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May 11, 1999

Interview with Legg Mason Focus Trust Manager
Robert G. Hagstrom

Part 2

Part 1 and an Introduction to Robert Hagstrom

YC: You mentioned Bill Miller and others like Ed Thorp and Charlie Munger, so why did you call the book The Warren Buffett Portfolio as opposed to something more general?

Hagstrom: I would not be honest if I didn't tell you there was a marketing angle from the publisher to want to attach the two books together, and I think the first half of the book is easily about the "Warren Buffett portfolio." The second half concerned other things you need to think about if you're going to run a concentrated portfolio. You need to think about psychology, you need to think about probabilities. Warren talks about probabilities, but he just doesn't give us verbiage to fill out a chapter. We've got verbiage everywhere on Berkshire Hathaway with which we could fill up a lot of books. But, he talks about probabilities and how important that is, and that he thinks in probabilities. He gives us the arbitrage example and he gives us the Wells Fargo story, which is a little example of probability thinking. But he just hasn't given us enough lines and pages to fill out a chapter.

So what do you do? You know it's important. But if he doesn't give it to you, what do you do? Well, you start to piece it together. You go back through Claude Shannon and J.L. Kelly and Ed Thorp and those guys, and they can give you the roadmap. That's been part of the criticism, which is, that we went off onto a tangent that's unrelated to Buffett. I think it's close. Buffett might say, "I have no idea who Kelly is and I've read Beat the Dealer, but I've never thought about it that way." It's at least defensible in thinking about making a big bet portfolio and to have some sense of how to weight probabilities, and that's all we were trying to figure out.

It would have been underserving to say a 15 stock portfolio should have 6 2/3% in each position. Well, that can't be right. He put a third of his net worth in Coca-Cola. He's made altering bets. Now why did he do that? My sense is that it was either gut, intuition, or instinct that this is a really solid thing. It has a high possibility of winning in the future, so why don't we bet a lot of money? If you go through the super catastrophe insurance underwriting business, it's a low frequency, high severity event, which is the same thing as a concentrated Buffett portfolio. If one of these things blows up, then you have a problem.

But the economic values of these businesses are such that the frequencies are going to be very low. The likelihood of these happening is very low. Same thing in the super-cat insurance market. If you go into the super catastrophe reinsurance market and talk to Ajit Jain [Berkshire's key super-cat underwriting executive and insurance thinker] and you talk to Charlie, it's a low frequency, high severity event. I said to Charlie, "It seems to me that the analogs between super catastrophe reinsurance and focus investing are very similar." Charlie got this big smile on his face and said, "The thinking's identical."

So I knew we had the pathway, but there's just not enough language out there, so we had to fill it in. There's a lot of language on psychology, but most of it comes from Charlie. You have to go through the USC lectures on the psychology of misjudgment. We threw in the stuff on risk tolerance because I thought it was pretty relevant, and that ties into the behavioral finance Charlie talks about with failure. I thought the whole idea of risk tolerance and the Walter Mitty effect was kind of interesting because I think people can relate to the tendency to overestimate your skills when things are going very well and grossly underestimate them when things are going badly.

I also thought it was interesting that in achievement motivation, personal control orientation, and contingency dilemmas, if you got all those parts right, you are very likely to be of a high risk profile. That is, you set goals, you want to have personal control of the environment you're in, and that you believe that the game you're in is a contingency dilemma that has rules that will give you a net benefit at the end (that it's not some lottery).

If you piece together how Warren thinks about the market, he's very achievement motivated, he's someone who believes he does have control over his environment, and he thinks there is a contingency dilemma to the stock market. Ben Graham's analogy of the market being a weighing machine in the long run and a voting machine in the short run illustrates that. You get the economics right, then pricing - it's a contingency dilemma. He's got that part figured out.

So if you put those three things down on Buffett, one would say, "Well, I can understand why he might have a higher risk tolerance in investing than someone else." Here again, risk. How do we define risk? He might be someone who's not unnerved by huge changes in prices because he basically understands this a little bit better. So we threw that in to try to give people a reference point to the psychological makeup that seems to work for focus investment portfolios. We talk about this with [Legg Mason's] brokers -- if you find a client doesn't fit these psychological attributes, don't give them Focus Trust. They're the first ones that're going to call when the thing goes down and they're going to be upset.

YC: Did you have a working title for the book?

Hagstrom: Yes. It was going to be called The Last Intelligent Investor. It was going to be a takeoff on The Intelligent Investor, trying to argue that we've got all these people going down one path, and then this symbolism of Buffett, Fisher, and just a few guys saying, "Wait a minute, don't go that way, go this way." So that was the working title and it was symbolic of who a focus investor is and needs to be.

DW: Well, the current title does make sense. Buffett is the best practitioner of this way of investing. And I think that's the right way. There are certain truisms, a sort of natural law, in investing, and I think Buffett's practices exemplify those. Along those lines, I think Economic Value Added [EVA] speaks to some of those truisms. Even though Buffett doesn't speak in the vocabulary of EVA according to Stern Stewart & Co., he's still speaking EVA.

Hagstrom: I agree 100%. Coca-Cola made a career out of EVA. Robert Goizueta understood it very well. He would say, "I've got this EVA stuff. I've got a cost of capital and I have to earn better than that, and whatever the difference is results in high profits for my shareholders." He ran that business like that for 10 years.

Next -- Page 2 of Part 2

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