Bill Miller: What's luck got to do with it?

(Money Magazine) -- The streak may be over, but Bill Miller remains the iconic fund manager of his generation. As manager of Legg Mason Value Trust, he beat the market for 15 years in a row until his run ended last year.

If you had invested $10,000 in Miller's fund in 1990, you would have $92,033 today.

Bill Miller

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With suits so rumpled they can resemble pajamas, Miller pays no attention to style. He shows the same contempt for convention when he invests.

While most value investors refuse to buy technology stocks, Miller has made a killing on Amazon (Charts, Fortune 500), AOL, Dell and eBay (Charts, Fortune 500).

A former graduate student in philosophy who earlier served as a military intelligence officer, Miller probably has the most original mind in the investing business.

Money Magazine's Jason Zweig caught up with him recently - below is the full transcript.

Question: Let's start with the most obvious question: How do you explain your performance streak?

Answer: How do I explain it?

Question: Yes. Was it luck? Were you just the chimp who happened to type Hamlet? Or was it something more?

Answer: I would explain it as a large degree of luck, and maybe some modicum of skill. And I'd define skill as actually just surviving in markets over long periods of time without blowing yourself up. My colleague, Michael Mauboussin, has written on this at some length.

And his point, after studying streaks of all sorts, is that typically to have long streaks involves some level of skill, and some level of luck, interweaving on each other.

The easiest example that he gives goes like this. Take any streaks you might have, free throw shooting in basketball, hitting streaks in baseball, that kind of thing. You don't expect the average person who's never picked up a basketball, who's an amateur, to have the same kind of free throw shooting record as a pro. Look at the people in the pros, the ones with the best records. They tend to be the better players. So there's some level of beginning ability which is then enhanced by the luck factor.

So that's probably at play here. Certainly on a purely random basis, the odds of 15 consecutive calendar years, you know, would be a couple of million to one.

Question: From the perspective of an individual investor, the typical reader of Money Magazine, what's the argument against just putting everything in index funds?

Answer: Well, first of all let me say that I think index funds ought to constitute, just from the broad standpoint of prudence, a significant portion of one's assets in equities. Because you know, the evidence is that over any substantial period of time - ten years, 15 years, 20 years - the odds that you will get a money manager who can outperform that period of time are about one in four.

So unless you're very lucky, or extremely skillful in the selection of managers, you're going to have a much better experience by going with the index fund. Your costs are lower, not just in management fees [but also in lower trading costs]. So there's a very significant case to be made for having your money in index funds.

The fact is, however, that index funds do not give you the results of the index. They give you the results of the index, less your costs - which are small, but real.

Question: Some very astute index managers, like Vanguard's Gus Sauter, have outperformed their benchmarks, but in general that's right.

Answer: Yes. On average, the index funds will guarantee that you'll underperform the index every year. If you want to have a prayer of outperforming, you've got to have some part of your money in active management. And I do think that over time, someone who is a careful reader of Money Magazine or other financial publications can probably come up with a list of money managers who have a long term record of actually doing better.

It's not that that will make sure that they'll do better in the future, but I think you can improve your probabilities of doing better than the index by diversifying and having some portion of your money in active management. So I'd say the strongest reason to have active management is it diversifies your risk moderately.

In any case, the biggest problem that people have isn't selecting the right money managers. It's the way they change managers all the time in response to fluctuations of short-term performance.

Question: Right. And when you say active management diversifies your risk, you mean that's because you're now adding stylistic factors. You're changing the weightings of the factors within your overall portfolio if you use some active management.

Answer: Yes. Uh-huh. For the same reason that you'll change things also if you add bonds to an all equity portfolio. Of course, if you get a really adverse selection you can harm yourself there. But I think that there's a case to be made that some active management is probably helpful.

Question: All right. Let's take it one step further. If you were trying to pick an active manager with what we might call likely expected outperformance, what attributes would you look for?

Forget for a minute that you're Bill Miller who knows all the best minds in the money management business. If you were an outsider, what are the attributes or characteristics you would look for?

