Michael J. Mauboussin Chief Investment Strategist Legg Mason Capital Management Long Term Investing in a Short Term World....
PIE <ul><li>P </li></ul><ul><li>I </li></ul><ul><li>E </li></ul>sychology ncentives xpectations Not
Agenda <ul><li>The Barriers </li></ul><ul><ul><li>Psychology </li></ul></ul><ul><ul><li>Incentives </li></ul></ul><ul><li>...
Barriers to Long Term Thinking <ul><ul><li>Phenomenon Effect </li></ul></ul><ul><ul><li>Availability bias Accounting versu...
Corporations Source: Brian J. Hall and Jeffrey B. Liebman, “Are CEOs Really Paid Like Bureaucrats?”  NBER Working Paper 62...
Corporations <ul><li>“Earnings are in a class by themselves” </li></ul><ul><li>Four reasons: </li></ul><ul><ul><li>Investo...
<ul><li>Firms are willing to sacrifice economic value in order to meet a short-run earnings target </li></ul><ul><li>The p...
Investors <ul><li>From Principals to Agents </li></ul>Individual investors Financial institutions 1950 2000 Source: John B...
Investment Management Profession Business •   Deliver superior results •  Generate sales •   Long term •  Asset gathering ...
<ul><li>Number of funds versus relative returns (1994-2003) </li></ul>Investment Management Source: Fidelity Investments. ...
Investment Management <ul><li>Ownership structure versus relative returns (1994-2003) </li></ul>Source: Fidelity Investmen...
Investors <ul><li>Bad timing exerts a huge toll </li></ul>Average Investor Return Source: John C. Bogle, “The Relentless R...
Investors <ul><li>Bad timing—chasing what has been hot </li></ul>Source: John C. Bogle, “Statement of John C. Bogle to the...
Investors “ At Cape Cod Barber Shop, Slumping Stocks Clip Buzz” “ Tech-Stock Chit-Chat Enriches Many Cape Cod Locals” 1995...
Investors All Styles Small Cap Value Small Cap Growth Mid Cap Value Mid Cap Growth Large Cap Value Large Cap Growth Note: ...
<ul><li>Bad timing </li></ul>Investors Last 5 year annual gain Rydex Weighting S&P 500 Weighting  Energy Precious Metals T...
<ul><li>In it for the short(er) term </li></ul>Investors Source: John Bogle, “The Mutual Fund Industry 60 Years Later: For...
<ul><li>Holding periods are shrinking </li></ul>Investment Managers Source: Bogle Financial Markets Research Center. 2006
Evidence <ul><li>The market is actually long-term oriented </li></ul><ul><ul><li>Takes many years of value-creating cash f...
Solution <ul><li>Minimize agency costs </li></ul><ul><li>Incentives (business) create a very suboptimal social context </l...
Solution <ul><li>The prison experiment (1971) </li></ul>“ Situational variables can exert powerful influences over human b...
Who Succeeds? <ul><li>Portfolio turnover </li></ul><ul><li>Portfolio concentration </li></ul><ul><li>Investment style </li...
Time Arbitrage - Expectations Source: Michael J. Mauboussin, “Capital Ideas Revisited-Part 2,”  Mauboussin on Strategy,  M...
Time Arbitrage - Expectations <ul><li>Time arbitrage </li></ul><ul><ul><li>Understand expectations </li></ul></ul><ul><ul>...
Conclusions <ul><li>Companies, investors, and investment managers behave suboptimally </li></ul><ul><li>Psychology and inc...
The views expressed in this commentary reflect those of Legg Mason Capital Management (LMCM) as of the date of this commen...
Michael J. Mauboussin Chief Investment Strategist Legg Mason Capital Management Long Term Investing in a Short Term World....
