Investment Adviser Report to Shareholders
Legg Mason Fund Adviser, Inc. For the Quarter Ended
Baltimore, MD December 31, 1996
Board of Directors
Raymond A. Mason, Chairman The
John F. Curley, Jr., President Legg Mason
Richard G. Gilmore Total
Charles F. Haugh Return
Arnold L. Lehman Trust, Inc.
Dr. Jill E. McGovern Primary Class
T. A. Rodgers
Edward A. Taber, III
Transfer and Shareholder Servicing Agent
Boston Financial Data Services
Boston, MA
Putting Your Future First
Custodian
State Street Bank & Trust Company
Boston, MA
Counsel
Kirkpatrick & Lockhart LLP
Washington, DC [Legg Mason Logo]
FUNDS
Independent Accountants
Coopers & Lybrand L.L.P.
Baltimore, MD
This report is not to be distributed unless preceded or
accompanied by a prospectus.
Legg Mason Wood Walker, Incorporated
- --------------------------------------------------------------------------------
111 South Calvert Street
P.O. Box 1476, Baltimore, MD 21203-1476
410 (bullet) 539 (bullet) 0000
[Recycled Logo] Printed on Recycled Paper
LMF-006
2/97
<PAGE>
To Our Shareholders,
The Total Return Trust had excellent results in the quarter and year ended
December 31, 1996.
In the quarter, the Trust's total return (appreciation in share value plus
dividends and distributions) was 12.5%, well ahead of the 6% and 8.3% returns on
the Value Line index of 1700 stocks and Standard & Poor's 500 stock composite
index in the same period. Net asset value per share rose from $17.61 to $19.01.
The latter figure is after payment in December of a long-term capital gain
distribution of $.555 per share and an ordinary income dividend of $.084 per
share.
In the full year, the Trust's total return was 31.1%, comparing very
favorably to returns of 16.2% and 23% on the Value Line and Standard & Poor's
indices.
On the following pages, Nancy Dennin and Bill Miller, the Trust's portfolio
managers, comment on the investment outlook.
Sincerely,
/s/ John F. Curley, Jr.
John F. Curley, Jr.
President
January 31, 1997
<PAGE>
Portfolio Managers' Comments
Your fund's results for the periods ended December 31, 1996 are shown below
with comparable data for the leading market indices:
Total Growth &
Return Income S&P Dow
Trust Funds+ 500 Jones
- ----------------------------------------------------
3 months 12.48% 7.42% 8.33% 10.22%
1 year 31.14% 20.78% 22.96% 28.91%
2 years 70.96% 58.27% 69.17% 76.26%
Your fund had a great year on both an absolute and relative basis. Even
more remarkable, 1996 was the second year in a row the Total Return Trust
appreciated over 30%. While these results are gratifying, stockholders should
understand that this is an equity fund and its results will tend to reflect
results in the equity market. The market is often subject to swings as earnings
expectations change and emotions move from one extreme to the other. We do not
try to time the market, an endeavor we regard as fruitless, and if the market
goes into a protracted decline we will most likely participate. That said, we
are reasonably optimistic about the market this year, and hope to do well.
The higher the market goes, the stronger the commentary about an imminent
correction. Market seers cite many different variables for the soon-to-hit
correction: high P/E (price/earnings) multiples, low dividend yields, record
deal levels, record flows of cash into the market, and low cash levels in mutual
funds are just a few of the items mentioned. While on the surface these
variables seem worrisome, they need to be examined in detail. For example, cash
as a percentage of total equity mutual fund assets stood at 5.8% at the end of
November, the lowest percentage in 20 years. However, the 5.8% cash level
equates to $100 billion, or 5.7 days' trading volume on the New York Stock
Exchange. In January 1992, stock funds held 7.2% of their assets in cash, but
that sum was equivalent to only 3.4 days' trading volume.
With individuals having invested a record $200 billion in net new cash into
the stock market in the first eleven months of 1996, the financial press often
cites the possibility of a potentially severe sell-off when the demand for
equities eventually recedes. While investors have been aggressively buying
equities, we believe this needs to be viewed in a broader context.
+As measured by Lipper Analytical Services, Inc.
First, the demand for equities is just one part of the equation. The supply
of equities also needs to be examined. Notwithstanding a record year for initial
public offerings, the market experienced a net shrinkage of $50 billion in
equity in the first three quarters of 1996, including $24.6 billion in the third
quarter alone. With U.S. based companies, in aggregate, generating excess free
cash flow and with reinvestment opportunities limited in a slowly growing world
economy, companies have been aggressively buying back their stock. Given our
outlook for continued slow growth (detailed in prior reports), we expect this to
continue.
