The Stock Picker's Defeat

William H. Miller spent nearly two decades building his reputation as the era's greatest mutual-fund manager. Then, over the past year, he destroyed it.

Fueled by winning bets on stocks other investors feared, Mr. Miller's Legg Mason Value Trust outperformed the broad market every year from 1991 to 2005. It's a streak no other fund manager has come close to matching.

Mr. Miller was in his element a year ago when troubles in the housing market began infecting financial markets. Working from his well-worn playbook, he snapped up American International Group Inc., Wachovia Corp., Bear Stearns Cos. and Freddie Mac. As the shares continued to fall, he argued that investors were overreacting. He kept buying.

What he saw as an opportunity turned into the biggest market crash since the Great Depression. Many Value Trust holdings were more or less wiped out. After 15 years of placing savvy bets against the herd, Mr. Miller had been trampled by it.

The financial crisis has created losers across the spectrum -- homeowners who can't afford their subprime mortgages, banks that loaned to them, investors who bought mortgage-backed securities and, as financial markets eventually crumbled, just about everyone who owned shares. But it has also brought low contrarians like Mr. Miller who had been lionized for staying a step ahead of the market. This meltdown has provided a lesson for Mr. Miller and other "value" investors: A stock may look tantalizingly cheap, but sometimes that's for good reason.

"The thing I didn't do, from Day One, was properly assess the severity of this liquidity crisis," Mr. Miller, 58 years old, said in an interview at Legg Mason Inc.'s Baltimore headquarters.

Mr. Miller has profited from investor panics before. But this time, he said, he failed to consider that the crisis would be so severe, and the fundamental problems so deep, that a whole group of once-stalwart companies would collapse. "I was naive," he said.

A year ago, his Value Trust fund had $16.5 billion under management. Now, after losses and redemptions, it has assets of $4.3 billion, according to Morningstar Inc. Value Trust's investors have lost 58% of their money over the past year, 20 percentage points worse than the decline on the Standard & Poor's 500 stock index.

The Higher They Soar…

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See how Legg Mason's Value Trust, under Mr. Miller's leadership, performed in comparison with the S&P, and track key investments.

These losses have wiped away Value Trust's years of market-beating performance. The fund is now among the worst-performing in its class for the last one-, three-, five- and 10-year periods, according to Morningstar.

"Why didn't I just throw my money out of the window -- and light it on fire?" says Peter Cohan, a management consultant and venture-capital investor who owns Value Trust shares. Mr. Miller's strategy, he says, "worked for a long time, but it's broken."

Mr. Miller's picks read like a Who's Who of the stock market's biggest losers: Washington Mutual Inc., Countrywide Financial Corp. and Citigroup Inc.

"Every decision to buy anything has been wrong," Mr. Miller said over lunch at a private club housed inside Legg's headquarters. In the 16th-floor dining room, Mr. Miller sat with his back against the wall, a preference he says he picked up as a U.S. Army intelligence officer in the 1970s. "It's been awful," he said.

Mr. Miller is chairman of Legg Mason Capital Management, a group of six mutual funds. He personally oversees Value Trust and the smaller Opportunity Trust. Although Mr. Miller's group accounts for only about $28 billion of Legg Mason's $840 billion in total assets, the firm's reputation is intertwined with that of its marquee star. Legg's stock is down 75% this year. The firm's woes have weighed on private-equity firm Kohlberg Kravis Roberts & Co., which took a $1.25 billion stake in Legg early this year.

Questions now swirl about whether Mr. Miller will quit or be replaced. He says his group's board of directors will decide whether he stays or goes, but he's not planning on calling it quits. Mark Fetting, Legg's chief executive and chairman of the board that oversees Mr. Miller's funds, said he supports Mr. Miller and his plans to improve performance.

Early Bet on RCA

Growing up in Florida, Bill Miller took an early interest in the market. As a high-schooler in the late 1960s, he says he invested the money he earned umpiring baseball games in stocks like RCA, making enough to buy a broken-down Ford. In the mid-1970s, in Germany during his Army stint, he visited a brokerage office in Munich to buy Intel Corp. shares. He studied philosophy in graduate school, but left to join a Pennsylvania manufacturing company where he eventually oversaw its investments.

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Bill Miller

By the early 1980s, Mr. Miller's then-wife worked at Legg Mason. Through her, Mr. Miller met the brokerage's founder, Raymond "Chip" Mason. Mr. Mason said he was thinking of starting some mutual funds. Mr. Miller jumped. He joined Legg Mason in 1981. Value Trust launched in 1982, with Mr. Miller as co-manager.

