Legg Mason Value Trust (LMVTX) Letter to Shareholders

Jan 24, 2007, 00:00 ET from Legg Mason from ,Legg Mason Value Trust

    BALTIMORE, Jan. 24 /PRNewswire/ -- The following is a letter to
 shareholders of Legg Mason Value Trust:
     Market Comments: Fourth Quarter 2006
     Calendar year 2006 was the first year since I took over sole management
 of the Legg Mason Value Trust in the late fall of 1990 that the Fund
 trailed the return of the S&P 500. Those 15 consecutive years of
 outperformance led to a lot of publicity, commentary, and questions about
 "the streak," with comparisons being made to Cal Ripken's consecutive games
 played streak, or Joe DiMaggio's hitting streak, or Greg Maddux's 17
 consecutive years with 15 or more wins, among others. Now that it is over,
 I thought shareholders might be interested in a few reflections on it, and
 on what significance, if any, it has.
     A common question I've gotten is whether I am in some sense relieved
 that it is over. The answer is no. Active managers are paid to add value
 over what can be earned at low cost from passive investing, and failure to
 do that is failure. We underperformed the S&P 500 in 2006 and did not add
 value for our clients and shareholders. It is little consolation that most
 mutual fund managers failed to beat the index in 2006, or that most
 managers of US large- capitalization stocks fail to outperform in most
 years, or that under 25% of them can outperform over long periods such as
 10 years, or that the next longest streak among active managers going into
 2006 - 8 years - also ended this year, or that it is believed that no one
 else has outperformed for 15 consecutive calendar years.(1) We are paid to
 do a job and we didn't do it this year, which is what the end of the streak
 means, and I am not at all happy or relieved about that.
     There was, of course, a lot of luck involved in the streak. It could
 hardly be otherwise, as the late Stephen Jay Gould pointed out in his
 analysis of Joe DiMaggio's 56 game hitting streak. My colleague Michael
 Mauboussin applied some of Gould's analysis to investing in Chapter 6 of
 his book More Than You Know. What are the chances it was 100% luck? There
 are two broad ways to look at it, one involving a priori, and the other a
 posteriori, probabilities. If beating the market was purely random, like
 tossing a coin, then the odds of 15 consecutive years of beating it would
 be the same as the odds of tossing heads 15 times in a row: 1 in 215, or 1
 in 32,768. Using the actual probabilities of beating the market in each of
 the years from 1991 to 2005 makes the number 1 in 2.3 million. So there was
 probably some skill involved. On the other hand, something with odds of 1
 in 2.3 million happens to about 130 people per day in the US, so you never
 know.
     Looking at the sources of our outperformance over those 15 years yields
 some observations that I think are applicable to investing generally. They
 fall into two broad categories, security analysis and portfolio
 construction. Analytically, we are value investors and our securities are
 chosen based on our assessment of intrinsic business value. Intrinsic
 business value is the present value of the future free cash flows of the
 business.
     I want to stress that is THE definition of value, not MY definition of
 value. When some look at our portfolio and see high-multiple names such as
 Google residing there with low-multiple names such as Citigroup, they
 sometimes ask what my definition of value is, as if multiples of earnings
 or book value were all that was involved in valuation. Valuation is
 inherently uncertain, since it involves the future. As I often remind our
 analysts, 100% of the information you have about a company represents the
 past, and 100% of the value depends on the future. There are some things
 you can say about the future with a probability approaching certainty, such
 as that Citi will make its next dividend payment, and some that are much
 iffier, such as that the present value of Google's free cash flows exceeds
 its current $150 billion market value. Some value investors such as those
 at Ruane Cunniff have a high epistemic threshold and do exhaustive analysis
 to create near certainty, or at least very high conviction, about their
 investments. Others such as Marty Whitman take a credit-driven approach and
 ground their margin of safety by insisting on strong balance sheets or
 asset coverage. What unites all value investors is that valuation is the
 driving force in their analysis.
     Trying to figure out the present value of the future free cash flows of
 a business involves a high degree of estimation error, and is highly
 sensitive to inputs, which is why we use every valuation methodology known
 to assess business value, and don't just do discounted cash flow analysis.
 We pay a great deal of attention to factors that historically have
 correlated with stock outperformance, such as free cash flow yield and
 significant stock repurchase activity. It all eventually comes down to
 expectations. Whether a company's valuation looks low or high, if it is
 going to outperform, the market will have to revise its expectations
 upward.
