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May 12, 1999

Interview with Legg Mason Focus Trust Manager
Robert G. Hagstrom

Part 3

Part 1 and an Introduction to Robert Hagstrom
Part 2

DW: Bill Miller made some interesting comments about "what is the market" these days. When you look at the S&P 500, that's really ceased to be "the market" because it's neither passive -- it's managed by people at Standard & Poor's -- and it's not a broad index, because it's really a small number of companies in there that are really dominating the economics of that portfolio. That has a number of implications for the capital asset pricing model [CAPM] and it also says something about the overly diversified, high-turnover approach.

Hagstrom: Clearly, if you deconstruct the S&P 500 index, it's not a passive index. It's a very Darwinian model where the strong survive and the weak perish. It's not bounded by position weightings; you just let it run. You let your winners run and you cut your losers. If you look at Value Trust, that's exactly what Bill does. I finally, after six to nine months of watching him run that portfolio, basically now understand it. His great success is that he's beating the S&P at their own game, which is, "I think I can do a little bit better picking than the S&P guys are and I'm going to let the winners run. And if you can't win the game in two or three years, I'm going to cut the losers off and replace them with a new group we think can win the game."

And he won because, when everybody cut back Dell and AOL to 1-2%, they all owned them, and he felt they were still appropriately priced relative to value. He didn't care if it got to 10% or 15% [of the portfolio]. Warren didn't care that Coca-Cola got to be 38%. He let the winners run. That's a Darwinian portfolio if I've ever seen it. He's basically letting the winners go and, the other ones that don't make it up the heap die off and go away. I don't know what to make of the S&P, but as Bill says, if that's your competition, you had better go analyze your competition and figure out what they're doing and beat them at their own game. It seems that, if that's our competition, we're not only beating them at their own game, but we're setting up our own game totally different than theirs. I think a focused portfolio is the only way to beat the S&P 500.

YC: Warren Buffett has been a successful investor for more than 40 years. Why do you think no one else has duplicated his performance? Do you think it's this idea of "the last intelligent investor" and focus investing?

Hagstrom: Well, investing is trying to figure out the value of a business and speculation is trying to predict the market, interest rates, and the hot sector. If you were to draw a line down the middle of the page and count the number of hours that you invest versus the number of hours that you speculate, I dare say that money managers in all probably spend way too much time on the speculating side and not enough hours investing. Warren's the kind of guy who never crossed the line. I mean, he just spent his whole life analyzing businesses.

On top of that, he had the competitive advantage of owning businesses at the same time he invested in businesses. When you run a business and then you go and analyze it, you can figure it out much quicker. Warren ran businesses at the same time he invested in them, so he could figure out the value drivers and the mistakes and tell the difference between good and bad managements. He had all that experience for decades. So already, that makes him a better analyst than anyone coming out of business school who has never run a business. Secondly, it comes from focusing the portfolio -- he optimized his bets.

The question is, "Why didn't more people emulate this style?" Where is Sequoia II? I'm no genius, I'm just copycating what these smart people have done. Like dad said, "You don't have to have an original idea. Just do what the smart people do." And that's kind of how I've approached this thing. The only reason I can come up with why there wasn't a Sequoia II was that the fear of underperformance was far greater than the fear of failing conventionally. In our business, if you're just close, you can keep your job another year. If you underperform by some magnitude, then you can really be in the hot seat, and focus investing opens you up to that possibility. I think the fear of being wrong kept people out of running a Sequoia II, more so than the attitude of "well, I didn't outperform the market, but I was close."

When you lay down 10% or 20% on a stock, you damn well better know you've got the right stock. A lot of portfolio managers don't have that confidence. Why? I don't think they're analyzing the businesses. Once you analyze the business, you break through the fog. You see the price and you see the business and it doesn't fluster you and you can feel more confident about the money you put into it. We put 20% of our portfolio in American Express and Citicorp at the peak of the emerging market crises, when they cut them in half. If I hadn't studied the businesses and knew how much money they had invested overseas, I wouldn't be able to do that.

If the [emerging markets components of those businesses] were valued at zero, which we knew wasn't the case, the most the market cap should have been was maybe 20% off. But they cut it down by 50%. Well, that had to tell you that was a massive mispricing. I didn't have a clue that the emerging markets would correct within such a short time, but I knew we were going to be fine buying Citicorp at $32 to $36 and American Express at $70. It was just a no-brainer. You could put 10% down and feel pretty good.

