June 6, 2006

Expectations Investing
Taking Advantage of a Short-Term World

Michael J. Mauboussin Chief Investment Strategist Legg Mason Capital Management

Barriers to Long-Term Thinking

Phenomenon
Psychology Availability bias Recency bias Stress

Effect
Accounting versus economic focus Betting on what has worked Creates a short-term focus

Expectations Incentives

Agency costs

Agent/principal shift

Diversity breakdowns

Expectations gaps

Expectations Investing

Groundwork

Expectations Investing

Groundwork
Fundamentals versus expectations
Perhaps the single greatest error in the investment business is a failure to distinguish between knowledge of a companys fundamentals and the expectations implied by the price.

Expectations Investing

Groundwork
Fundamentals versus expectations
The issue is not which horse in the race is the most likely winner, but which horse or horses are offering odds that exceed their actual chances of victory . . . This may sound elementary, and many players may think that they are following this principle, but few actually do. Under this mindset, everything but the odds fades from view. There is no such thing as liking a horse to win a race, only an attractive discrepancy between his chances and his price.
Steven Crist, Crist on Value, in Beyer, et al., Bet with the Best (New York: Daily Racing Form Press, 2001), 64.

Expectations Investing

Groundwork
Fundamentals versus expectations
I defined variant perception as holding a well-founded view that was meaningfully different from the market consensus . . . Understanding market expectation was at least as important as, and often different from, the fundamental knowledge.
Michael Steinhardt, No Bull: My Life in and Out of Markets (New York: John Wiley & Sons, 2001), 129.

Expectations Investing

Groundwork
Introduction
Investing, like many things in life, relies on expectations Changes in expectations trigger stock price changes The investors key task is to anticipate expectations revisions

Expectations Investing

Expectations Investing
Introduction
What expectations? Are all expectation revisions the same? Whats the best way to anticipate expectations revision?

Expectations Investing

Expectations Investing
Introduction
Expectations

are based on long-term cash flow Expectation revisions are not all the same Investors need to wed competitive strategy and finance to best anticipate important revisions

Expectations Investing

Groundwork
Three myths

Myth

The market is short-term oriented The market takes a long-term view

EPS dictate value

P/E multiples determine value

Reality

EPS tell us little about value

P/Es are a function of value

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Expectations Investing

Groundwork
ROIC and P/E multiplestheory
Return on Invested Capital 4% 24% Earnings Growth 4% 6% 8% 10% 6.1x 1.3 NM NM 12.5x 12.5 12.5 12.5 8% 16%

15.7x 18.1 21.3 25.5

16.7x 20.0 24.2 29.9

Assumes all equity financed; 8% WACC; 20-year forecast period.

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Expectations Investing

How the Market Values Stocks

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Expectations Investing

Basics of Valuation
First principles
(1) Cash flow

(2) Risk

Value

(3) Forecast horizon

These drivers are expectational in the stock market

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Basics of Valuation
Cash flow
Volume Pricing Expenses Leases Tax Provision Deferred Taxes Tax Shield Sales Operating Margin Cash Taxes minus A/R Inventories A/P Free Cash Flow Cash available for distribution to all claimholders Investment

Cash Earnings

Working Capital

Net PP&E Operating Leases

Capital Expenditures Acquisitions/ Divestitures

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Expectations Investing

Basics of Valuation
Amazon (2005) In $ millions
Revenues Net Sales Accounts receivable, net and other current assets Cost of Sales Inventories Accounts payable Accrued expenses and other current liabilities Additions to unearned revenue Interest payable Depreciation and amortization Depreciation of fixed assets, including internal-use software and website development, and other amortization Capital Expenditures: purchases of fixed assets, including internal-use software and website development Operating Expenses Fullfillment Marketing Technology and content General and administrative Stock-based compensation Amortization of previously unearned revenue Other operating (income) expense Gains on sales of marketable securities Interest income Interest expense Non-cash interest expense and other Other (expense) income, net Remeasurements and other Provision (benefit) for income taxes Deferred income taxes Cumulative effect of change in accounting principle Reported Net Income Operating Net Income Cash Flow Earnings 8490.0 (84.0) 8,406.0 (6,451.0) (104.0) 274.0 60.0 156.0 (6,065.0) Adjustment Cash Flow

