Down in the Dumps Again

If any portfolio manager needs a good year of performance, it has to be Legg Mason Capital Management's Bill Miller. Unfortunately, he didn't get it in 2010.

For the year to date through Dec. 22,  Legg Mason Capital Management Value Trust (LMVTX) is up 7.08%. That's not bad in absolute terms, but it is less than half the S&P 500 Index's 15.14% gain. It also puts the fund well in the large-blend category's worst decile--for the fourth time in the past five years.

The sluggishness continues to take a toll on the fund's longer-term results. Its 10-year return, a 1.61% annualized loss, also sits in the category's worst decile. And while its 7.09% annualized gain over the past 15 years is just outside the category's best quartile, it beats the index by only 27 basis points--which hardly seems enough considering the volatility fund shareholders have endured.

The past decade doesn't seem befitting of the manager who gained fame with his remarkably consistent performance throughout the 1990s and early 2000s--when he managed to beat the S&P 500 Index for 15 consecutive calendar years ... or is it?

Downside Matters
The year's performance continues a pattern of volatile performance--in part reflecting the market's own roller-coaster ride. To Miller's credit, he did manage to bring down the fund's standard deviation this year (though it's still higher than that of the S&P 500 Index), as he's moved into higher-quality, larger-cap, lower-beta stocks because of their more attractive valuations. As the markets vacillated between the beginning of the year and late April, the fund stayed roughly in line with the S&P 500 Index.

During the setback from late April to late August, though, the fund lost well more than the S&P 500 Index, as some of Miller's tech picks, including  Hewlett Packard (HPQ) and  Cisco Systems (CSCO) took a beating. Top pick  AES (AES), which has been part of the portfolio for more than 10 years, also dropped a great deal as investors have fretted about a dilutive stock sale to a subsidiary of China's sovereign wealth fund, as well as weakness in its North American power generation.

As the market has turned up since late August, the fund has gained nearly 18%. But that's actually behind the 20% return of the S&P 500 Index and thus not enough to keep the fund competitive for the full year.

The fund's weak performance in down markets isn't a new phenomenon. Although it held up reasonably well in the dot-com bust of the early 2000s, its downside capture ratio has long been above 100%. (Downside capture measures what percentage of a benchmark's returns have been realized by the fund during down periods.) True, 2008's horrific experience escalated the fund's downside capture during the last decade to 133.49%. But Value's downside capture even during the 10 years before, when it handily outperformed its benchmark and the competition, was 108.01%.

To a large extent, that's a function of the bold approach Miller has taken. In his quest to outperform the index and the competition, Miller's portfolios tend to be distinctive, often focusing on controversial stocks that have fallen on hard times. At the heart of the analysis on each stock is a "central tendency of value," akin to others' price targets. That central tendency of value is less precise and accounts for different scenarios, which can include a stock moving up exponentially or going to zero. As a portfolio manager, Miller incorporates his understanding of investor behavior when constructing the portfolio. In Value's case, that generally results a compact portfolio of 25 to 50 stocks.

The Good News
There is good news. The fund's volatility cuts both ways. So while it tends to lose more in downturns, it has also gained more in up markets.

Consider its spectacular 2009. Last year, Miller led the fund to a 40.64% advance, a top-decile showing. The fund was fueled by Miller's intrepidness. Even after being burned by financial stocks in 2008, he boldly moved back into the sector in 2009 and benefited as investors flocked to riskier stocks. Holdings such as  Capital One Financial (COF),  Wells Fargo (WFC), and  Prudential Financial (PRU) were winners. The fund was also boosted by some longer-term holdings, including top pick AES. Longer-held tech-oriented companies also drove returns:  Amazon.com (AMZN) gained 162%,  eBay (EBAY) 69%, and  Google (GOOG) 102%.

Over time, the fund's upside capture ratio has remained consistent. During both the 1990s and the most recent decade, its upside capture was about 120%. If equity markets have a better decade in the next one than they have in the past 10 years, particularly one where larger-cap blue-chip types excel, investors can expect this fund to shine again.

Other Potential Worries
The question is, of course, whether the fundholder has the risk tolerance, time horizon, and means to endure such a wild ride. Over the past five years, the answer for many has been a resounding "No." Shareholders have redeemed the fund almost every month since mid-2006, when assets were around $20 billion.

Today, assets are less than $4 billion (though LMCM also has some separate accounts in this strategy). While redemptions had tapered off between late 2009 and the first half of 2010, they have picked up again, with the fund seeing more than $500 million in outflows since June 2010. And at least one institutional client, MetLife, has also recently made a change to its variable life insurance and variable annuity accounts, swapping their Value shares (roughly $175 million) into  Legg Mason ClearBridge Aggressive Growth (SHRAX).

There are at least two complications associated with shareholder redemptions for a fund of this size. One, redemptions can get in the way of investment-driven portfolio management. It's arguably more of a problem during sell-offs, which is when most redemptions occur, because portfolio managers could be forced to sell stocks they do not want to sell. It could be particularly problematic here because Miller doesn't carry much cash. That said, today's portfolio is highly liquid.

Two, a shrinking asset base lends itself to diseconomies of scale. In other words, expenses could rise, creating a higher hurdle for portfolio managers to clear. At this point, Value's 2010 expense ratio on A shares of 0.99% lands in the cheapest quintile among other large-cap load funds. (Its C shares land in the second-cheapest quintile.)

One other notable point is that Miller is now comanaging the fund with Sam Peters, who also runs the mid-cap-focused  Legg Mason Capital Management Special Investment (LMASX). Peters has a similar approach to investing as Miller, so not much should change in the way the fund behaves. During Peters' nearly five yeas on Special Investment, the fund is essentially flat and lands in the mid-blend category's bottom decile. That makes it to tough to get too excited about, but the fund has also exhibited the same type of explosive performance when it is hitting on all cylinders.

All told, Value Trust feels like a long shot, especially considering a plethora of strong competitors. But those willing to take a chance on the fund now, as others are leaving, could find their timing smart.