Michael J. Mauboussin Chief Investment Strategist Legg Mason Capital ManagementLong Term Investing in a Short Term World.Its as Easy as PIELong Term Investing in a Short Term World2PIEPIEsychologyncentivesxpectationsNotLong Term Investing in a Short Term World3Agenda1.The Barriers1.Psychology2.Incentives2.The Evidence1.Corporations2.Investors/Investment managers3.The SolutionuSocial contextuA look at winnersuTime arbitrageLong Term Investing in a Short Term World4Barriers to Long Term ThinkingPhenomenonEffectAvailability biasAccounting versus economic focusRecency biasBetting on what has workedStressCreates a short-term focusAgent/principal shiftAgency costsIncentivesPsychologyLong Term Investing in a Short Term World5CorporationsSource: 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.19852005CEO Compensation1995Tied to stock market 43%Tied to stock market1% Tied to stock market 60%Long Term Investing in a Short Term World6Corporations“Earnings are in a class by themselves”Four reasons:Investors need a simple metric to summarize performanceEPS gets the broadest media distribution and coverageFocus on EPS makes the analysts job easierAnalysts evaluate a firms progress based on making EPSSource: John R. Graham, Campbell R. Harvey, and Shiva Rajgopal, “The Economic Implications of Corporate Financial Reporting,” NBER Working Paper, March 2004.Long Term Investing in a Short Term World7uFirms are willing to sacrifice economic value in order to meet a short-run earnings targetuThe preference for smooth earnings is so strong that 78% of surveyed executives would give up economic value in exchange for smooth earnings!EPS ObsessionSource: John R. Graham, Campbell R. Harvey, and Shiva Rajgopal, “The Economic Implications of Corporate Financial Reporting,” NBER Working Paper, March 2004.Long Term Investing in a Short Term World8InvestorsFrom Principals to AgentsIndividual investorsFinancial institutions19502000Source: John Bogle, “The Relentless Rules of Humble Arithmetic,” Speech: 60th Anniversary Conference of the Financial Analyst Journal, February 10, 2005.Direct stock holdingsIndividual investorsFinancial institutions1970Individual investorsFinancial institutionsLong Term Investing in a Short Term World9Investment ManagementProfessionBusiness Deliver superior results Generate sales Long term Asset gathering Contrarian Return for company, not shareholders PatientSource: Charles D. Ellis, “Will Business Success Spoil the Investment Management Profession?” The Journal of Portfolio Management, Spring 2001.Long Term Investing in a Short Term World10uNumber of funds versus relative returns (1994-2003)Investment ManagementSource: 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 fundsLong Term Investing in a Short Term World11Investment ManagementuOwnership structure versus relative returns (1994-2003)Source: Fidelity Investments. Data presented in John C. Bogle, “The Relentless Rules of Humble Arithmetic,” Financial Analyst Journal, November/December 2005.Shading represents private firmsLong Term Investing in a Short Term World12InvestorsuBad timing exerts a huge tollAverage Investor ReturnSource: 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 FundAverage Fund ReturnLong Term Investing in a Short Term World13InvestorsuBad timingchasing what has been hotSource: John C. Bogle, “Statement of John C. Bogle to the United States Senate Governmental Affairs Subcommittee,” available at Bogle Financial Markets Research Center. Long Term Investing in a Short Term World14Investors“At Cape Cod Barber Shop, Slumping Stocks Clip Buzz”“Tech-Stock Chit-Chat Enriches Many Cape Cod Locals”199520002005“All they ever say is, Buy, buy, buy, all the way down from $100 a share to bankruptcy.” NASDAQ“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, 2000July 8, 2002Long Term Investing in a Short Term World15InvestorsAll StylesSmall Cap ValueSmall Cap GrowthMid Cap ValueMid Cap GrowthLarge Cap ValueLarge Cap GrowthNote: 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+4.2Long Term Investing in a Short Term World16uBad timingInvestorsLast 5 year annual gainRydex WeightingS&P 500 Weighting EnergyPrecious