Bill Miller IV was recently a guest on the WealthTrack podcast to talk with Consuelo Mack about our approach to income investing. Here is an excerpt of that interview (note this has been edited for clarity and brevity). For the full interview, visit the WealthTrack website.
Consuelo Mack: It’s interesting to me that the Income Strategy came out of an unusual situation which was the depths of the financial crisis. You launched the Income Strategy in 2009. Define how it’s evolved since then.
Bill Miller IV: The thought process behind the Strategy was the idea that here’s a basket of securities that are higher up in the capital structure than equity, so theoretically safer, but they’re also priced to produce a very nice rate of return. Even if things didn’t recover in 2009 or 2010, we thought we would clip a very nice income stream while we waited for things to recover, and then potentially earn some return on top of that.
It’s evolved a little bit, but that’s still the basis of our thought process today. We’re looking around the world and up and down capital structures for securities that are kicking off a high level of yield, but also that we think are undervalued.
We build the portfolio on a name-by-name, fundamental value, bottom-up basis, so we’re not saying, “Our view of the world is X and, therefore, we want to buy securities that kind of match that view.” We’re looking at everything through screens, all kinds of systematic processes, then trying to figure out from there what might be undervalued, and then concentrate within those securities that present what we think will be the best risk-adjusted returns.
CM: It’s also different, your emphasis on high-yield, in that many income strategies for instance will say, “We’re going to avoid high-yield securities, number one,” and when I’m talking about high-yield securities, I’m talking specifically about stocks because if it’s among the highest yielding stocks, that means that the stock is probably under pressure for some reason, or the payout ratio is really high, and that means that the management is not doing proper capital investment back into the company, or there’s some other problem associated with it. It’s an unsustainable level, but you have some interesting research about the fact that the performance of high-yielding securities is actually pretty good over the long term. Can you explain the research, and maybe help us rethink our attitudes towards high-yield securities?
BMIV: The more work we ended up doing on higher-yielding securities after we launched the Strategy, the better we liked it for the risk-adjusted returns aspect. We happened upon a study that showed that if you had just purchased every single year the top 30 percent of the stock market just ranked by dividend yield and rebalanced once per year – this is going back to the 1920s all the way through a year or two ago – you would have outperformed the equity market by, I think, 130 basis points per year, with much lower volatility than the market. That’s again a very nice risk-adjusted return.
I think there are a few reasons for that, and these are hypotheses. First, I think part of it is the value effect. High-yield securities generally tend to have a low price-to-earnings ratio, as you just pointed out, and the value effect is a very well-known way to generate returns. I also think there’s an aspect to it whereby management teams have a much higher level of capital discipline if they’re paying out a high level of their cash flow to shareholders. So there’s kind of this implicit agreement that, hey, these cash flows are yours, and if we want to start a new business or reinvest, we actually have to go to the equity market or the debt market and validate those plans with someone else. So I think there’s an element of capital discipline there for management teams. Then finally, while I have not seen a lot of research on this, it seems to me that there is a very positive tailwind from carry. So if a security is going to be paying you a dividend every single quarter – that gets priced into the stock, and there’s kind of this cash flow carry element to it. So high-yield bonds, at least as an asset class, have historically returned roughly what equities have but on a much better risk-adjusted or volatility-adjusted basis, and I think that’s just because of the carry aspect where you get the cash flow behind you at all times.
CM: How does the Income Strategy differ from a lot of the other traditional income strategies out there? Again, when I think of the ones that I’ve been covering over the years, it’s either you’re in an income strategy because you want current income, or there are some income strategies that focus on companies with growing dividends. Then there are others that are focusing on total return. I mean how do you consider yourselves to be different?
BMIV: I think that the unconstrained nature of the Strategy is different from most things out there. Most investment “products” are slotted into some kind of style box or narrow set of objectives, whereas with this Strategy we can go anywhere in the capital structure, anywhere in the world and find what we think are the best risk-adjusted income streams and put them together in a portfolio. I also think this unconstrained nature is really important because the more constraints you put on an optimization problem – and creating a portfolio is an optimization problem – the less likely you are to get a good result.