Answer: Well, the most important thing is not so much the performance as the process. A good process will ultimately lead to good results in the long run, so you can't be distracted by what happens in the short term.

Think again about sports. Pedro Martinez might be the best pitcher in baseball, but he does lose games from time to time. You can't judge him overall by how he did on a bad day. So I would look first of all for a good process. And you say "What is a good process?" Well, there are a few signs.

• One, if the person's been around a long time, is there's some evidence that this manager actually adds value [either by outperforming or by getting attractive results with lower risk]?
• Two, I would look for a long-term orientation, and the evidence for that would be a relatively low portfolio turnover. In a world of 110% to 115% turnover, something in the 50% range or less - ideally in the 20% to 30% range - is what would make sense.
• Three, I would look for a value orientation. Doesn't mean that they would be necessarily a so-called value manager. I would look for somebody who actually thinks about the price that they're paying in relation to what this thing is worth, even if they're growth-oriented.
• Four, I would look for evidence of what Warren Buffett calls emotional stability. And I also agree with him [that managers need to understand] how markets operate, how [managing money for other people can create] external behavior modifiers, and how our own internal behavioral tendencies can [lead to] sub-optimal decisions.
• Five, if you can measure or try to evaluate them, then I think intellectual curiosity, adaptability and flexibility are also traits that I would look for.

Question: But that -

Answer: There's one last thing. Someone who is too dogmatic, too firm in their views, too sure they were right (even when they were right!) - I would be wary of that.

Question: But that brings us to the big question, which is how transparent are these characteristics to outside observers? If Joe Sixpack is trying to pick a manager, can he really run these kinds of tests from the outside?

Answer: Well, I think it depends on the nature of the observer. You know, when Money Magazine is looking for people to interview for your 35th anniversary, you all have some sort of sense of, y'know, whatever those categories are that you're looking to tap, who represents something that you would think your readers could benefit from.

And I think similarly, if an investor reads money managers' letters to shareholders, you can learn a lot (if they're part of an organization that actually allows them to write something). I think you can tell a lot when people are being interviewed in the press. That also gives you a sense of how they think about things.

So I do think that the evaluation of money managers is like the evaluation of anything else. One would assume that if I'm evaluating college basketball players, professional scouts can do it better than the average fan. So I would think that there's some ability which goes with experience.

So if I'm an individual reader, or an individual investor, I might want to supplement my own views with advice from other people that are purporting to do this. That could be Morningstar or other people like that who try to evaluate managers.

I think multiple sources are a good idea, just as we use multi-variate valuation models. When we value stocks, we're looking for things that converge towards central tendencies. And when people use multiple sources of information, multiple ways of evaluating managers, they should do better than people who are doing it less systematically.

Question: Right. Who's Puggy Pearson, and why should anybody care?

Answer: Well, the late Puggy Pearson was a professional gambler, lived in Las Vegas, had a 5th grade education, but nonetheless became legendary in poker, and really in other gambling circles, because of his undeniable skill at a game that involves a high degree of chance.

And he won the World Series of Poker, I think in 1973. He also told me he actually won it one other time, but they awarded it to somebody else, because they didn't want him to win it twice. (Laughter) Back in the early years.

Question: In the old days.

Answer: I didn't know whether to believe him or not, but that's what he said. But in any case, he summed up the skills required for successful poker in a pithy way. And those skills, in my view, are also the skills necessary for successful investment.

Somebody once asked Bill Ruane [the late manager of the legendary Sequoia Fund], and I happened to be in the audience that day, "How do you learn about investing?"

And Bill said, "Well, if you read Ben Graham's Security Analysis and The Intelligent Investor you'll be well versed in it. And then if you read Warren Buffett's shareholder letters and understand them too, you'll know everything there is to know about investing. And you will become a successful investor."

And I think Bill was right, but it takes a lot of time to do that. Puggy Pearson made it a little pithier when he said, his line was, "There ain't only three things to gambling. Knowing the 60/40 end of a proposition, money management, and knowing yourself."

