Is Bill Miller Toast?

Talk about a fall from grace. Legg Mason Value, managed by the once-revered Bill Miller, has performed so poorly the past two and a half years that Morningstar now gives the fund one star, our lowest rating. But should it really come as a surprise that Miller, who was once the talk of the investing world because he beat the stock market 15 consecutive calendar 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.

Many saw Miller as a cagey investor who was always one step ahead of other investors. 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 ten-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, too. However, he hates 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 financial stocks in crisis and natural resources very precious.

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

In addition, the fund's exposure to mid caps 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 Kodak, 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's to 50% (it was as much as 75% greater a couple of years ago).

Because sectors rotate in and out of favor, a reasonable scenario for the next ten years is that Miller's sector biases won't help as much as they did in the 1990s, but 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 the fund could beat the S&P three out of the next five years -- and we stop talking about streaks. 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.

Columnist Russel Kinnel is director of mutual fund research for Morningstar and editor of its monthly FundInvestor newsletter.