Michael J. Mauboussin Chief Investment Strategist Legg Mason Capital Management

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

2. PIE sychology ncentives xpectations P I E Not

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

4. Barriers to Long Term Thinking PhenomenonEffect 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

5. Corporations CEO Compensation 1985 1995 2005 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/MercerHuman 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 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.

7. 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 1970 2000 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 theFinancial Analyst Journal, February 10, 2005.

9. Investment Management ProfessionBusiness • 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. 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.

11. 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.

12. Investors • Bad timing exerts a huge toll Average Annual Return (1983-2003) S&P 500 Index Fund 12.8% Average Fund Return 10.0% Average Investor Return 6.3% Source: John C. Bogle, “The Relentless Rules of Humble Arithmetic,” Financial Analyst Journal, November/December 2005.

13. 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.

14. Investors “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 “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

15. Investors Mutual Fund Flows and Subsequent 2-Year Avg Return versus S&P 500 (%) High inflows, high valuations High outflows, low 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 -2.1 Large Cap Growth +4.2 Note: Data from 1979-2002. Source: Evergreen Capital Management, LLC. “An Asset Allocation Strategy for the Intelligent Investor.”

16. Investors • Bad timing Last 5 year annual gain S&P 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 S&P Data as of 5/30/06 Source: Bloomberg and S&P.

17. 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.

19. 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

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

21. 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

22. 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.

23. Time Arbitrage - Expectations 20 Trials 100 Trials Source: Michael J. Mauboussin, “Capital Ideas Revisited-Part 2,” Mauboussin on Strategy, May 20, 2005.

24. Time Arbitrage - Expectations • Time arbitrage • Understand expectations • Focus on signal • Long term growth, ROIC

25. 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

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