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Can Deep Thinking Lead to Great Investing?

Legg Mason Capital Management hopes so.

Bridget B. Hughes, 09/20/2010

Legg Mason Capital Management may be a shadow of its former self, but it is in no way a shrinking violet.

In just three years, Legg Mason Capital Management has seen its total mutual fund assets plummet. Following a horrific market loss between late 2007 and early 2009 as well as shareholder redemptions, total net assets of the six mutual funds offered by LMCM have dropped precipitously: Net assets have fallen to roughly $8 billion from a peak of around $37 billion in May 2007.

That kind of dive could justifiably rankle even the most stoic of mutual fund executives and investment departments. Consider that between March and September 2007, the advisor earned a $66 million management fee on Legg Mason Value Trust LMVTX alone (the shop's biggest offering then and now), according to its 2007 semiannual report; in that fund's most-recent annual report, though, the advisor recorded a management fee of just $16.8 million for the six months ended Oct. 31, 2009--a 75% reduction. All LMCM funds have experienced a similar pattern.

Although the firm's asset footprint may not be what it used to be, well-known manager Bill Miller and his team continue to be among the mutual fund industry's highest-conviction investors--and a force potentially to be reckoned with in the industry's competitive landscape. The funds' portfolios wear their hearts on their sleeves, complete with generally compact portfolios whose top holdings can regularly take up more than 5% of assets each. Specific sectors are either heavily represented or substantively underrepresented. Miller and the team's shareholder communications continue to offer clear opinions. Value's April 30, 2010, quarterly commentary reads, "We are in the sweet spot of the equity investment cycle." And, as 2009's sharp market rebound demonstrated, that kind of conviction can pay off: Five of the six LMCM funds landed in their categories' best quartiles, and all of them outperformed the S&P 500 Index, itself up more than 25%.

That assertiveness isn't hubris, however. Although one LMCM analyst did recently comment that the shop may have become "overconfident" after Miller's Value fund beat the S&P 500 for 15 years, from 1991 to 2005, LMCM is a group of thinkers. Investors can be assured that each action taken by LMCM, whether it is a new stock idea or a way of considering risk, is deliberate, thoughtful, vetted, and debated. The entire investment team meets daily for half an hour to discuss certain individual stocks or other specific ideas. The fund shop includes a book club, with a reading list on a variety of topics, from investments to how the brain works to organizational behavior. Two senior members of the team, chief investment strategist Michael Mauboussin and Legg Mason Capital Management Growth Trust LMGTX portfolio manager Robert Hagstrom, have each published their own books. The group regularly brings in outside experts in its quest for new ways to think about investing--even if they aren't obvious. For example, after 2008's financial and credit crisis, Miller studied consumers who bought insurance after natural disasters to ascertain how fearful investors might behave. Miller himself is on the board of trustees of the Sante Fe Institute, a research organization that studies "complex adaptive systems."

The investment team also is thoughtfully organized. It has identified three characteristics that it thinks will help it outperform: an informational edge, an analytical edge, and a behavioral edge. For instance, associate and research analysts help provide an informational edge by completing assigned projects and keeping portfolio managers informed of a variety of events and news. Meanwhile, research analysts and all security analysts cover stocks to give the firm an analytical edge. Finally, some security analysts manage money with a behavioral edge, which Miller thinks is the most enduring.PAGEBREAK

Those three edges may not consistently help the LMCM funds outperform, but the setup does help provide a career path for investment personnel. With six funds currently, not every analyst will become a portfolio manager, especially considering that most funds are run by just one portfolio manager. With this and analyst retention in mind, LMCM has seeded a variety of new portfolios, including a team-managed research fund that will feature the analysts' investment ideas and probably will launch as a mutual fund sometime in 2010. Five other portfolios also are in the works.

In addition to keeping talented analysts who want to move into the portfolio-management ranks, new funds have another benefit, according to LMCM CEO Jennifer Murphy: They can diversify LMCM's asset mix. Murphy says one of her goals is to move into other parts of the capital structure, such as bonds, and to diversify geographically. Considering LMCM has to date been primarily focused on U.S. large-cap equities, that likely means the firm would expand its analyst or portfolio-manager ranks. It could also help smooth the firm's assets under management to the extent that not all funds or styles would suffer simultaneously.

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