said, because I thoughtI might learn how to make money. He said, “My dear fellow, I havea Ph.D. in economics, and if I knew how to make money, I wouldn’tbe here.”
Miller: When I started worrying about stocks, it was the late 1930sand early 1940s and it didn’t seem like a good way to make moneythen, either. Stocks were in bad repute after 1929. A variety of ques-tions were being raised everywhere about the role of the stock marketPETER J. TANOUS
crash in bringing on the depression. There were also congressionalhearings and investigations, not only into the crash, but on the roleof the corporation in American economic life. The subject of stockswas very much in the news. As an economics undergraduate, I alsoworked on a part-time basis in Cambridge, Massachusetts, for acompany that was advising customers about portfolio decisions,writing reports. So I was constantly exposed to stocks, if only byreading through Moody’s and transcribing numbers for the customerreports.
As far as personal investing was concerned, I was more concernedwith my savings account than with stocks.
Tanous:! guess that was appropriate to the ’30s.
Miller: Yes, it was. You could get an interest-paying savings ac-count in Harvard Square, providing there wasn’t too much activityin your account. I would get my monthly allowance and put it in oneof the local banks, making small withdrawals every day to pay ex-penses. After awhile, I would get a notice from the bank saying thatthere was too much activity in my account and they were closing itout. So, I would walk my money across the street to one of the otherbanks. There were four of them, one on each corner. I just put themoney in the next bank. That way, I managed to have a checkingaccount without paying transaction fees. I didn’t feel guilty, becauseI knew that the banks had gotten the government to ban interest onchecking accounts. I was just doing to them what they were doing tome.
Tanous:I see the beginning of an economic theory here. As youknow, Professor, our book focuses on interviews with great investmentmanagers, but I also wanted to get some top academic points-of-viewon markets. I thought it might be interesting to begin our conversationby talking about your celebrated work with Franco Modigliani in thearea of corporate capital structure. I am referring, of course, to yourcombined work, amusingly known as “the M&M theorem.” As I recall,instead of asking investors how they might determine which of acorporation’s securities they might want to buy, you looked at it fromthe opposite perspective. You asked, how should corporations decidewhat securities to sell.
Miller: Yes. That was certainly part of it. Early on, I had to teacha course on corporate finance. I had never had a course in finance,or at least a business school variety course. My expertise was in
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public finance, particularly corporate taxation, since I had worked atthe U.S. Treasury. At first, | worked in the corporate tax unit of theDivision of Tax Research at Treasury, later in the government financeunit at the Federal Reserve. So, I knew the tax side of corporate fin-ance, and the economics of public finance, but not the standard fin-ance stuff.
In 1954 or so, before they let me teach a business school financecourse, at Carnegie Tech [now Carnegie Mellon], they said, you mustsit in on the class of someone who is teaching it the proper HarvardBusiness School way. So, I sat in the class. When we took up casenumber one in the case book, I remember being struck that the solu-tion was not obvious to me. After the instructor explained it, however,I said, Yeah. That’s right; that makes sense. Then we came to casetwo, and [ said, Okay, | remember how we solved case one, so theanswer must be this. And, of course, it was different. I couldn’t senseany connection from one case to the next. Everything was, as theysay on railway tickets, good for this train and this day only. For me,as an economist, it was frustrating to have no sense of a theory ofcorporate finance to tie all this material together.
Tanous:Do I sense the origins of M&M theory here? I think you aresaying that there wasn’t just one right solution to the cases youstudied. Likewise, in M&M, you were seeking the optimal capitalstructure for a corporation; in other words, how much debt, and howmuch equity a company should have. Then you found out it didn’tmatter. There wasn’t just one right answer.
Miller: That’s down the road a bit. First, the problem was to figureout what determines these choices. There are various analogousmodels in economics that could have been applied in this area, butnone of them seemed to work very well. Franco and I were bothworking on the problem, but from somewhat different perspectives -he from macroeconomics and me from corporate finance. I had someof the students in my finance class actually do some empirical workon capital structures, to see if we could find any obvious patterns inthe data, but we couldn’t see any. We couldn’t find any consistentpatterns and certainly no evidence of an optimal structure. We said,you know something, maybe there isn’t any optimum! [For example,in the proportions of debt and equity.] Franco and | then tried to proveour suspicion that there is no optimal capital structure.
