Investment Adviser
Legg Mason Fund Adviser, Inc.
Baltimore, MD
Board of Directors
Raymond A. Mason, Chairman
John F. Curley, Jr., President
Richard G. Gilmore
Charles F. Haugh
Arnold L. Lehman
Dr. Jill E. McGovern
T. A. Rodgers
Edward A. Taber, III
Transfer and Shareholder Servicing Agent
Boston Financial Data Services
Boston, MA
Custodian
State Street Bank & Trust Company
Boston, MA
Counsel
Kirkpatrick & Lockhart LLP
Washington, DC
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
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111 South Calvert Street
P.O. Box 1476, Baltimore, MD 21203-1476
410 o 539 o 0000
(recycled logo) Printed on Recycled Paper
LMF-009
Report to Shareholders
For the Quarter Ended
June 30, 1996
The
Legg Mason
Special
Investment
Trust, Inc.
Primary Class
Putting Your Future First
[Legg Mason Funds Logo]
FUNDS
<PAGE>
To Our Shareholders,
In the quarter ended June 30, 1996, the Special Investment Trust's net
asset value per share rose from $25.09 to $25.55. Assuming reinvestment of a
$0.374 per share short-term capital gain distribution and a $0.553 per share
long-term capital gain distribution paid in May, the Trust's total return (share
appreciation plus reinvested dividends and capital gain distributions) in the
quarter was 5.5%, compared to gains of 4.5% in Standard & Poor's 500 stock
composite index and 3.4% in the Value Line index of 1,700 stocks. In the six
months through June 30, the Trust's total return was 16.0%, compared to returns
of 10.1% and 8.4% on the Standard & Poor and Value Line indices.
On the following pages, Bill Miller, the Trust's portfolio manager,
comments on the investment outlook.
Many shareholders invest regularly in Trust shares on a dollar cost
averaging basis through a program we call Future First. Most do so by
authorizing automatic monthly transfers of $50 or more from their bank checking
or Legg Mason accounts. Dollar cost averaging is a convenient and sensible way
to invest which encourages continued purchases during market downswings when the
best values are available. Of course, it does not ensure a profit nor protect
against declines in the value of your investment. Your Legg Mason Investment
Executive will be happy to help you establish a Future First dollar cost
averaging account should you wish to do so.
Sincerely,
/s/ John F. Curley, Jr.
John F. Curley, Jr.
President
July 31, 1996
<PAGE>
Portfolio Manager's Comments
Your fund rose 5.49% in the second quarter, bringing our six month increase
to 16.04%. The quarter's return exceeded that of the S&P 500, which advanced
4.49%, and the Russell 2000, an index of small and mid-size companies, which
rose 5%.
Our returns for the quarter exceeded those of growth and mid-cap funds,
which rose 4.45% and 4.78%, respectively, and trailed those of small company
growth funds, which advanced 7.39%. For the six months our results are ahead of
the indices and all of the fund categories (as measured by Lipper Analytical
Services, Inc.) just noted.
The second quarter saw what may be the high water mark in speculation for
this cycle. Strong money flows into aggressive growth funds fueled the advance
of many small, speculative companies, whose valuations often reached
breathtaking levels. At the same time, interest rates continued to rise during
the quarter, and moved past 7% for the 30-year Treasury bond.
At the end of June, the results for bond and stock investors differed
dramatically. Those who bought long-term Treasuries at about 6% in January had
lost almost 10% of their money in six months, while equity investors were up by
about the same amount. The more venturesome small stock investors had average
returns in their mutual funds of over 15%. Bond and stock returns usually don't
diverge for very long. By the end of the second quarter the valuation gap
between stocks and bonds had widened such that we believed--and still
believe--that to be bullish on stocks you have to be bullish on bonds. In this
kind of environment, the best stocks should be those that look like bonds:
banks, insurance companies, credit card companies, thrifts. We are loaded with
these. Despite the fund's strong performance in the first half, our financial
stocks have turned in only a so-so performance. We think they are very
attractively valued and will perform well in the second half.