Additionally, we believe the secular forces of an aging baby boom
population will continue to drive the demand for equities. Many of the boomers
entered their prime spending and borrowing years in the late 1970s and early
1980s. New families were formed and spending on housing surged, as did the
willingness to borrow. Household balance sheets deteriorated and the savings
rate fell. Equities declined to only 18% of the typical household's financial
portfolio in the 1980s, compared to almost 45% held in equities in the late
1960s.
Now the reverse is occurring. Boomers are entering their peak earnings and
savings years. The fastest growing segment of the population in the late 1990s
is people aged 50-54; this is also the highest income earning age group. Not
coincidentally, cash flows into the market are on an uptrend. We believe this
secular force will have a positive impact on the market for quite some time.
Even after the recent record cash flows into equity mutual funds, equities
(including mutual funds) comprise only about 30% of households' discretionary
financial portfolios.
Another variable market seers often cite as cause for concern is the P/E
ratio. However, as we've mentioned in prior reports, the P/E ratio needs to be
viewed in the context of the inflationary environment. There is a strong inverse
correlation between inflation and P/E ratios. Over the last 70 years, during
periods of moderate inflation (defined as 3.5% or less), P/E ratios have
averaged 16x. When inflation has been 2.5% or less, P/E ratios have ranged
between 18-20x. Core inflation (which excludes the volatile food and energy
prices), as measured by the Consumer Price Index, was 2.6% in 1996, and is
expected to be in the 2.5-3.0% range in 1997. With the S&P 500 currently trading
at about 17x projected 1997 earnings, the market is currently fairly valued
relative to inflation.
2
<PAGE>
The argument that the market is overvalued because dividend yields are low
is also flawed, in our opinion. It fails to measure what really matters, that
is, whether companies are generating the cash to pay a dividend, rather than
whether or not they choose to do so. The average dividend yield has declined in
recent years largely because companies are paying out an ever-smaller portion of
their earnings as dividends. The current payout ratio is less than 35 percent,
the lowest level in over 20 years.
It may seem that we are "irrationally exuberant" about the market--we're
not. We believe it's highly unlikely the market will continue to generate the
types of returns experienced over the last two years. With the market fairly
valued relative to inflation, we expect stock prices in 1997, as measured by the
S&P 500, to appreciate in line with corporate earnings growth of about 6-8%.
Coupled with the current 2% dividend yield, equities should provide a quite
adequate total return of 8-10% over the next twelve months.
We sold several securities during the fourth quarter--Cigna Corp., duPont
(E.I.) de Nemours, and the Mexican Cetes--as they reached our price targets.
Collective Bancorp rapidly appreciated before we were able to acquire a
meaningful position. Tyco Toys announced an agreement to be acquired by Mattel.
Happily, we made a 100% return in the five months we owned the convertible.
We added four securities during the quarter, as shown in the accompanying
table. Ogden Corp. is a multi-industry company, operating in three distinct
areas: entertainment, aviation, and energy. The stock has declined about 20%
from its twelve month high due to disappointing earnings; however, management is
completing a restructuring program that should provide for future revenue and
operating margin growth. Coupled with the current 6.6% dividend yield, we
believe Ogden will provide a very attractive risk-adjusted return over the next
18 months.
LaSalle Re Holdings Ltd. is a Bermuda-based reinsurance company. Management
is very focused on returning excess capital to shareholders. As such, they
recently announced a share repurchase program, and a dividend policy of paying
out 50-60% of their prior year's earnings, resulting in a 9.7% current yield.
Colt Telecom Group recently completed its initial public stock offering,
and simultaneously issued "units," representing a 12% senior discount note and a
warrant to purchase stock. We purchased a small position in the units, and find
the Colt story very intriguing. Colt is a competitive communications carrier
established in 1991 to compete in the liberalizing European telecommunications
market. We believe the company will be either the first or the second carrier to
provide facilities-based competition to customers in the major financial centers
in Europe.
John Alden is an insurance company, primarily offering group health and
managed indemnity products. Earnings have been negatively impacted over the last
two years by various legislative initiatives at the state and federal level.
However, with the stock down over 25% from its 52 week high, we believe the bad
news is already being discounted by the market.
