By Ryan Fuhrmann, CFA
Below is Part 4 of a five-article write-up regarding legendary investor Bill Miller, CFA, during the 2006 Financial Analysts Seminar, hosted by the CFA Institute. Read through for a history of his career, current musings, and a number of stocks Mr. Miller currently finds interesting, as well as a comparison of his style to another legendary investor, John Neff, CFA, who also spoke at the conference.
Miller and his team calculate a discount rate for each firm, rather than relying on a general or average discount rate as a number of value investors do, including Warren Buffett. This includes a general adherence to calculating a cost of equity using a CAPM.
On a related note, it was interesting to learn that Miller is very interested in a firm’s capital structure and its subsequent ability to generate operating leverage. Since his primary focus is locating companies that return more than their cost of capital, Miller doesn’t mind if they use debt to expand rapidly, especially if a company is returning well above its cost of capital.
Implied rate of return
He then added that the name of the game is implied rate of return, or figuring out what type of growth is baked into a stock price versus what’s expected by the market. This includes calculating a company’s estimated free cash flow total return, a term coined by Miller, as far as I have found.
At The Motley Fool, we frequently discuss whether a stock is a value trap. Miller suggested that a value trap occurs when investors map a historical track record onto a future that will prove to be very different from a company’s past. Specifically, Miller avoids businesses whose fundamental economics have deteriorated and whose future returns on invested capital are permanently impaired by management’s inability to find compelling ways to allocate capital.
Miller believes that newspaper stocks fit the mold of “serious value traps” undergoing a secular decline in their businesses as advertising revenue moves to the Internet. Though he didn’t mention specific firms, some examples include larger operators such as Tribune(NYSE: TRB), Gannett(NYSE: GCI), or New York Times(NYSE: NYT).
As a contrast, he stated that because Eastman Kodak‘s (NYSE: EK) core business of film had quickly deteriorated as the industry embraced digital photography, management had no choice but to move to a new model rapidly. The problem with newspaper is that it is dying slowly, so it may be harder for managers to see the writing on the wall. Miller then told a recent story about when Warren Buffett asked a newspaper manager if his business would exist if the Internet had come first. The manager conceded that there was a real possibility it might not.
For further perspective, Miller highlighted that newspaper stocks are trading at eight to nine times EBITDA as their businesses are shrinking, while Sprint Nextel(NYSE: S) is trading at a similar multiple but still expanding its mobile phone business.
Miller explained a core reliance on DCF values, but also stressed the need to use models with more than one variable, or any model that will help him get a clearer picture of what a company is worth. This includes LBO models (which he’s using a lot these days, as are private equity shops) and comparative valuation models, as introduced by Professor Robert Parrino, who also spoke at the FAS seminar.
Miller believes that private equity shops are looking to the public markets because they’re finding compelling public valuations, and they still have access to attractive financing terms to make certain acquisitions. As an example, he referred to the recent acquisition of Petco(Nasdaq: PETC) at a 42% premium to its market value the day it was bought. He wondered about private equity guys’ belief they can make an excess return over their purchase price, or much more than the initial premium paid for Petco.
Fool contributor Ryan Fuhrmann has no financial interest in any company mentioned. The Fool has an ironclad disclosure policy. Feel free to email Ryan with feedback or to discuss any companies mentioned further.