Can Legg Mason Value Revisit Its Glory Days?

From first to worst--that summarizes  Legg Mason Value's (LMVTX) performance over the past decade. The fund has lagged the S&P by 23 percentage points for the 12 months ended July 28, 2008. As a result, investors who bought the fund even a decade ago have now experienced performance over that span that lands near the large-blend category's worst quartile and lags the S&P 500 Index, too. That's right--the fund that famously beat the index in each of the 15 calendar years from 1990 through 2005 has seen its once-superb record greatly tarnished by the severity of its recent underperformance.

Investors have subsequently fled the fund in droves. But while the fund's poor performance has been painful, we think it's time for investors to consider buying more shares.

What Went Wrong
The fund's troubles have been well-documented, most recently in a column by my colleague Russ Kinnel, Morningstar's director of mutual fund research. In a nutshell, portfolio manager Bill Miller and company have made significant mistakes. One, they underestimated the extent to which their financial holdings were exposed to shaky borrowers. ( Freddie Mac (FRE) is a painful example of this.) And two, they didn't recognize the extent of the bubble in the housing industry. Miller bought into builders after they initially dipped in late 2005, only to see the stocks fall much further. Another factor that hurt performance was the fund's avoidance of high-flying energy stocks--an area that Miller and company have largely ignored over the fund's lifetime. Amplifying the effects of problems in specific stocks is the fact that the portfolio is (and always has been) highly concentrated. When a top holding goes into free-fall here, it hurts. When four or five or six do, it's excruciating.

Baltimore Bound
As longtime readers know, we've always liked Miller's eclectic value style and we recognized that his bold, focused approach would mean bouts of short-term underperformance from time to time. We didn't anticipate underperformance as severe as this, however. So, we've kept in regular contact with Miller, and we also headed to Baltimore last week to ask some tough questions. Are they changing their approach? If they're sticking with many of the same bets, what's the case for them now? Do recent departures on the analyst team bode ill for performance? And can the fund make up the vast amount of ground it's lost to the index? Finally, what have they learned from their mistakes that can help them avoid repeating them down the road?

We spent a full day at the offices of Legg Mason Capital Management. We interviewed Miller and the other senior members of the investment team: portfolio managers Robert Hagstrom of  Legg Mason Growth (LMGTX), David Nelson of  Legg Mason American Leading Companies , Jay Leopold of  Legg Mason Partners All Cap , and Sam Peters of  Legg Mason Special Investment (LMASX), as well as investment strategist Michael Mauboussin and research director Randy Befumo. We came away confident and impressed.

Reasons For Optimism
Not everyone at the firm thinks exactly as Miller does, but the investment professionals share a common investing philosophy. Each of the five portfolio managers, for example, runs a concentrated portfolio, employs a long-term approach, and currently believes that financial stocks are undervalued and energy stocks too pricey after their lengthy rally. The managers point out that the valuations of commodities versus financial stocks are now at a 50-year high. Another shared belief is that the market is assuming much larger future write-offs due to bad loans and derivatives than Miller and company foresee. Those disparities represent reasons why Miller continues to stick with beaten-down financials such as  American International Group (AIG) and  Citigroup (C). They also help explain why Miller is betting bigger now than he has in years--he recently pared back the number of holdings at Legg Mason Value to 30 from 48, in part so that he can focus on what he believes are the very best opportunities out there. (Redemptions from the fund also drove the elimination of some of the smaller positions.)

We also like the thoughtful way the team is responding to this rough stretch. They're not panicking and veering from their successful long-term strategy, as demonstrated by their continued (and in some cases, increasing) commitment to financials they think will emerge from this mess alive and well. But they are trying to learn from their mistakes and are considering new information and potential tweaks that could help the fund avoid a repeat of its recent problems. Just after our visit, for example, the firm held a summit on the future of energy, bringing in outside experts from the industry, debating whether the current surge in energy prices is sustainable, and examining alternative energy's effect on prices. Miller and his team admit that shareholders would have been better off if the firm had gotten its arms around energy years ago, but we're still glad to see this display of open-mindedness. Similarly, Miller showed us a quantitative study undertaken by one of the analysts that looks at correlations between sectors and different types of business models, which could be used to tweak portfolio construction and potentially keep the fund from suffering so many blowups at the same time.

And then there's Miller himself. We like the fact that he isn't backing down from his time-tested investment philosophy, which gives Legg Mason Value a better chance to rebound strongly. The aforementioned valuation disparity between financials and commodities helps make the fundamental case for his current stance. One of the companies in that sector that Miller believes is dramatically undervalued is AIG. He argues that the firm still possesses a dominant franchise across the globe and that investors have greatly overreacted to the one area where it has significant issues: the lending portfolio of its life insurance business. The other portions of the company are performing well, he says, and he believes that new CEO Robert Willumstad will successfully reimplement the expense controls that former longtime head Hank Greenberg employed to bolster the company's profits. He thinks that the company is trading at 5 to 6 times what it will earn per share next year, which is less than half its historical average.

Miller's willingness to stand by his picks could result in significant outperformance if he's right. Indeed, when banks rebounded in late July and energy stocks tanked, the fund made up ground quickly--it won back 4 percentage points versus the S&P 500 in about a week, demonstrating its upside potential.

A Small Concern
During our visit, we discussed one unsettling fact: The firm has lost eight analysts in the past couple of years, including co-director of research Ira Malis. According to Befumo, many of those who left were part of a hiring surge between 2003 and 2005. At least some of those analysts left because, although their fundamental analysis was sound, they couldn't handle that the stocks they covered were declining so sharply. We also got the impression that the firm got away from its traditional practice of hiring younger analysts who don't have MBAs. Befumo says it's more difficult to train MBAs, because they're already practicing an approach that differs greatly from the firm's own, distinctive investing strategy approach. That change in hiring practices may have contributed to the poor performance.

Still, there is reason for optimism on the research front. With 10 securities analysts, the fund still has far more backing it than it did throughout the 1990s, when the fund thrived--and those who have remained are generally more experienced. The managers are also supported by lower-level investment professionals, including six research analysts (who tackle special projects, assisting in areas where research needs are greatest) and seven members of the market intelligence group, which collects and summarizes market and macroeconomic data and outside research.

We'll carefully monitor the analyst situation, but for now, we're comfortable.

Conclusion
Like most, we're disappointed in just how poorly the fund has performed over the past couple of years. It also reflects the fact that the fund, while historically one of the most volatile offerings in the large-blend category, has grown more turbulent in recent years (as Russ Kinnel pointed out in his column). However, the organization and research behind the fund are still fundamentally sound, and Miller's stock-picking remains thoughtful and diligent.

We'd also note that prominent managers whom we have supported in the past through difficult times have often come roaring back. For example,  Longleaf Partners (LLPFX) struggled mightily in the late 1990s when its deep-value philosophy clashed with the mania over tech stocks (and the disregard for so-called "Old Economy" stocks), but the fund went on to post superb returns after the market's early 2000 peak.

We continue to think that Legg Mason Value is appropriate as a core holding only for investors with high risk tolerances and long time horizons. Furthermore, the expense structure of the Primary shares (the most widely available share class) means that investors who get quality financial advice in exchange for paying those shares' 1% 12b-1 fee will be best served here. But we think that the long-term rewards for owning this fund will be great--and we wouldn't be surprised to see the fund go from worst to first again. 

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