We would like to thank our shareholders, both old and new, for their
confidence. As always, we appreciate your support and welcome your comments and
suggestions.
Nancy Dennin, CFA
Bill Miller, CFA
January 31, 1997
DJIA 6813.09
3
<PAGE>
Performance Information
Legg Mason Total Return Trust, Inc.
Total Return for One, Five, Ten Years and Life of Fund, as of
December 31, 1996
The returns shown are based on historical results and are not intended to
indicate future performance. The investment return and principal value of an
investment in the fund will fluctuate so that an investor's shares, when
redeemed, may be worth more or less than their original cost. Average annual
returns tend to smooth out variations in the fund's return, so they differ from
actual year-to-year results. No adjustment has been made for any income taxes
payable by shareholders.
The fund has two classes of shares: Primary Class and Navigator Class. The
Navigator Class, offered only to certain institutional investors, pays fund
expenses similar to those paid by the Primary Class, except that transfer agency
fees and shareholder servicing expenses are determined separately for each class
and the Navigator Class does not incur Rule 12b-1 distribution fees.
The fund's total returns as of December 31, 1996 were as follows:
Cumulative Average Annual
Total Return Total Return
- --------------------------------------------------------------------------------
Primary Class:
One Year 31.14% 31.14%
Five Years 105.83 15.53
Ten Years 216.15 12.20
Life of Class+ 223.46 11.14
Navigator Class:
One Year 32.51% 32.51%
Life of Class++ 69.15 28.63
- --------------------------------------------------------------------------------
+Primary Class inception--November 21, 1985
++Navigator Class inception--December 1, 1994
Selected Portfolio Performance
Biggest gainers for the 4th quarter 1996*
- --------------------------------------------------------------------------------
1. RJR Nabisco Holdings Corp.
Series C Depositary Shares +25.6%
2. Lloyds TSB Group plc +24.8%
3. Standard Federal Bancorporation +24.3%
4. Resource Mortgage Capital Corporation +23.7%
5. BankAmerica Corporation +21.5%
6. International Business Machines
Corporation +21.3%
7. Masco Corporation +20.0%
8. The Bear Stearns Companies, Inc. +19.9%
9. American Financial Group Incorporated +19.8%
10. Walden Residential Properties, Inc. +17.8%
* Securities held for the entire quarter.
Biggest laggers for the 4th quarter 1996*
- --------------------------------------------------------------------------------
1. Hercules, Inc. -21.0%
2. Olin Corporation -10.4%
3. J.C. Penney Company, Inc. -9.9%
4. Kmart Corporation 7.75% Cv. -0.3%
5. Ford Motor Company +2.0%
6. Telefonos de Mexico S.A. ADR +2.7%
7. Northrop Grumman Corporation +3.1%
8. United States Treasury Bond
6% 2-15-26 +3.6%
9. Federal National Mortgage Association +6.8%
10. Bank United Corp. +7.5%
Portfolio Changes
Securities Added
- --------------------------------------------------------------------------------
Colt Telecom Group - Units
0% 12-15-06
John Alden Financial Corporation
LaSalle Re Holdings Ltd.
Ogden Corporation
Securities Sold
- --------------------------------------------------------------------------------
CIGNA Corporation
Collective Bancorp, Inc.
duPont (E.I.) de Nemours
Mexican Cetes 1-30-97
Tyco Toys, Inc. Series C, Cv.
4
<PAGE>
Portfolio of Investments
Legg Mason Total Return Trust, Inc.
