Jeremy Miller has cut his teeth in the world of stock markets, starting off as a product manager in Credit Suisse First Boston, then moving over to the research side at Bank of America and Nomura. He now works for a top mutual fund company in America. Miller’s Warren Buffett’s Ground Rules that assimilates Buffett’s partnership letters theme-wise got accolades from none other than Buffett himself, who recommended the book in his annual letter this year. Within a couple hours of Buffett putting out the letter, the book’s ranking shot up from 2.5 million-odd to 2000-odd in the Amazon Best Sellers Rank. Soaring sales of the book is perhaps a very small reward compared with the amount of wisdom Miller gained in the process and his ecstatic experience of meeting the “Oracle of Omaha”. Sitting in the cafeteria of his iconic office building in Midtown Manhattan, Miller elucidates his insights.
Value investing either rings a bell for people or it doesn’t. I don’t know how and when I got to know about it, but I ferociously read everything I could get my hands on right from Warren Buffett’s letters to all his books. In 2007, I started going to the Berkshire annual meetings. At one dinner, I heard about the partnership letters and I got my hands on those. That was a trove of gold. Buffett’s partnership was set up like a hedge fund, very nimble and unconstrained by size. I just looked around if there was a book that was written on this and found none, so I thought I will put it together as a note. It was not at all intended to be a book, but eventually it turned out that way. Of course, through the process, my belief and understanding of value investing has only grown.
>>> Did you have any notions about investing that changed after you wrote this book?
The overarching one is really a concept that Buffett talked about in this year’s meeting, which is the idea that business is just a pile of capital. Often, we get wedded to being “in a business” versus being “in business.” He really expressed a deep understanding of the fungibility of capital. So, capital can be in the form of financial capital such as stocks or bonds or business capital in the form of working capital and so on. He was very astute in understanding that a stock is the conduit through which you own the assets of the business and if needed, they should be transferred or redeployed to higher and better use. In the case of Dempster Mill, he realised that the excess inventory delivering low return could be turned back into cash and redeployed into securities. The capital was misallocated and he reallocated it to better use. Companies have a fixed amount of capital, and the CEO’s job is to redeploy capital to get the maximum benefit. That is something I did not appreciate nearly as much as I do now. Investing in stocks, and being in business is the same thing — there is a semantic difference but practically it’s one and the same.
>>> How does this manifest in your approach?
This thinking ties the income statement to the balance sheet. Earnings for earnings sake is meaningless without the context of capital needed to produce the earnings. Wall Street is obsessed with the income statement. What differentiates this approach is that first we get to understand that there’s plenty that we have no idea about — the macros, the interest rates, the business cycle, the dollar etc. So one should give up on that. The trick is to find companies that understand their job is to deploy capital at the highest rate incrementally, so that the return on capital is optimised. If you invest in companies with a history of deploying and redeploying capital well, you will end up doing well.
>>> Did you face any challenge in understanding or interpreting any of the letters? Or did you find any of your biases getting in the way?
My aim was to write the book with the assumption that Buffett was looking over my shoulder. I had his permission to write it, of course, but he said he would not help. His language is simple, which made it easy. But the concepts are not easy, so trying to live up to Buffett’s simplicity while relaying the ideas was the biggest challenge. In terms of biases, the thing is that you don’t know they are there. But in retrospect, there is nothing that I feel that does not stand up to scrutiny. It’s still early though, I am sure I’ll find some eventually!
>>> What concepts did you find complex to comprehend?
If there was a question on whether you should be in cigar butts, mimicking the way Buffett was acting in early part of the career or in quality compounders like he is now, there was a bias on my part to say you should use Buffett from 1960s because that’s what my book was about. But the answer to that really is that it depends — it depends on your own framework, your individual set of talent and emotional fortitude and so on. I read Tobias Carlisle’s Deep Value, which makes a strong case for following Ben Graham as against Warren Buffett, while Tom Gayner (Markel Corporation) can give you a compelling argument about why you may be right only 10% of the time in quality compounders, but still you’ll do wonderfully well because the ones that work will make up for the rest. On both sides, you have compelling arguments. You see Buffett has migrated from one style to another, but that does not mean one was better than the other, it was just better for him at that point in time.
