Bill Miller fights back
The famed investor's flagship fund has a two-year losing streak vs. the S&P 500. Now he's loading up on takeover targets like Yahoo and Countrywide Financial. He explains his strategy to win again.
(Fortune Magazine) -- It's been a rough couple of years for Bill Miller. His $16.5 billion mutual fund, Legg Mason Value Trust, just turned in its worst two-year performance relative to the S&P 500 since 1990, trailing the index by ten percentage points in 2006 and by 12 last year. That would be a poor stretch by any standard, but it's even worse by Miller's own: Until 2006 his value-oriented fund outperformed the index every calendar year for an astounding decade and a half (see "The Man Who's Beaten the Market 15 Years Running," Nov. 27, 2006).
With relatively few stocks in the portfolio - fewer than 50 at present - Value Trust (LMVRX) has long been one of the most volatile funds in its category. But investors aren't used to seeing Miller lose, and they pulled more than $3 billion out of the fund in 2007, according to Financial Research Corp. Based on its expense ratio of 1.7%, that adds up to a $50 million annual drop in revenues from fees.
The loss of confidence in Value Trust reverberates loudly through Legg Mason (LM). Miller is not just the firm's star fund manager but also chairman and chief investment officer of its $59.6 billion equity investing group, Legg Mason Capital Management. And the stumble by its flagship fund has come at a particularly tough time for Legg. In January it finally completed a drawn-out CEO search to replace co-founder Raymond "Chip" Mason. Last quarter it had to take a $23 million charge related to asset-backed securities in its money market funds. And its stock has fallen 30% over the past year, way underperforming its peers. The Baltimore investing house could use a Miller comeback, and soon.
What's behind his slump? Ever a contrarian, Miller is famous for taking chances that most value managers avoid, such as buying high-multiple stocks like eBay and Google (GOOG, Fortune 500). During the past few years, however, he's made several wrong calls. By failing to pick up energy on the cheap in 2003, Miller missed out on the run-up in commodities. Exposure to homebuilders and troubled mortgage lender Countrywide Financial, meanwhile, have weighed on the fund.
And while owning fewer stocks helped fuel Miller's streak when his picks were beating the market, the highly concentrated fund has suffered disproportionately as its top sectors - consumer cyclicals, financials, and health care - have continued to lag.
If Miller is going to return to market-beating form in 2008, two big bets he's made in recent months will be key. He has built up stakes in a pair of companies, Countrywide (CFC, Fortune 500) and Yahoo (YHOO, Fortune 500), that are the targets of high-profile takeover bids - and he's been agitating for higher offers from their suitors. The famed money manager recently got on the phone with Fortune to share his strategy on each stock.
Miller began buying shares of Countrywide in 2004 - well before the mortgage meltdown sent the highflying lender's stock plummeting (from $40 to $4) last year. As he's done successfully in the past with falling stocks he likes (Amazon (AMZN, Fortune 500), for example ), Miller decided to double down. In the fall he bought Countrywide aggressively.
On Jan. 11, Bank of America made a $4 billion all-stock takeover bid for Countrywide. (BofA valued each share at $7.16.) Countrywide's board has approved the offer. But Miller questions conventional wisdom that the company can't survive on its own. "What you have is still the nation's largest mortgage originator and the largest mortgage servicer with a $1.5 trillion portfolio that's easily salable," he says. "The housing market is going to get better. When it does, Countrywide will be in a great position because so much of the competition has disappeared."
Not that he's necessarily against a merger, either. Legg Mason was already Countrywide's largest shareholder at the time of the bid, and Miller has since raised his firm's combined stake in the lender from 11.8% to 14.9%. He says the investment is a win-win. "If the deal goes through, we acquire Bank of America shares at a very attractive discount," he says. "If the deal gets turned down, it's because shareholders believe they can get a lot more value if the company remains independent." He hasn't yet said if he'll vote to approve BofA's offer.
Miller is even more outspoken about Microsoft's unsolicited bid for Yahoo. As with Countrywide, he's been building a large position in the online giant for a few years. As of Dec. 31, 2007, Yahoo was his ninth-largest holding in Value Trust, at 3.4% of the fund. (Overall, Legg Mason is Yahoo's second-largest shareholder, with more than 80 million shares.) Microsoft's offer - a 60% premium over Yahoo's prebid price - gave him a boost. But Miller is convinced that Microsoft needs to raise its bid to close the deal and gain on Google. "It's critically important to Microsoft," he says. "They're a distant No. 3 [in search], and they're under a big threat. I think ultimately they'll end up paying whatever it takes to get this thing." A proxy fight, Miller says, would be a losing proposition. "They're going to be left with something that's a lot less valuable than if they pay a little bit more and get everybody onboard," he says.
Reversing his fund's slide will depend on more than just good returns on Countrywide and Yahoo, of course. And history offers some solace to Miller's investors. As he noted in his latest letter to shareholders, Value Trust's last two-year slump directly preceded the beginning of his 15-year winning streak. He sees similar opportunities now after the market's recent stumbles.
"What took us into this malaise will be what takes us out," he wrote. Beaten-down sectors like financials and homebuilders, he says, increasingly look like bargains. And they should rebound when growth picks up. "We've already had the pain of a recession in our portfolio," he said in a January conference call with Smith Barney financial advisors. "As things fall, you've got to play more and more offense, not defense." As Miller knows, you don't win big by playing not to lose.