Will Bill Miller Rise from the Ashes?

Talk about a fall from grace. Legg Mason US Equity and the original US-sold version, Legg Mason Value, managed by the once-revered Bill Miller, has performed so poorly the past 2.5 years that Morningstar now gives the fund 1 star, our lowest rating. This year, the fund has lost an atrocious 28% of its value. In the US, we took the fund off our Analyst Picks list in 2003 when it was still riding high because its high total expense ratio was way too steep even with his record. Still, we've remained positive about Miller and his approach despite the dismal returns since then.

Should it really come as a surprise that Miller, who was once the talk of the investing world because he beat the stock market 15 consecutive calendar years, has hit a rough patch? No. The streak merely masked Miller's bold approach to stock-picking, a strategy that was sure to run out of steam at some point. Not that one would have expected this steep a drop.

Many saw Miller as a cagey investor who was always one step ahead of other investors. They figured he could sniff out the right industry just in time to beat his peers and the market. But that's not an accurate description of how Miller operates. Rather than flitting from one industry to another, Miller invests with a five- to 10-year horizon and consistently favours the same sectors.

Legg Mason US Equity: Right and Wrong Times
Miller likes financial, technology, and Internet stocks. And he typically holds some retail, media, and health-care stocks, too. However, he dislikes most commodity businesses, including oil and copper. Those sector biases were perfect for the markets of the 1990s but have hurt results since oil prices started to spike three years ago. It makes sense that Miller did well in low-inflation environments and has fared poorly in today's world, with financials stocks in crisis and natural resources very precious.

To me, the essence of Miller's strategy is conviction. He's willing to bet more and wait longer than just about any other manager out there. In 1999, he made a poor decision to buy shares of Amazon.com (links will open in a new window) in the $50s. He loved the franchise and saw its growth potential. You know what happened next: The dot-com bubble burst in 2000, and Amazon lost more than 80% of its value. Yet Miller dived in and bought with both fists. The stock rose 75% in 2002 and 179% in 2003, and Miller trimmed his position.

The stock slogged around a bit but came roaring back to gain 135% in 2007. So far in 2008, it has given back a slug of those gains. But Miller earned a great return on Amazon even though he got in too high. That's what separates him from the pack. Amazon is also a typical stock for the fund--the fund's best and worst performers are usually stocks it has held for years. It's hard to argue that the fund is drastically different now than when it was so successful.

Yet we know that Miller's portfolio changed in a couple of ways. Assets in the funds grew from a few billion dollars to about $23 billion at the peak, and now they're at about $13 billion. Those assets didn't water down the fund. It's about as concentrated today as it was 10 years ago. In addition, the fund's exposure to mid-caps is down only a hair. However, the fund now has much greater stakes in companies as a percentage of their outstanding shares, meaning it takes longer for the fund to buy or sell a full position. Although turnover hasn't changed much, it's possible that Miller is stuck holding on to some companies, such as Eastman Kodak that he would have sold otherwise, and that he won't bother investing in some smaller firms. But I think those are marginal considerations.

Another change is that Miller's increasing interest in Internet stocks has escalated volatility. The fund's standard deviation has gone from 30% higher than the S&P's to 50%. (It was as much as 75% greater a couple of years ago.)

One recent contemplated change isn't really a departure at all. Miller said he's considering diversifying a bit more. That had me worried that he was going to depart from his strategy. However, when I looked at the amount of assets he had in his top 10 holdings over time, I found that he's currently near the high end. He has 49% of assets in his top 10; that's off from a peak of around 55% but well above the sub-40% level the fund was in during the mid-90s. So it could be more of a return to his old ways than a departure if he takes his concentration down a notch.

Legg Mason US Equity: Where To Next?
Because sectors rotate in and out of favor, a reasonable scenario for the next 10 years is that Miller's sector biases won't help as much as they did in the 1990s, but they won't hurt as much as they have in the past three years. Put that together with the fact that the fund's trading sizes and volatility have changed, and maybe the fund could beat the S&P three out of the next five calendar years. If the fund didn't have such a steep expense ratio (1.71%), I might even give it five years out of the next eight.