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Bill Miller on Competitive Advantages in Investing

Early in April, Legg Mason’s Bill Miller spoke at the Columbia BusinessSchool before a Security Analysis class taught by his colleague at LeggMason, Michael Mauboussin. Below is an excerpt from the notes studentJohn Chew prepared following the talk.

Your Competitive Advantages in Choosing Investments

These slides are to give you illustrations of what you need to know whenoperating in capital markets. Mostly examples, things you shouldn’t be doing orexamples of how people go wrong in capital markets. If you eliminate theseerrors you will have a far better probability of being successful.

If you think about it, the only way to earn excess returns in capital markets is ifyou are exploiting some anomaly that is present, whether it is systemic ortemporary. You have to exploit some error the market is making. Coming at itdifferently, before you decide to make an investment to buy a company, youbetter have some sort of competitive advantage. And you have to figure out yourcompetitive advantage. If you can’t identify your competitive advantage infiguring it out, then you probably don’t have one.

I would say to you that there are probably three types of competitive advantagesthat you can bring to bear on the market:

1. An informational advantage2. An analytical advantage3. A psychological advantage

Here are examples of those. By the way, all the ones you are most likely toexploit are psychological.

We happen to manage money for several Middle Eastern governments. If Ihappen to go over to the Middle East and I sit down with the head honcho overthere and he says, “You know we are going to increase oil production by a factorof three in the next six months. We have all these fields coming on line in thenext six months. Nobody knows it, but it is going to happen. I thought youshould know that since you manage our money.” I have an informationaladvantage.

You know something that the market doesn’t know. Now the market is prettygood, so it doesn’t happen very often, but sometimes it does happen.

Then there is an analytical advantage. This means that you don’t know anythingthat the market doesn’t know, but you organize the information in a different way.The market says we know the following five things and roughly speaking you candisaggregate it. OK, you can say the market thinks this is most important, this is

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second most important, etc. Then you can shuffle these things around becausethere is a different thing going on here.

So that was the case, for example, mostly with Amazon.com and the otherInternet names that we owned. We didn’t know anything that anybody else didn’tknow. The company is very upfront – on every conference call they will say thesame thing. In the new annual report that they just released, the first line is “Wemanage for the present value of the future free cash flow per share." Sentencenumber one. They say that in every quarterly release.

They say we are managing towards a triple-digit return on capital. We aremanaging towards a double-digit operating margin. OK, so we now have a long-term economic model of their business, roughly speaking, and a little bit aboutwhat capital needs they have, but they will tell you that. Then you create a simplemodel which all comes down to sales growth and you can figure out what thisthing is worth. Fact is, most people don’t care about that, they care about whatnext quarter’s operating margin direction will be – up or down and by whatpercentage points. So the market has a totally different focus in Amazon andmost Internet names from what an investor does. Why? Because these aremomentum names, with a fast-turnover shareholder base. The interest is intrading, not investing; they are interested in stock price, not in value. So as along-term investor we can exploit that with an analytical advantage. As a long-term investor, we believe we know what they are worth.

One piece of advice for you, get to know the smartest people in your class,because their future cash flows will be really high. What I have tried to do overthe twenty-five years or so of doing this, is to talk to the smartest people I know.You get to know the people over time. You can sit down with a smart analyst orCFO and learn. For example, last week I sat down with the CFO of a companyand after an hour’s conversation I learned that they believe their stock is under-priced and I figured what their shares are worth and what their share buyback isgoing to do. And not because she told me anything she didn’t say publicly thenext day in a presentation. Because I know exactly how she thinks. I cantriangulate that stuff. I have an analytical advantage in using that information.

Lastly, the psychological advantages. In 1983, Bill Ruane was giving a talk at avalue investing conference. They asked him about what advice he would give tosomeone who wanted to learn about investing. He replied, “If you read BenGraham’s Security Analysis, that was everything you needed to know aboutinvesting up until the late 1950s, early 1960s. Then you read Warren Buffett’sannual shareholder letters. And if you understand those two things, then youunderstand everything you need to know about investing.”

I would say if you get to know what Michael [Mauboussin] teaches you, you willknow everything you need to know about investing. Or if you understand thequote that I am going to give you….

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“When we think about the future of the world we always have in mindwhere it would be if it continues to move as we see it moving now. Wedo not realize that it does not move in a straight line and that itsdirection changes constantly.” – Ludwig Wittgenstein.

This quote is at the top of every annual report of our fund. If you take this quoteto heart, then your default position in the market is that whatever you arecurrently experiencing in the market – high prices, low prices, making money orlosing money – is going to change. You can count on it. This is one of the fewclose to certainties that you can find. Because the market looks forward, becausethe market discounts, and because market prices reflect, in essence, the datarefracted through the decision procedures and emotions of investors, and then themarket will change as the world changes because it is incorporating newinformation.

There are two things that I tell our analysts. First, 100% of the information thatwe have about any company or any investment reflects the past. 100% of thevalue of that investment depends on the future. The real question is how the pastdata connects with the future. Think of how the future will be different than thepast.

Most people default to the directions and trends that they are currently observingor have been recently observing. When those things change dramatically, theysay, oh, things have changed. If they change subtly then it takes them a long timeto recognize the new trend. The important thing is that most things change. Theworld changes. In longer-term projections, Peter Bernstein says, that cone ofuncertainty gets wider as time goes out. An illustration of that is what if I say toyou, “What are the chances that IBM will be bankrupt tomorrow morning?”Probably none. A year from now? Five years from now? Or what about 100 yearsfrom now? The point being is that the possibilities increase as time horizon goesout.

So what you are trying to do as an investor is that you are trying to exploit the factthat [fewer] things will happen than can happen. So you are trying to figure outhow that probability distribution works and stay in the middle of what willhappen. The market has to worry about all the things that can happen.