Bill Miller on Competitive Advantage

In April, Bill Miller (Legg Mason) spoke before a Security Analysis class (at the Columbia Business School) taught by his colleague at Legg Mason, Michael Mauboussin. Below is an excerpt from the notes student, John Chew, prepared following the talk.

David
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Your Competitive Advantages in Choosing Investments

These slides are to give you illustrations of what you need to know when operating in capital markets. Mostly examples, things you shouldn't be doing or examples of how people go wrong in capital markets. If you eliminate these errors 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 if you are exploiting some anomaly that is present, whether it is systemic or temporary. You have to exploit some error the market is then making.

Coming at it differently, before you decide to make an investment to buy a company, you better have some sort of competitive advantage. And you have to figure out your competitive advantage. If you can't identify your competitive advantage in figuring 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 advantage
2. An analytical advantage
3. A psychological advantage

Here are examples of those. (By the way, most of the ones you are likely to exploit are psychological.)

We happen to manage money for several Middle Eastern governments. If I happen to go over to the Middle East and I sit down with the head honcho over there and he says, "You know we are going to increase oil production by a factor of three in the next six months. We have all these fields coming on line in the next six months. Nobody knows it, but it is going to happen. I thought you should know that since you manage our money." I have an informational advantage. You know something that the market doesn't know. Now the market is pretty good, so this doesn't happen very often, but sometimes it does happen.

Then there is an analytical advantage. This means that you don't know anything that 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 can disaggregate it. OK, you can say the market thinks this is most important, this is second most important, etc. Then you can shuffle these things around because there is a different thing going on here. That was the case, for example, mostly with Amazon.com and the other Internet names that we owned. We didn't know anything that anybody else didn't know. The company is very upfront - on every conference call they will say the same thing. In the new annual report that they just released, the first line is "We manage for the present value of the future free cash flow per share." Sentence number one. They say that in every quarterly release. They say we are managing towards a triple-digit return on capital. We are managing 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 about what capital needs they have, but they will tell you that. Then you create a simple model which all comes down to sales growth and you can figure out what this thing is worth. Fact is, most people don't care about that, they care about what next quarter's operating margin direction will be - up or down and by what percentage points. So the market has a totally different focus in Amazon and most Internet names from what an investor does. Why? Because these are momentum names, with a fast-turnover shareholder base. The interest is in trading, not investing; they are interested in stock price, not in value. As a long-term investors, we can exploit this 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 over the 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 or CFO and learn. For example, last week I sat down with the CFO of a company and after an hour's conversation I learned that they believe their stock is underpriced and I figured what their shares are worth and what their share buyback is going to do. And not because she told me anything she didn't say publicly the next day in a presentation. Because I know exactly how she thinks. I can triangulate that stuff. I have an analytical advantage in using that information.

Lastly, the psychological advantages. In 1983, Bill Ruane was giving a talk at a value investing conference. They asked him about what advice he would give to someone who wanted to learn about investing. He replied, "If you read Ben Graham's Security Analysis, that was everything you needed to know about investing up until the late 1950s, early 1960s. Then you read Warren Buffett's annual shareholder letters. And if you understand those two things, then you understand everything you need to know about investing." I would say if you get to know what Michael [Mauboussin] teaches you, you will know everything you need to know about investing. Or if you understand the quote that I am going to give you...

"When we think about the future of the world we always have in mind where it would be if it continues to move as we see it moving now. We do not realize that it does not move in a straight line and that its direction changes constantly." -- Ludwig Wittgenstein

This quote is at the top of every annual report of our fund. If you take this quote to heart, then your default position in the market is that whatever you are currently experiencing in the market - high prices, low prices, making money or losing money - is going to change. You can count on it. This is one of the few close to certainties that you can find. Because the market looks forward, because the market discounts, and because market prices reflect, in essence, the data refracted through the decision procedures and emotions of investors, and then the market will change as the world changes because it is incorporating new information.

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

Most people default to the directions and trends that they are currently observing or have been recently observing. When those things change dramatically, they say, oh, things have changed. If they change subtly then it takes them a long time to recognize the new trend. The important thing is that most things change. The world changes. In longer-term projections, Peter Bernstein says, that cone of uncertainty gets wider as time goes out. An illustration of that is what if I say to you, "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 years from now? The point being is that the possibilities increase as the time horizon extends out.

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