DW: Why did Warren Buffett commit as little new capital to American Express as he did at that time?

Hagstrom: He bought a million shares, so it was $70 million or so. I don't know� there was a conversational rumor at the time that this was the perfect time to take over the company. He knew he'd have the capital available with the Gen Re merger.

DW: Well, we know he acts rationally. Do you think there's something about Amex? Does he not like the way cards are going or some other aspect of the business?

Hagstrom: The only thing I can think about, for the next step at American Express, is that it needs a bigger distribution platform and maybe it is a Citigroup merger that takes it to the next level. If he kept it, he'd still have to do another deal for it to realize even more of its intrinsic value.

DW: Yi-Hsin and I were talking about this on the car ride up. Warren Buffett has said, and I'm paraphrasing here, "If I don't feel comfortable putting 10% of my net worth into a company, I just don't find it attractive." That being the case, why would he only buy half a million shares of Costco when Charlie Munger has said that he doesn't know a retailer that has brought more happiness to the world than Costco?

Hagstrom: I'm not going to tell you that everything he does makes a whole lot of sense to me, and I'm not going to say there's not some inconsistency. Some of the things are very perplexing. You never know what's also on his plate at the time.

DW: You own Avon. A couple years ago I fell in love with Estee Lauder. Cosmetics is a wonderful industry. Why wouldn't he own one of those?

Hagstrom: The thing that I think has kept him out of some of the stocks recently is that, if you go back and look at his purchases, he always bought when the stocks were on their backs. There was something wrong. You look at Gillette, Coca-Cola, American Express, Wells Fargo, Washington Post. With almost all of them there was a problem there that allowed him to get them at a large mispricing. We just haven't had that many opportunities to get things at large mispricings. His natural instinct being that contrarian -- "Be greedy when others are fearful" and vice-versa -- we just haven't had a lot of fearful periods that have lasted too long.

YC: I think it's fair to say that Buffett is somewhat sentimental when it comes to certain investments. Do you think there's such a thing as being too loyal to an investment, in that if you were to sell, you'd actually be doing a greater service to your shareholders?

Hagstrom: Yes, he's admitted that. He himself has said in the Berkshire Owners' Manual, "Let me tell you about something that's definitely going to effect our future rate of returns. We're not even going to sell a sub-performing business if we think it has at least some chance of netting out free for the year. As long as it doesn't cost us a lot of capital each year, we're going to keep it." That has probably allowed him to acquire some businesses that he otherwise might not have been to because people know that he's loyal and he'll stick around.

So when you sell a business to Berkshire Hathaway, you know that you're not going to get kicked out after four years if business doesn't go right. When people sell their businesses to Berkshire, that statement possibly has gotten him more valuable businesses in the long run than the ones that maybe don't generate a lot of money for him.

YC: Related to that, it seems like a lot of the deals he's done have been through personal relationships -- a CEO calls him up, and that wouldn't happen with most people. How do you then translate that into how other investors do things?

Hagstrom: Well, Warren obviously gets a lot more picks than I do, because everybody's probably showing him things that we're not ever going to see. That's just one of the advantages he has in the game. He has a lot more things to pick from, both common stocks and privately-held businesses, which is going to increase his net worth at a much faster rate than ours.

DW: Just to clarify what you were saying in the first part of that answer, you're saying that because he does that, because he's loyal to the businesses he acquires from private sellers, that strengthens his position as the "buyer of first resort?"

Hagstrom: Well, I don't have anything to back this up with, but my opinion would be that he's acquired a lot of beautiful businesses, I think because his history is that he doesn't fire things just because they become average or mediocre. This gives people a sense of confidence that they have a home at Berkshire and don't have to worry about being re-sold into the aftermarket at a later time if things don't go very well.

If I had a great business and I wanted to settle this issue of estate planning, stock, and how to monetize the value of the business, I don't have to worry about this holding company selling me to another holding company who's now going to change the rules and start messing with my business. It seems that Warren's consistency in how he acts is always going to attract the really quality situations where they know the rules when they sign up and they know the rules don't change. Now, does that penalize his future rate of returns when he holds onto mediocre businesses? Yes, but he might get more than his fair share of great businesses because of that.


Next -- Page 2 of Part 3

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