     Being valuation driven means that we minimize our exposure to the
 panoply of social psychological cognitive errors identified by the
 behavioral finance researchers. I think those are the source of the only
 enduring anomalies in an otherwise very efficient market, since they cannot
 be arbitraged away.
     What we try to do is to take advantage of errors others make, usually
 because they are too short-term oriented, or they react to dramatic events,
 or they overestimate the impact of events, and so on. Usually that involves
 buying things other people hate, like Kodak, or that they think will never
 conquer their problems, like Sprint. Sometimes it involves owning things
 people don't understand properly, such as Amazon, where investors wrongly
 believe today's low operating margins are going to be the norm for years.
     It is trying to invest long-term in a short-term world, and being
 contrarian when conformity is more comfortable, and being willing to court
 controversy and be wrong, that has helped us outperform. "Don't you read
 the papers?" one exasperated client asked us after we bought a stock that
 was embroiled in scandal. As I also like to remind our analysts, if it's in
 the papers, it's in the price. The market does reflect the available
 information, as the professors tell us. But just as the funhouse mirrors
 don't always accurately reflect your weight, the markets don't always
 accurately reflect that information. Usually they are too pessimistic when
 it is bad, and too optimistic when it is good.
     So grounding our security analysis on valuation, and trying to abstract
 away from the sorts of emotionally driven decisions that may motivate
 others, are what leads to the stocks that we own, and it is the performance
 of those stocks that has led to our performance.
     The other factor in our results is portfolio construction. We construct
 portfolios the way theory says one should, which is different from the way
 many, if not most, construct their portfolios. We do it on risk-adjusted
 rate of return. We do not do it based on the sector or industry or company
 weightings in the index. We do not approach things saying we want to be
 overweight financials because we think the Fed will ease, we want to have
 tech exposure because it is the right time in the cycle to own tech, or
 whatever. That is, we don't do things the way most others appear to do
 them.
     We do not start out thinking we need to be exposed to each sector in
 the market, because that would mean we would automatically be invested in
 the worst part of the market. (Some sector has to be the worst, and if your
 policy is to be in each of them you are going to be in the worst.) If we
 are in the worst part of the market, it is because we made a mistake, or we
 have a different time horizon from others, but it will not be as a matter
 of policy. We want our clients and shareholders to own a portfolio actively
 chosen based on long-term value, not based on index construction.
     A key reason for the streak has been our factor diversification. By
 that I mean we own a mix of companies whose fundamental valuation factors
 differ. We have high PE and low PE, high price-to-book and low
 price-to-book. Most investors tend to be relatively undiversifed with
 respect to these valuation factors, with traditional value investors
 clustered in low valuations, and growth investors in high valuations. For
 most of the 1980s and early 1990s we did the same, and got the same
 results: when so-called value did well, typically from the bottom of a
 recession to the peak of the economic cycle, so did we. And when growth did
 well, again usually as the economy was slowing and growth was harder to
 come by, we did poorly, along with other value types.
     It was in the mid-1990s that we began to create portfolios that had
 greater factor diversification. In the mid-1990s, many cyclical stocks were
 down and acting badly, just the sort of thing we tend to like. I looked at
 steels, and cement companies, and papers and aluminum, all things being
 bought by classic low PE, low price-to-book, value investors.
     At the same time, though, technology stocks were also selling at very
 cheap prices. Dell Computer was selling at about 5x earnings. Even Cisco
 could be had for about 15x earnings. I could not see why one would own
 cyclical companies that struggled to earn their cost of capital when you
 could get real growth companies that earned high returns on capital for
 about the same price. So we bought a lot of tech in the mid-1990s.
     Buying tech was not something value investors did back then. That was
 because tech was not thought to be predictable in the way something like
 Coke was, for example, since technology changes rapidly. But we had learned
 from Brian Arthur at the Santa Fe Institute about path dependence and lock
 in, which meant that while technology changes rapidly, technology market
 shares often don't, so they were much more predictable than they looked. We
 bought them and got lucky when tech values turned into a tech mania in 1998
 and 1999.
     The result was we did well when first-rate value investors such as
 Mason Hawkins and Bill Nygren did poorly. They had almost no tech, and if
 you didn't have it, you had almost no chance to outperform.
