Annual Report to Shareholders (2006)Full Document 

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Legg Mason

Investors Trust, Inc.

Investment Commentary and Annual Report to Shareholders March 31, 2006

American Leading Companies Trust

Balanced Trust

Financial Services Fund

U.S. Small-Capitalization Value Trust


Personalized Guidance. Intelligent Choices.SM






Investment Commentary


Glossary of Index Definitions


Annual Report to Shareholders


President’s Letter


American Leading Companies Trust


Management’s Discussion of Fund Performance


Expense Example


Performance Information


Financial Statements


Balanced Trust


Management’s Discussion of Fund Performance


Expense Example


Performance Information


Financial Statements


Financial Services Fund


Management’s Discussion of Fund Performance


Expense Example


Performance Information


Financial Statements


U.S. Small-Capitalization Value Trust


Management’s Discussion of Fund Performance


Expense Example


Performance Information


Financial Statements


Notes to Financial Statements


Report of Independent Registered Public Accounting Firm


Change in Independent Registered Public Accounting Firm


Directors and Officers


Board Consideration of Legg Mason American Leading Companies Trust’s Investment Advisory and Management Agreement


Board Consideration of Legg Mason Balanced Trust’s Investment Advisory and Management Agreement and Sub-Advisory Agreement


Board Consideration of Legg Mason Financial Services Fund’s Investment Advisory and Management Agreement and Sub-Advisory Agreement


Board Consideration of Legg Mason U.S. Small- Capitalization Value Trust’s Investment Advisory and Management Agreement and Sub-Advisory Agreement


Glossary of Index Definitions


ii    Investment Commentary


American Leading Companies Trust

Market Commentary

The U.S. equity market posted strong results in the first quarter of 2006 by any measure. The S&P 500 Index’s total return of 4.2% was its best first quarter showing since 1999, while the Nasdaq had its best March quarter since 2000, and the Dow Industrials its best since 2002.


     Total Returns Periods
Ending March 31, 2006
     3 Months     1 Year  

S&P 500 Stock Composite IndexA

   +4.21 %   +11.73 %

Dow Jones Industrial AverageA

   +4.24 %   +8.26 %

S&P 400 Mid-Cap IndexA

   +7.63 %   +21.62 %

Russell 2000 IndexA

   +13.94 %   +25.93 %

Nasdaq Composite IndexA

   +6.37 %   +18.02 %

The stars of the show in the March quarter continued to be the small- and mid-cap stocks. As shown in the above table, the S&P Mid-Cap Index was up 7.63% and the Russell 2000 Index gained a mind-blowing 13.94%. Is this surge a last hurrah for small-cap relative performance, or powerful evidence that the trend has further to run? We obviously can’t say for sure, but from our perspective, the valuation case for large-cap is becoming more compelling, while the valuation underpinnings are weakening in the small-cap sector. As a consequence, we believe the risk in small-caps is rising relative to large-caps.

We’ll get to the valuation case for large versus small stocks in a minute, but first we should note that the recent strength in small-caps may well have very little to do with relative valuation. We may instead be seeing evidence of piling on, or piling in, by the hedge funds. Many, if not most, hedge funds are trend followers. They go where the action is. Lately, the action has clearly been in small-caps. According to Albert Richards, Citigroup’s U.S. small-and mid-cap strategist, a representative sample of hedge funds have 59% of their assets in companies with market floats (shares outstanding less insider holdings) less than $10 billion, compared to the 28% that those companies represent of the Russell 3000 Index.

Recently, there is anecdotal evidence that investors have also been buying small-cap exchange traded funds (ETF) as a means of gaining exposure to the small-cap sector without having to choose individual stocks. The ETFs must then use their cash inflows to buy the underlying shares of the companies in their benchmark, thus adding democratically (or indiscriminately, depending how you look at it) to overall small-cap stock demand.

On a valuation basis, stocks in the Russell 2000 Index trade at 44 times 2005’s earnings, compared with 18 times for the S&P 500. Within the S&P 500 itself, the bottom decile of companies (the smallest 50 by market value) trades at 20.1 times estimated 2006 earnings, while the top decile trades at a cap-weighted average of 14.4 times earnings as of the end of March.


A See Glossary of Index Definitions on page xvi. It is not possible to invest in an index.

The Investment Commentary is not a part of the Annual Report to Shareholders.

Investment Commentary    iii


Is the P/E multiple premium currently accorded to small-cap stocks justified? Small-cap advocates think so. They argue that the largest companies in the S&P 500 are “too big” to grow very fast, while small-caps as a group have the opportunity to post superior growth rates for many years to come. Maybe so, but we remember when people made the exact opposite argument in 2000. Then, the conventional wisdom was that mega-caps should trade at a premium to the market because their results were more predictable and they were the primary beneficiaries of globalization. The small-caps, while admittedly cheap, were thought to warrant a discount valuation due to their greater business risk and illiquidity.

The truth is that investors’ views on the relative merits of small versus large-caps fluctuate over time. Since 1960, large- and small-cap stocks have traded at roughly the same average P/E multiples, with large-caps’ greater stability being valued about equally with small-caps’ probable superiority in terms of growth prospects. In our experience, investors’ enthusiasm for either group is heavily influenced by recent relative performance trends. Investors tend to gravitate toward groups or sectors that have been doing well, and avoid sectors that have not. Small-caps are popular now principally, in our view, because they have been going up sharply. Large-caps—and especially mega-caps—are unpopular because they have been performance dogs in recent years. The worm will turn, as it always does. The only question is when.