And if you translate that into investing, knowing the 60/40 end of a proposition means knowing when you have some competitive advantage over somebody else. And you don't bet, you don't gamble, you don't invest, unless you have some competitive advantage. I'll come back to what that means in a second.

Second, money management means well, okay, if I've got a competitive advantage, how much do I invest? Do I invest 10 percent? 20 percent? 50 percent? Three percent? So knowing the proper money-management strategy, the proper amount of money to invest is the second thing.

And then knowing yourself, that means knowing how you react to stress, how you react to adverse outcomes, how you react when things go well. Do you get giddy and overconfident when things are going well? Do you get morose and difficult when things go badly? Do you make bad decisions at both extremes? Just understanding your own psychology, what your weaknesses and strengths may be, as it comes down to evaluating decisions when the markets are at extremes.

Those three things are really all that successful investing involves.

Let's go back to the first one, though, and the 60/40 end of a proposition. There's three sources of competitive advantage in investing: informational, analytical and behavioral.

Informational is - well, let's say you manage money for a Middle Eastern government, and you go over there and the oil minister tells you that they're going to double oil production in the next three months, you know something other people don't know.

But informational advantages are very difficult to get. They're difficult for two independent reasons. Number one, the [U.S.] government tries to keep you from getting them, because they want a level playing field. There are rules against inside information and acting on it. People know when companies are going to release their earnings, and there's supposed to be equal access to that information. And then the hedge funds are the other independent reason. Many of them are trying to get an informational advantage. With so many of them out there doing this full time, it's very difficult for people to get an informational advantage - even other professionals such as ourselves.

The second category is analytical advantages. This is where you know the same things that other people know, but you weight them differently, you give them different probabilities. And that can happen a lot. If you've owned the company over a long period of time, you can get a sense of how their business is evolving, how their capital allocation is going to work, that other people aren't thinking about. And you might have a different sense of their risk, the risk in assessing the investment. So the analytical advantage involves different probabilistic weights on the same information that other people have.

And then the third one is behavioral. And that's the most enduring, because behavioral advantages arise out of the manifest tendencies of large numbers of people to react in predictable ways to certain kinds of situations. So we know that people are risk averse. We know that their coefficient of loss is about two to one - which means that they feel the pain of losing a dollar twice as intensely as they feel the pleasure of gaining a dollar.

Question: Correct.

Answer: People overweight the most recent information. They overreact to dramatic information, or dramatic circumstances. They tend to have what's called outcome bias, which is they judge things on their outcome, and not on their process. So a lot of these behavioral elements are things that you can actually identify and exploit to your advantage if you are aware of them - and aware also that no matter how much you're aware of them, you're not immune to them yourself. You really have to have a sense of discipline and patience, and understanding in that.

Question: Okay.

Answer: That was a very long explication of Puggy's very short, pithy remark.

Question: All explanations of short pithy remarks are long.

Answer: I think so, yes.

Question: What's the Kelly criterion?

Answer: The Kelly criterion is named after J.L. Kelly, Jr., who in 1956 wrote a paper for The Bell System Technical Journal called "A New Interpretation of the Information Rate," drawing on work by Claude Shannon, the father of information theory.

What Kelly did was to take an aspect of Shannon's work and derive a formula that had broad applicability outside of information theory. What it enabled you to do was to maximize the growth rate of anything, if you used this formula. So gamblers quickly used it to adopt money management strategies.

It's known as a fixed fraction strategy. So what it tells you is what fraction of your bank roll you should commit to any particular probabilistic endeavor, whether it be a gambling debt, or an investing debt, if you know the probabilities that pertain to it. And if you know those preconditions, you will either maximize your bankroll at the fastest possible rate, or you'll minimize your loss at the slowest possible rate.

The rough formula, in a grossly oversimplified form just for the purposes of discussion, is:

2p - 1

where p is the probability [converted from percentage to decimal form]. So, to make it easy, if you were 100% certain that a particular investment would pay off at your expected rate, then 2 times that p is 2.0, minus 1, yields 1. That means 100% of your bankroll should go into that investment.