     We realized that real value investing means really asking what are the
 best values, and not assuming that because something looks expensive that
 it is, or assuming that because a stock is down in price and trades at low
 multiples that it is a bargain. Federal regulations mandate how
 concentrated a mutual fund can be; they require a certain amount of
 diversification even in funds called non-diversified. Diversification has
 rightly been called the only free lunch available on Wall Street. It
 follows from the fact that the future is uncertain that one should multiply
 independent bets. Indeed, the Kelly formula, discussed in Bill Poundstone's
 Fortune's Formula, would indicate that if you were certain about something
 earning an excess rate of return, you should put 100% of your money in it.
     Although funds are subject to requirements regarding diversification by
 industry or company, they do not have to be diversified by factor, that is,
 by PE ratios, or price-to-book, or price-to-cash flow. And they mostly are
 not: value funds tend to have almost all their money in low PE, low
 price-to-book or cash flow, and growth funds have the opposite. Sometimes
 growth funds beat value funds and the market, as from 1995 through 1999,
 and sometimes value funds beat growth funds, as from 2000 through 2006.
 Sometimes growth is cheap, as it was in 1995, and is today in my opinion,
 and sometimes so-called value is cheap, as it was in 1999. The question is
 not growth or value, but where is the best value?
     We were fortunate to recognize that so-called growth was cheap in the
 mid- 1990s and so avoided the extended underperformance of many of our
 value brethren in the late 1990s. We were also fortunate to recognize it
 was expensive in 1999 and sold a lot of those names reasonably well. We
 were not so smart as to have realized we should have sold them all, so we
 did less well than many of our value friends during the bear market that
 ended in March of 2003.
     We continue to be factor diversified, which I think is a strength. We
 own low PE and we own high PE, but we own them for the same reason: we
 think they are mispriced. We differ from many value investors in being
 willing to analyze stocks that look expensive to see if they really are.
 Most, in fact, are, but some are not. To the extent we get that right, we
 will benefit shareholders and clients.
     It has been wrongly suggested that concentration, owning fewer rather
 than many stocks, is a strategy that adds value. Studies have shown that
 concentrated portfolios typically outperform others.(2) All true, but an
 example of what Michael Mauboussin would call attribute-based thinking. The
 real issue is the circumstances in which concentration pays, not whether it
 has in the past.
     We suffered from being too concentrated last year. Being more broadly
 diversified would have led to better results. We benefited, though, from
 our concentration during the streak period. But being too concentrated was
 one reason the streak ended.
     Concentration works when the market has what the academics call fat
 tails, or in more common parlance, big opportunities. If I am considering
 buying three $10 stocks, two of which I think are worth $15, and the third
 worth $50, then I will buy the one worth $50, since my expected return
 would be diminished by splitting the money among the three. But if I think
 all are worth $15, then I should buy all three, since my risk is then
 lowered by spreading it around. For much of the past 25 years, there were
 those $10 stocks worth $50 around. For the past few years, they have been
 largely absent, as inter-industry valuations have only been this
 homogeneous about 2% of the time.(3)
     Putting this stuff together gets us here: the streak was due to our
 being valuation driven, which typically gets us into stocks where the
 expectations are too low because of mostly social psychological reasons;
 being fortunate enough to have figured out tech was cheap when it was, and
 expensive when it was; concentrating the portfolio when it made sense to do
 so, constructing the portfolio rationally and not because of the way the
 S&P is constructed; and being lucky.
     The streak ended because all streaks eventually end, and because we
 made some mistakes, such as not being invested in energy in 2003 when it
 was cheap, in being too concentrated when concentration added no value, and
 due to some bad luck. Sometimes luck helps and sometimes it doesn't.
     The best thing about the streak is we helped clients and shareholders.
 For 15 consecutive years we actually added value after expenses and helped
 those who have entrusted money with us to achieve their goals. I am
 optimistic and confident we can continue to do so, but as they say, there
 are no guarantees in this business. One thing I can guarantee is that no
 one will work harder or care more about your money than the team at Legg
 Mason Capital Management.
     Bill Miller, CFA
     January 20, 2007
 
     (1) Source: Lipper Analytical
     (2) Source: Michael Mauboussin, Investing: Business or Profession?
