May 10, 1999
Recently, Dale Wettlaufer (DW) and Yi-Hsin Chang (YC) traveled to Wayne, Pennsylvania, to talk with Legg Mason Focus Trust portfolio manager Robert G. Hagstrom. Hagstrom, the author of the best-selling The Warren Buffett Way, was ahead of the curve in finding great value in NASCAR and in writing The NASCAR Way, and has recently written The Warren Buffett Portfolio.
In his latest book, Hagstrom looks at investing the Warren Buffett way from a multidisciplinary viewpoint, challenges long-held academic definitions of risk in portfolio management, and even takes on the mutual fund industry's approach to the way the world works. We will present Yi-Hsin and Dale's talk with Robert over the next few days, beginning today with what Hagstrom tried to accomplish in his new book.
DW: Robert, what did you want to achieve with The Warren Buffett Portfolio?
Hagstrom: If you look at The Warren Buffett Way in 1994, it was a very different time in the market. First of all, we came off that 1991 recession, markets were sloppy, nobody was making double-digit returns, much less triple-digit returns. It was a very difficult time. It was the first book that came out that kind of went into the case study analysis, and so when it hit, it really sparked quickly.
Since then, we've had about five books on Buffett. Roger Lowenstein did a great job [with Buffett: The Making of an American Capitalist], Andy Kilpatrick I still think does a great job with keeping up with the history [with biannual editions of Of Permanent Value: The Story of Warren Buffett], and then you had the Buffettology book and Buffett Speaks [Warren Buffett Speaks: The Wit and Wisdom from the World's Greatest Investor], and then Cunningham came out with the Cordozo Law Review compilation. So there's been a lot of stuff in the last three years, so we're reaching saturation on Buffett.
The second thing is, the market has been so powerfully strong that I think people are not looking for solutions because it's been rather easy. Bull markets typically make it easy. If you can just catch the trends wherever they are, you can generally make money. Also, technology is such a big part of the investment return, and Buffett is very well known as not having a high degree of participation there. So the idea [with investors in general] may be, "there's nothing here, I don't need help, I'm making money, technology's where it's at, and I already know that Warren Buffett's not there," so it's a different time today than it was in 1994.
I wrote the book for two reasons. One was very self-serving, because of Legg Mason Focus Trust, and the other was, I think that really the literature had not discussed what I thought was a really important part of the Warren Buffett process, which is now that we've got the stock selection process down, how do we make big-bet portfolios? The Buffett literature that was out never got into portfolio management too much. It's [presented] as kind of buy-and-hold, but it wasn't why you put 20-25% into something and what can happen when you do that. I thought this was an area that was completely underserved, but I was convinced it was also an area that explained how he got excess rates of return. You have to pick the right stocks, no doubt about it, but if he had bought 50 or 100 things, I'm not sure he would have gotten the returns that he got. Clearly, making big bets on high probability events was driving the high excess returns in the portfolio.
We figured that out when we started doing this research for AIMR [Association for Investment Research and Management] with Joan Lamm-Tennant, who was over at Villanova University and now works for General Re. The problem that I ran into when I first mentioned Legg Mason Focus Trust in 1995 was that there was a great deal of skepticism about, "did we know what we were doing and is this the right way to do it?" We didn't have that many data points to look at. You have Buffett, Charlie Munger, [GEICO chief investment officer] Lou Simpson, and [Sequoia Fund's] Bill Ruane. You only had four or five data points to look at.
Most of the people we interacted with said, "Well, that could all be intellectual fruit from the same tree," and they were really concerned that there weren't that many focus funds out there. If it was such a great idea, why hadn't Wall Street imitated it? So the research we were doing for AIMR and that we did with Lamm-Tennant was meant to try to give us some academic bearing on why concentrated portfolios have the potential to outperform broadly diversified portfolios.
The research paradigm was random selection. We had a database of 1,200 companies and the computer randomly selected 3,000 observations. According to the statistical people, once you get 3,000 observations, you've washed out enough noise that you can make some kind of conclusions. You can at least draw some conclusions. So when we did that first research and looked at the distributions of different portfolio sizes over a 10-year period, it was striking. It just jumps out at you immediately that, as you reduce the number of stocks in your portfolio, you begin to measurably increase the probability of generating high excess returns. The problem is you also increase the probability of generating very negative returns.
