risk areas of the market, even if that means enduring roller-coaster volatility.
Over his nearly four decades analyzing stocks, Miller’s unique value view has gotten him into trouble at times, especially during the 2007–2009 bear market, when his approach caused his fund at Legg Mason to crash. But before that, he racked up a 15-year record of beating the S&P 500 every year. And since the start of the current 10-year bull market, he has far outperformed that index, while most traditional value investors have lagged behind.
Here’s what Miller has learned from his successes and his failures in value investing that can benefit our readers…
How I Find Winners
For many investors, traditional value investing means hunting for the cheapest stocks using traditional metrics such as low price-to-earnings ratios (P/Es). It’s a less risky way of investing than chasing popular stocks because if a stock has plummeted, the company may need to show only modest improvements for the share price to perk up. The problem is that many cheap value stocks deserve to be cheap because they have limited potential for a turnaround.
I take a bolder, more eclectic approach. I don’t concentrate on P/Es as much as I focus on the following three questions…
Is it a solid business with strong free cash flow?
Does it have long-term growth potential that can produce a big turnaround?
Does the company have temporary problems that investors have misunderstood or overreacted to?
I need to have a lot of conviction before I invest in these types of value stocks because they can be prone to excessive volatility and tend to fall hard if the broad market takes a downturn.
Four Strategies I Use
• Take an all-cap approach. I go wherever I see a very large gap between how much a company is valued by most investors and how much I think it is worth. As a result, my portfolio owns some of the largest companies in the stock market, approaching a trillion dollars in market capitalization, but also small companies with market caps of a few hundred million dollars.
• Focus on industries where perceived risk is far greater than real risk. I often find my best investment ideas when an entire area of the stock market is in turmoil because of poor quarterly earnings, bad publicity, legal liabilities and/or other challenges and controversies. When investors flee a market niche, they dump the companies in that niche indiscriminately, even if some have brighter prospects than others. Examples of companies where perceived risk is far greater than real risk…
Drug manufacturers that sell prescription opioids. There are nearly 2,000 pending civil lawsuits brought by states and municipalities against a few dozen opioid drugmakers including Johnson & Johnson, which makes the fentanyl patch Duragesic, and Purdue Pharma, which makes OxyContin. The lawsuits contend that while the drugs were legal and sold to willing customers by doctors who overprescribed them, the companies downplayed the risk for addiction in their marketing and helped create a national epidemic. My favorite drug manufacturer now…
Teva Pharmaceutical Industries (TEVA) is the largest generic drug manufacturer in the world, with more than 3,500 medicines including the generic versions of the opioid painkillers Fentora and Actiq. Its stock price has plunged, in part, because of the opioid lawsuits. But the company has already settled out of court with one state, Oklahoma, for $85 million. And while it may wind up paying several billion dollars in other settlements, those costs will be amortized over many years and Teva can cover the payments with its massive amounts of cash flow, more than $2 billion annually.
Airlines. Historically, the industry has been plagued by high debt, labor strikes and serial bankruptcies. But since the end of the 2007–2009 recession, demand for air travel has boomed. Airline executives have run their businesses much more diligently, benefiting from long-term union contracts providing labor stability…higher revenues from once-free services such as checked bags…and reduced competition through mergers. Four airlines—American, Delta, Southwest and United—control about 75% of the US market. My favorite airline now…
Delta Airlines (DAL), one of the world’s largest and most profitable airlines, is the industry leader in on-time flights, making it a favorite for corporate travel. In the near-term, Delta has a significant advantage over competitors because it doesn’t have the grounded Boeing 737 MAX jet in its fleet.
• Factor in “black swans” when assessing investment risks. Black swans are worst-case political, economic and business scenarios that investors often ignore. They can cause value investors to misjudge the challenges that a company is actually facing and make big investing mistakes.
That happened to me in the 2007–2009 bear market with the former fund I ran, Legg Mason Capital Management Value Trust. As the stock market fell in 2007, I bought plummeting shares of major financial companies such as American International Group (AIG). I predicted that they would bounce back after the Federal Reserve cut interest rates to stimulate the economy and the calamity subsided. But I didn’t consider a far bleaker scenario that some analysts were predicting—the entire financial system had grown so shaky, due largely to the subprime mortgage crisis, that the US government had to bail out AIG and take control of the company. Its stock lost 97% of its value by the end of 2008.
What I do differently today: Instead of dismissing unlikely scenarios, I work them into my evaluation of an industry’s outlook. For instance, while oil and gas companies have tempted value investors for many years, I took seriously the possibility that the fracking boom would cause rapidly increasing energy production to outpace demand, restraining prices and hurting energy stocks, which is what happened.
• Look for powerful catalysts. I want to own stocks of misunderstood companies that have the potential for a robust multiyear rally. To do that, the companies need to have significant competitive advantages such as a dominant brand name or a bold business strategy. My favorite stocks with growth catalysts now…
ADT (ADT). The 140-year-old company provides monitored security for more than seven million residents and businesses in the US and Canada. It went public last year at $14 per share and has since fallen to about $5 per share because investors are worried about challenges from competitors offering much lower-priced install-it-yourself residential alarm systems that can be monitored with a smartphone.
My take: ADT stock is priced for minimal future growth as though it were a retail store going up against Amazon.com. In fact, its full-service customer support model will continue to see strong growth for commercial businesses. And on the residential side, older customers who tend to have more valuable possessions and are less tech-savvy don’t want to do their own home security, so they will continue to rely on companies such as ADT. With a 30% market share, ADT is by far the largest and most recognized player in a highly fragmented industry, growing revenues 6% to 8% a year and generating $500 million in free cash flow annually.
RH (RH), the upscale home furnishing chain previously called Restoration Hardware, began transforming its business model two years ago, rebranding itself as a high-priced luxury retailer with $8,000 Italian sofas and $900 table lamps. The company has turned about 90 of its stores into “design galleries,” expanding from about 7,000 to as much as 90,000 square feet. A half dozen of the galleries, including those in New York, Chicago and West Palm Beach, have been reconceived as social destinations with in-store barista bars and wine terraces to draw well-heeled customers. The new business model has lifted the company’s financial results, and I expect 20% annual revenue growth for the next five years.