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Smooth Transition Expected When Star Manager Departs

Bridget B. Hughes, CFA

Bridget Hughes: Hi, I'm Bridget Hughes. I'm one of the fund analysts here at Morningstar, and I'm here today with Sam Peters, who is currently the comanager of the Legg Mason Capital Management Value Trust portfolio. He will become the sole manager of that portfolio at the end of April when Bill Miller steps off that fund. Miller will continue to run the Opportunity Trust fund for Legg Mason Capital Management.

Sam, thanks for joining us today.

Sam Peters: My pleasure, Bridget.

Hughes: So, those are some big shoes to fill?

Peters: Sure.

Hughes: Bill Miller obviously has been around for a very long time and has a very good long-term performance record. What is your mind-set as you come in to taking over his baby of 30 years?

Peters: Of course, I'm honored. There is a lot of rich history here. With valuation-driven stock-picking, this was one of the icons in the industry for doing that. So, I'd break it into sort of two pieces, skill and luck. From a skill side, we have a process that's pretty well-established, and there is a lot of continuity there, like I mentioned around valuation.

We think about what I call our active bets and we are in concentrated portfolios and are long-term. But the key was when I joined Legg Mason Capital Management seven years ago, I was selected for those things. So, it's not like I was a square in a round hole. So, that's gone well, and we've been able to build up the team. Much of that team I have helped build out around this culture and around those tenets, and they are people that Bill and I have vetted and worked well with together. They understand the process and are doing an excellent job. I think I have a lot of skill there in the team to work with.

Then you look at luck. Look at the time; people aren't exactly enamored of U.S. active equities right now. Equity risk premiums as we measure them and different people measure them are certainly very elevated versus historical numbers.

Basically there has been a lot of headwinds against equities and a lot of tailwinds for fixed income. As a contrarian valuation guy, when would you want to take on a long-only, active product on the equity side? It's now. So, as those headwinds become some tailwinds, I think my chances of being lucky are pretty good, and that will sort of amplify the skill that I think is there both at my level, but also in executing with a great team.

Hughes: As I mentioned, Bill Miller has been on this portfolio for 30 years using a valuation-driven process. You mentioned the things are the same. It's valuation-driven process with active bets and concentrated portfolios and also is long-term. Just very quickly, can you tell me what you mean by "long-term" and then maybe can you talk a little bit about some of the evolution that you might bring to the process or the construction?

Peters: For me, [I think of] "long-term" [to mean] if we could get a great company that's a great compounder and people just misunderstand the value proposition in the company, we will own on it forever if we think we have edge there. But with long term--realistically and where we have a lot of our conversation with management teams when they come in and we interview several a day with our analysts--we're really thinking about three to five years. We're thinking about strategic and competitive analysis over that time. How will value be created or destroyed? That's really what we're trying to frame.

Clearly, we can't control the timing in the market. Sometimes our insight gets picked up very quickly. Other times, it can take a long time, and sometimes we're just wrong. So over that time, you've got to look at it, but generally it is three to five years that we're thinking of. We live in a short-term performance-driven world, so a lot of it is how do you balance those things and still execute around three to five years, and we've done some things to really to think about that.

But for me that's there, and the proof is in the pudding as I have said you several times, talk is easy. If you look at turnover, there were times when Miller's turnover on the fund during the last three years has been less than 10%. So, clearly that's 10 years-plus. I have typically been around 25% to--sort of at the very high end during crises--around 50%, but that's still two years-plus up to five years. That still fits with that three to five years, and you'll continue to see that.

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Hughes: Whether it be in the tools that you're using or other specifics that pertain to the construction of the portfolio, what are some other changes?

Peters: At the individual-name level, we're still expectations investors basically. How much can you win if you're right? How much can you gain, and how much can you lose? And we think about price-value gaps. So, every time we start with XYZ company, such as Apple at $630, one needs to be right for that to make sense. Really where we've evolved a lot is the portfolio-construction layer. Miller and I have done that together, and we've done it with the team. But we're really thinking about the active bets and the side bets.

So, in this environment where you have had high correlations, macroeconomic flares, strong interest in exchange-traded funds, and so on, it's almost like there is glue in the markets that during periods are making equity sort of a lump of risk assets, if you will. In environments where that happens, how do you look at the stock-picking that we've always done around valuation? How does the signal get up to the portfolio level? And we'd been spending an inordinate amount of time there.

So, if I say I'm looking and I find companies with good capital deployment, fast dividend growth and share buyback, and they look attractive, where are those bets at the portfolio level versus the market? We're doing much more in measuring that, substantiating what those are. That's because in this environment in our opinion, if you're not doing that and putting together your mispriced stocks as we see them intelligently at the portfolio level versus the index and really measuring it, really thinking about it, those macro flares can just create side bets that just sort of shove everything at the sides. So, we've done a lot of there.

A final thing, I grew up looking at health care, technology, and financials. There was a lot overlap with Miller, but especially in the parts of technology, health care, and some of the groups, he and I sort of complemented each other well. And that's always true on any team. So, you're going to see some differences, and we've already built it into the portfolio where Miller sort of had me do that. There will be some little differences there, but at the end of the day this is a lot more about continuity and fit.

So the strategy is contrarian valuation-driven, betting your convictions when you think you have edge, and, like you mentioned, being long-term is the core bedrock. But I can't be Bill Miller. I've got to be Sam Peters, and Miller's always encouraged me to act accordingly.

Hughes: The two of you have actually comanaged this portfolio since November 2010, and already people always wonder, "When the star manager comes off the portfolio, is there going to be a 100% turnover, and are things really going to change?" But having worked together already for 18 months, you'd say a lot of that change has already occurred?

Peters: Yes. And it's even more long-term than that. Typically when you say you're long-term, you have to act it at all levels. When I first came to Legg Mason seven years ago, Miller and I were co-portfolio managers on a fund then. Miller originally started Value Trust with Ernie Kiehne as a comanager. Miller and I were on other institutional products as comanagers. So, we've had a lot of practice, and we're thoughtful about this. And like I said, Miller is a very good comanager.

He and I get along; we generally see the world the same way. So, there is a lot of fit and a lot to work with. But we're also very honest with each other. We don't always agree on everything. We're willing to debate things, but as we've gone through this transition year, it's not perfectly linear. But you don't want to on day one [of having control of the portfolio] say, "Now I can go and really express myself." That's not how we do it. It's been looking to see where the big valuation opportunities are, and having me help him go out and execute that. And then it's taking on more day-to-day roles as you get close to transition; we've followed that model.

Hughes: Well, good. Thank you very much for coming in.

Peters: My pleasure. Thanks a lot.