In 1984, Mr. Miller paid a visit to influential Fidelity Investments manager Peter Lynch, who suggested Mr. Miller take a look at Fannie Mae. Much like today, the mortgage company had a portfolio full of troubled loans. Traders were betting it would go bust.

Mr. Miller found Fannie's case compelling: The bad loans would soon roll off its books, he recalls, the government-backed company would be able to borrow at preferred rates and its low cost structure could make it hugely profitable. "Is this thing really trading at only two times what it's going to earn in three or four years?" Mr. Miller recalls asking Mr. Lynch in a follow-up phone call.

Mr. Miller figures that by the time he sold out of Fannie in 2005, he had made 50 times his money.

All or Nothing

Such all-or-nothing bets would come to define Mr. Miller's style. He usually holds about three dozen stocks at a time, compared with a hundred or so in a typical mutual-fund portfolio. He has welcomed negative sentiment about companies, which has let him buy stocks as their prices fall, "averaging down" the per-share price he pays. The strategy can net him big stakes in companies -- an enviable position if shares rally and a sticky one if he needs to sell.

When asked how he would know he made a mistake in buying a falling stock, Mr. Miller once retorted: "When we can no longer get a quote." In other words, the only price at which he was unwilling to buy more was zero.

Mr. Miller's swing-for-the-fences approach makes even other value investors flinch. Christopher Davis, a friend of Mr. Miller's and a money manager at Davis Funds, recalls discussing his investment strategy with Mr. Miller in the early 1990s. "One of my goals is to just be right more than I'm wrong," Mr. Davis recalls telling Mr. Miller.

" 'That's really stupid,' " Mr. Miller countered, according to Mr. Davis. "Bill said, 'What matters is how much you make when you're right. If you're wrong nine times out of 10 and your stocks go to zero -- but the tenth one goes up 20 times -- you'll be just fine,' " Mr. Davis recalls. "I just can't live like that."

During the savings-and-loan crisis in 1990 and 1991, Mr. Miller loaded up on American Express Corp., mortgage giant Freddie Mac and struggling banks and brokerages. Financials eventually made up more than 40% of his portfolio.

He looked wrong at first. But these stocks eventually propelled Value Trust to the top of the performance charts. In 1996, Value Trust gained 38%, outpacing the S&P 500 by more than 15 percentage points. By then, Mr. Miller was loading up on AOL, computer makers and other out-of-favor tech stocks.

His good bets more than made up for the bad. Between 1998 and 2002, 10 stocks in the Value Trust portfolio lost 75% or more. Three, including Enron and WorldCom, went bankrupt.

As his winning streak grew, Mr. Miller's name was often preceded in press reports with the word "legendary." He was mentioned alongside the likes of Fidelity's Mr. Lynch. Legg Mason, meanwhile, grew from a regional brokerage house into one of the planet's largest money managers.

In 1999, he cut an unusually lucrative deal with Legg Mason to take the reins of Opportunity Trust, a new fund. The fund's management fees went to an entity half-owned by Mr. Miller. From 2005 through 2007, Opportunity Trust paid the entity $137 million. In 2006, he bought a 235-foot yacht, "Utopia."

The Fallen

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Investing is Mr. Miller's obsession, friends say. On visits to Manhattan, he convenes chief executives, stock analysts and other money managers for steak dinner at the Post House to discuss investment ideas. His yacht aside, these friends say, Mr. Miller pays little attention to wealth's trappings: His work shoes are a pair of black loafers, purchased at Nordstrom, that he gets resoled again and again.

In 2006, Mr. Miller's outperformance streak finally broke when he missed out on big gains in energy stocks. His performance suffered again in early 2007, thanks to losses in home-building stocks he had bought following signs of trouble in the real-estate market.

Seen It Before

In the early summer of 2007, two Bear Stearns hedge funds that made big bets on low-quality mortgages imploded. The stock market whipsawed in July and August, as investors worried that housing-market troubles could spread.

Mr. Miller thought investors were too pessimistic about the housing and credit markets. In the third quarter, he bought Bear Stearns. In the fourth quarter, as financial stocks fell, he took positions in Merrill Lynch & Co., Washington Mutual, Wachovia and Freddie Mac.

Explaining his moves to his shareholders in a fourth-quarter update, he compared the period to 1989-90, when he had also bought beaten-down banks. "Sometimes market patterns recur that you believe you have seen before," he wrote. "Financials appear to have bottomed."

In 2008, Mr. Miller continued to accumulate Bear Stearns. At a conference on Friday, March 14, he boasted that he had bought just that morning at a bargain price, north of $30 a share -- down from a recent high of $154.

Bear Stearns collapsed that weekend. In a takeover brokered by the Federal Reserve, J.P. Morgan Chase & Co. acquired the storied investment house in a deal that first valued it at $2 a share.