     (3) Source: Empirical Research Partners
     The Fund's Top Ten Holdings as of 12/31/06 were The AES Corporation,
 Tyco International Ltd., Sprint Nextel Corp., UnitedHealth Group Inc.,
 Amazon.com Inc., Google Inc., J.P. Morgan Chase and Co., Qwest
 Communications International Inc., Sears Holdings Corp., and Countrywide
 Financial Corp.
     Legg Mason Capital Management, Inc. ("LMCM") is the investment manager
 and adviser for Legg Mason Value Trust, Inc. ("Legg Mason Value Trust").
 Legg Mason Investor Services, LLC ("LMIS") is the distributor of the Legg
 Mason Value Trust. LMCM and LMIS are Legg Mason, Inc. affiliated companies.
 The views expressed in this commentary reflect those of LMCM as of the date
 of this commentary. Any such views are subject to change at any time based
 on market or other conditions, and LMCM, Legg Mason Value Trust, and LMIS
 disclaim any responsibility to update such views. These views may differ
 from those of portfolio managers for LMCM's affiliates and are not intended
 to be a forecast of future events, a guarantee of future results or
 investment advice. Because investment decisions for the Legg Mason Funds
 are based on numerous factors, these views may not be relied upon as an
 indication of trading intent on behalf of any Legg Mason Fund. The
 information contained herein has been prepared from sources believed to be
 reliable, but is not guaranteed by LMCM, Legg Mason Value Trust or LMIS as
 to its accuracy or completeness.
     You should consider a fund's investment objectives, risks, charges, and
 expenses carefully before investing. For a prospectus, which contains this
 and other information on any Legg Mason Fund, visit
 http://www.leggmasonfunds.com. Please read the prospectus carefully before
 investing.
     The S&P 500 Index is an unmanaged index of 500 stocks that is generally
 representative of the performance of larger companies in the U.S. An
 investor cannot invest directly in an index.
     The "Fed" is an abbreviation for the Federal Reserve Board, which is
 charged with, among other things, conducting the nation's monetary policy
 by influencing the monetary and credit conditions in the economy in pursuit
 of maximum employment, stable prices, and moderate long-term interest
 rates.
     "PE ratio" is an abbreviation for price/earnings ratio.
 
     (c)2007 Legg Mason Investor Services, LLC. Member
     NASD, SIPC
     (01/07) 07-0044
 
 

SOURCE Legg Mason; Legg Mason Value Trust
    BALTIMORE, Jan. 24 /PRNewswire/ -- The following is a letter to
 shareholders of Legg Mason Value Trust:
     Market Comments: Fourth Quarter 2006
     Calendar year 2006 was the first year since I took over sole management
 of the Legg Mason Value Trust in the late fall of 1990 that the Fund
 trailed the return of the S&P 500. Those 15 consecutive years of
 outperformance led to a lot of publicity, commentary, and questions about
 "the streak," with comparisons being made to Cal Ripken's consecutive games
 played streak, or Joe DiMaggio's hitting streak, or Greg Maddux's 17
 consecutive years with 15 or more wins, among others. Now that it is over,
 I thought shareholders might be interested in a few reflections on it, and
 on what significance, if any, it has.
     A common question I've gotten is whether I am in some sense relieved
 that it is over. The answer is no. Active managers are paid to add value
 over what can be earned at low cost from passive investing, and failure to
 do that is failure. We underperformed the S&P 500 in 2006 and did not add
 value for our clients and shareholders. It is little consolation that most
 mutual fund managers failed to beat the index in 2006, or that most
 managers of US large- capitalization stocks fail to outperform in most
 years, or that under 25% of them can outperform over long periods such as
 10 years, or that the next longest streak among active managers going into
 2006 - 8 years - also ended this year, or that it is believed that no one
 else has outperformed for 15 consecutive calendar years.(1) We are paid to
 do a job and we didn't do it this year, which is what the end of the streak
 means, and I am not at all happy or relieved about that.
     There was, of course, a lot of luck involved in the streak. It could
 hardly be otherwise, as the late Stephen Jay Gould pointed out in his
 analysis of Joe DiMaggio's 56 game hitting streak. My colleague Michael
 Mauboussin applied some of Gould's analysis to investing in Chapter 6 of
 his book More Than You Know. What are the chances it was 100% luck? There
 are two broad ways to look at it, one involving a priori, and the other a
 posteriori, probabilities. If beating the market was purely random, like
 tossing a coin, then the odds of 15 consecutive years of beating it would
 be the same as the odds of tossing heads 15 times in a row: 1 in 215, or 1
 in 32,768. Using the actual probabilities of beating the market in each of
 the years from 1991 to 2005 makes the number 1 in 2.3 million. So there was
 probably some skill involved. On the other hand, something with odds of 1
 in 2.3 million happens to about 130 people per day in the US, so you never
 know.