People often ask: Can you summarize your theory quickly? Well,
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I say, you understand the MétM theorem, if you know why this is ajoke: The pizza delivery man comes to Yogi Berra after the game andsays, Yogi, how do you want this pizza cut, into quarters or eighths?And Yogi says, cut it in eight pieces. I’m feeling hungry tonight.
Everyone recognizes that’s a joke because obviously the numberand shape of the pieces doesn’t affect the size of the pizza. And sim-ilarly, the stocks, bonds, warrants, etc., issued don’t affect the aggreg-ate value of the firm. They just slice up the underlying earnings indifferent ways.
Tanous:! recall a story that, after word got out that you had wonthe Nobel Prize in Economics, the media tracked you down and askedyou to explain your theorem in a way their audience might understand.Like in ten seconds.
Miller: The pizza story is one I often use. Another is, if you takemoney out of your left pocket and put it in your right pocket, you’reno richer. Reporters would say, you mean they gave you guys a NobelPrize for something as obvious as that? [Lots of laughter.] And I'dadd, Yes, but remember, we proved it rigorously. [More laughter.]Actually, we did use a new form of rigorous proof known as “arbit-rage” proof. Arbitrage proof has since been widely used throughoutfinance and economics.
Tanous:If I’m summarizing the M&M theorem correctly, the marketvalue of any firm is independent of its capital structure, so the pro-portions of stock [equity]and bonds [debt] doesn’t affect the value ofthe corporation. Now if that’s the case, are all these highly paid cor-porate chief financial officers wasting their time trying to figure outhow much preferred stock to issue, or how many bonds, or how muchcommon stock?
Miller: To some extent. But remember, the M&M proposition is thebeginning of wisdom; its not the end of it. To really utilize it best,you have to tip the proposition on its head. You say, look, in orderto make this proposition true, you must make the following 15 or soassumptions. So if people out there say, aha, the M&tM theorem doesn’thold true in the real world, then we say, it must be because one ormore of the 15 assumptions must be failing. And that has providedthe research agenda for the profession.
What happened after publication of our paper was that, for thenext 40 years, people said, all right, we now know the answer to thecapital structure question under ideal conditions. Let’s now drop, or
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telax, some of these assumptions and see how it affects some of theconclusions. That’s not the kind of undisciplined Harvard BusinessSchool, each case on its own, approach. It’s systematic. You can say,for example, as we did even in our first paper, suppose there’s a bigcorporate income tax with a 50% rate? That’s going to affect the op-timal choice between debt and equity. In fact, it’s going to make issu-ing debt, rather than equity, extremely desirable [since interest isdeductible for tax purposes]. Next, you go on from there and say,yeah, but firms don’t have 100% debt. Then you have to start to ex-plain why and think up additional reasons, such as agency costs oroffsetting taxes, that will keep them from going to extremes. That’swhat the profession has been doing for 40 years.
Tanous:It occurs to me that the great junk bond revolution mighthave had the effect of confirming or disproving the M&M theoremsince so many companies opted to go heavily in debt. Did the popular-ity of junk bonds affect corporate values?
Miller: The junk bond revolution fits right in with M&M. Junkbonds prove there’s nothing magical in a Aaa bond rating. Don’t passup big profit opportunities, or tax savings, just because of yourcredit rating. What counts is what you do with your money, not whereit came from.
I also want to mention the one example where the original M&Mtheorem can actually be seen holding in the real world. It comes fromthe field of options, where it is known as the put-call parity. It holdsto three decimal places. Options, of course, bring Myron Scholes, oneof my former students, to mind as well as my good friend FischerBlack.
Tanous:Their reputations are well established. These fellows de-veloped the famous Black-Scholes model. Could you explain it briefly?
Miller: I don’t have a pizza story, but Ido want to go on the recordsaying that I regard their Black-Sholes formula as one of the majorintellectual breakthroughs of the latter part of the 20th century inthis field. It was not only an intellectual achievement, but it spawneda whole new industry. Their model was an amazing development be-cause it is one of the few cases in finance where you can actuallycompute what a security is worth, not just in abstract terms, but inactual dollars.
