Michael J. Mauboussin Chief Investment Strategist Legg Mason Capital Management Introductory Thoughts September 25, 2008 Thought Leader Forum 2 Three Themes and What They Mean 1. The role of time 2. The distribution of outcomes 3. Critical points How do these fit with value investing? Thought Leader Forum 3 The Role of Time Time horizon is crucial Time Horizon Tool Short term Long term Volatility Margin of safety (price versus value) Thought Leader Forum 4 Source: LMCM analysis. The Role of Time S&P 500 Returns 1-Yr -50% -40% -30% -20% -10% 0% 10% 20% 30% 40% 50% 60% 5-Yrs 10-Yrs 15-Yrs 20-Yrs 25-Yrs Annual Return Note: Data from 1926-2007. Thought Leader Forum 5 The Role of Time What’s the worry? Hirota and Sunder model on market behavior ‹ Some long-term investors assure price and value converge ‹ Only short-term traders lead to significant price-to-value gaps Source: Shinichi Hirota and Shyam Sunder, “Price Bubbles Sans Dividend Anchors: Evidence from Laboratory Stock Markets,” Yale Working Paper, November 2006. Thought Leader Forum 6 Distribution of Outcomes Continuum of distributions A common error: using the wrong model Normal distribution Easy to model Gray Swans Black Swans Hard to model Thought Leader Forum 7 -25% -20% -15% -10% -5% 0% 5% 10% 15% Percent Change (Daily) Source: LMCM analysis. 1/1/1978 – 9/19/08 Days of >3 standard deviation price changes Distribution of Outcomes Volatility clusters Time Thought Leader Forum 8 Focus on consequences ‹ Problem of induction ‹ Pascal’s wager Distribution of Outcomes Thought Leader Forum 9 Where does volatility come from? Endogenous (within system) Exogenous (outside system) Critical Points Over 75 percent of big moves appear to be endogenous Thought Leader Forum 10 Crowds are smart when you have: ‹ Diversity ‹ Aggregation ‹ Incentives Critical Points We periodically get massive diversity breakdowns; non-linear effect on system Thought Leader Forum 11 Critical Points Small incremental changes → large scale outcomes No one can effectively manage a complex adaptive system Thought Leader Forum 12 Value Investing ‹ Risk in the long term is about margin of safety ‹ Gray swans lead to periodic challenges and opportunities ‹ Traditional tools of risk are suboptimal – Market returns are not normally distributed – Long term versus the short term Thought Leader Forum 13 Let the fun begin... Thought Leader Forum Introductory Thoughts Thought Leader Forum 15 The views expressed in this presentation reflect those of Legg Mason Capital Management (LMCM) as of the date of this presentation. 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 presentation 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 presentation. 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 presentation 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.