     Looking at the sources of our outperformance over those 15 years yields
 some observations that I think are applicable to investing generally. They
 fall into two broad categories, security analysis and portfolio
 construction. Analytically, we are value investors and our securities are
 chosen based on our assessment of intrinsic business value. Intrinsic
 business value is the present value of the future free cash flows of the
 business.
     I want to stress that is THE definition of value, not MY definition of
 value. When some look at our portfolio and see high-multiple names such as
 Google residing there with low-multiple names such as Citigroup, they
 sometimes ask what my definition of value is, as if multiples of earnings
 or book value were all that was involved in valuation. Valuation is
 inherently uncertain, since it involves the future. As I often remind our
 analysts, 100% of the information you have about a company represents the
 past, and 100% of the value depends on the future. There are some things
 you can say about the future with a probability approaching certainty, such
 as that Citi will make its next dividend payment, and some that are much
 iffier, such as that the present value of Google's free cash flows exceeds
 its current $150 billion market value. Some value investors such as those
 at Ruane Cunniff have a high epistemic threshold and do exhaustive analysis
 to create near certainty, or at least very high conviction, about their
 investments. Others such as Marty Whitman take a credit-driven approach and
 ground their margin of safety by insisting on strong balance sheets or
 asset coverage. What unites all value investors is that valuation is the
 driving force in their analysis.
     Trying to figure out the present value of the future free cash flows of
 a business involves a high degree of estimation error, and is highly
 sensitive to inputs, which is why we use every valuation methodology known
 to assess business value, and don't just do discounted cash flow analysis.
 We pay a great deal of attention to factors that historically have
 correlated with stock outperformance, such as free cash flow yield and
 significant stock repurchase activity. It all eventually comes down to
 expectations. Whether a company's valuation looks low or high, if it is
 going to outperform, the market will have to revise its expectations
 upward.
     Being valuation driven means that we minimize our exposure to the
 panoply of social psychological cognitive errors identified by the
 behavioral finance researchers. I think those are the source of the only
 enduring anomalies in an otherwise very efficient market, since they cannot
 be arbitraged away.
     What we try to do is to take advantage of errors others make, usually
 because they are too short-term oriented, or they react to dramatic events,
 or they overestimate the impact of events, and so on. Usually that involves
 buying things other people hate, like Kodak, or that they think will never
 conquer their problems, like Sprint. Sometimes it involves owning things
 people don't understand properly, such as Amazon, where investors wrongly
 believe today's low operating margins are going to be the norm for years.
     It is trying to invest long-term in a short-term world, and being
 contrarian when conformity is more comfortable, and being willing to court
 controversy and be wrong, that has helped us outperform. "Don't you read
 the papers?" one exasperated client asked us after we bought a stock that
 was embroiled in scandal. As I also like to remind our analysts, if it's in
 the papers, it's in the price. The market does reflect the available
 information, as the professors tell us. But just as the funhouse mirrors
 don't always accurately reflect your weight, the markets don't always
 accurately reflect that information. Usually they are too pessimistic when
 it is bad, and too optimistic when it is good.
     So grounding our security analysis on valuation, and trying to abstract
 away from the sorts of emotionally driven decisions that may motivate
 others, are what leads to the stocks that we own, and it is the performance
 of those stocks that has led to our performance.
     The other factor in our results is portfolio construction. We construct
 portfolios the way theory says one should, which is different from the way
 many, if not most, construct their portfolios. We do it on risk-adjusted
 rate of return. We do not do it based on the sector or industry or company
 weightings in the index. We do not approach things saying we want to be
 overweight financials because we think the Fed will ease, we want to have
 tech exposure because it is the right time in the cycle to own tech, or
 whatever. That is, we don't do things the way most others appear to do
 them.
     We do not start out thinking we need to be exposed to each sector in
 the market, because that would mean we would automatically be invested in
 the worst part of the market. (Some sector has to be the worst, and if your
 policy is to be in each of them you are going to be in the worst.) If we
 are in the worst part of the market, it is because we made a mistake, or we
 have a different time horizon from others, but it will not be as a matter
 of policy. We want our clients and shareholders to own a portfolio actively
 chosen based on long-term value, not based on index construction.