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  1. 1. Michael J. Mauboussin Chief Investment Strategist Legg Mason Capital Management Long Term Investing in a Short Term World... It’s as Easy as PIE
  2. 2. PIE <ul><li>P </li></ul><ul><li>I </li></ul><ul><li>E </li></ul>sychology ncentives xpectations Not
  3. 3. Agenda <ul><li>The Barriers </li></ul><ul><ul><li>Psychology </li></ul></ul><ul><ul><li>Incentives </li></ul></ul><ul><li>The Evidence </li></ul><ul><ul><li>Corporations </li></ul></ul><ul><ul><li>Investors/Investment managers </li></ul></ul><ul><li>The Solution </li></ul><ul><ul><li>Social context </li></ul></ul><ul><ul><li>A look at winners </li></ul></ul><ul><ul><li>Time arbitrage </li></ul></ul>
  4. 4. Barriers to Long Term Thinking <ul><ul><li>Phenomenon Effect </li></ul></ul><ul><ul><li>Availability bias Accounting versus economic focus </li></ul></ul><ul><ul><li>Recency bias Betting on what has worked </li></ul></ul><ul><ul><li>Stress Creates a short-term focus </li></ul></ul><ul><ul><li>Agent/principal shift Agency costs </li></ul></ul>Incentives Psychology
  5. 5. 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 market 43% Tied to stock market 1% Tied to stock market 60%
  6. 6. Corporations <ul><li>“Earnings are in a class by themselves” </li></ul><ul><li>Four reasons: </li></ul><ul><ul><li>Investors need a simple metric to summarize performance </li></ul></ul><ul><ul><li>EPS gets the broadest media distribution and coverage </li></ul></ul><ul><ul><li>Focus on EPS makes the analyst’s job easier </li></ul></ul><ul><ul><li>Analysts evaluate a firm’s progress based on making EPS </li></ul></ul>Source: John R. Graham, Campbell R. Harvey, and Shiva Rajgopal, “The Economic Implications of Corporate Financial Reporting,” NBER Working Paper , March 2004.
  7. 7. <ul><li>Firms are willing to sacrifice economic value in order to meet a short-run earnings target </li></ul><ul><li>The preference for smooth earnings is so strong that 78% of surveyed executives would give up economic value in exchange for smooth earnings! </li></ul>EPS Obsession Source: John R. Graham, Campbell R. Harvey, and Shiva Rajgopal, “The Economic Implications of Corporate Financial Reporting,” NBER Working Paper , March 2004.
  8. 8. Investors <ul><li>From Principals to Agents </li></ul>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 Individual investors Financial institutions 1970 Individual investors Financial institutions
  9. 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.
  10. 10. <ul><li>Number of funds versus relative returns (1994-2003) </li></ul>Investment Management 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
  11. 11. Investment Management <ul><li>Ownership structure versus relative returns (1994-2003) </li></ul>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
  12. 12. Investors <ul><li>Bad timing exerts a huge toll </li></ul>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
  13. 13. Investors <ul><li>Bad timing—chasing what has been hot </li></ul>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. 14. 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.” NASDAQ “ 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
  15. 15. 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 valuations High 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
  16. 16. <ul><li>Bad timing </li></ul>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
  17. 17. <ul><li>In it for the short(er) term </li></ul>Investors Source: John Bogle, “The Mutual Fund Industry 60 Years Later: For Better or Worse?”, Financial Analyst Journal , January/February 2005.
  18. 18. <ul><li>Holding periods are shrinking </li></ul>Investment Managers Source: Bogle Financial Markets Research Center. 2006
  19. 19. Evidence <ul><li>The market is actually long-term oriented </li></ul><ul><ul><li>Takes many years of value-creating cash flows to justify today’s price </li></ul></ul><ul><ul><li>Investors make short-term bets on long-term outcomes </li></ul></ul><ul><ul><li>Short-termism creates costs </li></ul></ul>
  20. 20. Solution <ul><li>Minimize agency costs </li></ul><ul><li>Incentives (business) create a very suboptimal social context </li></ul><ul><li>Fundamental attribution error </li></ul>
  21. 21. Solution <ul><li>The prison experiment (1971) </li></ul>“ Situational variables can exert powerful influences over human behavior, more so than we recognize or acknowledge.” Philip Zimbardo Stanford University Source: www.prisonexp.org. Used by permission.
  22. 22. Who Succeeds? <ul><li>Portfolio turnover </li></ul><ul><li>Portfolio concentration </li></ul><ul><li>Investment style </li></ul><ul><li>Geographic location </li></ul>Source: Michael J. Mauboussin, More Than You Know: Finding Financial Wisdom in Unconventional Places (New York: Columbia University Press, 2006), 17-19.
  23. 23. Time Arbitrage - Expectations Source: Michael J. Mauboussin, “Capital Ideas Revisited-Part 2,” Mauboussin on Strategy, May 20, 2005. 20 Trials 100 Trials
  24. 24. Time Arbitrage - Expectations <ul><li>Time arbitrage </li></ul><ul><ul><li>Understand expectations </li></ul></ul><ul><ul><li>Focus on signal </li></ul></ul><ul><ul><ul><li>Long term growth, ROIC </li></ul></ul></ul>
  25. 25. Conclusions <ul><li>Companies, investors, and investment managers behave suboptimally </li></ul><ul><li>Psychology and incentives explain much of this poor behavior </li></ul><ul><li>Understand the nature of investing, and carefully consider expectations </li></ul>
  26. 26. 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.
  27. 27. Michael J. Mauboussin Chief Investment Strategist Legg Mason Capital Management Long Term Investing in a Short Term World... It’s as Easy as PIE

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