Michael J.

Mauboussin
[email protected]
LEGG MASON
CAPITAL MANAGEMENT
Michael J. Mauboussin
[email protected]
LEGG MASON
CAPITAL MANAGEMENT




December 14, 2007

Death, Taxes, and Reversion to the Mean

ROIC Patterns: Luck, Persistence, and What to Do About It

Hegel was right when he said that we learn from history that man can never learn anything
from history.

George Bernard Shaw




Source: LMCM analysis.


Analysts modeling future corporate financial performance should use past ROIC
patterns, including a strong tendency toward mean reversion, as an appropriate
reference class but rarely do. Full consideration of the difficulty in sustaining high
returns should temper the optimism inherent in many models.

Some companies do post persistently high or low returns beyond what chance
dictates. But the ROIC data incorporate much more randomness than most
analysts realize.

We had little luck in identifying the factors behind sustainably high returns.

This analysis has concrete implications for modeling. We unveil some of the
common errors in discounted cash flow models and offer some thoughts on how
to improve them.

Time
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1997 1998 1999 2000 2001 2002 2003 2004 2005 2006
>100

Pa g e 2 L e g g Mas o n C api t a l Ma n ag emen t

The Inside-Outside View

Company financial models are often a cornerstone of the stock selection process for fundamental
investors. The model forecasts are based on crucial value drivers like sales growth rates, operating
profit margins, investment capital needs, and economic returns. When done properly, detailed long-
term models are laborious because they require input from a wide range of areas, including historical
corporate performance, firm-specific issues, competitive positioning, and the broader macroeconomic
backdrop.

Despite earnest and diligent study, analysts often produce company models that are wildly off the
mark, usually erring on the side of optimism. Even analysts who consider ranges of value outcomes
attach probabilities to favorable scenarios that are too high. Some researchers attribute this
inaccuracy to overconfidence, but that is only part of the story.
1

Another way to understand the challenge is based on what renowned psychologist Daniel Kahneman
calls the inside-outside view.
2
An inside view considers a problem by focusing on the specific task
and the information at hand, and predicts based on that unique set of inputs. This is the approach
analysts most often use in their modeling, and indeed is common for all forms of planning.

In contrast, an outside view considers the problem as an instance in a broader reference class.
Rather than seeing the problem as unique, the outside view asks if there are similar situations that
can provide useful calibration for modeling. Kahneman notes this is a very unnatural way to think
precisely because it forces analysts to set aside all of the cherished information they have unearthed
about a company. This is why people use the outside view so rarely.

This report seeks to shed light on an important reference class for company modelers: patterns of
return on invested capital (ROIC). Companies create shareholder value when they generate returns
on investment in excess of the cost of capital. A positive spread between a companys ROIC and cost
of capital is a fundamental indicator of value creation.

Earnings growth by itself gives no indication about value creation prospectsa company growing
rapidly but earning only its cost of capital will not enjoy a premium valuation.
3
More accurately,
growth amplifies: higher growth makes positive-spread companies more valuable, and, symmetrically,
higher growth makes negative-spread companies less valuable.

Assumptions about future corporate ROICs are embedded in analyst models, although they are rarely
explicit. More often than not, analysts are too optimistic in their assessment of future ROICs, in part
because they are unaware of how hard it is to sustain high returns. The goal of this report is to make
financial modelers aware of a broad reference classthe outside viewthat unequivocally shows the
rarity of generating high returns for a long time in a free market system. This awareness should
temper the optimism embedded in many models.

Here are some of the reports broad conclusions:

Reversion to the mean is a powerful force. As has been well documented by numerous
studies, ROIC reverts to the cost of capital over time. This finding is consistent with
microeconomic theory, and is evident in all time periods researchers have studied.
However, investors and executives should be careful not to over interpret this result
because reversion to the mean is evident in any system with a great deal of randomness.
We can explain much of the mean reversion series by recognizing the data are noisy.

Persistence does exist. Academic research shows that some companies do generate
persistently good, or bad, economic returns. The challenge is finding explanations for that
persistence, if they exist.

Explaining persistence. Its not clear that we can explain much persistence beyond chance.
But we investigated logical explanatory candidates, including growth, industry

Pa g e 3 L e g g Mas o n C api t a l Ma n ag emen t

representation, and business models. Business model difference appears to be a promising
explanatory factor.

Implications for modeling. The vast majority of modelsespecially discounted cash flow
modelsare uninformed by the outside view of ROIC patterns. This outside view
addresses a number of important aspects of modeling, including assumptions about growth
rates, capital needs, and terminal values.

Death, Taxes, and Reversion to the Mean

Researchers have convincingly showed that industries and companies follow an economic life cycle
(see Exhibit 1).
4
Young companies often apply substantial resources to their business without
immediate payoff, hence generating returns below the cost of capital. In mid-life, companies earn
excess returns as their investments bear fruit. Finally, competitive forces and/or shifts in the
marketplace drive returns down to the cost of capital. In situations where returns sink below the cost
of capital, bankruptcy, consolidation, and disinvestment often serve to lift returns back to cost-of-
capital levels. Empirical research shows that manufacturing companies, on average, generate excess
returns for shorter periods than they did in the past.
5


Exhibit 1: Generic Life Cycle


Source: LMCM analysis.

Various studies conducted over multiple decades document this reversion-to-the-mean pattern.
6
We
have reproduced the results here, using data from over 1000 non-financial companies from 1997 to
2006. (See Appendix A for details on the sample and methodology.) Exhibit 2 shows this process.
We start by ranking companies into quintiles based on their 1997 ROIC. We then follow the median
ROIC for the five cohorts through 2006. While all of the returns do not settle at the cost of capital
(roughly eight percent) in 2006, they clearly migrate toward that level.