     A key reason for the streak has been our factor diversification. By
 that I mean we own a mix of companies whose fundamental valuation factors
 differ. We have high PE and low PE, high price-to-book and low
 price-to-book. Most investors tend to be relatively undiversifed with
 respect to these valuation factors, with traditional value investors
 clustered in low valuations, and growth investors in high valuations. For
 most of the 1980s and early 1990s we did the same, and got the same
 results: when so-called value did well, typically from the bottom of a
 recession to the peak of the economic cycle, so did we. And when growth did
 well, again usually as the economy was slowing and growth was harder to
 come by, we did poorly, along with other value types.
     It was in the mid-1990s that we began to create portfolios that had
 greater factor diversification. In the mid-1990s, many cyclical stocks were
 down and acting badly, just the sort of thing we tend to like. I looked at
 steels, and cement companies, and papers and aluminum, all things being
 bought by classic low PE, low price-to-book, value investors.
     At the same time, though, technology stocks were also selling at very
 cheap prices. Dell Computer was selling at about 5x earnings. Even Cisco
 could be had for about 15x earnings. I could not see why one would own
 cyclical companies that struggled to earn their cost of capital when you
 could get real growth companies that earned high returns on capital for
 about the same price. So we bought a lot of tech in the mid-1990s.
     Buying tech was not something value investors did back then. That was
 because tech was not thought to be predictable in the way something like
 Coke was, for example, since technology changes rapidly. But we had learned
 from Brian Arthur at the Santa Fe Institute about path dependence and lock
 in, which meant that while technology changes rapidly, technology market
 shares often don't, so they were much more predictable than they looked. We
 bought them and got lucky when tech values turned into a tech mania in 1998
 and 1999.
     The result was we did well when first-rate value investors such as
 Mason Hawkins and Bill Nygren did poorly. They had almost no tech, and if
 you didn't have it, you had almost no chance to outperform.
     We realized that real value investing means really asking what are the
 best values, and not assuming that because something looks expensive that
 it is, or assuming that because a stock is down in price and trades at low
 multiples that it is a bargain. Federal regulations mandate how
 concentrated a mutual fund can be; they require a certain amount of
 diversification even in funds called non-diversified. Diversification has
 rightly been called the only free lunch available on Wall Street. It
 follows from the fact that the future is uncertain that one should multiply
 independent bets. Indeed, the Kelly formula, discussed in Bill Poundstone's
 Fortune's Formula, would indicate that if you were certain about something
 earning an excess rate of return, you should put 100% of your money in it.
     Although funds are subject to requirements regarding diversification by
 industry or company, they do not have to be diversified by factor, that is,
 by PE ratios, or price-to-book, or price-to-cash flow. And they mostly are
 not: value funds tend to have almost all their money in low PE, low
 price-to-book or cash flow, and growth funds have the opposite. Sometimes
 growth funds beat value funds and the market, as from 1995 through 1999,
 and sometimes value funds beat growth funds, as from 2000 through 2006.
 Sometimes growth is cheap, as it was in 1995, and is today in my opinion,
 and sometimes so-called value is cheap, as it was in 1999. The question is
 not growth or value, but where is the best value?
     We were fortunate to recognize that so-called growth was cheap in the
 mid- 1990s and so avoided the extended underperformance of many of our
 value brethren in the late 1990s. We were also fortunate to recognize it
 was expensive in 1999 and sold a lot of those names reasonably well. We
 were not so smart as to have realized we should have sold them all, so we
 did less well than many of our value friends during the bear market that
 ended in March of 2003.
     We continue to be factor diversified, which I think is a strength. We
 own low PE and we own high PE, but we own them for the same reason: we
 think they are mispriced. We differ from many value investors in being
 willing to analyze stocks that look expensive to see if they really are.
 Most, in fact, are, but some are not. To the extent we get that right, we
 will benefit shareholders and clients.
     It has been wrongly suggested that concentration, owning fewer rather
 than many stocks, is a strategy that adds value. Studies have shown that
 concentrated portfolios typically outperform others.(2) All true, but an
 example of what Michael Mauboussin would call attribute-based thinking. The
 real issue is the circumstances in which concentration pays, not whether it
 has in the past.
