Bill's Bad Bet

By William Green / Hong Kong

The stock market has a brutal way of making even the smartest people look foolish. Just ask Bill Miller, America's most celebrated mutual fund manager, whose Legg Mason Value Trust has beaten the S&P 500 stock index for 14 years running. A brilliant polymath whose intellectual passions range from chaos theory to Wittgenstein, Miller has trounced his rivals by thinking differently. But lately the investor, who is based in Baltimore, Md., has looked a tad less clever. In the past two years, oil and gas stocks surged as the price of oil nearly tripled, to $70 per bbl., yet Miller missed the entire runup. "It's a mistake we should not have made," he says, and he's paying for it. With Value Trust down 2.2% this year, he's trailing the S&P by 4 percentage points and is in danger of losing his unrivaled streak.

So, what went wrong? Two years ago, says Miller, he began to home in on oil and gas stocks. He had never liked them, knowing that oil prices had fallen in real terms over 150 years while demand had grown at a desultory pace--"a formula for a bad long-term investment." Still, after years of lackluster performance, the sector was cheap, so he drew up a list of buys, like Devon Energy, Apache and XTO Energy. But he never bought them. "I was preoccupied with other things," Miller admits. "When I got around to doing it, the prices had moved up about 5%, and I don't want to pay up for anything, so I said, 'What the heck?'" Since then, Apache has more than doubled; Devon and XTO have tripled.

Still, it would be foolhardy to underestimate Miller, given his extraordinary record. And get this: his current perspective is profoundly at odds with that of almost everyone else. With oil trading at about $65 per bbl., fears abound that a further rise will hobble consumer spending and doom the global economy to recession. Yet Value Trust's latest report showed that the fund still doesn't own a single oil and gas stock because Miller, never one to run with the herd, expects oil prices to tumble.

As Miller sees it, "Five thousand years of commodity-price history" says that oil should be priced at the "marginal cost of production"--the price at which it makes sense for companies to find and extract it from the ground. And that, Miller says, is currently about $40 per bbl. Oil has shot way higher for perfectly rational reasons, from booming global demand to Hurricane Katrina's impact on refining capacity, but overseas producers have every incentive to boost supply at today's prices, says Miller, which should make up for existing shortfalls. "Barring an unforeseen event"--another Katrina, say, or a 9/11-- all this suggests to Miller that oil should retreat to about $40 over the next year or two.

Miller believes that the fall has already begun. Even the ominous approach of Hurricane Rita, which in late September threatened further devastation to American refineries, failed to drive oil prices close to the post-Katrina high of $70.85--a sign, in his view, that the upward momentum has run out of gas. Miller also points out that oil's rise has been driven by trend-following hedge funds and traders piling into whatever is hot. With the oil price slipping, "that speculative money flow will reverse," as they bet instead that it will keep dropping.

As oil prices fall, easing pressure on the economy, Miller expects the somnolent stock market to revive. Among the companies he thinks will benefit are banking behemoths like J.P. Morgan Chase and Citigroup. He's also wagering that Internet company Expedia will profit from increased online travel bookings and that other consumer plays, like Sears Holdings and Home Depot, will rebound as concerns over high fuel costs fade.

His "anti-oil" portfolio, as Miller calls it, should rally sharply if the price of crude slumps. But will it happen in time for him to beat the market for the 15th straight year? Miller knows the odds are against him. If only he had bought those oil and gas stocks, he laments, "we'd be nicely ahead of the market now." For once, he understands how hapless the market makes the rest of us feel, but in Miller's case, that lesson in humility may prove as ephemeral as the gathering gloom over the price of oil.