Legg Mason's Miller says shifting investor sentiment should boost holdings

As mutual fund Legg Mason Value Trust comes off its worst quarter ever, star manager Bill Miller told shareholders he thinks the fund's beating in the market -- while it hurt -- should position it for strong returns in the future.

Miller is famous for beating the Standard & Poor's 500 index for 15 consecutive years, and investors pore over his quarterly letter to shareholders for market insights. But in the first quarter, Value Trust was down 19.7 percent, compared with 9.4 percent for the S&P. That was the fund's worst quarterly performance relative to the rest of the market in its 26-year history, and Miller didn't mince words, calling the quarter "awful."

"Few are more disappointed than the team here (at Legg Mason Capital), as we are substantial investors in our products," Miller wrote in his latest letter, released Wednesday. But Value Trust's portfolio "is in excellent shape, despite, or more accurately because of, its performance," said Miller, the best-known fund manager in Baltimore-based Legg Mason's (NYSE: LM) stable. The prices of stocks in the portfolio have declined far more than the worth of the businesses themselves, Miller said. That means when investor sentiment changes, the fund's holdings should benefit greatly.

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And investor sentiment will change, Miller said, noting a Barron's cover story from the late 1990s questioning whether investment sage Warren Buffett had blown it by not investing in technology stocks -- which soon crashed in the tech bust.

In the first few weeks of the second quarter, the S&P rose just over 5 percent and Legg Mason Value Trust rose a little more, Miller wrote. The Value Trust guru believes the collapse and bailout of investment bank Bear Stearns "ended the panic phase of the credit cycle," noting that stocks have risen since Bear's collapse. And Miller wrote that while headlines focused on Value Trust's ownership of Bear Stearns stock, "our position in J.P. Morgan was nearly three times larger." J.P. Morgan stock made up 5 percent of the fund's portfolio at March 31.

The stock market should benefit if commodity prices stop their "relentless" rise, Miller wrote, but if prices keep rising, "they have the potential to destabilize the global economy." Miller also said the Federal Reserve could help the economy by stopping its interest rate cuts. That would boost the weak U.S. dollar, which would help offset commodity price increases and inflation, Miller said.

In Miller's previous quarterly letter to shareholders, he weighed in on Microsoft's bid for Yahoo -- one of Value Trust's largest holdings, comprising 4.4 percent of its portfolio. But this time he made only an oblique reference to the bid. In discussing the gaps between stocks' price and their value in the current market, he described it as the reason "why Microsoft (NASDAQ: MSFT) can bid over 60 percent more than where Yahoo! (NASDAQ: YHOO) was trading and still be getting a great deal."