May 7 (Bloomberg) -- Bill Miller, Legg Mason Inc.’s most prominent stockpicker, said U.S. financial companies are his favorite investment for the next two years.

“Financials have the biggest potential to outperform” other stocks because of how far they’ve fallen in the worst bear market since the Great Depression, Miller said yesterday in an interview at a conference organized by the Investment Company Institute in Washington. The Standard and Poor’s 500 Financials Index tumbled 52 percent in the past year, compared with the 35 percent drop by the S&P 500 Index.

Miller, 59, whose Legg Mason Value Trust fund beat the S&P 500 a record 15 straight years through 2005, trailed the benchmark for the next three years as investments in homebuilders and banks soured. Those holdings led Value Trust to a 55 percent loss in 2008. The fund rose 8.7 percent this year through yesterday, leading the S&P 500 by about 5.9 percentage points.

The manager’s favorite financial stocks include San Francisco-based Wells Fargo & Co.,Capital One Financial Corp. in McLean, Virginia and New York-based American Express Co., all held by his $3.8 billion fund.

In a panel discussion earlier in the day, the Baltimore- based fund manager said investors are “shrugging off” the government’s stress tests of 19 financial institutions, designed to measure their stability in a further economic decline.

No Stress

Bank of America Corp., Citigroup Inc., Wells Fargo and GMAC LLC need to raise more capital, people familiar with the matter said yesterday. Goldman Sachs Group Inc., JPMorgan Chase & Co. and American Express were among those deemed not to need additional funds.

The S&P Financials Index rose 16 percent in the past seven sessions, while the S&P 500 climbed 7.3 percent.

“The market is telling you the stress test is a nonevent,” Miller said.

He criticized the government review for pushing banks to “raise capital when capital is in short supply,” and for signaling that banks can address the problem by converting preferred shares into common equity.

“It’s like moving money from one pocket to the other,” Miller said. “I don’t see what difference it makes.”

Miller said he expects U.S. housing prices to stabilize this year and for the economy to perform better than Federal Reserve projections. The Fed has forecast that gross domestic product will shrink by 0.9 percent in 2009.

Miller said U.S. equity markets will rise 20 percent to 30 percent in 2009. He also expected his fund to rebound.

Sensing a Rebound

“Every time we’ve had a bad year, we’ve come back from it,” he said.

Miller said emerging markets such as China will help lead developed nations to an economic recovery.

China “will pull the U.S. up with it” if its economy improves, he said during the panel discussion.

Miller pledged last year to broaden his holdings to make his main fund less dependent on any single industry. He boosted the number of stocks to 47 from 36 in the six months ended March 31, and bought energy shares for the first time since 2003.

Miller has run Value Trust since its opening in 1982. Miller, who initially managed the fund with Ernie Kiehne, took sole responsibility in 1990, the year before his winning streak began.

To contact the reporter on this story: Christopher Condon in Washington at ccondon4@bloomberg.net; Sree Vidya Bhaktavatsalam in Boston at sbhaktavatsa@bloomberg.net.

Last Updated: May 7, 2009 00:01 EDT