Does it not become a question of time then — Benjamin Graham’s strategy was the best for his times, but today when the market is trading at such a high valuation, you can’t hope to find Graham-type stocks…The eighties, of course, was a great time to bet on quality compounders in America given the secular growth in the economy for the next many years...
Yes, to a degree. But it need not be either-or. I own Berkshire Hathaway and I also own Nam Tai, a micro-cap net-net. I can do both. Both tend to be more readily available at cyclical lows and become harder to find at the extended phase of a bull run. If you looked at the value of the business, and then saw the price and found it significantly lower, it’s a good opportunity — whichever way you look at it. After all, intrinsic value is intrinsic value and market price is market price.
>>> Can you share some Buffett concepts that you found particularly useful?
Lots, right from the concept of compounding. The concept of Mr. Market by Graham, where he alludes to the fact that the market is to serve you, not the other way round. And then, stocks are not a piece of paper to be traded but piece of assets of the business you own. In the short term, the market is a function of supply and demand, which is a function of emotions. As we move out 3-5 years, the change in value of the stock is likely to be highly correlated to the change in book equity of the business, adjusting for net buyback/net change in share and dividends. Over that time frame, the stock will do what the business does, unless you buy when the stock is highly overvalued or undervalued. The longer you own the stock, the more closer it will track the business.
The concept of risk that Buffett talks about in the partnership letters and beyond is truly timeless. It’s different from mainstream thinking. Most would say that risk means beta or the amount the stock swings every single day. Buffett, on the contrary, says, risk is not knowing what you are doing. If you do not understand the company, what it is doing and what it is worth, you will no doubt get spooked if the stock goes down. That leads to another piece, which is the circle of competence. You have to confine yourself to areas that you truly understand and not try fishing across many sectors.
>>> Given that the context has changed so much from Buffett’s partnership days — the macro part, the efficiency of markets, the kind of players today, do you see any aspect that is no longer relevant?
The most remarkable thing is that there is really nothing that Buffett has gone back and revised or said, I no longer think that way. In fact, he has evolved and expanded the concepts. The letters he wrote 25 years ago, you can’t question the validity of those letters even today. It shows the degree to which he had mastered investing at that young age. The reason Buffett’s approach is timeless is because it is based on principles. These are intended to be relevant in all kinds of markets. These are not tactics that work in just one type of market situation.
>>> The famous article he wrote in Fortune magazine on the impact of interest rates on GDP, corporate earnings and valuation…In today’s context, when the interest rate is negative, it will appear as though stocks are incredibly cheap. But that’s probably not the case. How do you explain this conundrum?
When he wrote about interest rates in the Fortune magazine article back in 1977, he made the argument that the dynamics of capitalism being what they are, the long-term equilibrium RoE is going to range between 12-14%. You can see the figures and it has been quite accurate. The market is going to have a discount rate — it can be disaggregated between expected rate of inflation and the real growth rate of the economy or for the business.
If you talk about the market as a whole, the economy is going to grow at a certain rate and there is going to be some inflation, both together should equal the yield of the 10-year bond.
On the point you are raising, he explained this to a degree at the annual meeting this year. The concept that if the market starts to believe the current rates are normal, then the earnings yield (earnings over price) for the market minus the 10-year bond yield or the equity risk premium will seem very high, meaning that the market is very cheap. But the market does not believe that the 10-year yield is an accurate reflection of the economy as the rate is being manipulated by the quantitative easing measures. Should markets believe that it is an accurate reflection of low growth or low inflation or some combination thereof, asset prices will go significantly higher.
But Buffett does not care that much about macro, the tide is going to come in and out, so you choose the best swimmers. Munger said this year, what you need is patience and the willingness to act at the right time. Buffett and Munger have a system to divorce emotions from hard facts. They find businesses, which have an advantage economically, then reverse engineer scenarios that will kill that advantage, and when they are sufficiently satisfied that the advantage is sustainable, they look at the price. Then, when the price offers a return above the threshold suitable for them, they buy. If the business does not make the cut, it goes into the bin.