Black and Scholes developed a formula which priced options as afunction of observables. By observables, | mean that the warranted
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option price is a function of the strike price, the price of the underlyingsecurity, the interest rate, the time to maturity, and the volatility ofthe underlying security. The only thing that isn’t directly observableis the volatility, but that can be very closely approximated. Muchbetter to approximate the volatility of something than the mean ex-pected return, which is what stock pickers have to do. You can alwaysget a pretty good fix on the volatility, even though it’s not perfect.It’s still a lot easier than estimating the expected rate of return onshares. Incidentally, if you read the original Black-Scholes paper [“ThePricing of Options and Corporate Liabilities,” Journal of PoliticalEconomy, vol. 81, May-June, pages 637-659], you would note thatthey generously acknowledge the influence of the arbitrage prooffrom the M&M capital structure paper, which was earlier.
Tanous:Since Fischer Black and Myron Scholes were able to determ-ine option pricing by using all of the surrounding variables, might itbe possible to do the same thing for stocks?
Miller: No, you can’t really, except, perhaps, in some extreme cases.If a share is super highly leveraged, so that you just got this little thinsliver of equity over the debt, then Fischer and Myron pointed outthat it’s basically a call option, not a share. And you can, to someextent, price it that way. You can also do that with some kinds ofbonds. But, by and large, options are the only case in finance whereyou can successfully price something as a function of observables.
Tanous:That’s very interesting. Now let’s turn to the subject thatis a focal point of this book: active versus passive management. Letme ask you right off the bat, do you believe in active management inany form?
Miller: Not really. That’s based on my study of finance and mybelief that markets know much more as markets than an individualdoes as an individual. This is, of course, the subject we talked abouta couple of weeks ago. I should mention that I am a member of theboard of directors of Dimensional Fund Advisors.
Tanous:! had a long talk with Rex Sinquefield [page 257].
Miller: Rex is one of my students, too. Almost everybody is becauseI’ve been around so long!
Tanous:! spoke to another one of your students, Gene Fama [page167].
Miller: Of course. I favor passive investing for most investors, be-cause markets are amazingly successful devices for incorporating in-
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formation into stock prices. I believe, along with Friedrich Hayek[also a Nobel laureate, and a contemporary of John Maynard Keynes]and others, that information is not some big thing that’s locked in asafe somewhere. It exists in bits and pieces scattered all over theworld.
Everybody has a little piece of the total information. Even thedentist from Peoria, I always say, at least he knows whether or nothis patients are paying on time. So everybody has some information.The function of the markets is to aggregate that information, evaluateit, and get it incorporated into prices. But if information, as | insist,is widely scattered and diffuse, most individuals are not going to havemuch information relative to the total. Most people might just as wellbuy a share of the whole market, which pools all the information,than delude themselves into thinking they know something the marketdoesn’t. They can’t be hurt by doing that, because the price they paywill indeed reflect society’s best current information.
Tanous:I’ve tried to approach this as open-mindedly as possibleand I’ve talked to top-tier academics, you among them. I’ve also talkedto people in the business, like Rex Sinquefield, who is dogmatic onthis subject. Yet, when I talk to the active managers, especially thosewho have a fairly long performance history - what the academics call“persistence”- I keep running into anecdotes...
Miller: That’s all they are...
Tanous:But you keep running into these stories about information,seemingly previously unknown, that gets uncovered, with a certainamount of research. Isn’t it true that, until somebody does that re-search, it really wasn’t widely known?
Here’s an example: Michael Price, who runs Mutual Shares, hada wonderful story about a metal, tantalum, that was going up in price[page 37]. He did some research to find out which companies wereinvolved in tantalum, and, in fact, managed to discover them beforethe effect of the price rise was generally reflected in the prices of thosestocks. I expect there are many other stories like this.
Miller: Let me back up and say one thing more clearly, I hope.There are really two different groups of investors. One group, theoverwhelming majority, and the group I’ve been talking about, hasno significant private information not already in prices, and theyshould invest passively. They aren’t going to make above-normal re-turns, except by accident. But there’s another group that can hope to
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make money by careful research in the market. How much moneycan they expect to make? Taking the group as a whole, they makejust enough, on average, to cover the cost of their research.