The current situation is roughly the opposite of that prevailing at the
beginning of the year when bonds yielded under 6%. Then stocks were attractively
priced relative to bonds. But the sharp divergence in their performance has
changed all that, and the market has already begun to exact its toll on overly
complacent or enthusiastic stock investors. In just the first few weeks of the
third quarter, a swift correction has engulfed the stock market. The major stock
indices are down more than 8%, while the frothier over the counter market is off
over 15% from highs reached just recently. On most days when the stock market
has declined, which at this writing is most of them since the 114 point drop on
July 5, the bond market has rallied. This has begun to redress the valuation
imbalance, but has not yet rectified it.
The correction was kicked off by a jobs report which indicated continuing
strong demand for labor at a time of already low unemployment. More disturbing
to the market, real wages grew at the fastest rate in thirty years, which
rekindled fears of higher inflation. Although bonds fell sharply the day of the
report, they have rallied steadily since, indicating that 7% yields have already
discounted some upward movement in inflation.
Whatever the portent of the employment report, its effect on economists and
investors was immediate. The economic seers raised their forecasts for second
quarter growth to 4% or more and also increased their estimates of third quarter
growth from an average of 2-2.5% to 3-3.5%. At its present size, the economy
will generate an extra $60 billion of output in the next 90 days, if those
forecasts can be believed. A strong consensus has also emerged that the Federal
Reserve Board will raise rates at its August meeting, if not before.
Labor cost inflation is more problematic than the commodity price increases
that led to inflation fears earlier this year. Labor costs make up about
two-thirds of the cost of production. The supply of labor is relatively fixed
and when demand for labor passes a point called the non-accelerating inflation
rate of unemployment (abbreviated as NAIRU), theory says that labor costs may
fuel higher inflation as companies bid for other companies' workers.
Stock investors may be hurt in at least two different ways if wage
inflation takes hold. First, since pricing power is minimal, wage increases
cannot easily be passed along to customers. This raises concerns about profit
margins (and profits) getting squeezed. Pressure on profits means pressure on
stock prices, other things equal. Second, the Fed is known to be especially
sensitive to wage inflation, since it is difficult to halt once started. They
are much more likely to aggressively raise interest rates at signs of wage
inflation than if only commodity
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<PAGE>
prices are rising. Rising interest rates hurt stocks directly at these
relative valuation levels, and also increase the chances of recession,
another bad outcome if you own stocks (but not high quality bonds).
We do not believe the recent uptick in real wages signals the beginning of
a rise in core inflation. Real wages can (and should) rise when worker
productivity rises. In the first quarter, productivity shot ahead at more than a
4% rate, leading to a fall in unit labor costs. It should be no surprise that
after five years of economic expansion, real wages would move upward with
continued productivity growth. It may be that rising wage growth is signalling
continued gains in productivity, not increased inflation. Whatever the cost
pressures, if monetary policy does not accommodate them through more rapid money
growth, then inflation will not be able to take hold. We think rising wage
growth heralds solid productivity growth, especially when one views it in the
context of the other factors of production.
Core producer price index (PPI) numbers show a twelve month rate of growth
of 1.6%, but a three and six month growth rate of only 1%. Total PPIgrowth has
been inflated by the commodity surge of a few months ago, which has now abated.
Reported PPI data are beginning to move to the recent core rate of 1%. Consumer
prices have historically averaged about .5% above the core rate, so this
indicator is pointing toward inflation of under 2%. With commodity prices
falling, core PPI falling, and most cyclical stocks--which are barometers of
economic strength--falling, there is little evidence of inflation pressure
outside the wage data. That makes it unlikely, in our view, that wage increases
alone will fuel higher inflation.
