Michael J. Mauboussin Chief Investment Strategist Legg Mason Capital Management Long Term Investing in a Short Term World... It’s as Easy as PIE

Michael J. MauboussinChief Investment StrategistLegg Mason Capital Management

Long Term Investing in a Short Term World...

It’s as Easy as PIE

Long Term Investing in a Short Term World2

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Agenda

1. The Barriers Psychology

Incentives

2. The Evidence Corporations

Investors/Investment managers

3. The Solution Social context

A look at winners

Time arbitrage


Barriers to Long Term Thinking

Phenomenon Effect

Availability bias Accounting versus economic focus

Recency bias Betting on what has worked

Stress Creates a short-term focus

Agent/principal shift Agency costs

Ince

ntiv

es

Psy

cho

log

y


Corporations

Source: Brian J. Hall and Jeffrey B. Liebman, “Are CEOs Really Paid Like Bureaucrats?” NBER Working Paper 6213, October 1997; “2004 CEO Compensation Survey and Trends,” Wall Street Journal/Mercer Human Resource Consulting, May 2005; LMCM estimates.

1985 2005

CEO Compensation

1995

Tied to stock market43%

Tied to stock market 1%

Tied to stock market60%


Corporations

“Earnings are in a class by themselves”

Four reasons: Investors need a simple metric to summarize performance

EPS gets the broadest media distribution and coverage

Focus on EPS makes the analyst’s job easier

Analysts evaluate a firm’s progress based on making EPS

Source: John R. Graham, Campbell R. Harvey, and Shiva Rajgopal, “The Economic Implications of Corporate Financial Reporting,” NBER Working Paper, March 2004.


Firms are willing to sacrifice economic value in order to meet a short-run earnings target

The preference for smooth earnings is so strong that 78% of surveyed executives would give up economic value in exchange for smooth earnings!

EPS Obsession

Source: John R. Graham, Campbell R. Harvey, and Shiva Rajgopal, “The Economic Implications of Corporate Financial Reporting,” NBER Working Paper, March 2004.


Investors

From Principals to Agents

Individual investors

Financial institutions

1950 2000

Source: John Bogle, “The Relentless Rules of Humble Arithmetic,” Speech: 60th Anniversary Conference of the Financial Analyst Journal, February 10, 2005.

Direct stock holdings



1970




Investment Management

Profession Business• Deliver superior results • Generate sales

• Long term • Asset gathering

• Contrarian • Return for company, not shareholders

• Patient

Source: Charles D. Ellis, “Will Business Success Spoil the Investment Management Profession?” The Journal of Portfolio Management, Spring 2001.


Number of funds versus relative returns (1994-2003)


FirmEqual-Weighted Outperformance

No. of Funds Firm

Equal-Weighted Outperformance

No. of Funds Firm


No. of Funds

Dodge & Cox 98 4 Waddell & Reed 61 45 Eaton Vance 49 73First Eagle 97 5 USAA 61 31 Morgan Stanley Adv. 49 50Calamos 91 8 Oppenheimer 60 48 Goldman Sachs 49 34So. Eastern/Longleaf 90 3 MFS 59 61 The Hartford 48 33American Funds 79 26 Prudential 59 49 Putnam 47 54Royce 79 14 New York Life 58 22 John Hancock 47 35Harris Associates 77 7 US Bancorp 57 37 Dreyfus 45 126Vanguard 76 75 Columbia Mgmt. 56 72 Delaware 44 56PIMCO 76 31 AllianceBernstein 55 57 Strong 44 42Franklin Templeton 71 10 Banc One 54 36 Thrivent Financial 44 25T. Rowe Price 71 72 Neuberger Berman 54 14 Trusco 43 24Janus 70 21 Lord Abbett 53 27 Merrill Lynch 40 58ING 69 60 Scudder 52 65 Aim 39 62Nuveen 65 26 Van Kampen 52 43 Nations Funds 38 42American Century 64 54 Federated 52 37 American Express 37 60WM Advisors 64 15 Evergreen 51 57 BlackRock 36 32Davis 62 7 Citigroup 50 57 Pioneer 33 24Fidelity 62 207 Wells Fargo 50 39 JP Morgan 32 38

Source: Fidelity Investments. Data presented in John C. Bogle, “The Relentless Rules of Humble Arithmetic,” Financial Analyst Journal, November/December 2005.

Shading highlights firms that manage fifteen or fewer funds



Ownership structure versus relative returns (1994-2003)

FirmEqual-Weighted Outperformance Firm

Equal-Weighted Outperformance Firm


Dodge & Cox 98 Waddell & Reed 61 Goldman Sachs 49First Eagle 97 USAA 61 Morgan Stanley Adv. 49Calamos 91 Oppenheimer 60 Eaton Vance 49So. Eastern/Longleaf 90 Prudential 59 The Hartford 48Royce 79 MFS 59 John Hancock 47American Funds 79 New York Life 58 Putnam 47Harris Associates 77 US Bancorp 57 Dreyfus 45PIMCO 76 Columbia Mgmt. 56 Strong 44Vanguard 76 AllianceBernstein 55 Delaware 44T. Rowe Price 71 Banc One 54 Thrivent Financial 44Franklin Templeton 71 Neuberger Berman 54 Trusco 43Janus 70 Lord Abbett 53 Merrill Lynch 40ING 69 Van Kampen 52 Aim 39Nuveen 65 Scudder 52 Nations Funds 38American Century 64 Federated 52 American Express 37WM Advisors 64 Evergreen 51 BlackRock 36Davis 62 Wells Fargo 50 Pioneer 33Fidelity 62 Citigroup 50 JP Morgan 32

Source: Fidelity Investments. Data presented in John C. Bogle, “The Relentless Rules of Humble Arithmetic,” Financial Analyst Journal, November/December 2005.

