Legg Mason’s Bill Miller seeks redemption as housing bull

Legg Mason Inc.'s Bill Miller, who beat the S&P 500 for a record 15 years before crashing on bank stocks, is seeking redemption as a housing bull.

His Legg Mason Capital Management Opportunity Trust (LMOPX) has bet about a third of its holdings on a rebound in the property market through homebuilders, mortgage real estate investment trusts and loan insurers.

That had propelled the $952 million fund to a return of 29% this year through Oct. 11, surpassing 99% of peers, according to data compiled by Bloomberg. The fund lost 35% last year, last among its category, when Mr. Miller bet on a recovery prematurely.

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

The reversal shows how the Federal Reserve's decision to push down borrowing costs to record lows is helping drive a 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.

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

Shares of BofA could double within three years, he said.

BUYING UGLY

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

The Opportunity fund, which Mr. Miller has run since 1999, slumped last year 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,” Mr. Miller wrote.

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

Mr. Miller beat the S&P 500 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. (AMZN) and UnitedHealth Group Inc. (UNH} went awry.

During the 2008 credit crisis, the fund lost 55% 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% of comparable funds, Bloomberg data show.

Mr. Miller stopped managing the Value Trust fund in April.

Legg Mason (LM) chief executive Mark Fetting stepped down last month after failing to end almost five years of client redemptions. Under Mr. Fetting, Legg shares fell 65%.

Although conceding he was too early in expecting a turn in housing, Mr. Miller said that a bounce-back was “a mathematical inevitability.”

The housing slump drove starts and purchases so low that pent-up demand was bound to kick in, Mr. 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% in July, from a year earlier, the biggest jump since August 2010. The measure fell 35% from the peak in July 2006 to February 2012.

“Everything we see points that the worst is over,” BofA chief executive Brian Moynihan said about housing in an Oct. 11 interview with Bloomberg Television.

Mr. 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% this year and 2% in 2013, according to economists surveyed by Bloomberg.

The Opportunity fund had 13% of its money in homebuilders as of June 30, regulatory filings show.

Two of the stocks, Pulte and KB Home (KBH), have more than doubled this year, Bloomberg data show. The third, Lennar Corp. (LEN) is up 82%.

Mr. Miller bought KB and added to his holdings of Pulte in the second half of last year, regulatory filings show, as the Standard & Poor's Supercomposite Homebuilding Index reached its low point for the year. The three builder stocks have been 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, Sept. 25. Analyst Stephen Kim wrote: “It appears we have reached that point in the rally when investors are pricing in a "best-case scenario' for the strongest builders.”

Mr. Miller had 5.9% of his portfolio in mortgage REITs and another 4.1% in Ellington, which gets most of its earnings from non-agency home loans.

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

Mortgage REITs also have 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 ease rates have provided low-cost funding for the REITs, allowing them to offer double-digit yields to investors, said Samantha McLemore, assistant portfolio manager for 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 Mr. Miller's holdings, Invesco Mortgage Capital Inc., which invests both in agency and non-agency mortgages, is up 48% this year and has a yield of 13%, Bloomberg data show.

He also owns stocks that have an indirect link to housing, such as E*Trade Financial Corp. (ETFC). The discount broker expanded into home lending and got stuck with a troubled mortgage portfolio during the housing crisis.

The home loans, $10.7 billion as of June 30, have depressed the stock and prevented a possible sale of the firm.

Mr. Miller calls E*Trade “a backdoor way to play housing,” saying that an improving housing market, and the passage of time, will diminish the drag from the loan portfolio.

The stock, at $9 a share, could double in value, he said, though he declined to predict a time frame.

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

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

Not all Mr. Miller's housing bets have worked out. Mortgage insurers Genworth Financial Inc. (GNW) is down 16% and MGIC Investment Corp. (MTG) has dropped 56% this year after losses tied to home loans drained capital.

Investors are missing the positives, Mr. Miller said.

Both companies have been making money on insurance policies written since 2008, even as they continue to “pay through the nose” on policies issued in the 2003-06 period.

In Genworth's case, Mr. Miller said, the good business eventually will 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 it may be forced by regulators to raise capital, a move that could dilute existing shareholders, he said.

Related Topics: Mortgages