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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.

Murphy, a relative newcomer to LMCM's CEO role but a 20-plus-year Legg Mason veteran, and Miller also share another big priority: succession planning. Many of the firm's institutional clients have asked who will succeed Miller, who has worked in Legg Mason's investment department since 1981.

While he has not announced any retirement plans, in spring 2010, Miller designated Sam Peters as his successor to eventually take over Value. (Miller hasn't specifically named a successor to Legg Mason Capital Management Opportunity Trust LMOPX, but that fund does have an assistant portfolio manager, Samantha McLemore.) Peters will begin comanaging Value with Miller later in 2010--just as Miller comanaged the fund with his predecessor, Ernie Kiehne. Peters currently manages Legg Mason Capital Management Special Investment LMASX, which focuses on mid-cap stocks but shares the same valuation-based investment philosophy as Value. Peters, who joined LMCM from Fidelity in 2005, isn't a mini-Miller, though. He brought some quantitative thinking to LMCM, for example. More specifically, he has studied stock, industry, and other correlations, particularly as they relate to portfolio construction and risk. Nonetheless, Peter's Special Investment behaves similarly to Value--returns can be dramatic on both the upside and downside.

In addition to addressing succession risk, LMCM also has examined investment risk more systematically in recent years. Regular, staggered quarterly risk assessments are becoming commonplace, perhaps in response to the fund's staggeringly weak performance in the 2007-09 bear market. While these risk reviews include industry-standard information such as sector bets versus a benchmark, they also examine similarities among holdings' underlying business models regardless of sector and also consider a broader set of correlations as well as historic valuations. Given the high-conviction nature of LMCM's portfolio managers, it's tough to imagine a risk review triggering a major shift in a portfolio. However, Peters has said it's a goal to give investors a smoother ride.

LMCM's introspection is encouraging, but it was necessary following the sharp volatility and weak recent returns that took a toll on the funds' long-term results. The firm deserves some credit for being willing to adapt to changing environments. But changing too much can be dangerous. Bad timing is a concern, and changes can be confusing to fundholders and other clients.

In fact, the funds' distributor, LMIS, spends much of its time educating clients and prospective clients on the firm's investment approach. Drew Bowden, the firm's sales and service director, says he knows that LMCM's approach isn't for everyone and acknowledges that investors' appetites for volatility have vastly diminished. In the "core-satellite" vernacular of present-day active-management searches, LMCM is happy to be a satellite approach, meaning that most investors should use LMCM's funds in more-supporting roles in their portfolios.

Meanwhile, LMCM recently has done more to broaden its reach. Once sold exclusively through Legg Mason brokers, LMCM funds are now available through a variety of brokerages. In early 2009, it introduced several new share classes, including A shares that charge a front-end sales charge of 5.75% but also have much smaller 12b-1 fees than the older C shares.

Broader distribution of LMCM funds would certainly benefit the boutique investment shop's parent, Legg Mason Inc. LM, a publicly traded asset-management firm. LMCM isn't Legg Mason's only investment manager. The parent has assembled a strong lineup of asset managers, including Western Asset, Royce, and ClearBridge, as well as LMCM. It has allowed these managers to remain largely independent, so they are free to continue employing the methods and strategies that have made each of them generally successful. That independence has also likely contributed to manager retention, as successful fund managers aren't likely to take kindly to outsiders telling them how to run their funds. Legg Mason's focus historically hasn't been on gathering assets but on the long-term interests of its clients and on supporting and protecting the independence of the investment process of the firm's managers. 

Bridget B. Hughes is a mutual fund analyst with Morningstar.

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