     We suffered from being too concentrated last year. Being more broadly
 diversified would have led to better results. We benefited, though, from
 our concentration during the streak period. But being too concentrated was
 one reason the streak ended.
     Concentration works when the market has what the academics call fat
 tails, or in more common parlance, big opportunities. If I am considering
 buying three $10 stocks, two of which I think are worth $15, and the third
 worth $50, then I will buy the one worth $50, since my expected return
 would be diminished by splitting the money among the three. But if I think
 all are worth $15, then I should buy all three, since my risk is then
 lowered by spreading it around. For much of the past 25 years, there were
 those $10 stocks worth $50 around. For the past few years, they have been
 largely absent, as inter-industry valuations have only been this
 homogeneous about 2% of the time.(3)
     Putting this stuff together gets us here: the streak was due to our
 being valuation driven, which typically gets us into stocks where the
 expectations are too low because of mostly social psychological reasons;
 being fortunate enough to have figured out tech was cheap when it was, and
 expensive when it was; concentrating the portfolio when it made sense to do
 so, constructing the portfolio rationally and not because of the way the
 S&P is constructed; and being lucky.
     The streak ended because all streaks eventually end, and because we
 made some mistakes, such as not being invested in energy in 2003 when it
 was cheap, in being too concentrated when concentration added no value, and
 due to some bad luck. Sometimes luck helps and sometimes it doesn't.
     The best thing about the streak is we helped clients and shareholders.
 For 15 consecutive years we actually added value after expenses and helped
 those who have entrusted money with us to achieve their goals. I am
 optimistic and confident we can continue to do so, but as they say, there
 are no guarantees in this business. One thing I can guarantee is that no
 one will work harder or care more about your money than the team at Legg
 Mason Capital Management.
     Bill Miller, CFA
     January 20, 2007
 
     (1) Source: Lipper Analytical
     (2) Source: Michael Mauboussin, Investing: Business or Profession?
     (3) Source: Empirical Research Partners
     The Fund's Top Ten Holdings as of 12/31/06 were The AES Corporation,
 Tyco International Ltd., Sprint Nextel Corp., UnitedHealth Group Inc.,
 Amazon.com Inc., Google Inc., J.P. Morgan Chase and Co., Qwest
 Communications International Inc., Sears Holdings Corp., and Countrywide
 Financial Corp.
     Legg Mason Capital Management, Inc. ("LMCM") is the investment manager
 and adviser for Legg Mason Value Trust, Inc. ("Legg Mason Value Trust").
 Legg Mason Investor Services, LLC ("LMIS") is the distributor of the Legg
 Mason Value Trust. LMCM and LMIS are Legg Mason, Inc. affiliated companies.
 The views expressed in this commentary reflect those of LMCM as of the date
 of this commentary. Any such views are subject to change at any time based
 on market or other conditions, and LMCM, Legg Mason Value Trust, and LMIS
 disclaim any responsibility to update such views. These views may differ
 from those of portfolio managers for LMCM's affiliates and are not intended
 to be a forecast of future events, a guarantee of future results or
 investment advice. Because investment decisions for the Legg Mason Funds
 are based on numerous factors, these views may not be relied upon as an
 indication of trading intent on behalf of any Legg Mason Fund. The
 information contained herein has been prepared from sources believed to be
 reliable, but is not guaranteed by LMCM, Legg Mason Value Trust or LMIS as
 to its accuracy or completeness.
     You should consider a fund's investment objectives, risks, charges, and
 expenses carefully before investing. For a prospectus, which contains this
 and other information on any Legg Mason Fund, visit
 http://www.leggmasonfunds.com. Please read the prospectus carefully before
 investing.
     The S&P 500 Index is an unmanaged index of 500 stocks that is generally
 representative of the performance of larger companies in the U.S. An
 investor cannot invest directly in an index.
     The "Fed" is an abbreviation for the Federal Reserve Board, which is
 charged with, among other things, conducting the nation's monetary policy
 by influencing the monetary and credit conditions in the economy in pursuit
 of maximum employment, stable prices, and moderate long-term interest
 rates.
     "PE ratio" is an abbreviation for price/earnings ratio.
 
     (c)2007 Legg Mason Investor Services, LLC. Member
     NASD, SIPC
     (01/07) 07-0044
 
 SOURCE Legg Mason; Legg Mason Value Trust

RELATED LINKS

http://www.leggmason.com