Exhibit 2: Median ROIC Reversion
-15
-10
-5
0
5
10
15
20
25
0 1 2 3 4 5 6 7 8 9
Number of years following portfolio formation
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Source: LMCM analysis.
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S
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Pa g e 4 L e g g Mas o n C api t a l Ma n ag emen t

The gap between the median ROICs from the best to the worst quintiles is 30.5 percentage points in
1997. That gap narrows significantly to 8.6 percentage points in 2006. Further, as the reversion
model would predict, the top quintiles saw declines in median ROICs and the bottom quintiles saw
improvement (see Exhibit 3). While nine years may not be a sufficient amount of time for returns of all
quintiles to converge on the cost of capital, its clear that the process is well under way.

Exhibit 3: Change in Median ROIC by Quintile

Source: LMCM analysis.

This result, however, requires careful interpretation. Any system that combines skill and luck will
exhibit mean reversion over time.
7
Francis Galton demonstrated this point in his 1889 book, Natural
Inheritance, using the heights of adults.
8
Galton showed, for example, that children of tall parents
have a tendency to be tall, but are often not as tall as their parents. Likewise, children of short parents
tend to be short, but not as short as their parents. Heredity plays a role, but over time adult heights
revert to the mean.

The basic idea is outstanding performance combines strong skill and good luck. Abysmal
performance, in contrast, reflects weak skill and bad luck. Even if skill persists in subsequent periods,
luck evens out across the participants, pushing results closer to average. So its not that the standard
deviation of the whole sample is shrinking; rather, lucks role diminishes over time.

Separating the relative contributions of skill and luck is no easy task. Naturally, sample size is crucial
because skill only surfaces with a large number of observations. For example, statistician J im Albert
estimates that a baseball players batting average over a full season is a fifty-fifty combination
between skill and luck. Batting averages for 100 at-bats, in contrast, are 80 percent luck.
9


To illustrate this skill and luck mix, we analyzed the batting averages of 100 major league baseball
players who had at least 250 at-bats for each of the past five seasons (see Exhibit 4). These results
likely show some survivorship bias, as the average career of a major leaguer is only 5.6 years.





Q1 Q2 Q3 Q4 Q5
1997 Groups
97
06
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06
-15
-10
-5
5
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25
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Pa g e 5 L e g g Mas o n C api t a l Ma n ag emen t

Exhibit 4: Mean Reversion in Major League Baseball Player Batting Averages
0.220
0.240
0.260
0.280
0.300
0.320
0.340
2003 2004 2005 2006 2007
Season
B
a
t
t
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A
v
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r
a
g
e

Source: Baseball Prospectus and LMCM analysis.

The 80 basis point gulf between the best and worst quintile (a .320 versus a .240 average) is cut in
half by the final year (.300 versus .260).
10
This does not mean that the skill level of the players mean
reverted, just that luck evened out over time. For a company, skill is the equivalent of sustainable
value creation, including industry effects and managerial capability. Luck captures external factors,
including competition, business cycles, regulatory shifts, and technological change.

Defying Gravity: Persistence in the ROIC Data

The next question is whether any companies buck the reversion-to-the-mean trend and sustain high
(or low) ROICs throughout the sample period. To answer, we need to measure persistencethe
likelihood a company will stay in the same quintile throughout the measured time frame. To state the
obvious, staying in the top quintile is generally desirable, as it means the company is successfully
fending off competition.
11
Conversely, dwelling in the lowest quintile is unwelcome.

Exhibit 5 shows one measure of persistence: the degree of quintile migration.
12
This exhibit shows
where companies starting in one quintile (the vertical axis) ended up after nine years (the horizontal
axis). Most of the percentages in the exhibit are unremarkable, but two stand out. First, a full 41
percent of the companies that started in the top quintile were there nine years later, while 39 percent
of the companies in the cellar-dweller quintile ended up there. Independent studies of this persistence
reveal a similar pattern. So it appears there is persistence with some subset of the best and worst
companies. Academic research confirms that some companies do show persistent results. Studies
also show that companies rarely go from very high to very low performance or vice versa.
13


Exhibit 5: ROIC Persistence

Source: LMCM analysis.

39
17
14
11
19%
18
40
25
11
6%
17
22
28
22
12%
12
13
21
32
23%
24
15
8
41%
13
Q1
Q2
Q3
Q4
Q5
Q5 Q2 Q3 Q4 Q1
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9
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ROIC Qui ntil e in 2006

Pa g e 6 L e g g Mas o n C api t a l Ma n ag emen t

Before going too far with this result, we need to consider two issues. First, this persistence analysis
solely looks at where companies start and finish, without asking what happens in between. As it turns
out, there is a lot of action in the intervening years. For example, less than half of the 41 percent of
the companies that start and end in the first quintile stay in the quintile the whole time. This means
that less than four percent of the total-company sample remains in the highest quintile of ROIC for the
full nine years.

The second issue is serial correlation, the probability a company stays in the same ROIC quintile from
year to year. As Exhibit 5 suggests, the highest serial correlations (over 80 percent) are in Q1 and
Q5. The middle quintile, Q3, has the lowest correlation of roughly 60 percent, while Q2 and Q4 are
similar at about 70 percent.