It is the prospect of wage inflation that sent stock investors into a
panic. In a classic turn of phrase, one rattled analyst, observing the selling
frenzy, said, "we are watching the lemmings fly out the window."
The change in investor psychology occasioned by a little selling is always
fascinating to behold. The major stock indices are off by 8%. The Russell 2000,
after being up over 10% on July 1, is now down for the year. In the past 30
years, half the days the market has been open it has been trading at 5% or more
from the peak. Over the past 95 years, there have been 54 corrections of 10% or
more, the most recent occurring intraday on July 16. For long-term investors,
sell-offs provide an opportunity. For speculators, they provide a lesson.
We think, though, that it will be tough for stocks to beat bonds in the
second half. Valuation and trend are in bonds' favor. With inflation running at
3%--or less--bond yields in the 7% range provide real returns well above
historical norms. The trend in many sensitive inflation indicators, such as
gold, oil, and industrial commodities prices, has been down from peaks reached a
few months ago. A more subtle feature of the favorable bond outlook is the trend
in the economy's growth rate. Even those economists who just raised their growth
rate for this quarter believe the second quarter will be the peak in economic
momentum. Bond prices tend to be coincident indicators of economic momentum.
Prices often rise as the economy slows, as happened in the second half of last
year, and fall when economic growth is accelerating, as in the first half of
this year.
We agree with the consensus (for a change) that economic growth will
decelerate in the second half of this year. If so, that would tend to underpin
bond prices. We disagree, though, that the Fed will be forced to raise rates in
August. On that point, we are agnostic, except to note that when the Fed voted
to hold policy steady at its last meeting on July 3, the vote was unanimous.
Inflation worries were then largely absent.
Since the stock market has so quickly swung from enthusiasm to despair, we
think if the Fed does not raise rates in August a nice rally may ensue. Perhaps
perversely, the worse the market acts from now to then may play a role in the
Fed's decision. At the July meeting, they noted that a market correction may
provide clues about the economy's prospects. The worse stocks act, the more the
Fed will think the economy is cooling off without the need for a rate hike.
We mention all this macroeconomic stuff not because we try to predict the
economy or the market. We don't. We do try to understand the economic forces
operating at any given time and what the valuation of various asset classes is
implying about the future.
Our stock selection, though, is one by one, valuation driven, and long-term
oriented. Quarterly
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<PAGE>
transactions remain at a low level. We sold a variety of smaller positions in
the past three months, continuing our practice of trying to keep the portfolio
tightly focused.
A significant portion of our research time is being dedicated to
technology, a sector that has been through a spectacular decline in the past
nine months. Many stocks are down 60 or 70% from their peaks. Two of the group's
bellwethers, Motorola and Hewlett Packard, reported poor results and suffered
sharp falls in their stock prices a few weeks ago. The best companies are
usually the last to decline, and we think bargains have begun to appear in this
group.
We bought two technology stocks in the quarter, Intergraph and Western
Digital. Intergraph stock has declined steadily for most of the past five years
as the company's growth slowed and it began to embark on a painful transition
from proprietary to open systems. The stock rallied early in the year to over
$20 on expectations that the long awaited turnaround had begun. When they missed
a software release date and had disappointing earnings, investors sold the stock
back to its current level of about $11, which approximates book value. We think
investors lost patience too early, and that the turnaround will be visible
within a quarter or two. We estimate the company could earn over $2.00 per share
within two years.
Western Digital is a leading supplier of disk drives for computers. The
disk drive industry, while fiercely competitive, has consolidated from 55
manufacturers in 1989 to 12 at the end of June to 11 today. Hewlett Packard
announced they were dropping out of the business when they announced their
earnings. New management at Western Digital has jettisoned ancillary businesses
to focus on the core drive operations. The company earns 20% on total capital,
has $6.00 per share in cash, trades at 8x next year's earnings and is
repurchasing its shares in the market.
As always, we appreciate your support and welcome your comments.
