Investor Essentials Daily

This investor eschewed all investing labels, and his reward was market-dominating performance for a decade and a half—UAFRS shows why

August 14, 2020

People often classify investors into two buckets. The first is growth investors looking for fast growing companies with high multiples. The second is value investors searching for underappreciated low-multiple businesses.

Some investors reject both labels and invest in companies they believe can exceed the market’s embedded expectations. Today’s fund was made famous by a legendary investor who did just that, and beat the market 15 years in a row as a result.

In addition to examining the portfolio, we are including a deeper look into the fund’s largest current holding, providing you with the current Uniform Accounting Performance and Valuation Tearsheet for that company.

Investor Essentials Daily:
Friday Uniform Portfolio Analytics
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It takes significant strength to be humble when you are the only institutional investor known to have beaten the S&P 500 15 years consecutively. And yet, that is what makes Bill Miller who he is.

He calls the results of his streak “probably 95% luck.” He also mentions that it was more “an accident of the calendar.” If the reporting year ended on a different month, the streak would have ended long before 15 years.

The reality though is his fund’s success was not because of luck. It was because of a sound strategy based on the root of something great investors understand that the average investor doesn’t.

Miller has said “the first duty of the investor or analyst is to figure out what is embedded in the price, what is discounted…the failure to address that question is the main source of the poor relative results of most money managers.”

Fundamentally, you need to understand what the market is expecting a company to do, also known as “embedded expectations.” Only then can you begin to create an opinion on whether the stock is going to go up or down.

Miller further states “A stock’s performance depends on fundamentals relative to expectations. For big winners, the gap between how a company actually performs and how it’s expected to perform is the widest.”

He has focused on buying companies with future expectations below what he thinks the firms will perform at.

Miller has built his entire investing career on this concept and by rejecting the notions of “value” or “growth” companies. Instead, he has built success searching for mispricing through understanding what the market expects of a firm.

Sometimes “value” stocks are expensive based on their market expectations. On the flip side, “growth” stocks can be cheap compared to embedded expectations.

Most traditional multiples are backward-looking and do not take into account the prospects of a company.

This philosophy led him to be a major early investor in Amazon. He owned close to 6% of shares of the company in 1999, well before it ever broke a profit.

This investment would have been considered ludicrous for a so-called “value investor,” but Miller’s understanding of future expectations and his rejection of typical investing terminology allowed him to see past this.

Miller is also focused on the cash flow of a business, rather than net income and metrics such as price-to-earnings (P/E) ratios. Businesses investing capital today to grow the business later will not look good under traditional GAAP accounting.

He produced these incredible returns, beating the market 15 years in a row, at Legg Mason Value Trust where he first joined as an analyst way back in 1981. He ultimately left in 2016 and formed his own company Miller Value Partners.

Looking at Legg Mason’s current holdings in the context of Miller’s historical viewpoints can be instructive since it hasn’t completely abandoned Miller’s philosophy.

It is crucial to use Uniform Accounting when analyzing this fund’s current holdings to see what Miller was seeing though.

Using only as-reported metrics, it would appear Legg Mason is buying sub-par companies with low returns and high market expectations. In reality, these names are significant players with high profitability.

See for yourself below.

Using as-reported accounting, investors would think Legg Mason is picking weak companies, unable to generate a high return on assets (ROA).

On an as-reported basis, many of these companies are poor performers with returns below 10%, with the average as-reported ROA right around 7%.

In reality, the average company in the index displays an impressive average Uniform ROA of 25%.

Once we make Uniform Accounting (UAFRS) adjustments to accurately calculate earnings power, we can see the underlying strength of Legg Mason’s picks.

When the distortions from as-reported accounting are removed, we can see that Intercontinental Exchange (ICE) does not have a negligible return of 2%, but a sizable ROA of 65%.

Similarly, DXC Technology’s (DXC) ROA is really 22%, not at 5%. While as-reported metrics are portraying the company as a business below cost-of-capital, Uniform Accounting shows the company’s truly robust operations.

Alphabet (GOOGL) is another great example of as-reported metrics mis-representing the company’s profitability. It does not have an 9% ROA, it is actually at 24%.

The list goes on from there, for names ranging from Microsoft (MSFT) and Oracle (ORCL), to Facebook (FB), CVS Health (CVS), and Amazon (AMZN).

