Legg's Miller seeks redemption as housing bull

Star manager's bets on property rebound look good...so far

Oct 15, 2012 @ 9:34 am

Legg Mason Inc. (LM)'s Bill Miller, who beat the Standard & Poor's 500 Index for a record 15 years before crashing on bank stocks, is seeking redemption as a housing bull.

Miller's Legg Mason Capital Management Opportunity Trust (LMOPX) has bet about a third of its holdings on a property rebound through homebuilders, mortgage real estate investments trusts and loan insurers. That's propelled the $952 million fund to a return of 29 percent this year through Oct. 11, surpassing 99 percent of peers, according to data compiled by Bloomberg. The fund lost 35 percent in 2011, last among its category, when he prematurely bet on a recovery.

“Housing fundamentals are likely to be positive for years,” Miller, 62, said in a telephone interview. “The stocks have run, but in our judgment are not even close to reflecting that long cycle.”

The reversal shows how Federal Reserve efforts to push down borrowing costs to record lows are helping drive a more sustained recovery in real estate after a six-year slump. Gains in mortgage applications, prices and sales of new and existing homes have lifted stocks and bonds linked to housing, after being pummeled last year.

Miller's winners this year include homebuilder PulteGroup Inc., which has doubled after dropping 16 percent in 2011; Ellington Financial LLC (EFC), a mortgage bond investor that's up 30 percent following a 22 percent decline; and firms tied to a housing rebound such as Bank of America Corp. (BAC), which has gained 64 percent after plunging 58 percent last year.

Buying Ugly

Shares of the Charlotte, North Carolina-based bank could double within three years, said Miller.

Miller's willingness “to go out on a limb and buy things that look ugly,” explains the performance swings, Bridget Hughes, an analyst with Chicago-based Morningstar Inc., said in a telephone interview. “It can be painful sometimes, but when it works, he knocks the ball out of the park.”

The Opportunity fund, which Miller has run since 1999, slumped in 2011 as housing and financial stocks were hurt by investor concerns about Europe's sovereign debt crisis, he told shareholders in a January letter. “The worst things to own were mostly where we were invested,” Miller wrote.

Hughes said in a December 2011 note about the Opportunity fund, “you have to look hard for the redeeming qualities.”

Miller set a record for beating the S&P for 15 years through 2005 by picking inexpensive financial shares and out-of- favor technology companies. His flagship Legg Mason Capital Management Value Trust, (LMVTX) started trailing after investments in Amazon.com Inc. and UnitedHealth Group Inc. went awry.

During the 2008 credit crisis the fund lost 55 percent betting on financial stocks, prompting a wave of withdrawals after peaking at $21 billion. In 2006, 2008 and 2010 the fund underperformed at least 98 percent of comparable funds, Bloomberg data show. Miller left Value Trust in April.

Legg Mason Chief Executive Officer Mark Fetting stepped down in September after failing to end almost five years of client redemptions. Under Fetting, shares at the Baltimore, Maryland-based company fell 65 percent.

While conceding he was too early in expecting a turn in housing, Miller said a bounceback was a “a mathematical inevitability.”

The housing slump drove starts and purchases so low that pent-up demand was bound to kick in, Miller said. The combination of low interest rates and affordable prices has given the rally additional strength, he said.

'Worst Over'

The S&P/Case-Shiller index, which gauges property values in 20 cities, rose 1.2 percent in July from a year earlier, the biggest 12-month jump since August 2010. The measure fell 35 percent from the peak in July 2006 to February 2012.

“Everything we see points that the worst is over,” Bank of America Chief Executive Officer Brian Moynihan said about housing in an Oct. 11 interview with Bloomberg Television in Tokyo.

Miller goes further. “The surprise on the economy is that the economy will get better because housing will get better,” he said.

The U.S. economy will expand 2.1 percent this year and 2 percent in 2013, according to economists surveyed by Bloomberg.