The Investment Commentary is not a part of the Annual Report to Shareholders.

iv    Investment Commentary


Investment Results

Total returns for the American Leading Companies Trust (“Fund”) for various periods ended March 31, 2006, are presented below, along with those of some comparative indices:







    Average Annual Total Returns
Through March 31, 2006

American Leading Companies


Primary Class

     +1.74 %   +12.54 %   +19.16 %   +6.12 %   +9.55 %   +9.46 %

Institutional Class

     +2.01 %   +13.63 %   +20.35 %   N/A     N/A     +6.54 %

S&P 500 Stock Composite Index

     +4.21 %   +11.73 %   +17.22 %   +3.97 %   +8.95 %   +10.51 %

Dow Jones Industrial Average

     +4.24 %   +8.26 %   +14.13 %   +4.60 %   +9.19 %   +11.53 %

Lipper Large-Cap Core FundsA

     +3.94 %   +11.63 %   +15.46 %   +2.57 %   +7.31 %   +9.02 %

Lipper Large-Cap Value FundsA

     +4.55 %   +11.40 %   +18.82 %   +5.11 %   +8.55 %   +10.09 %

The performance data quoted represents past performance and does not guarantee future results. The performance stated may have been due to extraordinary market conditions, which may not be duplicated in the future. Current performance may be lower or higher than the performance data quoted. To obtain the most recent month-end performance information for the Primary Class please visit; for the Institutional Class please call 1-888-425-6432. The investment return and principal value of the Fund will fluctuate so that an investor’s shares, when redeemed, may be worth more or less than the original cost. Calculations assume reinvestment of dividends and capital gain distributions. Performance would have been lower if fees had not been waived in various periods. Performance figures for periods longer than one year represent average annual returns.

American Leading Companies Trust had a subpar March quarter, trailing all its principal benchmarks and peer fund averages. Returns on a one, three, five-year and ten-year basis are more encouraging. American Leading Companies’ performance is ahead of all relevant benchmarks and peer averages over those time periods.

For the twelve months ended March 31, 2006, the leading percentage gainers in the portfolio among stocks owned for the entire period were: Phelps Dodge Corporation, Transocean Inc., Health Net Inc., Baker Hughes Incorporated, Hewlett-Packard Company, Merrill Lynch & Co., Inc., Nokia Oyj—ADR, Anadarko Petroleum Corporation, Devon Energy Corporation and Texas Instruments Incorporated. Laggards included: Tyco International Ltd., Sara Lee


B The inception date of the Primary Class is September 1, 1993. The inception date of the Institutional Class is June 14, 2001. Index returns are for periods beginning August 31, 1993.

The Investment Commentary is not a part of the Annual Report to Shareholders.

Investment Commentary    v


Corporation, Intel Corporation, Kimberly-Clark Corporation, Johnson & Johnson, IBM Corporation, Liberty Media Corporation, Wal-Mart Stores, Inc., Pfizer Inc. and Time Warner Inc.

On a performance contribution basis, which takes into account both price change and portfolio weighting, the leading positive contributors for the fiscal year were: Health Net Inc., Phelps Dodge Corporation, UnitedHealth Group Incorporated, Sprint Nextel Corporation and J.P. Morgan Chase & Co. The largest detractors from performance were: Tyco International Ltd., Liberty Media Corporation—Series A, Intel Corporation, IBM Corporation and Bristol-Myers Squibb Company. The two sectors which contributed most positively to the Fund’s relative performance for the fiscal year were commodity stocks and managed-care companies.

For the latest twelve months, we would describe portfolio activity as moderate, with turnover averaging about 20%. A complete listing of new purchases and liquidations is presented elsewhere in this report. In broad terms, during the year, we expanded the number of holdings in the portfolio by about 16%, from 57 to 66. The biggest single change in the portfolio’s structure during the year was an approximate 6.5 percentage point increase in technology holdings with new positions in Dell Inc., Symantec Corporation, Accenture Ltd. and additions to our existing holdings of Intel Corporation, Applied Materials Inc. and Hewlett-Packard Company. In addition, we added to our e-commerce holdings with the purchase of eBay Inc. and Yahoo! Inc., and additions to our holdings of Expedia Inc. and, Inc. We also repositioned our holdings in a number of sectors. In materials, we broadened our diversification by reducing our positions in three existing holdings to fund the purchase of U.S. Steel Corporation. In pharmaceuticals, we sold Merck & Co., Inc. and Bristol-Myers Squibb Co. to buy more Pfizer Inc. and Johnson & Johnson. In financials, we sold Fannie Mae and reduced our positions in MGIC Investment Corporation, Washington Mutual, Inc. and Lloyds TSB Group plc to buy a new position in re-insurer, XL Capital, and add to Countrywide Financial Corporation. In the consumer discretionary sector, we sold grocer Albertson’s—which is being taken over—and bought Pulte Homes, Inc. and Eastman Kodak Company. Finally, we took advantage of favorable prices to reduce our portfolio weightings in energy stocks and managed-care companies. We are now underweight energy, but remain overweighted in the managed-care sector.

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