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Aug 04, 2016

Our Valuation-Based Investment Approach

Bill Miller

An excerpt from Bill Miller’s recent interview with John Rotonti, analyst with The Motley Fool.

John Rotonti: How do you define a growth company?

Bill Miller: When we refer to a growth company, we typically refer to growth of revenues. Over the long term, the expectation is that revenue growth will translate into growth in profits and free cash flow. The value of any investment is the present value of future free cash flows, so that is ultimately of the most importance to us. It's important to note that growth does not always create value. A company can grow, but if it doesn't earn above the cost of capital, that growth destroys value. In order for growth to create value, a company must earn returns above its cost of capital.

Rotonti: Would you rather invest in a company that is reinvesting most or all of its earnings into growth or in one that can both grow and return cash to shareholders through dividends and buybacks?

Miller: We prefer to see companies make these capital allocation decisions with an objective of maximizing the present value of free cash flows. If a company can invest in its business and earn returns in excess of the cost of capital, it should usually do that. If a company returns cash to shareholders in the form of dividends, that capital earns the market return. If a company buys back stock, the return depends on whether the stock is under, over or fairly valued. We typically like to see a management team that makes these decisions rationally and quantitatively. If the return on buying back stock is greater than what a company can earn investing in its business, buying back stock makes sense. Managements tend to be, and should be, optimistic about their business, so we do our own work on whether management projections and assumptions are reasonable.

Rotonti: What common characteristics or patterns do you recognize in some of your biggest winners?

Miller: The major commonality among our biggest winners is a starting point of low expectations. A stock's performance depends on fundamentals relative to expectations. For big winners, the gap between how a company actually performs and how it's expected to perform is the widest. Our biggest winners tend to be companies that continue to compound value over many years as well, like Amazon, Inc. (AMZN).

Rotonti: What lessons did you learn or patterns did you recognize from some of your losers?

Miller: We always look for low expectations. With our biggest losers, we thought expectations were too low when in fact they weren'tÍž they were too high. Typically, this happens when business fundamentals deteriorate for one reason or another.

Rotonti: How should value investors try to avoid value traps?

Miller: One change we made a few years ago after an exhaustive review of our performance to understand how we could improve was to sell more quickly when fundamentals deteriorate. Value traps look cheap, but they aren't actually cheap because underlying fundamentals continue to erode over time. Market prices adjust downward as fundamentals deteriorate. Typically, in the short term, especially in this risk averse market, the negative stock reaction overdoes what is justified by the fundamentals. However, when a company serially disappoints, the intrinsic business value is usually dropping. This is when you can make a big mistake. For this reason, we are quicker to exit on the back of disappointing fundamentals in order to protect against losing a lot of money.

Rotonti: What goes on at the Santa Fe Institute and what you have learned from your time there?

Miller: I have been involved with the Santa Fe Institute, one of the world's leading scientific research institutions, since the early '90s. The Santa Fe Institute's research focus is on complex adaptive systems such as the stock market, the economy, cultures, the immune system, evolution, and so on. Our involvement gives us the opportunity to sit down with Nobel Prize winners in physics and economics, and with historians, biologists, and computer scientists to get a broad look at the issues on which they are working. It also provides a diversity of perspective the firm has found valuable as it thinks about the investment landscape. Investing is an idea business, so having access to diverse and leading edge ideas provides great insight.

Read the full interview here.

Any views expressed are subject to change at any time, 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, and there is no guarantee dividends will be paid or continued.

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