A Worthy Replacement for a Star Manager

Not too many years ago, Bill Miller would have been the toughest act to follow in investing. His record of beating Standard & Poor’s 500-stock index for 15 straight years while managing Legg Mason Capital Management Value Fund (symbol LMVTX) earned him guru status. The streak ended in 2005, and the fund’s performance since has been mercurial, so Miller’s act is no longer so tough to follow. But given his reputation, his newly designated successor, Sam Peters, still has big shoes to fill.

If you like Bill Miller’s style, Peters appears to be a worthy replacement because their MOs are so similar. They own relatively few stocks in their funds, use a value strategy and stick to a buy-and-hold approach—for better or worse. Still, they’re not clones. As Peters told us recently: “It’s incredible working with the guy, but I can’t be Bill. I have to do things that make sense to me.” More on their differences later. Here’s the heir’s pedigree and the succession plan:

Before coming to Value, Peters, 40, worked as an analyst and fund manager at Fidelity, where he ran the Select Health Care (FSPHX) and the Select Medical Equipment and Systems (FSMEX) sector funds. He moved to Miller’s shop in 2005 to co-manage Legg Mason Capital Management Special Investment Trust (LMASX) with Miller, and he became the solo manager in 2006.

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Peters will become co-manager of Value later this year, though when he’ll take over is anyone’s guess. Miller, 61, says he has no plans to retire, and there’s precedence for a long partnership: Miller co-managed Value for eight years before assuming sole responsibility for it in 1990.

Special Investment Trust’s performance under Peters’s watch has closely followed that of Miller’s Value fund. In 2007 and 2008, both were in the bottom 10% of funds in their respective classes (Morningstar categorizes Value as a large-company blend fund and Special as a midsize-company blend fund). One explanation for the dismal performance in those years: Both managers stubbornly clung to hefty stakes in financial stocks. That same resolve paid off, though, in 2009, when Value gained 41% (after losing 55% in 2008) and Special roared back 79% (after losing 54%). Both funds currently have about one-fourth of their assets in financials.

Both funds are lagging in what so far has been a turbulent year for stocks. Year-to-date through June 15, Special returned 5.8%, compared with a gain of 8% for Standard & Poor’s MidCap 400-stock index, while Value has dropped 2.7%, versus a loss of 0.9% for the S&P 500.

Peters says that there are many similarities in the way he and Miller approach stock picking and that their differences are relatively minor. The variations are enough, however, to surmise that Value may become less volatile when Peters takes over. Both men seek to buy stocks that are selling for less than a company’s intrinsic value, or true worth. Often that means beaten-up companies, but sometimes they’ll buy healthy, growing companies they figure will grow faster than the market predicts.

Peters says he’s more likely to buy a “quality stock,” meaning one that’s in less trouble than the kind of stock Miller gravitates to. But a portfolio of such stocks doesn’t mean bigger gains over the long term, he says. “All a quality stock does for you is mitigate the upside and the downside.” Also, while Peters says his ten biggest holdings will typically account for up to 30% of the fund’s assets, Miller tends to run a more concentrated portfolio. Currently, the top ten holdings in Value add up to 38% of assets. And Peters says he will typically hold a greater number of stocks—what he calls his “farm team”—and won’t hold on to them as long as Miller normally does.

Peters offers no predictions about whether these changes will result in a smoother ride for Value shareholders. And he cautions that volatility is baked into funds that invest in “low expectation” stocks. That won’t change, he says. “We never want to change the core process of what we do.”