Can Bill Miller rise from the ashes?

By Morningstar

Talk about a fall from grace. Legg Mason Value (LMVTX, news, msgs), managed by the once-revered Bill Miller, has performed so poorly the past two and a half years that Morningstar now gives the fund 1 star, our lowest rating.

This year, the fund has lost an atrocious 35% of its value. We took the fund off our Analyst Picks list in 2003 when it was still riding high because its high expense ratio was way too steep even with Miller's record. Still, we've remained positive about Miller and his approach despite the dismal returns since then.

Should it really come as a surprise that Miller, who was once the talk of the investing world for beating the stock market 15 consecutive years, has hit a rough patch? No. The streak merely masked Miller's bold approach to stock picking, a strategy that was sure to run out of steam at some point. Not that one would have expected a drop this steep.

Many saw Miller as a cagey investor who was always one step ahead. They figured he could sniff out the right industry just in time to beat his peers and the market. But that's not an accurate description of how Miller operates. Rather than flitting from one industry to another, Miller invests with a five- to 10-year horizon and consistently favors the same sectors.

Right and wrong times

Miller likes financial, technology and Internet stocks. And he typically holds some retail, media and health care stocks.

However, he dislikes most commodity businesses, including oil and copper. Those sector biases were perfect for the markets of the 1990s but have hurt results since oil prices started to spike three years ago. It makes sense that Miller did well in low-inflation environments and has fared poorly in today's world, with financials stocks in crisis and natural resources very precious.

To me, the essence of Miller's strategy is conviction. He's willing to bet more and wait longer than just about any other manager out there.

In 1999, he made a poor decision to buy shares of Amazon.com (AMZN, news, msgs) in the $50s. He loved the franchise and saw its growth potential. You know what happened next: The dot-com bubble burst in 2000, and Amazon lost more than 80% of its value. Yet Miller dived in and bought with both fists. The stock rose 75% in 2002 and 179% in 2003, and Miller trimmed his position.

The stock slogged around a bit but came roaring back to gain 135% in 2007. So far in 2008, it has given back some of those gains.

But Miller earned a great return on Amazon even though he got in too high. That's what separates him from the pack. Amazon is also a typical stock for Legg Mason Value: The fund's best and worst performers are usually stocks it has held for years. It's hard to argue that the fund is drastically different now than when it was so successful.

Yet we know that the fund has changed in a couple of ways. Assets in Legg Mason Value and a similar fund grew from a few billion dollars to about $23 billion at the peak, and now they're down to about $13 billion. Those assets didn't water down the fund. It's about as concentrated today as it was 10 years ago.

In addition, the fund's exposure to midcaps is down only a hair. However, the fund now has much greater stakes in companies as a percentage of their outstanding shares, meaning it takes longer for the fund to buy or sell a full position. Although turnover hasn't changed much, it's possible that Miller is stuck holding on to some companies, such as Eastman Kodak (EK, news, msgs), that he would have sold otherwise and that he won't bother investing in some smaller firms. But I think those are marginal considerations.

Another change is that Miller's increasing interest in Internet stocks has escalated volatility. The fund's standard deviation has gone from 30% higher than the S&P 500 Index's ($INX) to 50%. (It was as much as 75% greater a couple of years ago.)

Where to next?

One recent contemplated change isn't really a departure at all.

Miller said he's considering diversifying a bit more. That had me worried that he was going to depart from his winning strategy. However, when I looked at the amount of assets he had in his top 10 holdings over time, I found that he's near the high end. He has 49% of assets in his top 10; that's off from a peak of around 55% but well above the sub-40% level the fund was in during the mid-1990s. So it could be more of a return to his old ways than a departure if he takes his concentration down a notch.

Because sectors rotate in and out of favor, a reasonable scenario for the next 10 years is that Miller's sector biases won't help as much as they did in the 1990s but that they won't hurt as much as they have in the past three years.

Put that together with the fact that the fund's trading sizes and volatility have changed, and maybe Legg Mason Value could beat the S&P three out of the next five calendar years. If the fund didn't have such a steep expense ratio (1.69%), I might even give it five years out of the next eight.

This article was reported and written by Russel Kinnel of Morningstar and first appeared in Kiplinger's Personal Finance Magazine.