Cashing in on the undervalued

Step aside, mutual-fund managers, Ludwig Wittgenstein is back.

The ideas of the 20th century Austrian philosopher have helped win some of the most stunning mutual-fund gains during the current bull market.

"Impossible!" skeptics might say: Philosophers tend to shrink from the under-the-hood grunge work needed to shake down shareholder value.

But don a college gown, toss back the mortar board tassel, and meet William Miller, manager of the Legg Mason Value Trust (800-577-8589). With Mr. Miller there's no ivory tower, just pure ivory.

The former PhD philosophy student logged a 48 percent surge last year. He has beaten the Standard & Poor's 500 Index in each of the past five years with an average annual gain of 33 percent. So far in 1999, his mutual fund has returned 26 percent, compared to the S&P's 11 percent (as of 4/27/99). The fund's total assets have nearly tripled since early last year to $11 billion.

For all this high-octane performance, Mil-ler credits Wittgenstein, William James, and John Dewey for inspiring his "pragmatic" investment style. He spurns "preexisting notions about the right way to invest" and instead looks for business plans that "work."

That means Miller seeks value, nabbing companies with shining earnings potential overlooked by the market. In recent years, such an approach has taken a back seat to growth-oriented managers who focus on rocketship earnings with less regard for a stock's price.

But there's a twist to Miller's value investing. It helps explain why his fund has outpaced even leading growth funds.

Like most value managers, Miller sizes up stocks with yardsticks like price-earnings ratio or book value per share. But he goes further by estimating future free cash flow.

"A lot of times reported earnings are not a good proxy for free-cash generation because many companies are working-capital intensive," Miller says. "At the end of the day what the owner of a business cares about is what cash he can take out of the business."

Pursuing such forward-leaning value investing, Miller has seized on stocks classed as players in a go-go growth climate.

Three years ago, for example, he bought America Online and Dell, two of Wall Street's darlings. Since then the share prices have exploded 30 times and 40 times, respectively.

Miller also takes pages from the playbooks of Benjamin Graham, the grandfather of value investing, and Warren Buffett, the value-oriented "oracle of Omaha."

This means that, like Mr. Buffett, Miller buys promising companies when they are out of favor. Then he waits. Annual turnover in his portfolio is just 13 percent.

With Dell, that meant buying just after the market soured on high tech. With AOL, it meant buying amid talk the company was on its way down. "When we're right we get a huge, long run, and if we're wrong the stocks were cheap to begin with so we won't lose a lot," he says.

Following this strategy, Miller so far this year has embraced a flock of ugly ducklings: Gateway 2000, BankBoston, Starwood Hotels & Resorts Worldwide, and United HealthCare Corp.

In the past two months he has put substantial sums into Toys 'R' Us, which, he says, is hatching an impressive Internet strategy. Among sectors, he favors financial stocks, especially savings-and-loans and mortgage companies.

That said, Miller is wary of a market tumble. "I agree with [Federal Reserve Chairman Alan] Greenspan that we are so finely balanced and things are going so well that difficulties could crop up from any side and make for a very difficult period."

Miller notes the threat from an inflation scare, a worsening Kosovo conflict, or a flaring of global financial turmoil.

Internet stocks are perhaps most vulnerable. "Although the sector is a wonderful economic opportunity," he says, "the stocks at this stage are highly speculative and dangerous."

Even so, the pragmatist acknowledges that a sell-off caused by inflation anxiety would not even spare a value portfolio, especially one like Value Trust relying on financial stocks and future free cash flow.

Legg Mason Value Trust

The Legg Mason Value Trust has been the top-performing, large-cap value fund over the past decade, according to mutual-fund tracker Morningstar Inc. The fund, easily beating the Standard & Poor's 500 Index, invests heavily in three sectors: technology (40 percent of its portfolio), financial (31.5 percent), and services (12.3 percent).

Fund return YTD 1-yr. 3-yr.* 5-yr*

Legg Mason Value Trust 26.2% 59.7% 48.3% 38.5%

S&P 500 Index 11.0 26.6 29.9 27.2

Source: Morningstar Inc. as of 4/27 close.

*Annualized

Top 5 fund holdings

Company Percentage of portfolio

America Online 13.4%

Dell Computer 6.4

Chase Manhattan 3.9

Berkshire Hathaway 3.1

Citigroup 3.0

Source: Morningstar Inc. as of 3/31.