Now if you were only 60% sure, then it would be two times .60, which is 1.20, minus 1, equals .20. So 20% of your bankroll should go into that proposition.

What the Kelly criterion does is it gets you to focus on the probability that you are correct in your assessment, and then to understand that the amount of money you should commit is directly related to the probability that you are correct. It also shows that if you have less than a 50/50 proposition, you shouldn't bet at all. Which again, makes perfect sense.

Question: Let's boil all that down for people who can't do 2p - 1, because it's too much math.

Answer: (Laughter) Well, what Kelly says is the same thing Puggy Pearson says, which is you have to know the 60/40 end of the proposition. You have to be confident that you have an edge, that you have some positive probability of an expected positive gain, before you commit any amount of money. And if you can't identify that edge, you probably don't have it. And if you can't identify it, you probably shouldn't commit the capital to it.

Question: Right. And how much capital you commit -

Answer: - depends crucially on your assessment of how big your edge is. And that's why the government punishes inside information. Right? If you have a tip that comes from somebody that knows Company X is bidding for Company Y, then you would commit large amounts of your personal capital to that, following perfect Kelly fashion.

Question: Right, because your P is 100.

Answer: Exactly. Your P is 100.

Question: But doesn't this bring us to a really difficult problem which is that since humans have an incorrigible tendency to be overconfident, how do you calibrate your P so that it's correctly less than 100?

Answer: Well, I wouldn't advise people to go so far as to try to do calibrations on it. I would advise them basically to understand, A) people are overconfident, and B) that therefore whatever probability you think you have of being right, it's probably less than you think.

So if you think you have a small edge, you probably don't have any edge at all.

Question: Okay. What does this mean? It's one of your favorite expressions: "The guy with the lowest average cost wins."

Answer: Yes, I wrote in the shareholder letter, which will be out shortly, about Opportunity Fund. The steel stocks have done great, and home builder stocks have done terrible. And so we're less confident about steel, and more confident about home builders.

For most investors in general, selling the expensive asset, and buying the cheap asset, seems like a logical strategy - except when you actually try to do it. Because most people are actually not wired to be selling what's expensive and going up, and buying what's cheap and going down.

Question: That's correct.

Answer: Loss aversion.

Question: Yes.

Answer: Because when they buy what's going down, it hurts.

Question: You bet it does.

Answer: And so my point is that if you think about any investment, your profit is the difference between your average purchase price and your average selling price. And so it follows that the portfolio with the lowest average cost will win.

It will be the best portfolio [with the highest return]. So typically if you have a chance to lover your average cost, you should do so. And if you're raising your average cost, you have to understand that you are thereby reducing the difference between your purchase and your sale price.

Now the counter-argument to that is: Ah, but my Kelly P is going up if the stock is rising. The rising price shows show me that I'm right.

I would just say that that's probably another cognitive error. (Laughter) Because the direction of the stock price doesn't tell you anything at all except for the direction that day or that week or that month. It tells you nothing about the direction of the future.

Question: Yes, and it also doesn't tell you anything about the value of the business.

Answer: Exactly. And one of the things that we have always done for the 25 years that I've been here, and my 90-year-old partner Ernie Kiehne did for years before that, is what he has described as "throwing good money after bad."

You know, Bernard Baruch said nobody buys at the bottom and sells at the top except for liars. So what follows from that is, if you're not buying at the bottom and selling at the top, then that stock will go down after you bought it. And it will go up after you sold it.

Because if it doesn't do one of those things, then you bought at the bottom, and sold at the top.

Question: In which case you're a liar.

Answer: Right. So you need to understand that your stock will go down after you buy it, and it will go up after you sell it. On average over time.

But what you want it to do is go down immediately after you bought it, and be lower then. You don't want it to be lower three years, or five years, or ten years. If you understand this, then the strategy of being willing to lower your average cost [by buying more when a stock drops] is a great strategy.