This result may seem counterintuitive at first, as it suggests results for really good and really bad
companies (Q1 and Q5) are more likely to persist than for average companies (Q2, Q3, and Q4). But
this outcome is a product of the methodology: since each years sample is broken into quintiles, and
the sample is roughly normally distributed, the ROIC ranges are much narrower for the middle three
quintiles than for the extreme quintiles. So, for instance, a small change in ROIC level can move a Q3
company into a neighboring quintile, whereas a larger absolute change is necessary to shift a Q1 and
Q5 company. Having some sense of serial correlations by quintile, however, provides useful
perspective for investors building company models.

To summarize, while the results reflect a lot of randomness, some companies appear to demonstrate
persistence of high returns above and beyond what we can attribute solely to chance.
14
But similar to
the challenge in active investing, the question is, can we identify the persistent value-creating
companies ahead of time?

Can We Explain Persistence?

Up to this point our results, while useful and instructive, are reasonably well known in the academic
literature. The real question for an investor is whether we can explain ROIC persistence ex ante. We
explore this question by looking at three variables that appear as good candidates to explain
persistence: corporate growth, the industry in which a company competes, and the companys
business model. One of the virtues of these variables is they are to a large degree tractable. But
clearly other variables may be relevant, including management quality. As such, the variables we
investigate may be more proximate than causal.

Lets start with growth, where there is good news and bad news. The good news is there appears to
be some correlation between growth and persistence. Companies that start and end in the top two
quintiles enjoy average growth just above the 9.4 percent for the full sample. The four growth rates
closest to the upper-left corner in Exhibit 6 show this.

Similarly, the companies that start and end in the bottom two quintilesthe four rates near the
bottom-right corner of the exhibitgrew at a well-below-average five percent rate. We can say much
less about companies that went from good to bad (upper-right corner) or companies that went from
bad to good (bottom-left corner) because the sample sizes are substantially smaller than the rest of
the exhibit.
15














Pa g e 7 L e g g Mas o n C api t a l Ma n ag emen t

Exhibit 6: Earnings Growth by Quintile


Source: LMCM analysis.

It is important to emphasize that we cannot infer cause and effect from these results. We dont know
whether growth allows the company to sustain high returns or whether the growth is a consequence
of the high returns. But it is safe to say that high returns appear difficult to sustain over time without
satisfactory growth. Further, the exhibit shows that growth by itself does little to assure attractive
economic returns; the companies that ended in the fifth quintile generated aggregate growth faster
than the total sample.

The bad news about growth, especially for modelers, is it is extremely difficult to forecast. While there
is some evidence for sales persistence, the evidence for earnings growth persistence is scant. As
some researchers recently summarized, All in all, the evidence suggests that the odds of an investor
successfully uncovering the next stellar growth stock are about the same as correctly calling coin
tosses.
16
This observation has important implications for modeling.



Industry effects are another candidate to explain persistent excess returns. One approach is to simply
see which industries are overrepresented in the highest return quintile throughout our measured
period. Industries that satisfy this requirement include pharmaceuticals/biotechnology and software.
This approach is flawed, however, because it fails to consider the full industry populations. For
industries with large-variance ROIC distributions, some companies will look good simply by virtue of
that distribution. Looking solely at the successful companies in these large-variance industries paints
a misleading picture of performance.
17
And, unfortunately, selecting successful companies and
attaching attributes to them is a common practice in research.
18


Lets go back to our overrepresented industries, pharmaceuticals/biotechnology and software. It turns
out these industries are not only represented in the highest quintile, but are also overrepresented in
the lowest quintile. Further, other industriesutilities and telecom serviceshave little representation
in the best or worst quintiles. We can explain this by examining the ROIC distribution variance (see
Exhibit 7). Wide-variance industries have high- and low-performing companies, while the narrow-
variance industries are clustered in the middle ROIC quintiles. The main point is to avoid selection
bias when seeking explanations for persistent returns.












Q1 Q2 Q3 Q4 Q5
Q1
8% 10% 15% 6% 16%
Q2
11% 9% 14% 10% 19%
Q3
12% 8% 8% 11% 16%
Q4
6% 14% 8% 9% -6%
Q5
9% 8% 6% 6% 12%
EBIT Growth (10-Year CAGR)
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ROIC Quintile in 2006

Pa g e 8 L e g g Mas o n C api t a l Ma n ag emen t

Exhibit 7: Some Industry Success a Result of Industry ROIC Variance

Source: Bin Jiang and Timothy M. Koller, Data Focus: A Long-Term Look at ROIC, The McKinsey Quarterly, 1, 2006. Used with permission.

Another strand of research considers the regularities in abnormal profits, both good and bad.
19
This
work suggests industry effects are more important than firm-specific effects for high-performing
companies, while the opposite is true for low-performing companies. This descriptive work suggests
positive, sustainable ROICs emerge from a good strategic position within a generally favorable
industry. So industry does matter for explaining persistence, especially for sustainable above-average
returns. More accurately, persistent high ROICs, on average, combine an attractive industry with a
good business model. There is also good strategy research on the threats to sustainable superior
performance.
20


This leads to a closer look at business models. Michael Porter introduced two generic sources of
competitive advantage: differentiation and low-cost production. These are also known as consumer
and production advantages.
21
We can relate these generic strategies to ROIC by breaking ROIC into
its two prime components, net operating profit after tax (NOPAT) margin and invested capital
turnover. NOPAT margin equals NOPAT/sales, and invested capital turnover equals sales/invested
capital. ROIC is the product of NOPAT margin and invested capital turnover.

Generally speaking, differentiated companies with a consumer advantage generate attractive returns
mostly via high margins and modest invested capital turnover. Consider the successful jewelry store
that generates large profits per unit sold (high margins) but doesnt sell in large volume (low turnover).
In contrast, a low-cost company with a production advantage will generate relatively low margins and
relatively high invested capital turnover. Think of a classic discount retailer, which doesnt make much
money per unit sold (low margins) but enjoys great inventory velocity (high turnover). Exhibit 8
consolidates these ideas in a simple matrix.