Bill Miller, CFA
July 31, 1996
DJIA 5528.91
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<PAGE>
Performance Information
Legg Mason Special Investment Trust, Inc.
Total Return for One, Five, Ten Years and Life of Fund,
as of June 30, 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.
Total returns as of June 30, 1996 were as follows:
Cumulative Average Annual
Total Return Total Return
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Primary Class:
One Year +25.89% +25.89%
Five Years +103.15 +15.23
Ten Years +212.31 +12.06
Life of Class(dagger) +276.96 +13.47
Navigator Class:
One Year +27.25% +27.25%
Life of Class(dagger)(dagger) +44.02 +25.90
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(dagger) Primary Class inception--December 30, 1985.
(dagger)(dagger) Navigator Class inception--December 1, 1994.
Selected Portfolio Performance
Biggest gainers for the 2nd quarter 1996*
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1.Cott Corporation Quebec +47.1%
2.Storage Technology Corporation +46.4%
3.Somatix Therapy Corporation +43.8%
4.Sunrise Medical, Inc. +37.5%
5.World Color Press, Inc. +33.6%
6.Mac Frugal's Bargainso
Close-outs Inc. +26.8%
7.John Alden Financial Corp. +25.5%
8.Mirage Resorts, Incorporated +23.1%
9.Gateway 2000, Inc. +22.0%
10.Circus Circus Enterprises, Inc. +21.9%
* Securities held for the entire quarter.
Portfolio Changes
Securities Added
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Intergraph Corporation
Western Digital Corporation
Biggest laggers for the 2nd quarter 1996*
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1. Stratosphere Corporation -43.9%
2. Salant Corporation
Class B Warrants -37.5%
3. Boomtown Inc. -22.0%
4. America Online, Inc. -21.9%
5. Salant Corporation -18.1%
6. Physician Corporation of America -17.2%
7. Value Health, Inc. -14.1%
8. Mego Financial Corporation
Warrants -11.8%
9. Standard Federal Bancorporation -9.4%
10. Pioneer Group, Inc. -7.8%
Securities Sold
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Asarco, Inc.
Biogen, Inc.
Grupo Mexicano de Desarrollo S.A. ADR
Piper Jaffray Incorporated
Summit Properties, Inc.
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<PAGE>
Portfolio of Investments
Legg Mason Special Investment Trust, Inc.
June 30, 1996 (Unaudited)
(Amounts in Thousands) Shares Value
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Common Stocks and Equity Interests -- 94.4%
Advertising -- 4.1%
WPP Group P.L.C. 10,200 $ 34,375
WPP Group P.L.C. ADR 89 2,981
37,356
Apparel -- 0.2%
Salant Corporation 450 1,659(A)
Salant Corporation Class B Warrants 285 22(A)
1,681
Banking -- 2.6%
Grupo Financiero Serfin S.A.