Question: Yes, but it's amazing how hard it is for people to understand this. It can make intellectual sense to people when they hear it spelled out very carefully. But it almost never makes emotional sense to them.

Answer: Yes. Well, that's why I put it that way in the letter: It seems logical, except when you actually do it. (Laughter) Then it's emotionally difficult to do.

Question: I have a theory that great investors are not unemotional, but inversely emotional: They get worried when the market is making most people happy, and they feel good when everyone else is worried about it. Ben Graham had that quality, and so does Warren Buffett. Do you see that in yourself?

Answer: Yes, I'm definitely that way. I'm always much happier when stocks are trading at their 52 week lows than I am at 52 week highs. It's simple: If you have a valuation discipline, then you know that stock prices change more rapidly than business value.

You also know that rising stock prices mean lower future rates of return and falling stock prices mean higher rates of return. So I was much happier in the summer of '02 when you buy everything on sale than I was in the Spring of 2000 when a lot of things were super-expensive.

I have virtually no loss aversion as far as I can tell. In fact, my thinking goes contrary to what Warren [Buffett] says: "The first rule is, don't lose money. The second rule is, don't forget the first rule."

My view, instead, is that the evidence is overwhelming that most people are too risk averse. And that therefore they should be taking a lot more risk than they feel like is right.

The problem is that real risk and perceived risk are two different things. And that's where people get into trouble, because they perceive risk to be high when prices are low, and they perceive risk to be low when prices are high. That's the psychological problem that most people have.

Back in the fall of 1987 I was interviewed by the Washington Post on the Friday before the crash, and the market had been falling since August. And I think it was down probably 20% from the peak. And the Post reporter asked me what I thought about it.

And he quoted me saying something like, "I'm pretty happy about that, because we can find much better bargains right now than we could in August."

And then the market crashes 20 percent on Monday, and the reporter writes (Laughter), "Well, I guess Miller must be ecstatic today after the crash, because think how good things look right now!"

Of course he was being sarcastic about it."

Question: But, of course, you were happier.

Answer: Well, let's put it this way. I wasn't happy that the market crashed, obviously, and I wasn't happy that people lost large amounts of money on that day. But we had had 25 percent cash going into the crash, and we put it all to work right away.

And we actually had a contrary view to what most people thought, which was that the crash of '87 was had fundamentally different sources than the crash of '29. And so we actually got that right for the right reasons.

So we were happy to get the chance to buy lots of things at low prices, though we weren't happy obviously that there was a lot of consternation and economic dislocation.

Have you read that book Way of the Turtle yet?

Question: No. Should I?

Answer: Yes. Well, it's really interesting, because what happened was, [veteran trader] Richard Dennis got all these resumes in, and he gave people questionnaires, and then he tested them, and he got ten people he was going to teach how to trade according to his system.

And the system was mechanical. There was no judgment involved. And as it turned out, as the guy that wrote the book pointed out, that after two months of trading, he was the only one of the 10 people that actually followed the system.

And the reason was, all these behavioral things. Because the system showed you lots of losses. And then it would tend to show you big gains. The losses made people nervous, and so the whole point of the book is that Dennis actually had understood or internalized, before people like [psychologists Daniel Kahneman and Amos Tversky] had come along, that there was a whole plethora of behavioral anomalies that will keep people from behaving optimally in capital markets.

Question: Yes, yes, yes.

Answer: And what's fascinating about it, was that even with all the screening and selection of people - these guys were, like, math professors, professional gamblers, etc. - he tried to get a group that behaviorally would actually do this stuff right, and still only one out of ten did it.

Question: Are you going to be the next Chief Investment Officer of Berkshire Hathaway? And if not, who should?

Answer: I don't think so.

Question: You haven't gotten the call?

Answer: A) I'm not available, and B) Warren didn't call me. So I think until at least one of those two things happens, there's zero chance of it occurring.

Question: Do you have any nominations?

Answer: The guy from Markel, Tom Gayner.

He's the right age. He's in his 40s. He's a very sensible guy. Chris Davis [of Davis Funds] put him on his board and says he's great. Buffett's getting a good look at him on the Post board.