Exhibit 8: Linking Competitive Advantage to ROIC Components


Source: LMCM analysis.
0 5 10 15 20 25 30 35 40
Pharmaceuticals, biotechnology
Software, services
Telecommunication services
Utilities
Median annual ROIC, excluding goodwill, 1963-2004 (%)
Consumer
Advantage
Consumer and
Production
Advantage
No
Advantage
Production
Advantage
Invested Capital Turnover
N
O
P
A
T

M
a
r
g
i
n
s

Pa g e 9 L e g g Mas o n C api t a l Ma n ag emen t

We looked at the 42 companies that stayed in the first quintile throughout the measured period to see
whether they leaned more toward a consumer or production advantage (see Exhibit 9). Not
surprisingly, this group outperformed the broader sample on both NOPAT margin and invested capital
turnover, but the impact of margin differential (2.4 times the median) was greater on ROIC than the
capital turnover differential (1.9 times). While equivocal, these results suggest the best companies
may have a tilt toward consumer advantage.

Exhibit 9: ROIC Components for High-Performing Companies


Source: LMCM analysis.

A look at the roughly 30 companies that remained in the fifth quintile is also revealing. Symmetrical
with the high-performing companies, they posted NOPAT margins and invested capital turnover
below the full samples median. This group was persistently unprofitable, posting negative NOPAT
margins for the measured period. Invested capital turns, while poor, were roughly 60 percent of the
median. The results for both the best and worst companies also reflect the reality that the distribution
of NOPAT margins is much wider than that for invested capital turnover.

Exhibit 10 summarizes the performance composition for the best and worst companies, starting with
the median ROIC for the full sample (bar on the far left), then substituting invested capital turns
(second from the left), then substituting NOPAT margins (third from left), and finally showing the
returns for the whole subgroup (far right).









1%
10%
100%
1 10 100
Invested Capital Turnover (log)
N
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M
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(
l
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)
Sample Median
S
a
m
p
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M
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d
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1%
10%
100%
1 10 100
Invested Capital Turnover (log)
N
O
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M
a
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g
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s

(
l
o
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)
Sample Median
S
a
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M
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Pa g e 1 0 L e g g Mas o n C a pi t a l Ma n ag e me n t

Exhibit 10: Decomposition of Persistently Best and Worst Companies




Source: LMCM analysis.

Our search for factors that may help us anticipate persistently superior performance leaves us little to
work with. We do know persistence exists, and that companies that sustain high returns over time
start with high returns. Operating in a good industry with above-average growth prospects and some
consumer advantage also appears correlated with persistence. Strategy experts Anita McGahan and
Michael Porter sum it up:
22


It is impossible to infer the cause of persistence in performance from the fact that persistence
occurs. Persistence may be due to fixed resources, consistent industry structure, financial
anomalies, price controls, or many other factors that endure . . . In sum, reliable inferences
about the cause of persistence cannot be generated from an analysis that only documents
whether or not persistence occurred.

Implications for Modeling

The objective of our brief tour through the world of ROIC patterns is to provide guidance for investors
building company models. More specifically, these empirical findings can help modelers avoid
common errors. Here are the main implications for modeling:

-100
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Q5 Margins
Q5 Turnover
and Margins
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Q1 Margins Q1 Turnover
and Margins
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Understand the results from the reference class. People who model and plan are often too
optimistic about the future because they limit their inputs to the specific task at hand and the
relevant information they have gathered for that task. The research of ROIC patterns, which has
spanned decades, provides a large and robust reference class that can inform the inputs for any
individual company. We know a small subset of companies generate persistently attractive
ROICslevels that cannot be attributed solely to chancebut we are not clear about the
underlying causal factors. Our sense is most models assume financial performance that is unduly
favorable given the forces of chance and competition.

Understand the models hidden assumptions. The errors here tend to come in two distinct areas.
First, analysts frequently project growth, driven by sales and operating profit margins,
independent of the investment needs necessary to support that growth. As a result, both
incremental and aggregate ROICs are too high. A simple way to check for this error is to add an
ROIC line to the model. An appreciation of the degree of serial correlations in ROICs provides
perspective on how much ROICs are likely to improve or deteriorate.

The second error is with the continuing, or terminal, value in a discounted cash flow (DCF) model.
The continuing value component of a DCF captures the firms value for the time beyond the
explicit forecast period. Common estimates for continuing value include multiples (often of
earnings before interest, taxes, depreciation, and amortizationEBITDA) and growth in
perpetuity. In both cases, unpacking the underlying assumptions shows impossibly high future
ROICs.
23

Take, for example, a simple growth-in-perpetuity continuing value that equals NOPAT divided by
the cost of capital less growth. This assumption assumes that NOPAT can grow without
additional capital, leading to an upward drift of ROIC (see Exhibit 11). This assumption is clearly
inconsistent with the vast empirical evidence that returns mean revert.

Exhibit 11: Exposing the Hidden Assumptions Behind the Growth-in-Perpetuity


Source: Tim Koller, Marc Goedhardt, and David Wessels, Valuation: Measuring and Managing the Value of Companies, Fourth Edition (New York: John Wiley & Sons,
2005), 286. Used with permission.