This distinction I’ve been making, between traders with significantnonpublic information and those without it - which includes mostinvestors, including pension fund and mutual fund managers - isknown as the Grossman/Stiglitz theorem. Sandy Grossman is a brilliantyoung economist at Wharton (and a former student of mine, needlessto say). He was here at Chicago, and then went on to Stanford, Prin-ceton, and now Wharton. Joe Stiglitz went from Yale to Stanford,and is now the President’s chairman of the Council of Economic Ad-visors. They wrote a famous paper on rational expectations and prices[“On the Impossibility of Informationally Efficient Markets,” AmericanEconomic Review, Vol. 70, 1980, pp 393-408]. Their proof that boththe informed, and the uninformed, investors can expect to make thesame return, on average, is neat.
The essence of the efficient market thing is, after all, as we in eco-nomics have always held: There’s no free lunch. You can’t just sitback in your office scanning the newspapers, reading research reports,and listening to “Wall Street Week,” and hope to earn above-normalrates of return. To beat the market you'll have to invest serious bucksto dig up information no one else has yet. Because it looks easy, manypeople may be tempted to try it. But there’s no automatic reward frominvesting in trying to dig up important non-public information. It’slike gold mining. A few lucky ones may strike it rich, but most “active”investors are just wasting their time and money. Once they realizethat average returns on investment in information are zero or less, ifthe industry becomes overcrowded, the smart ones will stop tryingand will leave the search industry. They become indexers.
Tanous:Isn’t the research and the hard work you do the price youpay for the reward you achieve?
Miller: Yes, but it just compensates you for the expenses. Of course,I don’t mean you, personally. I mean you, on the average. Remember,as economists, not psychologists, we deal with behavior on the aver-age. This is just my view, of course. It’s not the opinion of everybodyin the finance or economics profession, needless to say.
Tanous:! sensed that even Gene Fama [page 167] and Bill Sharpe[page 89] believe that a very few managers, like Peter Lynch at Fidelity
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Magellan, have persistently outperformed the market, and that isborne out by the data.
Miller: Well, we’ve heard many of these tales. We used to hear, forexample, that Value Line had some kind of an edge. These tales comeand go. They don’t usually stand up forever, although sometimes theyseem to last for many years. You can make a huge living in the in-vestment field, moreover, if you can once get the reputation of beinga winner. It’s going to take a long time to reverse it.
I always use an example that dates back to the ’30s. The big namethen was Bernard Baruch. A genius. He was everybody’s favoritepundit. There wasn’t any economic issue where the press didn’t go tosee Barney. When you study his fabulous record, however, I think hewas right once. But, he was right in a big way. If you make a bigscore way out on the right hand tail of the distribution, then theprobabilities you face from then on are mostly the little moves to theleft and to the right in the center of the distribution. You’re not goingto get that first big gain removed. You only need to make one bigscore in finance to be a hero forever.
Tanous:I see your point. That one score will keep your average gainhigh for years. But take the whole outlier theory - the right tail of thedistribution curve where you find the Peter Lynches and Warren Buf-fetts. What separates the men from the boys, so to speak, is persist-ence, isn’t it?
Miller: Perhaps it would be, if we could measure persistence accur-ately. But in practice, it often comes down to not suffering a loss asbig as the huge gain you made a while ago. Thus, a fellow like GeorgeSoros may be skating on thin ice. You see, he made a big killing andif he would now just do modest investments, he would never lose it.He’d be a winner on balance over any time horizon. But if he insistson plunging again, he’s just as likely to take a bigger loss. He maywind up giving it all back.
Tanous:It’s funny. One of the managers I’m interviewing, RichardDriehaus, said about Soros, “He had a hunch and bet a bunch!”
Miller: Right. And he’ll have another hunch, and he’ll bet anotherbunch, and this time he'll lose. But if he doesn’t do it that way, if hehas a hunch and bets a bunch and wins, and thereafter plays theconservative game, he’ll go down in history as the genius of all time.The gains and losses average out, but only in the very, very long run.
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Tanous:To me, the name of the game is finding the people whoshow persistence at beating the market.