If investors were to only look at as-reported metrics, they would assume Legg Mason has thrown away sound investment strategy to embrace low-return businesses. On the contrary, the fund is making smart investments to compound returns.

Beating the market isn’t just about buying great companies though. As Miller highlighted, it is about finding companies where market expectations are far too low based on the company’s fundamental potential.

When looking at the fund’s holdings through Uniform Accounting, it is clear it is doing just that.

This chart shows three interesting data points:

  1. The 2-year Uniform EPS growth represents what Uniform earnings growth is forecast to be over the next two years. The EPS number used is the value of when we take consensus Wall Street estimates and we convert them to the Uniform Accounting framework.
  2. The market expected Uniform EPS growth is what the market thinks Uniform earnings growth is going to be for the next two years. Here, we show by how much the company needs to grow Uniform earnings in the next 2 years to justify the current stock price of the company. If you’ve been reading our daily analyses and reports for a while, you’ll be familiar with the term embedded expectations. This is the market’s embedded expectations for Uniform earnings growth.
  3. The Uniform EPS growth spread is the spread between how much the company’s Uniform earnings could grow if the Uniform earnings estimates are right, and what the market expects Uniform earnings growth to be.

The average company in the US is forecast to have 5% annual Uniform Accounting earnings growth over the next 2 years. Legg Mason’s stocks are projected to outpace this, with a 21% average Uniform EPS growth.

The market is pricing these companies for a virtual EPS stagnation, at just 2% a year. This huge gap between market expectations and analyst predictions shows how Legg Mason looks to pick stocks with high EPS growth potential.

One example of a company with high growth potential is AbbVie (ABBV). While the market expects AbbVie to shrink by 7% over the next two years, analysts forecast the firm to see a 24% growth over the same period.

Another company with similar dislocations is Oracle (ORCL). The company is forecast for Uniform EPS to grow by 10% a year, and the market is expecting the company to in fact shrink by 2%.

Yet another example is CVS Health (CVS). The company is cheap, as it is priced for a 5% contraction in Uniform earnings, but the company is forecast to in fact grow their EPS by 10% in the next two years.

That being said, there are some companies that are forecast to have earnings growth less than market expectations. For these companies, like Amazon (AMZN) and Exelon (EXC), the market has growth expectations in excess of analysts’ predictions.

In conclusion, investors spend too much time focusing on labels like “value” or “growth.” Those with a firm grasp of what the market is expecting a company to do can pick companies across the spectrum that will outperform.

By emphasizing companies with lower future expectations, Legg Mason has managed to create value for investors with smart picks, as seen with Uniform Accounting.

SUMMARY and Amazon.com, Inc Tearsheet

As one of Legg Mason’s highest individual stock holdings, we’re highlighting Amazon.com, Inc.’s tearsheet today.

As the Uniform Accounting tearsheet for Amazon.com, Inc. (AMZN:USA) highlights, the Uniform P/E trades at 47.6x, which is above corporate average valuation levels and its historical average valuations.

High P/Es require high EPS growth to sustain them. In the case of Amazon, the company has recently shown a 15% growth in Uniform EPS.

Wall Street analysts provide stock and valuation recommendations that in general provide very poor guidance or insight. However, Wall Street analysts’ near-term earnings forecasts tend to have relevant information.

We take Wall Street forecasts for GAAP earnings and convert them to Uniform earnings forecasts. When we do this, Amazon’s Wall Street analyst-driven forecast is an 8% UAFRS EPS shrinkage for 2020 and a 14% growth for 2021.

Based on current stock market valuations, we can use earnings growth valuation metrics to back into the required growth rate to justify Amazon’s $3,167 stock price. These are often referred to as market embedded expectations.

In order to justify current stock prices, the company would need to have Uniform earnings grow by 25% each year over the next three years. What Wall Street analysts expect for Amazon’s earnings growth is below what the current stock market valuation requires in 2021.

Furthermore, the company’s earning power is 3x the corporate average. Also, the company’s cash flows and cash on hand is 2x their total obligations—including debt maturities, capex maintenance, and dividends—for the next five years. This signals low credit and dividend risk.

To conclude, Amazon’s Uniform earnings growth above its peer averages in 2020. Therefore, as is warranted, the company is trading above average peer valuations.

Best regards,

Joel Litman & Rob Spivey

Chief Investment Strategist &
Director of Research
at Valens Research