Understand the difficulty in sustaining high growth and returns. Both companies and investors
tend to be too optimistic about future growth rates. As the record shows, few companies sustain
rapid growth rates, and predicting which companies will succeed in doing so is very challenging.
Exhibit 12 illustrates this point. The distribution on the left is the actual 10-year sales growth rate
for a large sample of companies with base year revenues of $500 million, which has a mean of
about six percent. The distribution on the right is the three-year earnings forecast, which has a 13
percent mean and no negative growth rates. While earnings growth does tend to exceed sales
growth by a modest amount over time, these expected growth rates are vastly higher than what is
likely to appear. Further, as we saw earlier, there is greater persistence in sales growth rates than
in earnings growth rates.
Average
ROIC
WACC
CV
WACC g
NOPAT
=
CV
WACC
NOPAT
=
Forecast period Continuing
value period
Average
ROIC
WACC
CV
WACC g
NOPAT
=
CV
WACC
NOPAT
=
Forecast period Continuing
value period

Pa g e 1 2 L e g g Mas o n C a pi t a l Ma n ag e me n t

Exhibit 12: Great Growth Expectations
0%
1%
2%
3%
4%
5%
6%
7%
8%
9%
10%
-50% -38% -26% -13% -1% 11% 23% 36% 48%
10-Year CAGR
F
r
e
q
u
e
n
c
y

Source: Michael J. Mauboussin, More Than You Know: Finding Financial Wisdomin Unconventional Places, Updated andExpanded(New York: Columbia Business
School Publishing, 2008), 179.

Understand the need to think probabilistically. One powerful benefit to the outside view is
guidance on how to think about probabilities. The data in Exhibit 5 offer an excellent starting point
by showing where companies in each of the ROIC quintiles end up. At the extremes, for instance,
we can see it is rare for really bad companies to become really good, or for great companies to
plunge to the depths, over a decade.

Heres a way to visualize the probabilities using Exhibit 5. Assume you randomly draw a company
from the highest ROIC quintile in 1997, where the median ROIC less cost of capital spread is in
excess of 20 percent. Where will that company end up in a decade? Exhibit 13 shows the picture:
while a handful of companies earn higher economic profit spreads in the future, the center of the
distribution shifts closer to zero spreads, with a small group slipping to negative.

Exhibit 13: Great to Good

Source: LMCM analysis.
-60
-40
-20
0
20
40
60
80
100
1997 1998 1999 2000 2001 2002 2003 2004 2005 2006
Time
R
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(
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Frequency
-60
-40
-20
0
20
40
60
80
100
1997 1998 1999 2000 2001 2002 2003 2004 2005 2006
Time
R
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(
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Frequency
Ten-year actual sales
Three-year earnings growth forecast

Pa g e 1 3 L e g g Mas o n C a pi t a l Ma n ag e me n t

Understand the chances of a turnaround. Investors often perceive companies generating subpar
ROICs as attractive because of the prospects for unpriced improvements. The challenge to this
strategy comes on two fronts. First, research shows low-performing companies get higher
premiums than average-performing companies, suggesting the market anticipates change for the
better.
24
Second, companies dont often sustain recoveries.

Defining a sustained recovery as three years of above-cost-of-capital returns following two years
of below-cost returns, Credit Suisse research found that only about 30 percent of the sample
population was able to engineer a recovery. Roughly one-quarter of the companies produced a
non-sustained recovery, and the balancejust under half of the populationeither saw no
turnaround or disappeared. Exhibit 14 shows these results for nearly 1,200 companies in the
technology and retail sectors.

Exhibit 14: Ive Fallen and I Cant Get Up

Technology
a
Retail
b

(%) (%)
No turnaround 45 48
Nonsustained turnaround 26 23
Sustained turnaround 29 29

a
Sample of 712 companies from 1960 to 1996.
b
Sample of 445 companies from 1950 to 2001.

Source: HOLT and Michael J. Mauboussin, More Than You Know: Finding Financial Wisdomin Unconventional Places, Updated andExpanded(New York: Columbia
Business School Publishing, 2008), 169.

Understand expectations. This discussion has focused exclusively on firm performance
fundamentalsand has purposefully avoided shareholder returns. For active investors, of course,
the objective is to find mispriced securities or situations where the expectations implied by the
stock price dont accurately reflect the fundamental outlook.
25
A company with great fundamental
performance may earn a market rate of return if the stock price already reflects the fundamentals.
You dont get paid for picking winners; you get paid for unearthing mispricings. Failure to
distinguish between fundamentals and expectations is common in the investment business.

One purpose of this report is to underscore the importance of embracing an inside-outside view in
model building. Modelers uninformed about broader ROIC patterns are at a marked disadvantage
to those who recognize and reflect these empirical findings in their thinking. As Daniel Kahneman
stresses, the outside view feels unnatural because it requires letting go of what you (think you)
know.

Another purpose is to highlight what we dont know. Randomness plays a large role in the
aggregate figures, whether or not we recognize it. And while we see some companies generate
persistently superior ROICsthat is, a greater number than chance alone allowswe dont know
precisely why their returns are so good. Most of the proposed causal explanations fall prey to the
halo effect.


* * *

Special thanks to Brian Lund for his valuable input throughout this project. He was crucial in all
aspects of data analysis and provided valuable comments and feedback on the report.

Pa g e 1 4 L e g g Mas o n C a pi t a l Ma n ag e me n t

Appendix A: Explanation of the Methodology

Our data came from Capital IQ. We started with the Russell 3000 (as of October 1, 2007) and narrowed the
sample by eliminating financials and companies where we didnt have data for the full 1997 through 2006 sample
period. That left us with 1,115 non-financial companies.

Return on invested capital (ROIC) is defined as NOPAT margin x invested capital turnover, where:





* We calculate invested capital by taking an average of the end of period and beginning of period
balance sheets.

