Expectations Investing

1
Long Term Investing in a Short Term World...
Its as Easy as PIE
Michael J. Mauboussin Chief Investment
Strategist Legg Mason Capital Management
2
PIE

• P
• I
• E

sychology ncentives xpectations
Not
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Agenda

• The Barriers
• Psychology
• Incentives
• The Evidence
• Corporations
• Investors/Investment managers
• The Solution
• Social context
• A look at winners
• Time arbitrage

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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

Psychology
Incentives
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Corporations
CEO Compensation
1985
2005
1995
Tied to stock market 1
Tied to stock market 43
Tied to stock market 60
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.
6
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 analysts job easier
• Analysts evaluate a firms 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.
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EPS Obsession

• 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!

Source John R. Graham, Campbell R. Harvey, and
Shiva Rajgopal, The Economic Implications of
Corporate Financial Reporting, NBER Working
Paper, March 2004.
8
Investors

• From Principals to Agents

Direct stock holdings
1950
2000
1970
Financial institutions
Financial institutions
Financial institutions
Individual investors
Individual investors
Individual investors
Source John Bogle, The Relentless Rules of
Humble Arithmetic, Speech 60th Anniversary
Conference of the Financial Analyst Journal,
February 10, 2005.
9
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.
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Investment Management

• Number of funds versus relative returns
  (1994-2003)

Shading highlights firms that manage fifteen or
fewer funds
Source Fidelity Investments. Data presented in
John C. Bogle, The Relentless Rules of Humble
Arithmetic, Financial Analyst Journal,
November/December 2005.
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Investment Management

• Ownership structure versus relative returns
  (1994-2003)

Shading represents private firms
Source Fidelity Investments. Data presented in
John C. Bogle, The Relentless Rules of Humble
Arithmetic, Financial Analyst Journal,
November/December 2005.
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Investors

• Bad timing exerts a huge toll

Average Annual Return (1983-2003)
12.8
SP 500 Index Fund
10.0
Average Fund Return
Average Investor Return
6.3
Source John C. Bogle, The Relentless Rules of
Humble Arithmetic, Financial Analyst Journal,
November/December 2005.
13
Investors

• Bad timingchasing 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.
14
Investors
I dont think anything could shake my confidence
in this market...even if we do go down 30, well
just come right back.
March 13, 2000
Tech-Stock Chit-Chat Enriches Many Cape Cod
Locals
NASDAQ
July 8, 2002
All they ever say is, Buy, buy, buy, all the
way down from 100 a share to bankruptcy.
At Cape Cod Barber Shop, Slumping Stocks Clip
Buzz
1995
2000
2005
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Investors
Mutual Fund Flows and Subsequent 2-Year Avg
Return versus SP 500 ()
High outflows, low valuations
High inflows, high valuations
-4.9
8.7
All Styles
-6.7
17.8
Small Cap Value
Small Cap Growth
-9.5
1.7
Mid Cap Value
-5.8
14.5
-8.4
Mid Cap Growth
10.3
Large Cap Value
1.4
6.5
Large Cap Growth
-2.1
4.2
Note Data from 1979-2002.
Source Evergreen Capital Management, LLC. An
Asset Allocation Strategy for the Intelligent
Investor.
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Investors

• Bad timing

Last 5 year annual gain
SP 500 Weighting
Rydex Weighting
Overweight
Energy
10.7
31.2
9.8
Precious Metals
18.7
22.6
0.4
Underweight
15.1
Technology
-5.9
2.8
4.8
2.9
21.6
Financials
Performance Data as of 5/26/06 Rydex Data as of
5/26/06 SP Data as of 5/30/06
Source Bloomberg and SP.
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Investors

• In it for the short(er) term

Source John Bogle, The Mutual Fund Industry 60
Years Later For Better or Worse?, Financial
Analyst Journal, January/February 2005.
18
Investment Managers

• Holding periods are shrinking

2006
Source Bogle Financial Markets Research Center.
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Evidence

• The market is actually long-term oriented
• Takes many years of value-creating cash flows to
  justify todays price
• Investors make short-term bets on long-term
  outcomes
• Short-termism creates costs

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Solution

• Minimize agency costs
• Incentives (business) create a very suboptimal
  social context
• Fundamental attribution error

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Solution

• The prison experiment (1971)

Source www.prisonexp.org. Used by permission.
Situational variables can exert powerful
influences over human behavior, more so than we
recognize or acknowledge. Philip
Zimbardo Stanford University
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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.
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Time Arbitrage - Expectations
20 Trials
100 Trials
Source Michael J. Mauboussin, Capital Ideas
Revisited-Part 2, Mauboussin on Strategy, May
20, 2005.
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Time Arbitrage - Expectations

• Time arbitrage
• Understand expectations
• Focus on signal
• Long term growth, ROIC

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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

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