Cash flow as a % of income stmt item

99.0%

94.0%

121.0 (204.0) (83.0) (745.0) (198.0) (451.0) (166.0) 87.0 (149.0) 7.0 (1.0) (1,663.0) 44.0 (92.0) 5.0 2.0 42.0 (95.0) 26.0 359.0 454.0 529.0 116.5% 70.0 (26.0) (25.0) (42.0) (41.0) 103.5%

(47.0)

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Expectations Investing

Basics of Valuation
Cost of capital
Opportunity cost of capital providers Cost of equity is greater than the cost of debt Cost of capital can be tricky to estimate

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Expectations Investing

Basics of Valuation
Competitive advantage period (CAP)

Excess Returns

CAP

Time

Period of time a company can generate excess returns on new investments

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Basics of Valuation
Competitive advantage period (CAP)
U.S. Technology CFROI Fade
15 12 9 6 3 0 (3) (6) (9) (12) (15) 0 1 2 3 4 5 6 7 8 9 10 Years Forward After Quartile Ranking 1
Source: HOLT.
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CFROI (%)

Basics of Valuation
Competitive advantage period (CAP)
Reversion to the mean fastest in fast-changing industries Some companies and industries demonstrate persistence CAPs cluster by investment neighborhood

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Expectations Investing

Expectations Investing Process

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Expectations Investing

Expectations Investing
A fundamental shift in stock selection
The Expectations Investing Steps 1. Estimate price-implied expectations 2. Identify expectations opportunities 3. Make buy and sell decisions

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Expectations Investing

Expectations Investing
Step 1: Estimate price implied expectations
Uses the sound DCF model Bypasses need to forecast Overcomes the shortcomings of traditional analysis (i.e., price/earnings ratio)

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Expectations Investing

Expectations Investing
Step 2: Identify expectations opportunities
Apply appropriate competitive strategy framework Determine which expectations revisions matter most

Value neutral Value creating

incremental returns incremental growth

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Expectations Investing

Expectations Investing
Competitive strategy analysis

Five forces assessing industry structure Value chain assessing activities and where companies create value Innovators dilemma why great companies fail Information rules contrast between physical and knowledge businesses Game theory capacity additions and pricing

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Expectations Investing

Expectations Investing
Expectations infrastructure
Value Triggers Value Factors
1 Volume 2 Price and Mix Sales 3 Operating Leverage 4 Economies of Scale Operating Costs 5 Cost Efficiencies 6 Investment Efficiencies

Operating Value Drivers

Sales Growth Rate (%)

Operating Profit Margin (%)

Incremental Investment Rate (%)

Investments

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Expectations Investing

Expectations Investing
Step 3: Make buy and sell decisions

Expected value analysis

Frequency of correctness is not the key Magnitude of correctness matters Turnover Transaction costs Taxes

Incorporate margin of safety

Consider decision-making pitfalls

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Expectations Investing

Case Study
Coca-Cola
Cash flow
6.5% EBITA growth 45% Incremental investment rate

Cost of capital

7.6%

$44

CAP

12 years

Source: Value Line Investment Survey, May 5, 2006, and LMCM estimates.

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Expectations Investing

Barriers to Long Term Thinking

Phenomenon
Psychology Availability bias Recency bias Stress

Effect
Accounting versus economic focus Betting on what has worked Creates a short-term focus

Expectations Incentives

Agency costs

Agent/principal shift

Diversity breakdowns

Expectations gaps

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Expectations Investing

expectationsinvesting.com

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Expectations Investing

June 6, 2006

Expectations Investing
Taking Advantage of a Short-Term World

Michael J. Mauboussin Chief Investment Strategist Legg Mason Capital Management

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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Expectations Investing