** We consider any cash above three percent of sales to be excess cash.

In the rare instances where a company had a negative NOPAT margin and negative invested capital
turnover, the product of these two figures results in a positive ROIC calculation. In such cases, we left
excess cash in the invested capital calculation, making invested capital positive and making ROIC
negative.


(Total assets) (current liabilities) +(short-term debt)
(long-term investments) - (excess cash) **
Invested Capital Turnover*
Sales
=
EBITA (1 effective tax rate)
NOPAT Margin
=
Sales

Pa g e 1 5 L e g g Mas o n C a pi t a l Ma n ag e me n t

Appendix B: Independent Analysis by Credit Suisse HOLT

To independently verify our results, we asked our friends at Credit Suisse HOLT to do similar analysis
using their return measure, cash flow return on investment (CFROI

). CFROI is a real (i.e., inflation-

adjusted), after-tax measure of economic returns. The sample, at just under 1,000 companies, is
modestly smaller than ours.

Exhibit 15 shows a pattern very similar to that of Exhibit 2. Likewise, Exhibit 16 offers results on
persistence close to those in Exhibit 5.

Exhibit 15: Median CFROI Reversion
-8
-4
0
4
8
12
16
1 2 3 4 5 6 7 8 9 10
Number of years following portfolio formation
C
F
R
O
I

-

W
A
C
C

(
%
)

Source: HOLT and LMCM analysis.


Exhibit 16: CFROI Persistence

Source: HOLT and LMCM analysis.

CFROI

is a registered trademark in the United States and other countries (excluding the United
Kingdom) of Credit Suisse or its affiliates.
41
19
18
12
7%
25
35
16
11
13%
16
25
28
20
12%
10
13
25
30
23%
26
8
7
46%
14
Q1
Q2
Q3
Q4
Q5
Q5 Q2 Q3 Q4 Q1
C
F
R
O
I

Q
u
i
n
t
i
l
e


i
n

1
9
9
7
CFROI Quinti l e i n 2006

Pa g e 1 6 L e g g Mas o n C a pi t a l Ma n ag e me n t

Endnotes

1
J ames Montier, Behavioral Investing: A Practitioners Guide to Applying Behavioral Finance (West
Sussex, England: J ohn Wiley & Sons, 2007), 105-110.
2
Daniel Kahneman and Dan Lovallo, Timid Choices and Bold Forecasts: A Cognitive Perspective on
Risk Taking, Management Science, Vol. 39, 1, J anuary 1993, 17-31. Also, Roger Buehler, Dale
Griffin, and Michael Ross, Inside the Planning Fallacy: The Causes and Consequences of Optimistic
Time Predictions, in Thomas Gilovich, Dale Griffin, and Daniel Kahneman, Heuristics and Biases:
The Psychology of Intuitive Judgment (Cambridge, UK: Cambridge University Press, 2002), 250-270.
Finally, Dan Lovallo and Daniel Kahneman, Delusions of Success: How Optimism Undermines
Executives Decisions, Harvard Business Review, J uly 2003, 56-63. Also
http://www.edge.org/3rd_culture/kahneman07/kahneman07_index.html.
3
Alfred Rappaport and Michael J . Mauboussin, Expectations Investing: Reading Stock Prices for
Better Returns (Boston, MA: Harvard Business School Press, 2001), 15-16.
4
Ichak Adizes, Corporate Lifecycles: How and Why Corporations Grow and Die and What to Do
About It (Englewood Cliffs, NJ : Prentice Hall, 1988).
5
Robert R. Wiggins and Timothy W. Ruefli, Sustained Competitive Advantage: Temporal Dynamics
and the Incidence and Persistence of Superior Economic Performance, Organizational Science, Vol.
13, 1, J anuary-February 2002, 82-105; L.G. Thomas and Richard DAveni, The Rise of
Hypercompetition from 1950 to 2002: Evidence of Increasing Industry Destabilization and Temporary
Competitive Advantage, Working Paper, October 11, 2004.
6
Horace Secrist, The Triumph of Mediocrity in Business (Evanston, IL: Bureau of Business Research,
Northwestern University, 1933); Dennis C. Mueller, Profits in the Long Run (Cambridge: Cambridge
University Press, 1986); Pankaj Ghemawat, Commitment: The Dynamic of Strategy (New York: Free
Press, 1991); Bartley J . Madden, CFROI Valuation (Oxford, UK: Butterworth-Heinemann, 1999);
Krishna G. Palepu, Paul M. Healy, and Victor L. Bernard, Business Analysis & Valuation (Cincinnati,
OH: South-Western College Publishing, 2000); Tim Koller, Marc Goedhart, and David Wessels,
Valuation: Measuring and Managing the Value of Companies, 4
th
ed. (New York: J ohn Wiley & Sons,
2005). In some cases, some companies may enjoy increasing returns. See W. Brian Arthur,
Increasing Returns and the New World of Business, Harvard Business Review, J uly-August 1996,
101-109; and Carl Shapiro and Hal Varian, Information Rules: A Strategic Guide to the Network
Economy (Boston, MA: Harvard Business School Press, 1998).
7
Stephen M. Stigler, Regression Towards the Mean, Historically Considered, Statistical Methods in
Medical Research, Vol. 6, 1997, 103-114.
8
Francis Galton, Natural Inheritance (London: MacMillan, 1889). You can find the book at
http://galton.org/.
9
J im Albert, Comments on Underestimating the Fog,' By the Numbers, February 2005. The same
phenomenon appears to apply to models explaining company performance; error terms tend to
decline with sample size. See, for example, Anita M. McGahan and Michael E. Porter, How Much
Does Industry Matter, Really? Strategic Management Journal, Vol. 18, 1997, 15-30.
10
Besides a clear survivorship bias, there is a concern about an age effect: a players skills tend to
improve as he gets into his late 20s and diminishes after that. We dont think there are strong age
influences here. The average age for each quintile in the initial year is 27, 29, 28, 27, and 27 for
quintiles one through five, respectively.
11
Sustaining high returns does not maximize shareholder value if a company forgoes value-creating
opportunities solely to maintain the high returns. See Bin J iang and Timothy Koller, How to Choose
Between Growth and ROIC, McKinsey Quarterly, September 2007.
12
We based this analysis on Koller, Goedhart, and Wessels, 150. Also see similar analysis by HOLT
in Appendix B.
13
Mueller; Geoffrey F. Waring, Industry Differences in the Persistence of Firm-Specific Returns,
American Economic Review, Vol. 86, 5, December 1996, 1253-1265; Anita M. McGahan and Michael
E. Porter, The Emergence and Sustainability of Abnormal Profits, Strategic Organization, Vol. 1, 1,
February 2003, 79-108; Wiggins and Ruefli. For work on turnarounds, see J effrey L. Furman and
Anita M. McGahan, Turnarounds, Managerial and Decision Economics, Vol. 23, 2002, 283-300.
There is also evidence for persistent superior performance among mutual fund managers. See
Robert Kosowski, Allan Timmerman, Russ Wermers, and Hal White, Can Mutual Fund Stars Really
Pick Stocks? New Evidence from a Bootstrap Analysis, Journal of Finance, Vol. 61, 6, December
2006, 2551-2595.