de C.V. ADR 1,554 7,965(A)
Peoples Heritage Financial
Group, Inc. 750 15,281
23,246
Biotechnology -- 1.9%
Somatix Therapy Corporation 1,980 14,108(A,B)
Somatix Therapy Corporation Warrants 152 437(A,B)
Targeted Genetics Corporation 477 2,266(A)
16,811
Broadcast Media -- 0.6%
Argyle Television, Inc. 225 5,625(A)
Computer Services and Systems -- 15.7%
America Online, Inc. 1,180 51,625(A)
Bell & Howell Company 300 9,788(A)
Gateway 2000, Inc. 500 17,000(A)
InaCom Corp. 805 15,094(A,B)
Intergraph Corporation 297 3,605(A)
Storage Technology Corporation 900 34,425(A)
Western Digital Corporation 425 11,103(A)
142,640
Energy -- 2.1 %
Calenergy, Inc. 750 19,125(A)
Entertainment -- 10.2%
Boomtown Inc. 900 4,388(A,B)
Circus Circus Enterprises, Inc. 750 30,750(A)
Hollywood Park, Inc. 1,775 17,084(A,B)
Mirage Resorts, Incorporated 274 14,791(A)
Players International, Inc. 2,000 19,500(A,B)
Stratosphere Corporation 1,025 6,150(A)
92,663
(Amounts in Thousands) Shares Value
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Finance -- 8.3%
Federal National Mortgage Association 375 $ 12,562
Mego Financial Corporation Warrants 300 1,965(A,B)
Pioneer Group, Inc. 700 18,725
The Bear Stearns Companies Inc. 525 12,403
United Asset Management Corporation 1,238 30,331
75,986
Food, Beverage and Tobacco -- 3.9%
Cott Corporation Quebec 3,800 35,625(B)
Health Care -- 8.3%
Magellan Health Services, Inc. 930 19,995(A)
Physician Corporation of America 1,500 19,875(A)
Sunrise Medical, Inc. 872 16,792(A)
Value Health, Inc. 801 18,912(A)
75,574
Insurance -- 13.6%
CMAC Investment Corporation 400 23,000
Enhance Financial Services Group Inc. 550 15,400
John Alden Financial Corp. 975 21,572
Leucadia National Corporation 100 2,450
Life Partners Group, Inc. 894 20,327
Orion Capital Corporation 590 30,090
PennCorp Financial Group, Inc. 354 11,246
124,085
Manufacturing -- 2.1%
Briggs & Stratton Corporation 217 8,924
Danaher Corporation 236 10,266
19,190
Miscellaneous -- 1.2%
Olsen & Associates AG 300 2,400(A,C)
Stewart Enterprises, Inc. 265 8,281
10,681
Publishing -- 0.5%
World Color Press, Inc. 165 4,187(A)
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(Amounts in Thousands) Shares Value
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Real Estate -- 1.6%
Resource Mortgage Capital
Corporation 466 $ 10,483
Walden Residential Properties, Inc. 217 4,427
14,910
Savings and Loan -- 7.1%
Cal Fed Bancorp Inc. 900 16,425(A)
Standard Federal Bancorporation 660 25,414
Washington Mutual, Inc. 770 23,004
64,843
Services -- 3.6%
Ideon Group Incorporated 2,458 33,183(B)
Specialty Retail -- 6.8%
Home Shopping Network, Inc. 3,025 36,300(A)
Mac Frugal's Bargains
(bullet) Close-outs Inc. 1,453 25,794(A,B)
62,094
Total Common Stocks and Equity
Interests
(Identified Cost-- $603,018) 859,505
Preferred Stock -- 0.2%
Mego Financial Corporation
Series A 12% Cum.
(Identified Cost -- $2,000) 200 2,000(B,C)
Principal
(Amounts in Thousands) Amount Value
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Sovereign Obligation -- 1.8%
Republic of Argentina Par Bonds
5.25%D 3-31-23
(Identified Cost-- $11,458) $30,000 $ 16,481
Repurchase Agreement -- 2.5%
Prudential Securities, Inc.
5.48% dated 6-28-96, to be
repurchased at $22,372 on
7-1-96 (Collateral: Federal
National Mortgage Association
Mortgage-backed securities,
$7,720 7.5% due 6-1-26 and
$14,046 10% due 4-1-25,
value $22,914)
(Identified Cost-- $22,362) 22,362 22,362
Total Investments -- 98.9%
(Identified Cost -- $638,838) 900,348
Other Assets Less Liabilities -- 1.1% 9,989
Net assets-- 100.0% $910,337
Net asset value per share:
Primary Class $25.55
Navigator Class $25.81
(A) Non-income producing
(B) Affiliated Companies -- As defined in the Investment Company Act
of 1940, an "Affiliated Company" represents Fund ownership of at
least 5% of the outstanding voting securities of the issuer.
(C) Private placement
(D) Coupon increases 0.25% annually until April 1, 1999, thereafter
remains fixed at 6.0% until maturity.
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