Transcript Expectations Investing

Long Term Investing in a
Short Term World...
It’s as Easy as PIE
Michael J. Mauboussin
Chief Investment Strategist
Legg Mason Capital Management
PIE
P sychology
I
ncentives
E xpectations
Not
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Long Term Investing in a Short Term World
Agenda
1. The Barriers
 Psychology
 Incentives
2. The Evidence
 Corporations
 Investors/Investment managers
3. The Solution
 Social context
 A look at winners
 Time arbitrage
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Long Term Investing in a Short Term World
Incentives
Psychology
Barriers to Long Term Thinking
4
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
Long Term Investing in a Short Term World
Corporations
CEO Compensation
1985
Tied to stock
market
1%
1995
Tied to stock
market
43%
2005
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.
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Long Term Investing in a Short Term World
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.
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Long Term Investing in a Short Term World
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.
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Long Term Investing in a Short Term World
Investors
From Principals to Agents
1950
Direct stock holdings
1970
2000
Financial
institutions
Individual
investors
Financial
institutions
Individual
investors
Financial
institutions
Source: John Bogle, “The Relentless Rules of Humble Arithmetic,” Speech: 60th Anniversary Conference of the
Financial Analyst Journal, February 10, 2005.
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Long Term Investing in a Short Term World
Individual
investors
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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Long Term Investing in a Short Term World
Investment Management

Number of funds versus relative returns (1994-2003)
Shading highlights firms that manage fifteen or fewer funds
Firm
Dodge & Cox
First Eagle
Calamos
So. Eastern/Longleaf
American Funds
Royce
Harris Associates
Vanguard
PIMCO
Franklin Templeton
T. Rowe Price
Janus
ING
Nuveen
American Century
WM Advisors
Davis
Fidelity
Equal-Weighted
Outperformance
98
97
91
90
79
79
77
76
76
71
71
70
69
65
64
64
62
62
No. of
Funds
4
5
8
3
26
14
7
75
31
10
72
21
60
26
54
15
7
207
Equal-Weighted
Firm
Outperformance
Waddell & Reed
61
USAA
61
Oppenheimer
60
MFS
59
Prudential
59
New York Life
58
US Bancorp
57
Columbia Mgmt.
56
AllianceBernstein
55
Banc One
54
Neuberger Berman
54
Lord Abbett
53
Scudder
52
Van Kampen
52
Federated
52
Evergreen
51
Citigroup
50
Wells Fargo
50
No. of
Funds
45
31
48
61
49
22
37
72
57
36
14
27
65
43
37
57
57
39
Equal-Weighted
Firm
Outperformance
Eaton Vance
49
Morgan Stanley Adv.
49
Goldman Sachs
49
The Hartford
48
Putnam
47
John Hancock
47
Dreyfus
45
Delaware
44
Strong
44
Thrivent Financial
44
Trusco
43
Merrill Lynch
40
Aim
39
Nations Funds
38
American Express
37
BlackRock
36
Pioneer
33
JP Morgan
32
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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Long Term Investing in a Short Term World
No. of
Funds
73
50
34
33
54
35
126
56
42
25
24
58
62
42
60
32
24
38
Investment Management

Ownership structure versus relative returns (1994-2003)
Shading represents private firms
Firm
Dodge & Cox
First Eagle
Calamos
So. Eastern/Longleaf
Royce
American Funds
Harris Associates
PIMCO
Vanguard
T. Rowe Price
Franklin Templeton
Janus
ING
Nuveen
American Century
WM Advisors
Davis
Fidelity
Equal-Weighted
Outperformance
98
97
91
90
79
79
77
76
76
71
71
70
69
65
64
64
62
62
Equal-Weighted
Firm
Outperformance
Waddell & Reed
61
USAA
61
Oppenheimer
60
Prudential
59
MFS
59
New York Life
58
US Bancorp
57
Columbia Mgmt.
56
AllianceBernstein
55
Banc One
54
Neuberger Berman
54
Lord Abbett
53
Van Kampen
52
Scudder
52
Federated
52
Evergreen
51
Wells Fargo
50
Citigroup
50
Equal-Weighted
Firm
Outperformance
Goldman Sachs
49
Morgan Stanley Adv.
49
Eaton Vance
49
The Hartford
48
John Hancock
47
Putnam
47
Dreyfus
45
Strong
44
Delaware
44
Thrivent Financial
44
Trusco
43
Merrill Lynch
40
Aim
39
Nations Funds
38
American Express
37
BlackRock
36
Pioneer
33
JP Morgan
32
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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Long Term Investing in a Short Term World
Investors

