<SPECIAL FEATURE>
May 11, 1999
Interview with Legg Mason Focus Trust Manager
Robert G. Hagstrom
Part 2 Continued
DW: If you asked Charlie Munger specifically about EVA, he'd say it's "twaddle," but Warren Buffett sets a cost of capital for his managers.
Hagstrom: He tells you it's 15%.
DW: He speaks in terms of the rate at which he'd like to grow intrinsic value. You've done EVA models, that's the way you build them.
Hagstrom: If you and I were running Borsheim's and we wanted to expand and put up a new building or open up something in Lincoln, Nebraska, and we approached Warren and asked, "What are you going to charge for the capital?" He'd say, "15%. I expect you to be able to invest it, make a return on it, and get at least 15% if not more. And if you can't do that, then I shouldn't give you the capital." Well, 15% is Berkshire's internal intrinsic value growth rate benchmark. He's saying, "That's my charge for capital. That's what I'm going to charge my subsidiaries and new companies that come in. They have to hit that benchmark. If they don't, I'm not doing 15%." That's his cost of capital. He says it's not too scientific, but it gets their attention.
DW: Well, that's the thing. I think a lot of discussions of EVA try to make it too scientific. As long as you're aware of the effect of your actions on balance sheet and not just the income statement, you're getting it.
Hagstrom: Well, the only thing is, they run the beta model and CAPM [Capital Asset Pricing Model] model, and Warren just really dislikes those. He's not going to get anywhere near anything that has to do with beta and CAPM. The rule that "for every dollar retained, you're supposed to create at least one dollar of market value" is a variant of EVA if I've ever seen one. He just figured it out 15 years before Stern Stewart &Co. did.
DW: That's why I think it's natural financial law.
Hagstrom: I agree 100%.
YC: How do you reconcile the fact that Warren Buffett doesn't run a mutual fund but runs a company that's actually involved in manufacturing, retail, insurance, and services?
Hagstrom: If you go back and look at the history of Warren, he started as a money manager and a partner. In 1969, when he wrapped it up, the world wasn't making a lot of sense to him. Here again, the rationalist doesn't play games in which he doesn't think it's operating right. He had bought Berkshire Hathaway as a wholly owned company back in '65-'66 and owned the majority of the company. And I think the market was getting kind of wacky then (not WACCy). My sense is that he felt the game was up, and he tried to get Ben Graham to convene with a number of other money managers that he and Buffett knew. They asked Graham, "Can you give us some guidance, should we be in this game anymore, is it getting crazy, should we walk away?"
Graham wouldn't give them any answers and they were all perplexed. My sense is that Warren had made some pretty good dough and was financially secure and he had this little textiles company. The idea was, "Maybe I'll go do this for a while, because I can't make much sense of the market and I can't find values and I can't buy things that I'm comfortable with. So why don't I wrap it up and I'll go run this for a while and we'll see what happens." The best thing that he figured out very quickly was, it wasn't textiles, it was insurance [he wanted to do], and he bought National Indemnity. National Indemnity allowed him to live vicariously as an investor through the insurance float.
The first thing he did was -- this was one of these insurance floats that has 80% of its money in fixed income and probably no equity. The first thing he did, realizing it was long-tailed policies, he just reversed that out and slowly built in stocks. He could still be the portfolio manager, he could still be the investor, but he didn't have to have a partnership or a mutual fund to do it. He could do it through the float. A lot of people can bring a lot of money in the insurance business if they can write responsibly and know how to invest money. He didn't get the part about writing insurance right the first number of years. But he could invest the money well enough.
Then he turned over the pricing decisions to someone else who could price policies better and just stuck with the float. And then basically started to enjoy the people. If you go back and look to a lot of the literature, he just really loved these people and he loved the guys at National Indemnity. He loved Gene Abegg at Illinois National, liked the Chase family at Berkshire. I think he just really enjoyed the interaction.
He loved operating businesses and he could be the investment manager with the investment float. So all of a sudden this $16 stock in 1965 started to be something pretty impressive. So then the game becomes, "How high can I get this stock price and how do I get the price higher?" I think he recognized that the game is not getting the biggest mutual fund. Warren's is, "Well, the stock's now $70. I wonder if I can get it to $100. Now it's $100, can I get it to $200? Now it's $200, can I get it to $800?" I think he was still able to be an investor, he just didn't necessarily need the common structures to get it done.
DW: On the flipside of Yi-Hsin's question, why are you running a mutual fund rather than a partnership where you have more latitude or running a holding company?
Hagstrom: We should have. We should have run a partnership from day one. We would have a lot more latitude -- we wouldn't have SEC regulations on us and it would have cost us a lot less to do it. We might have done a hedge fund -- although I don't have any experience with shorting, but here again we could have run it unconstrained. But we could have borrowed. When you've got Citicorp on its back in 1990, you don't just put 10% in it, you put in 10% and borrow another 10%, and that's how you would optimize the portfolio. So we could have gone long leverage in a hedge fund and done pretty well.
I had the misguided notion that with a best-selling book and only the third mutual fund in the country to come out and publicly state that they'll own less than 20 stocks, that we're just going to have a ton of people show up. Kind of like this Kevin Costner image of Field of Dreams -- "If you build it, they will come." So I had the mutual fund, I had the book, I had the 1-800 number and I waited. And nobody came. We would have been much better off doing a limited partnership or a hedge fund. The cost structure would have been different; we would have more flexibility. In the first two years, I would have said, "Why did I do a mutual fund?"
Now today, even though the partnership and hedge fund would have been easier in the beginning, I think the mutual fund is going to work out pretty well. You know, Sequoia Fund [which has been closed to new investors for some time] has given up their leading role. I went to the Sequoia annual meeting, and I have the highest regard for Bill Ruane and Bob Goldfarb, but they seem like they don't want to compete as vigorously as they could have. They are the pioneers and we've modeled ourselves after the Sequoia Fund. I've stated publicly that we would have been hard-pressed to justify doing this.
There are a lot of focus funds now, but they're not big-bet funds where you put 10-20% in one position and you're low turnover. Marsico's out there, but he's burning that thing up at 80% to 90% a year. PBHG Large Cap 20 did very well, but they're burning that thing up. There are not many managers that will do 10-20% positions and then hold them for five years. It seems like we're in a position now to rank there with Sequoia and maybe Longleaf. If we keep our nose clean and can build a record and be one of that category, that wouldn't be a bad way to carve out a market.
</SPECIAL FEATURE>