>>> If you are not sure where the interest rate is going to settle at for a reasonable period of time, how do you calculate intrinsic value and how reliable can that metric be?
You use your own discount rate. Buffett likes to use the 10-year rate. But it does not matter what rate you use as long as you use the same discount rate for all companies because it pits them in the same playing field. The point is not to calculate the intrinsic value for just one stock but to compare the intrinsic value across all your options. If you take a cash flow stream and we do all the risk adjusting based on our confidence in the business, and use the same discount rate for all stocks, we can calculate the premium we are asked to pay for all the stocks. You can then see if the multiple we are asked to pay is reasonable compared with history. Then, see the rate at which the intrinsic value of the business will grow based on the revenue growth, the margin profile and the velocity of sales over the asset base. All that will give us an estimate of the kind of returns it can generate every year. If we are right on all the above parameters, then we will be right on the business.
Ultimately, the discount rate is going to be a function of your long-term view on growth. In his partnership letters, you can see Buffett’s long-term expectation on the equity market are in the 6-8% range.
>>> Growth is such an important element when you talk about quality compounders. Isn’t the importance of macro largely underplayed, even by Buffett? If you are looking at cigar butts, then you are picking up really cheap stocks and it does not really matter...
I like the line from this year’s meeting — micro is business and macro is what we ignore. There are plenty of businesses that rely on macro — the price of oil, interest rates, currency etc, if we could predict those we could make a lot of money but Buffett and Munger recognise that it’s impossible to predict these. That removes a huge swath of eligible securities to invest in. They fall in the “too hard” bucket.
So they — Buffett and Munger — simply focus on companies that have and can earn high rates of return at the right price. There is surely more quantitative security around them as long as you calculate their value correctly.
>>> Which of Buffett’s ground rules is the most important?
My favourite ground rule — it’s probably because of the time we are living in — is this idea of Buffett saying explicitly that “we are not in the business of making predictions and if you think it is necessary to an investment, you should not be in the partnership.” The world spends so much time trying to think about what the prices will be next week, next month, next year and so on; people can really liberate themselves by saying “no idea” to 80% of the questions that come their way. It frees up a lot of time. The fact is that most people making these predictions will also tell you that they are at the best making an educated guess but they won’t stake their children’s money on those predictions. So it’s just a giant waste of time. Buffett refuses to be judged on anything less than three years and strongly prefers five years. Anything less than that is chance — the voting machine versus weighing machine argument depends on time.
>>> Are there any tactics from Buffett’s partnership days that can be applied today?
The biggest mistake that hedge fund managers today make is to run their funds as though it is for their consultants. So they say, I can’t invest in micro-caps because if I do well, the consultants are not going to believe those numbers are replicable. I say, forget that, Buffett when he started out, really invested in micro- caps. Berkshire Hathaway itself had $23-million in book equity when the partnership got heavily involved in 1965, when they got control. Even if we go back and adjust it for the rate of inflation, it is still tiny. Go further back and see Dempster Mill or Sanborn Maps. Sometimes they traded several shares a month but they were cheap. They had the ability to move the needle for his funds. So you should seek the highest rate of return for capital that you can get. That is one.
There was also an element of activist investing he was engaging in. For instance, in Sanborn Map (in 1958 Buffett bought a major stake in the Sanborn Map Company, a publisher of detailed maps of all US cities and towns), he had only a couple of million dollars in the partnership but he got 40% of Sanborn, enough to get himself on the board and threaten a proxy, and force a distribution of the balance sheet that was full of really valuable securities that the market was not recognising. Sometimes cheap stocks stay cheap and there are opportunities to be a catalyst for change. People think that activism is limited to Bill Ackman or someone like that, but here you see someone with very limited resources taking a very aggressive stance, when necessary, to unlock value.
That apart, generally Buffett has concentrated his bets heavily. That can be a double-edged sword. But Buffett has enhanced return significantly by doing just that.