Bad timing exerts a huge toll
Average Annual Return (1983-2003)
12.8%
S&P 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.
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Long Term Investing in a Short Term World
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.
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Long Term Investing in a Short Term World
Investors
6000
“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.”
NASDAQ
5000
March 13, 2000
“Tech-Stock Chit-Chat Enriches Many Cape Cod Locals”
4000
3000
2000
1000
“All they ever say is, ‘Buy, buy, buy,’ all
the way down from $100 a share to
bankruptcy.”
0 1995
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Long Term Investing in a Short Term World
2000
July 8, 2002
“At Cape Cod Barber Shop,
Slumping Stocks Clip Buzz”
2005
Investors
Mutual Fund Flows and Subsequent 2-Year Avg Return versus S&P 500 (%)
High inflows, high valuations
-4.9
All Styles
Mid Cap Value
Mid Cap Growth
+8.7
-6.7
Small Cap Value
Small Cap Growth
High outflows, low valuations
+17.8
-9.5
+1.7
-5.8
+14.5
-8.4
+10.3
Large Cap Value
Large Cap Growth
+1.4
-2.1
+6.5
+4.2
Note: Data from 1979-2002.
Source: Evergreen Capital Management, LLC. “An Asset Allocation Strategy for the Intelligent Investor.”
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Long Term Investing in a Short Term World
Investors

Bad timing
Last 5 year
annual gain
Rydex Weighting
S&P 500
Weighting
Energy
10.7%
31.2%
9.8%
Precious Metals
18.7%
22.6%
0.4%
Technology
-5.9%
2.8%
15.1%
Financials
4.8%
2.9%
21.6%
Overweight
Underweight
Performance Data as of 5/26/06
Rydex Data as of 5/26/06
S&P Data as of 5/30/06
Source: Bloomberg and S&P.
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Long Term Investing in a Short Term World
Investors
In it for the short(er) term
Annual Turnover of Shares by Equity Fund Investors
Source: John Bogle, “The Mutual Fund Industry 60 Years Later: For Better or Worse?”, Financial Analyst Journal,
January/February 2005.
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Long Term Investing in a Short Term World
2004*
2003
2002
2000
1995
1990
1985
1980
1975
1970
1965
1960
1955
1950
50
45
40
35
30
25
20
15
10
5
0
1945
Shares Redeemed as Percent of Assets

Investment Managers
Annual Turnover Rate (%)

Holding periods are shrinking
120
100
80
60
40
20
0
1946 1951 1956 1961 1966 1971 1976 1981 1986 1991 1996 2001 2006
Source: Bogle Financial Markets Research Center.
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Long Term Investing in a Short Term World
Evidence

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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
Long Term Investing in a Short Term World
Solution

Minimize agency costs

Incentives (business) create a very suboptimal
social context
 Fundamental
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attribution error
Long Term Investing in a Short Term World
Solution

The prison experiment (1971)
Source: www.prisonexp.org. Used by permission.
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“Situational variables can exert powerful influences over human
behavior, more so than we recognize or acknowledge.”
Philip Zimbardo
Long Term Investing in a Short Term World
Stanford University
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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Long Term Investing in a Short Term World
Time Arbitrage - Expectations
100
20 Trials
90
90
80
80
Percentage of Heads
Percentage of Heads
100
70
60
50
40
30
20
70
60
50
40
30
20
10
10
0
0
0
2
4
6
8
10
12
14
Number of Trials
16
18
20
100 Trials
0
10
20
30
40
Long Term Investing in a Short Term World
60
Number of Trials
Source: Michael J. Mauboussin, “Capital Ideas Revisited-Part 2,” Mauboussin on Strategy, May 20, 2005.
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50
70
80
90
100
Time Arbitrage - Expectations

Time arbitrage
 Understand expectations
 Focus on signal
• Long term growth, ROIC
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Long Term Investing in a Short Term World
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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Long Term Investing in a Short Term World
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
Long Term Investing in a
Short Term World...
It’s as Easy as PIE
Michael J. Mauboussin
Chief Investment Strategist
Legg Mason Capital Management