Miller: Well, let me tell you one of my favorite stories. I once askeda pension fund manager, why don’t you just index your funds insteadof doing all this churning you’re doing there? And he said, I can’tindex the fund because then I wouldn’t be worth $400,000 dollars ayear! If you ask people in the trade, how come you make so muchmoney? What do you want them to say? Oh, it was just dumb luck,Professor. I don’t think you'll get that response very often.
Tanous:The more typical answer is that it was our brilliant deduct-ive analysis that got you that great performance.
Miller: Yeah. There are people like Bill Sharpe and Gene Fama whoare working all the time to test various hypotheses about it, but tome the sample is way too small to judge “persistence,” that is, to beable to tell luck from skill. There’s another story I love to tell: Thebursar of a British college, at Oxford, had members who werepounding on him that they weren’t earning enough. He answered bysaying, I admit our returns have been down recently but you mustremember that the last two hundred years have been very unusual!
Tanous:Big consolation!
Miller: I don’t know how long is long enough to get rid of the in-fluence of sample flukes.
Tanous:I have no doubt that Bill Sharpe and Gene Fama’s workall supports the efficient market theory.
Miller: I can’t speak for them, of course, but I believe that mosteconomists would accept the view that, while you sometimes canmake a score by sheer luck, you can’t do it constantly, unless you’rewilling to put the resources in. One way or another, you have to getsignificant non-public information, which most fund managers don’thave.
Tanous:In fact, I thought the most convincing of Gene Fama’s pointswas that he took ten years of mutual fund data from The Top 20Morningstar funds and looked at their performance for the followingten years.
Miller: And there was no correlation. It has all the earmarks of arandom process. One amusing thing that the SEC once did was, theysaid you can’t bring out a new commodity fund unless you've gotfive years of experience. So what do you do? You run your fund onthe small until you manage to hit five good years. Then you’ve got
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a track record, and you say we’ve done it five years in a row! Andthen you go public, of course. All the studies have found that thereis no correlation between the results of the previous five years andthe subsequent five years. Virtually no correlation. But that’s a massstatistical test. There may be one fund that was high in both periods.But remember, in economics, we work with statistical aggregates, notindividuals, so that is bound to happen sometimes. Individuals, quitenaturally, resent our pointing that out. They say, don’t treat me as astatistical aggregate. I’m an individual!
Tanous:!’ve got to tell you, I spoke to Peter Lynch, who was abso-lutely wonderful. I said, Peter, you’ve got to realize that to the greatacademicians, and we're talking Nobel Prize winners, you are themillionth monkey, the lucky orangutan at the typewriter who wroteRomeo and Juliet. And Peter is not the only one with a great record.
Miller: That’s why they’re where they are and I’m where I am. It’sa tough argument to counter. He did have success. Anything we saysounds like sour grapes. If we’re so smart, why aren’t we rich?
Tanous:No. They don’t talk like that. That would be very inelegant.They wouldn’t do that. The point they do make is, wait a minute, letme tell you how I did it! I mean, this is the process that I use, andcontinue to use, and guess what? It’s not magic. It’s just commonsense, and it works.
Miller: Here’s the way to look at it. There’s a famous trader in thebond market at the board of trade - I’m getting so old, I can’t remem-ber his name - but he made huge amounts of money trading bondsand bond futures. He said, I’ve got a foolproof trading system here.But here’s the acid test of whether I really have a winning system. Iwill accept a few hand-picked students and teach it to them. The testis whether they make money. Can you explain it to a third person,and if that third person trades, does he make money? He set up a littleschool and he trained these people. You know what happened? He’snow out of the business and so are the students. Maybe Peter Lynchcan do it, but can he teach another person to do it? If he could, we’dhave some evidence that it’s more than just luck.
Tanous: Well, he says he can in his books. The way I put it to PeterLynch was, if I read both of your books, which I have several times,I'd find the answer to getting rich is to hang out at the mall and seewhat’s selling.
Miller: I don’t read the books. But that’s the thing that makes us
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academics so skeptical. If it’s a teachable skill, then perhaps you canteach it to many others. That may generate enough data to tell skillfrom luck. After all, when a 15 handicap golfer breaks par, which canhappen, you know it’s just dumb luck. But to be considered a realchamp, you have to break par in hundreds of matches. My point isthat you can’t tell skill from luck unless you have large samples. Wejust don’t have them for testing skill in stock picking.
Tanous:! have to ask you a favor.
