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What went wrong with Bill Miller’s Legg Mason Value Trust Fund?

Bill Miller, Chairman and Chief Investment Officer of Legg Mason Capital Management – the fund manager for Legg Mason Value Trust fund, the fund that made him famous – from 1991 to 2005 it’s a steak no other fund manager has come close to matching.

He was named by Money magazines as “The Greatest Money Manager of the 1990s”, by Morningstar.com as the “Fund Managerof the Decade” and many other infamous awards. But over the past year, he destroyed it.

What went wrong? A year ago when troubles in the housing market began infecting financial markets, leveraging from his well-worn playbook, he snapped up American International Group Inc, Wachovia, Bear Stearns and Freddie Mac. As the shares continued to fall, he argued that investors were overreacting. He kept buying. What he saw as an opportunity turned into the biggest market crash since the Great Depression. Many Value Trust holdings were more or less wiped out.

A lesson for ‘value’ investors: A stock may look tantalizingly cheap, but sometimes that’s for good reason.

Mr Miller has profited from investor panics before. During the savings-and loan crisis in 1990 and 1991, Mr Miller loaded up on American Express, Freddie Mac and struggling banks and brokerages. Financials eventually made up more than 40% of his portfolio. He looked wrong at first. But these stocks eventually propelled Value Trust to the top of the performance charts. In 1996, Value Trust gained 38%, 15% more than the S&P 500. By then, Mr Miller was loading up on AOL, computer makers and other out-of-favour tech stocks. His good bets more than made up for the bad. Between 1998 and 2002, 10 stocks in the Value Trust portfolio lost 75% or more. Three, including Enron and Worldcom, went bankrupt. As his winning steak grew, Mr Miller’s name was often preceded in press reports with the word ‘legendary’. He was mentioned alongside the likes of Fidelity’s Mr Lynch.

But this time, he said, he failed to consider that the crisis would be so severe, and the fundamental problems so deep, that a whole group of once-stalwart companies would collapse. “I was naive,” he said.

Mr Miller’s strategy – worked for a long time but it’s broken. In the early summer of 2007, two Bear Stearns hedge funds that made big bets on low-quality mortgages imploded. The stock market whipsawed in July and August, as investors worried that housing-market troubles could spread. Mr Miller thought investors were to pessimistic about the housing and credit markets. In the 3rd quarter, he bought Bear Stearns. In the 4th quarter, as financial stocks fell, he took positions in Merrill Lynch, Washington Mutual, Wachovia and Freddie Mac. Explaining his moves to his shareholders in a 4th quarter update, he compared the period to 1989-90, when he had also bought beaten-down banks. “Sometimes market patterns recur that you believe you have seen before,” he wrote. “Financials appear to have bottomed.” In 2008, Mr Miller continued to accumulate Bear Stearns. At a conference on Friday, March 14, he boasted that he had bought just that morning at a bargain price, north of $30 a share – down from a recent high of $154. Bear Stearns collapsed that weekend.

Mr. Miller says the conversation with Bear Stearns’s new owner left him satisfied that he’d fairly valued the investment house’s troubled mortgage holdings. But his team had missed Bear Stearns’s vulnerability to a “run on the bank” collapse: The heavily leveraged firm was borrowing huge sums to function day-to-day, and when lenders walked away, it collapsed. Mr. Miller says he was also surprised that the Federal Reserve would play an active role in a transaction that would let stockholders be largely wiped out.

Mr. Miller worried that Wachovia and Washington Mutual were vulnerable to a similar squeeze on capital. He sold both.

But he didn’t abandon financials. During the second quarter, he added to Freddie Mac and insurer AIG. In an April letter to shareholders, he wrote that the rebounding stock and bond markets suggested a corner had been turned. “The credit panic ended with the collapse of Bear Stearns,” he wrote. “By far the worst is behind us.”

By the end of June, Mr. Miller’s group held 53 million Freddie shares — about 8% of the company.

Financial stocks continued to fall though the spring and summer. Many value investors, such as John Rogers at Ariel Investments, sold or at least stopped buying the sector.

With Freddie and Fannie under particular pressure, some at Legg Mason Capital Management were worried that group-think had set in. “There were hedge-fund guys out there arguing that Fannie and Freddiewere going to zero,” said Sam Peters, a fund manager in Mr. Miller’s group.

Mr. Peters, whose fund also owned Freddie Mac, suggested putting together a team of Legg research analysts to argue the case against Freddie. In early-August meetings devoted to the mortgage giant, the so-called “Red Team” said Freddie may need to raise substantial capital, which would massively dilute existing stockholders’ shares.

Mr. Peters stopped accumulating Freddie shares. Mr. Miller kept buying them for his Opportunity Trust portfolio.

The risk, as Mr. Miller saw it, was that the housing market could perform worse than he expected. But he dismissed talk that the government could nationalize Freddie and Fannie. He took comfort in Treasury Secretary Henry Paulson‘s mid-July statement that the government was focused on supporting the agencies in their “current form.” If anything, he believed, Freddie would recapture market share as private-sector competitors failed.

By the end of August, declines in AIG and Freddie left Value Trust down 33% over the previous 12 months — 21 percentage points worse than the S&P 500 over the same period. Mr. Mason, Legg’s founder, received complaints from brokers about Mr. Miller. Mr. Fetting, Legg’s chief executive, fielded questions about whether Mr. Miller would be replaced.

The news got worse on the weekend of Sept. 6 and 7. The Treasury announced it was taking over Fannie and Freddie, rendering private shareholders’ stakes nearly worthless. On Monday, shares in Freddie, which had started the year at $34 and entered the weekend at $5, were trading at less than $1. A government takeover was the one outcome for which Mr. Miller hadn’t prepared…

The thing I didn’t do, from Day One, was properly assess the severity of this liquidity crisis,” Mr Miller, 58 years old, said in an interview at Legg Mason Inc’s.

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