That was the first insight. The second insight was, if you had a 100-250 stock portfolio, the probabilities of your generating high excess returns relative to the market… the probabilities just weren't there for you. You were in the 1 in 3,000 or 5 of 3,000 that could get it done. We didn't adjust, and we're going to do some of this in a [yet-to-be-published] monograph, for market impact cost, expense ratios, and that sort of thing. According to Fidelity, at an 80% to 100% turnover ratio, you can get market impact costs of two percentage points in the portfolio, just the buying and selling action. So you're two points behind there. You have another point or so in expense ratio and you're now three points behind.
DW: And that's not even counting taxes.
Hagstrom: Absolutely. Already, you're three points behind before taxes and you've got a 100-200 stock portfolio, which statistically isn't going to be one of the portfolios that can get you ahead of the market. You kind of recycle back and look at the fact that since 1990, 97% of the money managers haven't been able to outperform the market. I'm beginning to think the reason why is that we're structured all wrong. Did you read Peter Bernstein's article on "Where Are the .400 hitters?"
It was in the last chapter of The Warren Buffett Portfolio. Peter came about it in a very interesting way, which is that perhaps the competition has gotten so intense that we can't get high excess returns. When we went through Peter's paper, it seemed to me that he was absolutely right structurally, but he left the back door open. The back door was that you can get this done if you're willing to assume high standard deviations. He said that if you're willing to accept that, you probably can be a .400 hitter. Well, when we went back and looked at Buffett, Munger, and Ruane, all of them were high standard deviations relative to the market.
Very bouncy roads, along the lines of Warren Buffett's [preference for] a bumpy 15% compound annual return over the long term rather than a smooth 12% long-term return. I just basically started to put this stuff together and said perhaps the reason why we're not performing is that we have too many stocks, we're too concerned about the smooth ride, and we're just not going to get there from here. I mean, you just cannot generate those high excess returns. So if we're paid to beat the market and clients are expecting that... it seems to me that this is the smart way in which to do it.
The book was written to explain that. One, we under-emphasized that in The Warren Buffett Way. And two, we wanted to really drive home the point that, you first have to pick the stocks and secondly, you've got to put them together in a portfolio. The thing that really kind of took me aback after I wrote The Warren Buffett Way was that it seemed like everyone had "Warren Buffett conversation" down: "We only buy the right businesses, we want good managers, we're looking for high returns on capital, good profit margins, cash flow and earnings, and we always buy them for less than they're worth." That's the Warren Buffett Way. Then you find out about the portfolio they manage; it's got 140 stocks, turnover ratio of 90%. They got the stock selection part down, but not the portfolio management aspect. That was part of the driving force in writing the book.
When we started Focus Trust, there was a lot of skepticism about this. "Are you sure 10-12 stock portfolios are the way to go?" we were asked. "Sure, Warren's doing it." And they would respond "Well, that's right for Warren, but what do you know about it?" So the book was written to flesh out the academic defense for doing this. And that was the first half of the book.
DW: Do you feel good about what you accomplished?Hagstrom: I think so. Mike Mauboussin at CS First Boston was helpful with the book, went through it and said "yeah, this looks good." [Legg Mason Value Trust portfolio manager] Bill Miller went through the book with me and read every chapter and went through it all and said "yeah, makes sense to me." Joan Lamm-Tennant is a Ph.D. and is statistically competent, writes papers for the CFA group, and they said it's fine. Keith Brown down at AIMR said "yeah, looks good to me." So we've got all these people who are saying the research design looks fine, so we think we went about it correctly. Now the big question begs itself: "If it's correct, why aren't we [the mutual fund industry] doing it?" I've got guesses why, but I really don't know why we don't do more of this. Why aren't there another 200 or 500 focus funds out there?
DW: One thing I wanted to ask about is risk in terms of "beta." There's a riddle that Warren Buffett included in a letter to shareholders , which was one of Abraham Lincoln's favorites. It goes: "How many legs does a dog have if you call his tail a leg?" The answer is: "Four, because calling a tail a leg does not make it a leg." In quantifying risk in terms of beta, are we calling beta a leg?