Miller: Okay.
Tanous: You know that you’re noted for having a wonderful senseof humor. There’s a story, and I don’t know if its true or not, but ifit is I’d love you to tell it. It’s about a speech you were supposed togive in Hamburg.
Miller: Whether it’s true or not, here is the story. I was travelingin Germany many years ago and a friend of mine, a German professor,arranged for me to give a talk to the finance faculty at the universityin each city. I wanted to see all of the big cities in Germany, includingHamburg, but my friend said, I can’t send you to the University ofHamburg because they’re all communists there. There is, however,one school in Hamburg where the communists haven’t taken over,and that’s the high command staff school of the German army, theHochschule der Bundeswehr. Vl set it up for you, he said.
So I went from Cologne to Hamburg on a military pass. I get intothe Hochschule der Bundeswehr and, like he said, it’s a military school.The students, all in uniform, went everywhere running at a trot, notonly in the corridors, but up the stairs. Now the only talk I had forthis trip was on a fairly technical subject of interest only to financeprofessors. So I looked down from the lectern at the rows of younguniformed faces sitting politely at attention in the high-tech auditor-ium, and the only thing I could think of to say was: “Gentlemen:Tomorrow we invade Poland!” [Gales of laughter.]
Tanous:We’re nearing the end of our talk, professor. I wonder if Imight ask you, based on your experience, how do you think peopleshould invest for the future, be it their retirement, or college education,or what have you? Should they buy index funds?
Miller: Absolutely. I have often said, and I know this will get someof your readers mad, that any pension fund manager who doesn’thave the vast majority - and I mean 70% or 80% of his or her portfolio- in passive investments is guilty of malfeasance, nonfeasance or
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some other kind of bad feasance! There’s just no sense for most ofthem to have anything but a passive investment policy. And I knowpeople will say, yeah, but if everybody invested passively, who woulddiscipline the corporations? Well, as I explained earlier, the few peoplewho are willing to spend the money to do it. And they will get enoughextra returns to compensate for their costs. But that’s about it. Mostpension fund managers cannot even reasonably hope to do any betterthan a passive fund. And, on a risk adjusted basis, they don’t! I believethat data are quite strong on this.
Tanous:In fact, Bill Sharpe thinks only “mad money” should beactively managed.
Miller: That’s based on the principle that, as long as you keep theamounts of active money reasonably small, the active managers won’tdo too much damage. Ill tell you another story that will irritate youraudience: The first time I made this point was in the ’50s, when therewas a guy at a pension fund who was explaining to me that he hadfive separate managers. At the end of each year, he’d see whichmanager did the best and which did the worst. He fired the worst andhe brought in another one.
Tanous:A fairly common tactic and theory.
Miller: A common theory. Well, I always say that’s like having apassive fund, all right. Only it’s the most expensive way to do it. Be-cause if you have five separate managers, you're going to wind uppretty much with the market average. So why not just go there in thebeginning and stop all this style analysis nonsense. Some people, I’msure, make a handsome living tracking styles and so forth. ’'m veryskeptical. If I were in charge of a pension fund, | would put it inpassive management.
Tanous:But the style thing does have relevance. The academics havedemonstrated that styles of stock vary together. In other words, thegrowth stocks tend to perform similarly but, for example, the growthand the value styles don’t perform the same way.
Miller: Well, you know, I suppose if you take 50/50 growth andvalue, you get back to the market. How are you going to tell whichone is due to take off?
Tanous: You can’t. The idea is that you allocate assets by style. Onething I find interesting is that the data show that value stocks outper-form growth stocks.
Miller: They show that they have over some period of time. As I
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said, ’'m always worried that the last two hundred years, or whateveryour sample period is, have been somewhat unusual. I take a verylong view and I’m not convinced, yet, that simple passive investingisn’t the best way to go for the vast bulk of all investors. Unless youcan explain to me why some strategy that everybody could follow issuperior.
Tanous:Oh, they explain it all right. They explain it by risk. Theysay you get rewarded for the risk you take. Value stocks are riskier.Ergo, you get more reward with value stocks. Now, that’s controversial.
Miller: Yeah. But if it is risk that accounts for the differential, andit has to be if the differential is not just some random sampling fluke,then some