Bill Miller's 4th Quarter Commentary 2003
Mulligan
The title of this piece does not refer to my friend Richard Mulligan, Mallinckrodt Professor of Genetics at Harvard Medical School, and recipient of a MacArthur "genius" award for his work on retroviral vectors. His research is fascinating, and underpins a holding in one of our funds, but the term "mulligan" in the title refers to golf.
I haven't played golf in probably 20 years. Growing up in Florida, I learned and played till I went to graduate school, where lack of ability to pay green's fees ended my golfing days. By the time I had the resources to play again, business and family responsibilities intruded. Golf takes a lot of time, and I was reminded of Bill Bradley's comment about why he practiced basketball so much. He said he figured when he wasn't practicing, somewhere, someone was, and when they met, that person would win. I have the same view about the stock market. This is not a business where ignorance is an asset; the more you work at it, the better you ought to be, other things equal. Doesn't leave a lot of time for golf.
Now that our kids are away from home, some extra time is available. I promised my wife I would take lessons with her, and we could putter around on the course together. But she has inexplicably taken up bridge, and now spends her time taking lessons and studying bridge tomes. There are more of those than there are study materials for the CFA. Cards are too complicated for me. I am somewhat heartened by Warren Buffett's apparent bridge addiction. When he is playing, he is not studying companies, which gives the rest of us a chance.
"Mulligan" in golf refers to a second shot you can take without penalty. Like a second chance to correct a mistake; a do-over. I think I may have a mulligan with eBay.
I feel really dumb about eBay. I serve on a board with Pierre Omidyar, the founder of eBay, so it's not like I never had the opportunity to get the picture from the one who created it. Pierre gave a talk in Santa Fe a few years back about how he conceptualized the business, what its history was, how it was a self-organizing system, and so on. The stock was a lot lower then.
We bought our initial position after I spent some time with Meg Whitman, the CEO. She is very smart, thoughtful, low key, and has done a great job. I realized then that there was a description problem with eBay, similar to the one that used to plague Dell. Most people think of eBay as an auction site, although almost 30% of their business is fixed price. It took a long time before people stopped thinking of Dell as a company that sold mail order computers.
Descriptions matter. In the area the professors call support theory, which is related to prospect theory, which is what Dan Kahneman won the Nobel Prize for, it has been noted that probabilities attach to descriptions of events, and not to the events themselves. Most investors do not adequately distinguish between, for example, a company and their description of that company. Investors whose description of Amazon.com was that it was a money losing company with a bad business model made a very different assessment of its probable investment merits from those whose description centered on its customer loyalty and potential to generate significant free cash flow at scale.
Investing is about making decisions with your money. All of those decisions are probabilistic. As former Treasury Secretary (and maybe future Chairman of the Fed) Robert Rubin emphasizes in his new book, there is no certainty-except uncertainty-and decision procedures need to reflect that. In a recent speech, Fed Chairman Greenspan makes much the same point, and elaborates on the difference between the most likely outcome and low probability but high impact outcomes.
Decision procedures and outcomes also need to be clearly distinguished. A decision is not bad or wrong because the outcome turns out badly. And a good decision is not the same as one that turns out well. A decision is bad if the process that engendered it was bad, regardless of the outcome. Bad outcomes-losing a lot of money in an investment-can happen even if the process is sound; and good outcomes can occur even if the process is lousy. A market that is mostly efficient can distribute outcomes all over the place.
Thinking about poor decisions, those that result from bad reasoning, is useful. Decisions such as our buying Dell and Amazon on the IPO and selling them because they went up a lot and looked expensive: those were bad decisions. Not because Dell is, oh, almost a 400 bagger in the 15 or so years since it came public; or bubble and all, the buy and hold investor of Amazon is up about 40 times since the 1997 IPO. They were bad decisions because looking expensive and being expensive are not the same thing.
As with most things in our business, Warren Buffett figured this out a long time ago, paying historically high valuations for Coke back in the 80's, then making 10 times his money on it. I remember puzzling over his purchase until I realized Coke had experienced a very sharp increase in its return on capital, and could probably sustain that return. If so, time and compounding would take care of the seeming premium price being paid.