The Opportunity fund had 13 percent of its money in homebuilders as of June 30, regulatory filings show. Two of the stocks, Bloomfield Hills-based Pulte, (PHM) and Los Angeles, California-based KB Home (KBH), more than doubled this year, Bloomberg data show. The third, Lennar Corp. (LEN) of Miami, Florida is up 82 percent.

Homebuilder Stocks

Miller bought KB and added to his holdings of Pulte in the second half of 2011, regulatory filings show, as the Standard & Poor's Supercomposite Homebuilding Index reached its low point for the year. The three builder stocks were among the biggest individual contributors to the fund's 2012 performance, Bloomberg data show.

Barclays Plc cut its rating on Lennar to equal weight from overweight on Sept. 25. Stephen Kim, the analyst, wrote, “It appears we have reached that point in the rally when investors are pricing in a 'best-case scenario,' for the strongest builders."

Miller had 5.9 percent of his portfolio in mortgage REITs and another 4.1 percent in Old Greenwich, Connecticut-based Ellington, which gets most of its earnings from non-agency home loans.

Subprime Mortgages

The debt, which includes subprime, prime mortgages and Alt- A, a type of home loan that typically required less documentation, climbed in 2012 on improving housing fundamentals and shrinking supply.

Ellington could pay a special dividend at the end of the year because earnings have been so strong, Miller said.

Mortgage REITs have also benefited from gains in agency mortgage bonds, those guaranteed by government-backed Fannie Mae and Freddie Mac or U.S.-owned Ginnie Mae.

The Fed's efforts to push down rates have provided low-cost funding for the REITs, which has allowed them to offer double- digit yields to investors, said Samantha McLemore, assistant portfolio manager on the Opportunity fund. Because mortgage securities have risen so far this year, the outlook for additional capital gains on REITs “is more muted and the risks have increased,” she wrote in an e-mail.

One of Miller's holdings, Invesco Mortgage Capital, an Atlanta-based firm that invests in both agency and non-agency mortgages, is up 48 percent this year and yields 13 percent, Bloomberg data show.

Indirect Bets

Miller also owns stocks where the link to housing is indirect, such as discount broker E*Trade Financial Corp. (ETFC) The New York-based firm expanded into home lending during the last decade and got stuck with a troubled mortgage portfolio.

The home loans, $10.7 billion as of June 30, have depressed the stock and prevented a possible sale of the firm. Miller calls E*Trade “a backdoor way to play housing.” His logic: An improving housing market, and the passage of time, will diminish the drag from the loan portfolio. The stock, currently at $9 a share, could double in value, Miller said, without providing a time frame.

Bank of America's role as a major originator and servicer of mortgages means it will participate in the housing rebound, boosting shares, according to Miller.

The lender ranked fourth among U.S. mortgage originators in the second quarter with a 4.7 percent market share, data from Inside Mortgage Finance show. San Francisco-based Wells Fargo & Co. (WFC) ranked first with 32 percent.

Genworth, MGIC

Not all of Miller's housing bets have worked out. Mortgage insurers Genworth Financial Inc. (GNW) of Richmond, Virginia is down 16 percent and Milwaukee, Wisconsin-based MGIC Investment Corp. (MTG) 56 percent this year after losses tied to home loans drained capital.

Investors are missing the positives, Miller said. Both firms have been making money on insurance policies written since 2008, even as they continue to “pay through the nose,” on policies issued in the 2003-2006 period.

In Genworth's case, said Miller, the good business will eventually be bigger than the bad and the stock, at $5.47 a share, could reach $8 to $10 in 12 months. Gains are also possible at MGIC, even though the firm may be forced by regulators to raise capital, a move that could dilute existing shareholders, said Miller.

Robert Shiller, the Yale University professor who predicted the bursting of the dot-com and subprime-mortgage bubbles, doesn't share Miller's optimism about U.S. housing. Asked about the prospects for a housing revival in an Oct. 5 interview on Bloomberg Television's “Surveillance,” Shiller said, “Are we at an upward turning point? I am calling that a big question. Most likely nothing much is going to happen.”

Miller's confidence is unshaken. When it comes to housing, he said, “things are better than people believe, not worse.”

(Bloomberg News)


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