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December 1, 2005

Expectations Investing Reading Stock Prices for Better Returns

Michael J. Mauboussin Chief Investment Strategist Legg Mason Capital Management

Agenda

1. Groundwork

2. How the Market Values Stocks

3. Expectations Investing Process

4. Case Study

Groundwork

Groundwork Fundamentals versus expectations

Perhaps the single greatest error in the investment business is a failure to distinguish between knowledge of a company’s fundamentals and the expectations implied by the price

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.

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.

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

Introduction ‹ What expectations?

‹ Are all expectation revisions the same?

‹ What’s the best way to anticipate expectations revision?

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

Groundwork

Three myths

The market is EPS dictate value Myth short-term oriented

The market EPS tell us little Reality takes a about value long-term view

10 P/E multiples determine value

P/E’s are a function of value

Groundwork ROIC and P/E multiples—theory Return on Invested Capital 4% 8% 16% 24%

4% 6.1x 12.5x 15.7x 16.7x

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

How the Market Values Stocks

Basics of Valuation First principles

(1) Cash flow

(2) Risk Value

(3) Forecast horizon

These drivers are expectational in the stock market

Basics of Valuation

Cash flow

• Volume Sales

• Pricing

• Expenses Operating

• Leases Cash Margin Earnings

• Tax Provision

• Deferred Taxes Cash

• Tax Shield Taxes

minus

• A/R ∆ Working

• Inventories Capital

• A/P

• Net PP&E Capital Investment

• Operating Leases Expenditures

Acquisitions/ Divestitures

14 Free Cash Flow

Cash available for distribution to all claimholders

Basics of Valuation Microsoft (2005)

Cash flow as a % In $ millions Earnings Adjustment Cash Flow of income stmt item Sales 39,788.0 + Increase in unearned revenue 13,831.0

• Recognition of unearned revenue from prior periods (12,919.0)

• Increase in accounts receivable (1,243.0) 39,457.0 99% Cost of revenue (6,200.0)

• Increase in other assets 172.0

• Increase in other liabilities 1,245.0 (4,783.0) 77%

Depreciation and amortization expense + Depreciation expense 855.0

• Capital expenditures (1,019.0) (164.0)

Research and development (6,184.0)

Compensation

• Stock-based compensation 2,448.0 Sales and marketing (8,677.0)

General and administrative (4,166.0) (16,579.0) Operating income 14,561.0 Losses on equity investees and other 0.0 Investment Income 2,067.0 + Investment income (527.0) 1,540.0 Income before income taxes 16,628.0 Income tax expense (4,374.0)

• Deferred taxes (179.0)

• Stock option tax benefits 668.0 (3,885.0) 89%

Reported Net Income 12,254.0 Operating Net Income 12,254.0 Cash Flow 15,586.0 127.2%

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

Basics of Valuation Competitive advantage period (CAP)

Excess Returns

CAP

Time

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

Basics of Valuation Competitive advantage period (CAP)

25.00%

20.00%

Source: CSFBEdge database.

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

Expectations Investing Process

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

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)

Step 2: Identify expectations opportunities ‹ Apply appropriate competitive strategy framework ‹ Determine which expectations revisions matter most ¾ Value neutral incremental returns ¾ Value creating incremental growth

Competitive strategy analysis ‹ Five forces – assessing industry structure ‹ Value chain – assessing activities and where companies create value ‹ Innovator’s dilemma – why great companies fail ‹ Information rules – contrast between physical and knowledge businesses ‹ Game theory – capacity additions and pricing

Expectations infrastructure Value Value Triggers Factors

Volume

Price and Mix Sales Operating Leverage Economies of Scale Operating Cost Costs Efficiencies Investment Investments Efficiencies 25 Operating Value Drivers

Sales Growth Rate (%)

Operating Profit Margin (%)

Incremental Investment Rate (%)

Step 3: Make buy and sell decisions ‹ Expected value analysis ¾ Frequency of correctness is not the key ¾ Magnitude of correctness matters

‹ Incorporate margin of safety ¾ Turnover ¾ Transaction costs ¾ Taxes

‹ Consider decision making pitfalls

Case study

Case Study Coca-Cola

Cash flow 6.0% EBITA growth 45% Incremental investment rate

Cost of capital 7.5% $42

CAP 12 years

Source: Value Line Investment Survey, November 4, 2005 and LMCM estimates.

Case Study Options-derived distribution L Jan 08 35 call @ $9.40 S Jan 08 40 call @ $6.20

‹ Pay $3.20 net ($9.40 minus $6.20) for the possibility of receiving a maximum of $5 ($40 minus $35)

‹ $3.20 divided by $5 equals a 64% probability the stock will exceed $37.50 (mid point of the strikes) and 36% probability the stock will be at or below $37.50

Source: Bloomberg, November 17, 2005.

Case Study KO options-implied distribution

Case Study Sales growth is the key trigger for KO Value Value Operating Value Triggers Factors Drivers

Sales Volume Growth Rate (%)

Price and Mix Operating Sales Profit Margin (%)

Operating Leverage

Incremental Investment Economies Rate (%)

of Scale

Operating Cost Costs Efficiencies

Investment Investments Efficiencies

Case Study KO options-implied distribution Based on January 2008 options 60.0%

50.0% Implied sales growth = 6.0%

40.0%

30.0% Implied sales growth = 1.7% Implied sales growth = 8.7%

expectationsinvesting.com

Legg Mason Capital Management ("LMCM":) is comprised of (i) Legg Mason Capital Management, Inc. ("LMCI"), (ii) Legg Mason Funds Management, Inc. ("LMFM"), and (iii) LMM LLC ("LMM").

The views expressed in this commentary reflect those of 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.

December 1, 2005

Expectations Investing Reading Stock Prices for Better Returns

Michael J. Mauboussin Chief Investment Strategist Legg Mason Capital Management