Pa g e 1 7 L e g g Mas o n C a pi t a l Ma n ag e me n t

14
For a thoughtful dissenting view, see J erker Denrell, Random Walks and Sustained Competitive
Advantage, Management Science, Vol. 50, 7, J uly 2004, 922-934. Denrell argues long leads in
random walks show up as sustained differences in interfirm profitability.
15
You can calculate the sample size by multiplying the percentages in Exhibit 5 by 223. Since the
total sample is 1,115 companies, each quintile contains 223 companies. So, for instance, the upper-
left corner of Exhibit 5 would include roughly 91 (0.41 x 223) companies. The growth rate in Exhibit 6
relates to those companies. Note some of Exhibit 6s growth rates represent a very small sample. For
example, the growth rate of companies that started in Q4 and ended in Q1 is eight percent, but the
sample size is only approximately 18 companies (0.08 x 223). Evenly distributed, each cell would
contain approximately 45 companies (1,115 sample size divided by 25 cells). It turns out the upper-
left and bottom-right corners are overrepresented, with roughly 1.5 times the companies that an equal
distribution would imply, and the bottom-left and upper-right corners are underrepresented, with about
0.6 times the companies an equal distribution would imply.
16
Louis K.C. Chan, J ason Karceski, and J osef Lakonishok, The Level and Persistence of Growth
Rates, Journal of Finance, Vol. 58, 2, April 2003, 643-684.
17
J erker Denrell, Selection Bias and the Perils of Benchmarking, Harvard Business Review, April
2005.
18
Phil Rosenzweig, The Halo Effect . . . and the Eight Other Business Delusions That Deceive
Managers (New York: Free Press, 2007).
19
Anita M. McGahan and Michael E. Porter, The Emergence and Sustainability of Abnormal Profits,
Strategic Organization, Vol. 1, 1, February 2003, 79-108; Anita M. McGahan and Michael E. Porter,
The Persistence of Shocks to Profitability, The Review of Economics and Statistics, Vol. 81, 1,
February 1999, 143-153.
20
Pankaj Ghemawat, Strategy and the Business Landscape, 2
nd
ed. (Upper Saddle River, NJ :
Pearson Prentice Hall, 2006), 95-123.
21
Michael E. Porter, Competitive Advantage: Creating and Sustaining Superior Performance (New
York: The Free Press, 1985);

Bruce Greenwald and J udd Kahn, Competition Demystified: A Radically
Simplified Approach to Business Strategy (New York: Portfolio, 2005).
22
Anita M. McGahan and Michael E. Porter, Comment on Industry, Corporate and Business-
Segment Effects and Business Performance: A Non-Parametric Approach by Wiggins and Ruefli,
Strategic Management Journal, Vol. 24, September 2003, 861-879.
23
Michael J . Mauboussin, Common Errors in DCF Models, Mauboussin on Strategy, March 16,
2006.
24
Furman and McGahan.
25
Rappaport and Mauboussin.


Pa g e 1 8 L e g g Mas o n C a pi t a l Ma n ag e me n t

Resources

Books

Adizes, Ichak, Corporate Lifecycles: How and Why Corporations Grow and Die and What to Do About
It (Englewood Cliffs, NJ : Prentice Hall, 1988).

Galton, Francis, Natural Inheritance (London: MacMillan, 1889).

Ghemawat, Pankaj, Commitment: The Dynamic of Strategy (New York: Free Press, 1991).

_____., Strategy and the Business Landscape, 2
nd
ed. (Upper Saddle River, NJ : Pearson Prentice
Hall, 2006).

Greenwald, Bruce, and J udd Kahn, Competition Demystified: A Radically Simplified Approach to
Business Strategy (New York: Portfolio, 2005).

Koller, Tim, Marc Goedhart, and David Wessels, Valuation: Measuring and Managing the Value of
Companies, 4
th
ed. (New York: J ohn Wiley & Sons, 2005).

Madden, Bartley J ., CFROI Valuation (Oxford, UK: Butterworth-Heinemann, 1999).

