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Dec 27, 2016

Bill Miller's Interview with The Investors Podcast

Bill Miller

Bill Miller joins Preston Pysh and Stig Brodersen on episode 117 of The Investors Podcast to talk about determining intrinsic value, the state of markets and how we look at names like Amazon and Apple. 

Listen to the full interview:

Here's an excerpt:

Stig Brodersen: We feel that one of the best ways to discover value in the market is filtering results based on a ratio of EBIT versus Enterprise Value. What are your thoughts on this and do you perhaps have better means for looking across a broad range of securities and sectors to find value investing gems?

Bill Miller: I think that is very sensible. Every screening technique has pluses and minuses. What Enterprise Value versus EBITDA does is get stocks in the right order from the cheapest to the most expensive, and then you can make adjustments based on the balance sheet, leverage or after tax adjusting, EBIT, for example. I think it’s a good solid way to approach things.

Preston Pysh: Where would you look for risk mitigation after getting a fair price? What would you be looking at to pin down that you’re not entering a value trap at that point?

Miller: We don’t use that as a screening technique, for a variety of reasons. The one that we find most useful for ourselves is free cash flow yield. We find stocks that have a high free cash flow yield relative to the market, which is at about 5.5%-6% right now. We don’t typically get interested in stocks unless they are at about 9- 10%. Then we have to look at free cash flow yield normalization - why is the free cash flow yield so high here and is it because the company needs to ramp up their capital spending program, or because return on capital is dropping and the business is getting worse. There are all kinds of different reasons and this gives us a filter to compare. We look at sustainability because our view is that everything is priced off of the risk-free rate. There is the risk-free rate, equity risk premium, median free cash flow yield of the whole market and outliers in play. And then the question is, are they justified? Is it likely to revert to the mean over time or go below that.

Pysh: To clarify, are you taking a conservative approach for estimating free cash flow and then comparing those payments to the current market price to determine the corresponding discount rate?

Miller: Partly. We also use free cash flow total return. In essence, if you take a company like Amazon, who historically tends to trade at around 2-3% free cash flow yield, but it is growing its free cash flow at 30% a year. That’s a 33% free cash flow total return, which kills the market. The question is can they sustain that? This forces you to think long term.

Pysh: Would you agree with the approach of looking at top-line revenue opposed to other elements that are lower on the income statement when trying to understand the valuation of growth companies like Amazon?

Miller: Absolutely – If you look at the old Dupont formula to aggregate the source of returns. Simplifying it, if you earn above your cost of capital with other things equal in that formula, the revenue growth rate represents the growth of value in the underlying business. So, the faster the revenue growth, the greater the value appreciates. If you look at Amazon, a great example, in the late 1990s, they had a high growth rate, and then we had the bust. They had to focus on the balance sheet at the time because they weren’t profitable, and they had to slow down the growth rate significantly, which made the stock collapse. Then, as the growth rate came back up, the stock followed.

But every company is somewhat different. With Amazon, for example, we performed a regression on about 200 variables against each other to see what really was correlated to Amazon’s stock price. And, as you might expect, it isn’t GAAP earnings, free cash flow even. It was growth of gross profit dollars. That was a really interesting thing and something we suspected. Jeff Bezos made a comment about 15 years ago that he wasn’t focused on margin, but on growth of gross profit dollars. Lo and behold, that had a 95% correlation with Amazon’s stock price. This makes perfect sense because gross profits, in essence, is the cash they had to work with after costs of goods sold. Everything they did with that cash was “an investment”. If the aggregate for those things was earning above the cost of capital, then that was a perfect correlation.

Pysh: A lot of people do not understand that in GAAP accounting, some things are not necessarily listed in the balance sheets. They are getting costed out on the income statement and not capitalized onto the balance sheet.

Miller: One of the most interesting things about that is when people talk about Amazon never making any money, well now they make money, but it trades at stupid multiples, is that we’ve seen this movie before with John Malone and the cable business. If you invested with John Malone when he first took over TCI and sold the stock when he sold them to AT&T, you made 900 times your money with him and he never reported a profit, ever. This happened because he created a lot of value, it just wasn’t showing up in normal GAAP accounting profits.

The views expressed in this report reflect those of the LMM LLC (LMM) strategy’s portfolio manager(s) as of the date published. Any views are subject to change at any time based on market or other conditions, and LMM disclaims any responsibility to update such views. The information presented should not be considered a recommendation to purchase or sell any security and should not be relied upon as investment advice. It should not be assumed that any purchase or sale decisions will be profitable or will equal the performance of any security mentioned. Past performance is no guarantee of future results.

©2016 LMM LLC. LMM LLC is owned by Bill Miller and Legg Mason, Inc.