I then promptly forgot the lesson and, as proof of that, in 1990 wrote a really stupid piece about how expensive Microsoft was, comparing it unfavorably to Ryoei Saito's purchase of Van Gogh's Portrait of Dr. Gachet ($82.5 million), which at least had the quality of scarcity going for it.
Microsoft then had a market capitalization of around $8 billion, and looked expensive on most metrics value investors use to assess value. Today it has a market value of over $300 billion, and has more free cash flow every 8 months than its $8 billion of market value in 1990. Microsoft looked expensive, but in fact was a bargain.
Microsoft, of course, is an exception. Most companies that sport lofty valuations fail to generate results that justify them. Today's New York Times has an article referring to an academic study that shows "companies trading at high price-to-earnings ratios almost never grow as quickly as they need to justify their high valuations." I read the study when it was published in the Journal of Finance last April, and you should too, if you care about valuation. What is fascinating about the article, though, is the stock they chose to illustrate the point: eBay. My favorite part of the article is this:
Professor Lakonishok has not studied eBay's business in particular [b]ut, he said, "[b]ased on the experience of US companies over the last 50 years, the probability that a large company will achieve such a growth rate is probably not higher than winning the lottery."
I have studied eBay's business in particular, and I rate the odds considerably higher; not that any large company will achieve such a growth rate, but that this one will. The pay-off in the lottery is huge compared to the amount wagered, which is why the odds are so bad. What is the pay-off in eBay?
EBay has about the same revenues Microsoft did when I wrote my spectacularly wrong assessment of it. Here are some more numbers that you may find interesting:
As you can see, the economics of the two companies are remarkably similar, at a similar stage of growth. It was clear then that Microsoft had exceptional economics, as is the case with eBay now. There are two salient differences between the companies. First, eBay is roughly twice as expensive today as Microsoft was in 1991. Second, eBay is a natural monopoly that is unlikely ever to face serious competition. I once heard Bill Gates say that whenever people told him Microsoft had too much cash when they had 10 or $20 billion on the balance sheet, he knew they did not understand how risky Microsoft's business really was. EBay has far less business risk than Microsoft does.
On the surface, eBay appears to be a lot more expensive now than Microsoft was then, but in 1991, interest rates were well over 8%. With 10-year bond rates now only half that, valuations should be a lot higher, so the discrepancy is not as great as it appears, adjusted for today's interest rates.
As to growth rates, eBay's has exceeded that of Microsoft when matched on a similar scale. There are some slides on eBay's web site that are instructive on this topic, for those who care.
The question on eBay is simple: how long will the growth continue, and at what rate? That will determine whether it is like Microsoft in 1990, a bargain, or like most companies with high expected growth rates, a dud. Part of the answer lies in the description.
What is eBay's business? If it is an auction site where individuals, mostly, sell unwanted items; sort of like an internet enabled flea market, then it probably is fully priced. That is not how the company describes its business, though. Here is their description of what they do: "We make inefficient markets efficient." For those who can size markets, that is all you need to know, if you believe it.
I got Microsoft totally wrong in 1990. It was a great value, and no value investors owned it. It looked expensive; it wasn't. EBay looks expensive too. Mulligan.
- Bill Miller
January 25, 2004
In An Uncertain World: Tough Choices from Wall Street to Washington, Robert E. Rubin and Jacob Weisberg (Random House, 2003). Risks and Uncertainty in Monetary Policy, Alan Greenspan (January 3, 2004).
As of 12/31/03, the percentage of holdings in the Value Trust of the companies mentioned were as follows: eBay Inc. 1.53%, Dell Inc. 0.00%, Amazon.com, Inc. 8.34%, The Coca-Cola Company 0.00%, Microsoft Corporation 0.00%. The portfolio breakdown is subject to change.
"That Five-Year Forecast Looks Great, or Does It?", Mark Hulbert, The New York Times (January 25, 2004).
Chan, L., Karceski, J., & Lakonishok, J. 2003. "The Level and Persistence of Growth Rates." Journal of Finance, 58: 643-684.
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