Mr. Miller and his team spent the following days and evenings trying to figure out what had gone wrong. Mr. Miller, who also owns J.P. Morgan shares, says he called J.P. Morgan Chief Executive Jamie Dimon to run his Bear Stearns valuations past him.

Mr. Miller says the conversation with Bear Stearns's new owner left him satisfied that he'd fairly valued the investment house's troubled mortgage holdings. But his team had missed Bear Stearns's vulnerability to a "run on the bank" collapse: The heavily leveraged firm was borrowing huge sums to function day-to-day, and when lenders walked away, it collapsed. Mr. Miller says he was also surprised that the Federal Reserve would play an active role in a transaction that would let stockholders be largely wiped out.

Mr. Miller worried that Wachovia and Washington Mutual were vulnerable to a similar squeeze on capital. He sold both.

But he didn't abandon financials. During the second quarter, he added to Freddie Mac and insurer AIG. In an April letter to shareholders, he wrote that the rebounding stock and bond markets suggested a corner had been turned. "The credit panic ended with the collapse of Bear Stearns," he wrote. "By far the worst is behind us."

By the end of June, Mr. Miller's group held 53 million Freddie shares -- about 8% of the company.

Financial stocks continued to fall though the spring and summer. Many value investors, such as John Rogers at Ariel Investments, sold or at least stopped buying the sector.

“The thing I didn't do, from Day One, was properly assess the severity of the liquidity crisis… Every decision to buy anything has been wrong.” Bill Miller, manager, Value Trust

With Freddie and Fannie under particular pressure, some at Legg Mason Capital Management were worried that group-think had set in. "There were hedge-fund guys out there arguing that Fannie and Freddie were going to zero," said Sam Peters, a fund manager in Mr. Miller's group.

Red Team's Report

Mr. Peters, whose fund also owned Freddie Mac, suggested putting together a team of Legg research analysts to argue the case against Freddie. In early-August meetings devoted to the mortgage giant, the so-called "Red Team" said Freddie may need to raise substantial capital, which would massively dilute existing stockholders' shares.

Mr. Peters stopped accumulating Freddie shares. Mr. Miller kept buying them for his Opportunity Trust portfolio.

The risk, as Mr. Miller saw it, was that the housing market could perform worse than he expected. But he dismissed talk that the government could nationalize Freddie and Fannie. He took comfort in Treasury Secretary Henry Paulson's mid-July statement that the government was focused on supporting the agencies in their "current form." If anything, he believed, Freddie would recapture market share as private-sector competitors failed.

By the end of August, declines in AIG and Freddie left Value Trust down 33% over the previous 12 months -- 21 percentage points worse than the S&P 500 over the same period. Mr. Mason, Legg's founder, received complaints from brokers about Mr. Miller. Mr. Fetting, Legg's chief executive, fielded questions about whether Mr. Miller would be replaced.

The news got worse on the weekend of Sept. 6 and 7. The Treasury announced it was taking over Fannie and Freddie, rendering private shareholders' stakes nearly worthless. On Monday, shares in Freddie, which had started the year at $34 and entered the weekend at $5, were trading at less than $1. A government takeover was the one outcome for which Mr. Miller hadn't prepared.

New Rules

He realized then that his old playbook had failed him. He began to bail out of AIG, which insured the debt of many troubled financial firms. How could his group managers invest in financials if "we don't know the rules," Mr. Peters remembers him saying.

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In September, the Baltimore police and fire retirement pension board reportedly fired Mr. Miller from their $2.2 billion fund. A representative for the board did not return calls seeking comment.

Mr. Miller and his staff, who invest alongside shareholders in their funds, have also felt the pain. For the first time, Mr. Miller's group fired staff, an experience he calls "devastating." Mr. Miller won't disclose his personal worth or losses.

The fund manager says he's adjusting his stock-picking screens for a new world, in which he expects investors to be risk-averse for several years. He's re-reading a biography of John Maynard Keynes, focusing on the famed economist's experience as a money manager during the 1930s. He says he's scouring markets for industry-leading companies with big dividends. He thinks there are also opportunities in battered corporate bonds.

But improving performance will take a long time, he says. "I can't accelerate it."

Mr. Miller notes that in the final years of his winning streak, people often asked him why he didn't quit while he was ahead. Asked over lunch whether he wished he had stepped aside then, he looked out the window, over Baltimore's Inner Harbor. "That would have been a really smart thing to have done," he said, adding he has no plans to step aside.

"The idea of him retiring to the Riviera just isn't him," says his friend, Mr. Davis. "The money has meaning, but the record is a lot more meaningful."

Mr. Davis continued: "He wants to win."