Morningstar Advisor - Fall 2008 - 47

RH: The uncertainties of the cash flows. When we went into the Internet space in the beginning, it was very difficult. The other thing is that in technology the business models are rapidly evolving, competition is more intense, and the certainties are not there always, so you really have to do an analytical judgment that’s very challenging. KK: It sounds like you are saying that some- it’s exhausting.” We try to get the message out. We emphasize over and 25000that we’re not concerned with over short-term performance, no matter how much it is a driving force in how people make decisions. 20000 We talk about the fact that 95% of my net worth in 15000 the stock market is in this fund. I’m doing everything in this fund so that my family will benefit along with you. But as you know, 10000 Kunal, it resonates with some people and they get it. And others say, “Yeah, it makes sense,” but then they have trouble with the volatility. KK: A lot of the Legg Mason funds have Legg Mason Growth Trust LMGTX $25K 20 15 S&P 500 TR times it’s hard to imagine the way growth may evolve. What do you do that other growth managers don’t? RH: We take a longer-term approach. We’re 03 04 05 06 07 08 Category 7 Large Growth Morningstar Rating QQ Minimum Investment $1,000 Expense Ratio (%) 1.84 5-Yr Anl Total Rtn (%) -3.23 5-Yr. Rtn Rank Category (%) 100 looking for secular growth as opposed to cyclical growth. We’re trying to think about how something may look three and five years from now. Internet was quite easy in that aspect; I didn’t have to worry about it being a 18-month cycle. If you thought about how the Internet was evolving, it was clear that all of the Amazons, the e-Bays, the Googles, and the Yahoos were going to have a tremendous wind to their back and that secular growth forces were going to be strong for a long period of time. That’s the first thing that I think about as a growth manager. I’m trying to look for those landscapes that are going to be friendly for us for years. If I’ve got that working for me, it allows us to take the bumps. There’s a lot of bounciness in this space, but if I have a high degree of confidence that the tail wind behind us will keep pushing the industry and the companies forward, we can take those bumps a little easier. KK: Although I imagine a big challenge is that underperformed recently, and you guys have lost some prominent accounts. How’s morale at the firm? RH: Morale, believe it or not, is high. Bill has built this organization for the past 25 years with a belief that valuation wins out. You go through periods where value may not matter, but ultimately, valuation wins out. If it doesn’t, then we need to close up the Berkshire Hathaway annual reports and Ben Graham and put them away. But clearly, valuation and contrarian strategies have been miserable strategies to follow the past two to three years, whereas momentum strategies have worked. KK: But some value managers have done fairly Jan-03 Data as of Sept. 30, 2008. Jan-04 Jan-05 Jan-06 Jan-08 cost of capital and they’re miserable investments. This cycle turned into a “supercycle” Feb-03 Feb-04 Feb-05 Mar-06Dec-06Sep-07Jun-08 Mar-03 Apr-04 Mar-05 Apr-06 Feb-07Nov-07Aug-08 Apr-03 May-04 Apr-05 May-06 Mar-07 Feb-08 May-03 Jun-04 May-05 Jun-06 Apr-07 Mar-08 Jun-03 Jul-04 Jun-05 Jul-06 May-07 Apr-08 Jul-03 Aug-04 Jul-05 Aug-06 Jun-07 May-08 Aug-03 Sep-04 Aug-05 Sep-06 Jul-07 Jul-08 Sep-03 Oct-04 Sep-05 Oct-06 Aug-07 Sep-08 Oct-03 Oct-05 Nov-06 Oct-07 and Nov-03 much longer than we recognized. lasted Nov-04 Nov-05 Dec-03 Dec-04 Dec-07 Mar-04 Dec-05 Feb-06 Jan-07 well during this time. RH: Yes, and I congratulate them, because they did one or two things well that we didn’t. We underestimated the severity of the credit contraction in the housing market. We believed the system would self-correct. So being overweight in financials certainly wasn’t the right call. Second, we had no energy exposure. We knew at the time that commodities were moving, and we knew that there was probably a period of excess return in commodities relative to the market, but maybe we have too much Buffett DNA in our system. Commodities are tricky. They earn the excess return for a very short period of time. Then, supply and demand come into balance, and they earn below the We’ve been thinking about energy extremely hard. We recently had an “energy summit” here for three days and brought in a lot of experts— Daniel Yergin [Pulitzer Prize-winning author of The Prize: The Epic Quest for Oil, Money, and Power], a lot of guys from the Santa Fe Institute—to look at renewables and alternative energy sources, trying to get an idea about this supercycle that we’ve gone through. Does it moderate and come back down, or are we now in a new secular phase? Which energy will be an above-average performer, not just for two or three years but for 10? KK: You guys have done a lot to beef up your analyst ranks. When you go through a market like this with a stay-the-course philosophy, how do you keep younger analysts focused on it? RH: One of the things that we constantly are trying to get the analysts to understand is process outcome. I want to make sure that we’re following the right process of how to shareholders in your funds have the opposite reaction that you’re having. How do you manage that? RH: The late Bill Ruane, who started the Sequoia Fund SEQUX, gave me a great bit of advice. He said, “Robert, make sure you get the shareholders that you want, because if you don’t, you constantly have to replace them and MorningstarAdvisor.com 47

http://www.MorningstarAdvisor.com

Morningstar Advisor - Fall 2008

Table of Contents for the Digital Edition of Morningstar Advisor - Fall 2008