Michael Mauboussin
Senior Vice President, Chief Investment Strategist, Legg Mason Capital Management

"Thought Leader Forum Introduction"

I am very pleased that you could all join us for the 2007 Thought Leader Forum. I would like to spend a few moments setting up this year's forum. The goal is to bring together our clients and friends with people who have been influential in our investment process. We want to give you insight into how we think. Second, we want to encourage free-flowing interaction. We call this a forum and not a conference on purpose. We want people to talk and discuss. The questions and discussion after Steve Crist's presentation set a great tone for the event. As you listen to the presentations, please jot down thoughts, questions and comments, and let's have some great dialogue. Finally, we want to create an enjoyable experience for you. If there is anything that we can do for you, please let us know.

I would like to talk about three topics to set up the forum. First, I want to discuss how value investing fits into the theme of disruptive innovation. Second, I want to talk more specifically about the role of expectations. Finally, I want to talk about how disruptive innovation fits in with all of these ideas.

In investing, there is a very important difference between fundamentals and expectations, but this difference is too often blurred. Fundamentals are best understood as the value of the company. To use the horse racing metaphor, this is how fast the horse will actually run. Many analysts spend a lot of time thinking about how fast the horse will run and how well the company will do. That is not actually going to make you any money. What makes you money are mispricings between the fundamentals and the expectations. The price is in a sense the tote board - the collective wisdom of the investment community. We are constantly thinking about the differences between the value and the price, and we are looking for those mispricings. As Crist mentioned about horse racing, this kind of mispricing does not happen every day in investing. It happens only periodically, but you need to be alert and aware and thinking about the world in this way all the time.

Fundamentals are typically going to be defined as long term cash flows for the business. That will comprise things like earning a return on invested capital higher than your cost of capital over time. It will also include measures of growth. It will include measures of sustainable value creation or sustainable competitive advantage. We will analyze these fundamentals in terms of strategic and financial analysis.

Expectations for future financial performance are reflected in the stock price, and expectations will be measured via valuation.

Where does the concept of disruptive innovation fit in? This is an extraordinarily useful part of the strategic analysis, although it is only one part of our analysis. The notion of innovation itself is obviously crucial. How do companies innovate? Is it a random process? Or is there a set of theories that can help us think about how innovation happens? There is a well-known model in venture capital that for every ten investments, two or three work out well, most of them are middling, and a couple of them flame out. This reflects an approach to dealing with innovation as relatively random.

What if through the lens of disruptive innovation we could develop a set of theories for thinking about innovation that would give us a much higher probability of success? The follow-up questions are obvious - which companies are going to win and which companies are going to lose?

There is often a sense of optimism in the stock market, and expectations are therefore often high. We did a recent study. We looked at 750 non-financial companies in the US of $300 million market value or more. We asked three simple questions. Of that sample, how many could grow sales faster than 8% over a ten-year period? The answer is roughly 40%. How many of these companies can grow sales and earnings over 8% over that ten-year period? About 33% of these companies can do that. Finally, how many companies can grow sales and earnings and earn above an 8% return on capital over the ten-year period? Less than 25% can do this. Less one in four companies grow sales and earnings more than 8% and earn more than their cost of capital. Interestingly enough, Bain has indicated that roughly two thirds of all companies plan to grow in double digits. Most companies plan rapid growth, but very few companies achieve it.

The Corporate Executive Board has shown that once companies launch into the Fortune 50, their growth rates often peter out. They grow rapidly in the two or three years prior to their acceptance into that group, and then their growth rates slow to approximately the GDP growth rate.

We also see a powerful reversion to the mean with return on invested capital. This data set includes over 1,000 non-financial companies. We put them into quintiles in 1997, and we followed those groups over ten years. There is a very strong tendency for most of these companies to revert back to the cost of capital. It does not happen fully over a ten-year period, but the trend is definitely strong.

Following up on the same study, we did a test of persistence. If you are a top-quintile company, what is the probability that you will stay in the top quintile over the ten year period? About 40% of the companies in the top quintile could remain in the top quintile. There is also a strong persistence trend among low-performers - 38% of the worst companies in terms of return on capital stayed in the worst quintile. Of the 40% of the companies who were in the top quintile in 1997 and 2006, most of them did not stay in the top quintile the entire time. So we asked how many companies could start and stay in the top quintile for the entire period. Roughly 16% of the top performers remained top performers for the entire period. That tells us that of the 1,000 companies in our sample, only 3% start with high returns on capital and sustain them throughout the period. It is a very daunting task to deliver high returns for long periods of time.

Where does disruptive innovation fit? We want to find companies that will enjoy high and sustained returns on invested capital that is not yet reflected in the stock price. Like in horse racing, if it is reflected in the price, it will not make us excess returns. We need to find situations in which these returns are not yet reflected. We also want to avoid companies that are going to be disrupted, but for whom that disappointment is not yet reflected in the stock price. We want to anticipate where disruption may take place in the future.

With those comments, I would like to introduce our first speaker, Clay Christensen.

Legg Mason Capital Management ("LMCM") is comprised of (i) Legg Mason Capital Management, Inc., and (ii) LMM LLC.

The comments, opinions and any forward predictions presented about any particular security, the economy or "the market" are based on the analysis of the speaker. These are not necessarily the opinion of, and should not be construed as a recommendation on the part of Legg Mason Capital Management or any of its affiliates.