Mauboussin, Michael J ., More Than You Know: Finding Financial Wisdom in Unconventional
PlacesUpdated and Expanded (New York: Columbia Business School Publishing, 2008).

Montier, J ames, Behavioral Investing: A Practitioners Guide to Applying Behavioral Finance (West
Sussex, England: J ohn Wiley & Sons, 2007).

Mueller, Dennis C., Profits in the Long Run (Cambridge: Cambridge University Press, 1986).

Palepu, Krishna G., Paul M. Healy, and Victor L. Bernard, Business Analysis & Valuation (Cincinnati,
OH: South-Western College Publishing, 2000).

Porter, Michael E., Competitive Advantage: Creating and Sustaining Superior Performance (New
York: The Free Press, 1985).

Rappaport, Alfred, and Michael J . Mauboussin, Expectations Investing: Reading Stock Prices for
Better Returns (Boston, MA: Harvard Business School Press, 2001).

Rosenzweig, Phil, The Halo Effect . . . and the Eight Other Business Delusions That Deceive
Managers (New York: Free Press, 2007).

Secrist, Horace, The Triumph of Mediocrity in Business (Evanston, IL: Bureau of Business Research,
Northwestern University, 1933).

Shapiro, Carl, and Hal Varian, Information Rules: A Strategic Guide to the Network Economy (Boston,
MA: Harvard Business School Press, 1998).

Articles and Papers

Albert, J im, Comments on Underestimating the Fog,' By the Numbers, February 2005.

Arthur, W. Brian, Increasing Returns and the New World of Business, Harvard Business Review,
J uly-August 1996, 101-109.

Barney, J ay B., Strategic Factor Markets: Expectations, Luck, and Business Strategy, Management
Science, Vol. 32, 10, October 1986, 1231-1241.


Pa g e 1 9 L e g g Mas o n C a pi t a l Ma n ag e me n t

Buehler, Roger, Dale Griffin, and Michael Ross, Inside the Planning Fallacy: The Causes and
Consequences of Optimistic Time Predictions, in Thomas Gilovich, Dale Griffin, and Daniel
Kahneman, Heuristics and Biases: The Psychology of Intuitive Judgment (Cambridge, UK:
Cambridge University Press, 2002), 250-270.

Chan, Louis K.C., J ason Karceski, and J osef Lakonishok, The Level and Persistence of Growth
Rates, Journal of Finance, Vol. 58, 2, April 2003, 643-684.

Denrell, J erker, Random Walks and Sustained Competitive Advantage, Management Science, Vol.
50, 7, J uly 2004, 922-934.

_____., Selection Bias and the Perils of Benchmarking, Harvard Business Review, April 2005.

Furman, J effrey L., and Anita M. McGahan, Turnarounds, Managerial and Decision Economics, Vol.
23, 2002, 283-300.

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J iang, Bin, and Timothy Koller, Data Focus: A Long-Term Look at ROIC, McKinsey Quarterly,
Winter 2006.

_____., How to Choose Between Growth and ROIC, McKinsey Quarterly, September 2007.

Kahneman, Daniel, and Dan Lovallo, Timid Choices and Bold Forecasts: A Cognitive Perspective on
Risk Taking, Management Science, Vol. 39, 1, J anuary 1993, 17-31.

Kosowski, Robert, Allan Timmerman, Russ Wermers, and Hal White, Can Mutual Fund Stars Really
Pick Stocks? New Evidence from a Bootstrap Analysis, Journal of Finance, Vol. 61, 6, December
2006, 2551-2595.

Lovallo, Dan, and Daniel Kahneman, Delusions of Success: How Optimism Undermines Executives
Decisions, Harvard Business Review, J uly 2003, 56-63.

Mauboussin, Michael J ., Common Errors in DCF Models, Mauboussin on Strategy, March 16, 2006.

McGahan, Anita M., and Michael E. Porter, How Much Does Industry Matter, Really? Strategic
Management Journal, Vol. 18, 1997, 15-30.

_____., The Persistence of Shocks to Profitability, The Review of Economics and Statistics, Vol. 81,
1, February 1999, 143-153.

_____., The Emergence and Sustainability of Abnormal Profits, Strategic Organization, Vol. 1, 1,
February 2003, 79-108.

_____. Comment on Industry, Corporate and Business-Segment Effects and Business Performance:
A Non-Parametric Approach by Wiggins and Ruefli, Strategic Management Journal, Vol. 24,
September 2003, 861-879.

Rumelt, Richard P., How Much Does Industry Matter? Strategic Management Journal, Vol. 12,
1991, 167-185.

Schmalensee, Richard, Do Markets Differ Much? American Economic Review, Vol. 75, J une 1985,
341-351.

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_____., Regression Towards the Mean, Historically Considered, Statistical Methods in Medical
Research, Vol. 6, 1997, 103-114.

Pa g e 2 0 L e g g Mas o n C a pi t a l Ma n ag e me n t

Thomas, L.G., and Richard DAveni, The Rise of Hypercompetition from 1950 to 2002: Evidence of
Increasing Industry Destabilization and Temporary Competitive Advantage, Working Paper, October
11, 2004.

Waring, Geoffrey F., Industry Differences in the Persistence of Firm-Specific Returns, American
Economic Review, Vol. 86, 5, December 1996, 1253-1265.

Wiggins, Robert R., and Timothy W. Ruefli, Sustained Competitive Advantage: Temporal Dynamics
and the Incidence and Persistence of Superior Economic Performance, Organizational Science, Vol.
13, 1, J anuary-February 2002, 82-105.
































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.
Predictions are inherently limited and should not be relied upon as an indication of actual or future
performance.