CM: Give us another example that’s not a private equity firm, that again exemplifies your approach that when you looked at it you said, “Yes, this is the debt or the stock or whatever for us.”
BMIV: Well, one of the pieces I wrote was called “In Search of Uncertainty Discounts,” and the private equity managers are a great example of an uncertainty discount. Another uncertainty discount – which by the way is going to be uncorrelated with this group of stocks – is a company called National CineMedia (NCMI). It’s essentially the advertising network on most of the movie screens in the U.S.
The dividend yield today on that is about 10%, and that’s on a reduced dividend, by the way, because they wanted to reinvest in digital and all these other initiatives, so it’s very well covered by free cash flow. The interesting thing about it is that it’s sort of like the private equity firms. Movie attendance and how attractive the slate is to advertisers is very hard to predict in a given quarter, but if you look at movie attendance over a longer period of time, it’s declining roughly one percent a year.
So what kind of happened for a little while there I think is it was a weak slate of movies. Attendance was down quarter over quarter, and you string together a couple of these quarters, and the market starts discounting as though that’s happening into perpetuity. But if you take a little bit of a longer-term view of what movie attendance is likely to be, we realized that it’s a hit-driven business and very hard to predict over the short term. I think that the stock for a while traded in the $12 to $15 range, and I think that’s probably about fair value, whereas today it trades at seven. So the market is just discounting this current trend into perpetuity, and I think if you just wait and clip some dividends, you’ll see some gradual appreciation back to what it’s worth.
CM: Let’s talk about the bigger issue that investors are talking about and that is the active versus passive approach. At Miller Value Partners, you are very actively engaged in security selection and investment strategy. There’s a lot of competition from the more passive approaches which have worked quite well over the last decade in this bull market. So how do you respond to those who say, “Why don’t I just get a high-yield ETF?”
BMIV: Well, I think the passive trend is real and for good reason. Active managers as a group have failed to outperform their indexes, and mathematically that’s going to continue because active managers as a group are essentially – well, plus the passive guys – but they are the market, and so you take the market and you deduct fees, and you’re going to be at a return lower than the market. But I think it’s important to note a couple things. One, passive strategies don’t actually give you the index’s return. They give you the index’s return less fees. If you look at the returns to the high-yield ETFs that are supposed to track those indexes, they’ve historically been much lower than the “unmanaged” and un-investable index just because you have to pay some sort of premium for that daily liquidity that you get in the ETF, and it’s in the form of lower returns than the actual benchmark. So you’re not always going to get the benchmark returns, and some of the comparisons are not always fair.
With that said, again I think that the shift to passive is going to continue, but despite that, I think there is still room for active managers, and there are a couple things you want to look for when you hire an active manager. Aside from the obvious things such as low fees or reasonable fees and low turnover, I think the most important thing is something I touched on earlier which is an unconstrained approach, in that if you look at the way most institutional money management firms are set up or strategies are set up, they’re set up in a way that kind of boxes in the managers in a big way. They say you can’t deviate from the index. You can only deviate from the index in certain ways. You can’t overweight certain names too much. You can’t underweight certain indices too much because it’s a business concern, frankly, for a lot of these firms. If you take a big swing and a big active bet against the index and you miss, well, you’re going to get fired and you’re going to get paid a lot less money. It’s a survival mechanism that a lot of people have developed, but unfortunately, it’s also created a huge headwind for them. So having an unconstrained approach where you can actually take real bets relative to the index is very important, and the academic research shows that strategies that have what’s called a high active share are much more likely to outperform, and so having that unconstrained approach is immensely important in my opinion.
CM: In fact a high active share means that you’re not correlated with the market, and in the interest of diversity you don’t want to be and, therefore, you’re not an index hugger and you’re doing something that’s very different than what an index would do.
For the full interview, visit the WealthTrack website.