And Warren has talked about how there's probably no one that's ever going to be like him, having a synthetic ability over a wide variety of asset classes with the risk/reward insight that he does.

And it may be better for Berkshire to have four or five people with specific areas of expertise. Somebody who's great in stocks, or U.S. or global stocks. Somebody else who's great with bonds. Somebody else who might be good at I don't know, hard assets, or whatever the case may be.

And then have somebody orchestrating that, you know, a conductor on top of that, the way that David Swensen does [as chief investment officer] at Yale, for example.

Question: Yes, exactly.

Answer: Swensen's an interesting choice. He's clearly not somebody who's in it for the money. He's clearly a guy who's a creative and independent thinker. And I think he'd be a great choice to run Berkshire. He'd be a great loss to Yale, but he might find the challenge at Berkshire a challenge worth doing.

I think Chris Davis would do it as well. I think he'd be great for it as long as he gives up running his funds. [Contacted by Money Magazine, Davis said he would not consider such an offer.]

Question: I'll tell him you said that. Now I have to ask you a question from the editors. What's the best lesson you ever got about money, and who gave it to you?

Answer: (Pause) Well, I can tell you, it wasn't meant to be a great lesson, and it's a story I've told before, but it stuck with me from a very young age, the way a little duck gets "imprinted" on a person who feeds it.

I was nine years old, and I walked in to see my father reading the financial pages of the newspaper. And they didn't look like the sports pages or the comics or whatever.

So I asked him what they were. And he said they were financial pages.

And I said, "What does that mean?" And he said, "Well, these are stocks."

I said, "What's a stock?" And he said, "Well, look at this thing. See this thing? This represents a company." And he said, "And see this '+ .25'?"

And I said, "Yeah." He said, "Well, that means that if you own this company, one share of it, which cost you like ten dollars, then if you owned it yesterday, then today you have 25 cents more than you had yesterday."

And I said, "Well, what do you have to do to get that 25 cents?" He said, "You don't have to do anything. It does it by itself." (Laughter)

And I said, "You mean, I can go to bed, I can have this thing yesterday, I can go to sleep, wake up the next day, and have 25 cents more than I had yesterday, and not do any work?" (Laughter) And he said, "Yes."

Now I had come in from mowing the grass, for three hours, to earn 25 cents. So the idea of being able to make 25 cents when I'm asleep, or at least by doing no work, had a great appeal to me. And I immediately said to myself, "This is something I have to understand."

And so the lesson I took from it, at nine years old, was that in the stock market you can make money without doing any work. And since I have always had an almost infinite capacity for indolence, I thought, "This is great."

Of course, I only realized many years later that you could earn the market rate of return by doing no work. But to earn an excess rate of return certainly does require some work!

Question: Can an individual investor do what you've done - beat the market for years on end?

Answer: Oh, sure. I don't think it's something that just anybody off the street could do. You know, give 'em some money, and say, 'Go ahead, go beat the market.'

But I think that individuals [are not hampered by the obstacles] that prevent many professionals from behaving in optimal ways.

And, more importantly, a thoughtful individual investor doing a moderate amount of homework can easily - and I emphasize easily - do better than the S&P 500.

Standard & Poor's uses a selection methodology that has nothing to do with value, growth or anything else. It just has to do with we're going to have 500 stocks that are tradable, they're liquid, they're profitable, they have decent balance sheets, and they're representative of their industry, and they're probably diversified.

And that beats most people most of the time. And the reason it does, is not because it's esoteric, but because that portfolio which is diversified, is just allowed to evolve.

The S&P doesn't make a prediction and say "We think the economy's going to slow, so we want to have more defensive stocks" or "We think that oil's going up," or "We think there's a commodity boom, we want to have more commodity stocks."

They just let the portfolio evolve over time. And because the world is largely unpredictable, a diversified portfolio that's well representative of the U.S. economy (or the global economy for that matter), which is just allowed to evolve, is likely to do better than the average professional.