Shading represents private firms


Investors

Bad timing exerts a huge toll

Average Investor Return

Source: John C. Bogle, “The Relentless Rules of Humble Arithmetic,” Financial Analyst Journal, November/December 2005.

12.8%

10.0%

6.3%

Average Annual Return (1983-2003)

S&P 500 Index Fund

Average Fund Return


Investors

Bad timing—chasing what has been hot

Source: John C. Bogle, “Statement of John C. Bogle to the United States Senate Governmental Affairs Subcommittee,” available at Bogle Financial Markets Research Center.


0

1000

2000

3000

4000

5000

6000

Investors

“At Cape Cod Barber Shop, Slumping Stocks Clip Buzz”

“Tech-Stock Chit-Chat Enriches Many Cape Cod Locals”

1995 2000 2005

“All they ever say is, ‘Buy, buy, buy,’ all the way down from $100 a share to bankruptcy.”

NA

SD

AQ

“I don’t think anything could shake my confidence in this market...even if we do go down 30%, we’ll just come right back.”

March 13, 2000

July 8, 2002


Investors

All Styles

Small Cap Value

Small Cap Growth

Mid Cap Value

Mid Cap Growth

Large Cap Value

Large Cap Growth

Note: Data from 1979-2002.

Source: Evergreen Capital Management, LLC. “An Asset Allocation Strategy for the Intelligent Investor.”

Mutual Fund Flows and Subsequent 2-Year Avg Return versus S&P 500 (%)

High outflows, low valuationsHigh inflows, high valuations

-4.9

-8.4

+1.4

-2.1

-9.5

-5.8

-6.7 +17.8

+8.7

+1.7

+14.5

+10.3

+6.5

+4.2


Bad timing

Investors

Last 5 year annual gain Rydex Weighting

S&P 500 Weighting

Energy

Precious Metals

Technology

Financials

Overweight

Underweight

10.7%

18.7%

31.2%

22.6%

9.8%

0.4%

-5.9% 2.8% 15.1%

4.8% 2.9% 21.6%

Source: Bloomberg and S&P.

Performance Data as of 5/26/06

Rydex Data as of 5/26/06

S&P Data as of 5/30/06


In it for the short(er) term

Investors

Source: John Bogle, “The Mutual Fund Industry 60 Years Later: For Better or Worse?”, Financial Analyst Journal, January/February 2005.

Annual Turnover of Shares by Equity Fund Investors

05

1015

2025

3035

4045

50

19

45

19

50

19

55

19

60

19

65

19

70

19

75

19

80

19

85

19

90

19

95

20

00

20

02

20

03

20

04

*

Sh

are

s R

ed

ee

me

d a

s P

erc

en

t of A

sse

ts


Holding periods are shrinking

Investment Managers

0

20

40

60

80

100

120

1946 1951 1956 1961 1966 1971 1976 1981 1986 1991 1996 2001

An

nu

al T

urn

ove

r R

ate

(%

)

Source: Bogle Financial Markets Research Center.

2006


Evidence

The market is actually long-term oriented Takes many years of value-creating cash flows to

justify today’s price

Investors make short-term bets on long-term outcomes

Short-termism creates costs


Solution

Minimize agency costs

Incentives (business) create a very suboptimal social context

Fundamental attribution error


Solution

The prison experiment (1971)

“Situational variables can exert powerful influences over human behavior, more so than we recognize or acknowledge.”

Philip ZimbardoStanford University

Source: www.prisonexp.org. Used by permission.


Who Succeeds?

Portfolio turnover

Portfolio concentration

Investment style

Geographic location

Source: Michael J. Mauboussin, More Than You Know: Finding Financial Wisdom in Unconventional Places (New York: Columbia University Press, 2006), 17-19.


0

10

20

30

40

50

60

70

80

90

100

0 2 4 6 8 10 12 14 16 18 20

Number of Trials

Per

cent

age

of H

eads

0

10

20

30

40

50

60

70

80

90

100

0 10 20 30 40 50 60 70 80 90 100

Number of Trials

Per

cent

age

of H

eads

Time Arbitrage - Expectations

Source: Michael J. Mauboussin, “Capital Ideas Revisited-Part 2,” Mauboussin on Strategy, May 20, 2005.

20 Trials 100 Trials


Time Arbitrage - Expectations

Time arbitrage Understand expectations

Focus on signal

• Long term growth, ROIC


Conclusions

Companies, investors, and investment managers behave suboptimally

Psychology and incentives explain much of this poor behavior

Understand the nature of investing, and carefully consider expectations


The views expressed in this commentary reflect those of Legg Mason Capital Management (LMCM) as of the date of this commentary. These views are subject to change at any time based on market or other conditions, and LMCM disclaims any responsibility to update such views. These views may not be relied upon as investment advice and, because investment decisions for clients of LMCM are based on numerous factors, may not be relied upon as an indication of trading intent on behalf of the firm. The information provided in this commentary should not be considered a recommendation by LMCM or any of its affiliates to purchase or sell any security. To the extent specific securities are mentioned in the commentary, they have been selected by the author on an objective basis to illustrate views expressed in the commentary. If specific securities are mentioned, they do not represent all of the securities purchased, sold or recommended for clients of LMCM and it should not be assumed that investments in such securities have been or will be profitable. There is no assurance that any security mentioned in the commentary has ever been, or will in the future be, recommended to clients of LMCM. Employees of LMCM and its affiliates may own securities referenced herein.

Michael J. MauboussinChief Investment StrategistLegg Mason Capital Management

Long Term Investing in a Short Term World...

It’s as Easy as PIE

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Michael J. Mauboussin Chief Investment Strategist Legg Mason Capital Management Long Term Investing in a Short Term World... It’s as Easy as PIE