Legg Mason fund manager betting 'the bear' is about to take final bow

August 28, 1994|By New York Times News Service

"Exit, pursued by a bear." That stage direction from Shakespeare's play "The Winter's Tale" introduced William H. Miller III's June shareholder report for the Legg Mason Special Investment Trust.

It reflects Mr. Miller's belief that the worst is over. The stock market may yet fall, he wrote, "but with 70 percent of stocks already down, the dollar on the front page and people lining up at the Citibank branch in Tokyo to get out of the dollar at its all-time low, with pessimism about stocks at a five-year high, and analysts speculating about when the next Fed rate hike will come, the scene is set for the bear to exit."

A look at some numbers shows Mr. Miller has not often been

wrong. Legg Mason Special lost money in only one full year since its 1986 inception, quite a feat for a fund that owns risky small-company shares. It is down nearly 3 percent through mid-August, but the year's not over yet.

Mr. Miller's style is hard to pin down. He calls himself a value investor but owns some high-flying stocks that would fit snugly into a growth portfolio.

The common factor: "We look for large discounts to economic value," he said. That is based on today's value of a business' future free cash flows, a figure that factors out depreciation and other noncash expenses and adds back capital expenditures and similar items omitted from profit calculations.

To figure economic value, Mr. Miller uses typical measures such as ratios of price to earnings or price to book value. That discovers many classic value stocks.

But, he said, "We also have companies that don't look anything like that," that "look like growth stocks," in fact, because of their earnings potential. But by his calculations, they are also good value investments.

One example is Diagnostek Inc., a company that manages prescription drug benefits for large corporations. Mr. Miller said Diagnostek, the only stock he bought in the second quarter, sells for about half of what it is worth based on recent purchases of similar companies by major pharmaceutical concerns. But he said he expects a healthy jump in earnings, too -- from 90 cents a share in 1994 to $1.35 in 1995.

Following his style produces a big chunk of financial services stocks. They account for 32 percent of the fund "because the market has valued the broad sector more cheaply than other comparable businesses for the last 20 years," he said.

But those were terrible years, he said. "We believe that the 1990 bank collapse marked a secular bottom in bank stock valuations," he said, and that financial services stocks will be the best performer of the 1990s. He noted that Warren E. Buffett, the classic value investor, made two big purchases in the decade: Wells Fargo Bank and Salomon Bros., the investment firm.

In financial services, the fund's five largest holdings are Standard Federal Bank in Troy, Mich.; Pioneer Group, the Boston mutual fund company; the CMAC Investment Corp., a mortgage insurer in Philadelphia; United Asset Management, a money management company in Boston; and Shawmut Bank of Boston.

Mr. Miller's second-biggest bet is entertainment (14 percent), especially gaming, given the low share prices created by intense competition and regulatory problems.

Caesars World, the fund's biggest holding -- 4 percent of the portfolio -- sells for less than 10 times its next 12-month earnings, he said. Next are Boomtown Inc., a Reno-based gaming company; Hollywood Park Inc., a Los Angeles-area racetrack getting into other types of gambling, and Home Shopping Network.

After financial services and entertainment are health care and specialty retail (7 percent each), telecommunications (5 percent) and computer services (4.5 percent).

Turnover is a low 30 percent, meaning that stocks are held for three-plus years. "It's tough to get below that number because we're wrong about one-third of the time, and we eliminate companies that we made errors on," he said.

The first half of the year was especially hard for Legg Mason Special, with the fund losing 9.8 percent through June, compared with 7.9 percent for all small-company funds. But the fund rebounded in the last few weeks, and, as of Aug. 19, was down only 2.9 percent.

Mr. Miller has been rewarded for sticking with certain picks. Like Mexico, which accounts for most of the fund's 15 percent foreign holdings. Mexican stocks played a big part in the fund's poor showing through June because of plunges in the country's stock market and in the United States dollar.

But with prices depressed, Mr. Miller continued to buy and reaped the benefits when the market rebounded. He was also hurt by many gaming stocks earlier this year, but many of them also turned around recently.

How did someone who stopped his studies just short of a doctoral degree in philosophy turn to money management? Basically, the philosophy was for fun because his interest in investing started early. At 9 years old, he asked his father what newspaper stock listings meant, and when told that a plus sign indicated that the share price rose and investors made money, he asked what he could do to make "pluses."

When his father said he need do "nothing," he decided to become an investor. But, he says now, "I underestimated how much work it really is."

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