Bill Miller's Streak Might End. Horrors!

After beating the S&P 500 Index for a remarkable 15 consecutive years, Bill Miller of  Legg Mason Value (LMVTX) is lagging the benchmark by nearly 11 percentage points for the year to date through Oct. 26, 2006. The extent to which the fund trails the S&P--which in turn has taken a toll on its longer-term comparisons with the benchmark--has some investors spooked. For example, after my colleague Russ Kinnel wrote a recent column that placed Miller among the 10 best current mutual fund managers, he received an e-mail from a reader who wrote that Miller, due to his bout of severe underperformance, is no longer among the industry's elite.

We beg to differ, of course. True, it does look increasingly likely that Miller's streak of beating the S&P will end this year, for although the fund has had strong fourth-quarter returns at times (due to holdings that thrive during the holidays, such as  Amazon.com (AMZN)), the current gap will be difficult to overcome in just two months. But we don't think the end of the streak would diminish the fund's attractiveness in the least.

In a way, it might be something of a positive if it helps investors better understand the fund's volatile nature (which the streak has masked). Miller runs a concentrated portfolio, takes big stakes in both racy fare such as  Google (GOOG) and turnaround situations such as  Eastman Kodak , and is willing to hang on to his picks through sharp downturns, so the fund's returns have long been among the most turbulent in the large-blend category. Earlier this year, Miller himself called his winning streak an "accident of the calendar," and it's easy to see why. Since the streak began in 1991, the fund has lagged the S&P in 47 of 178 rolling 12-month periods--more than 26% of the time (and by double-digit percentage points at times in the past). Furthermore, prior to the fund's recent struggles--and despite its consistency during calendar years--it trailed the index over several three-year rolling periods.

Putting The Streak In Perspective
The potential end of Miller's streak brings up a larger point. Even the very best managers tend to underperform, often for extended stretches. For example, two large-blend funds have outpaced or matched Legg Mason Value's return since the start of 1991 with the same lead manager at the helm:  Longleaf Partners (LLPFX) and  Vanguard Primecap (VPMCX). The former lagged the S&P 500 in seven of the past 15 calendar years, including five in a row in the late 1990s' bull market. And Vanguard Primecap trailed the index in five of those 15 years. The cause of this underperformance is clear. In order to beat the benchmark decisively, a manager has to be willing to build a portfolio that looks significantly different than the index and stick to his or her guns when that style is out of favor. (It's no coincidence that all three funds have had consistently low portfolio turnover.) The Longleaf fund typically owns just 20 stocks and will let cash build when appealing ideas are scarce, while the Primecap team tends to hold big stakes in its favorite sectors, particularly tech.

For his part, Miller certainly isn't shy about deviating from the benchmark. Of Legg Mason Value's 44 holdings, 36 are constituents of the S&P, but they comprise less than a fifth of that capitalization-weighted index. Five of the fund's top 10 holdings-- Sprint Nextel , utility concern  AES  (AES), telecom provider  Qwest Communications International  ,  Sears Holdings , and Amazon--consume nearly a fourth of the fund's assets but less than 1% of the index. Furthermore, the fund has no holdings within the surging energy sector, a big reason why it merely squeaked by the index in 2004 and 2005. As a result of all these characteristics, the fund's returns are less correlated with those of the index than the vast majority of its category peers'.

Looking Ahead
Given the fund's atypical look and the generally uneven return profile of the best-performing funds, this fund could very well underperform the index beyond 2006; Miller's picks can sometimes take years to work out. But although his approach should normally lead to significant dry spells, it lends this fund tremendous appeal. Miller and his analyst team meticulously research each firm before purchase, ignoring most short-term metrics and focusing on long-term value. Miller is a fearless contrarian; if one of the fund's holdings gets hammered but the fundamental case for it hasn't changed much (if at all), he'll eagerly scoop up more shares. That tack has often resulted in bursts of superb performance. For all the hand-wringing about the fund's wide performance gap versus the index this year, it's worth noting that the fund beat the S&P by an even larger margin in 1996, 1998, and 2003. Ultimately, the best thing the fund's shareholders can do is ignore its short-term gyrations. They're better off worrying about how they're going to eat or dispose of all that leftover Halloween candy.