December 31, 1996 (Unaudited)
(Amounts in Thousands) Shares Value
- --------------------------------------------------------------------------------
Common Stocks and Equity Interests -- 84.8%
Aerospace -- 2.3%
Northrop Grumman Corporation 100 $ 8,275
- --------------------------------------------------------------------------------
Automotive -- 7.9%
Chrysler Corporation 314 10,362
Ford Motor Company 250 7,969
General Motors Corporation 175 9,756
- --------------------------------------------------------------------------------
28,087
- --------------------------------------------------------------------------------
Banking -- 10.4%
BankAmerica Corporation 100 9,975
Lloyds TSB Group plc 2,140 15,805
The Chase Manhattan Corporation 125 11,156
- --------------------------------------------------------------------------------
36,936
- --------------------------------------------------------------------------------
Chemicals -- 6.2%
Hercules, Inc. 305 13,191
Olin Corporation 230 8,654
- --------------------------------------------------------------------------------
21,845
- --------------------------------------------------------------------------------
Commercial Services -- 1.3%
Ogden Corporation 240 4,515
- --------------------------------------------------------------------------------
Computer Services and Systems -- 5.1%
International Business Machines
Corporation 120 18,120
- --------------------------------------------------------------------------------
Construction Materials -- 2.0%
Masco Corporation 200 7,200
- --------------------------------------------------------------------------------
Finance -- 5.7%
Federal National Mortgage Association 252 9,387
The Bear Stearns Companies, Inc. 387 10,798
- --------------------------------------------------------------------------------
20,185
- --------------------------------------------------------------------------------
Gas and Pipeline Utilities-- 2.7%
Williams Companies, Inc. 255 9,562
- --------------------------------------------------------------------------------
Insurance -- 12.1%
American Financial Group Incorporated 229 8,645
Enhance Financial Services Group Inc. 305 11,143
IPC Holdings Limited 463 10,360
John Alden Financial Corporation 300 5,550
LaSalle Re Holdings Ltd. 245 7,151
- --------------------------------------------------------------------------------
42,849
- --------------------------------------------------------------------------------
(Amounts in Thousands) Shares Value
- --------------------------------------------------------------------------------
Real Estate -- 12.9%
National Golf Properties, Inc. 346 $ 10,942
Nationwide Health Properties, Inc. 140 3,395
Regency Realty Corporation 373 9,778
Resource Mortgage Capital Corporation 315 9,253
Summit Properties, Inc. 223 4,941
Walden Residential Properties, Inc. 300 7,463
- --------------------------------------------------------------------------------
45,772
- --------------------------------------------------------------------------------
Retail Sales -- 2.9%
J.C. Penney Company, Inc. 215 10,482
- --------------------------------------------------------------------------------
Savings and Loan -- 10.9%
Bank United Corp. 223 5,968
Great Western Financial Corporation 289 8,372
Standard Federal Bancorporation 217 12,342
Washington Federal, Inc. 447 11,847
- --------------------------------------------------------------------------------
38,529
- --------------------------------------------------------------------------------
Telecommunications -- 2.4%
Telefonos de Mexico S.A. ADR 255 8,415
- --------------------------------------------------------------------------------
Total Common Stocks and Equity
Interests
(Identified Cost-- $205,635) 300,772
- --------------------------------------------------------------------------------
Preferred Shares -- 4.5%
RJR Nabisco Holdings Corp.
Series C Depositary Shares 1,011 6,822
Kmart Corporation
7.75% Cv. 184 8,989
- --------------------------------------------------------------------------------
Total Preferred Shares
(Identified Cost-- $15,663) 15,811
- --------------------------------------------------------------------------------
Principal
Amount
- --------------------------------------------------------------------------------
Yankee Bond(A) -- 0.1%
Colt Telecom -Units
0%(B) 12-15-06
(Identified Cost-- $279) $ 500 295
- --------------------------------------------------------------------------------
5
<PAGE>
Portfolio of Investments--Continued
Legg Mason Total Return Trust, Inc.
December 31, 1996
Principal
(Amounts in Thousands) Amount Value
- --------------------------------------------------------------------------------
U.S. Government Obligation -- 4.9%
United States Treasury Bond
6.00% 2-15-26
(Identified Cost-- $16,518) $19,000 $ 17,293
- --------------------------------------------------------------------------------
Repurchase Agreement -- 5.6%
Prudential Securities, Inc.
7.15% dated 12-31-96, to be
repurchased at $19,971 on
1-2-97 (Collateral: $20,666
Federal Home Loan Mortgage
Association Mortgage-backed
securities, 7.0% due 10-1-26,
value $20,393)
(Identified Cost-- $19,963) 19,963 19,963
- --------------------------------------------------------------------------------
Total Investments -- 99.9%
(Identified Cost-- $258,058) 354,134
Other Assets Less Liabilities-- 0.1% 437
- --------------------------------------------------------------------------------
Net assets-- 100.0% $354,571
- --------------------------------------------------------------------------------
Net asset value per share:
Primary Class $19.01
- --------------------------------------------------------------------------------
Navigator Class $19.10
(A) Yankee Bond -- Dollar-denominated bond issued in the U.S. by foreign
entities.
(B) Stepped coupon bond -- This Colt Telecom bond will amortize to par by
December 15, 2001 at which time it will begin to accrue interest at
12.0% until maturity.
6