Hagstrom: I think so. In Chapter 2, "The High Priests of Modern Finance," we go through that and ask, "How did we come up with this whole idea of modern portfolio theory?" It looks like it came up because we screwed it up in the first place. The money management business basically blew it. We walked into 1972-1973 like a Lamborghini at 190 miles per hour and just blew it up. Everybody looked around like "what happened?" Some of these academic types said "well, we'll take a swipe at it." And we had no clues, so we signed onto that.
That's my very anecdotal analysis. You go through Bernstein's Capital Ideas and it basically reads to me like nobody had a clue, so "let's just do what these guys are proposing and see if that works." And their whole game, it seems to me was, wide diversification creates smooth rides and reduces downside risk. And what everyone was upset about in 1973-1974 was that you lost 60-70% of your money. So these guys said, "We've got a way in which this won't happen again." Everyone was saying, "I'll sign up for that!" Money managers were signing up to sell that, because that's what their clients wanted. Along the way, it seems like we got ourselves into a situation where we can't beat the market because modern portfolio theory just basically limits those opportunities.
Beta does not define risk, in my book, but we don't have any other way. Jack Treynor has an article this month in Financial Analysts Journal, and I talked with Jack about this. He's basically trying to disassociate himself from beta. He's saying that he really doesn't think this stuff explains risk at all. He wants to go to an economic risk model. He wants to define risk from an economic base, which is what Warren Buffett tries to do. Of course, how do you quantify this, how do you model it, how do you get it to a decimal? It's easier to come up with a beta with stock prices than it is to try to quantify whether Coca-Cola has more economic risk than Gap. They both had the same beta at one time, but which one has more economic risk? It's not an easy concept to get to a decimal. Obviously, with a focused portfolio, the risk is not beta, it's economic risk.
We've taught for 25 years that "bounce" is bad and you don't like it. And we're saying the only way to get high excess returns relative to the market is to accept bounce. Then the academics come back and say "well, of course you have to take more risk." They all have high betas, high standard deviation portfolios. They're saying, "Nothing new here. To get high returns, you have to have high risk." And I'm saying, "You guys defined it wrong in the first place. Let's let Warren define it differently, which is [that] risk has to do with certainty in management to allocate capital, the certainty with which the business can continue to proceed. That's risk, in my mind. Smooth is more pleasant, but it doesn't get you a higher number than Jack Bogle's [S&P 500 index fund] number does at the end of the period.
When we go out and talk to clients, the first thing we say is you have to be somewhat psychologically ready for some of this, because we'll look brilliant one quarter and sloppy another, which will have nothing to do with what we're doing in the portfolio -- it's just that the market's sunshine moves from one point to another.
The second half of the book is really more influenced by Bill Miller. We've got Charlie Munger in there, we've got Bill on complex adaptive systems, we've got [mathematician and author on gaming] Ed Thorp on probability. Bill introduced me to [mathematician and information theory inventor] Claude Shannon and [mathematician and gaming theorist] J. L. Kelly. Now we've got these 10-15 stocks -- how do we now optimize this? It's weighting the probabilities. There's the analogy of the card game -- if you bet one dollar on every hand, how much money would you end up with compared to a person who could alter their bet based upon the draw of the cards. Considering they are both equal players, the guy who can alter the bet, based on probabilities, should end up with money.
Well, how are portfolios designed? 100-200 stock portfolios have 1/2% to 1% of assets in each stock. They're not equally weighted events. One of these is a better stock than another but you're not weighting them according to their probabilities. You've already got that suboptimized. I already know that a 100-stock portfolio with 1% in each stock is totally suboptimized from a mathematical standpoint, and we try to draw that out.
I also wanted to throw in the psychology of investing and complex adaptive system discussion, because the one thing that Warren doesn't do very well is that he just basically says you can't predict the market. I always thought it was fascinating to try to figure out why we can't. The concept of complex adaptive systems finally helped me understand why we can't. The mathematics just aren't invented yet to explain the agent-based system with continuous feedback loops. Once I went out to Santa Fe [the Santa Fe Institute], I said OK, I've got no problem with not predicting the market. Now I understand why. Instead of just saying it can't be, well, I always thought there might be a way. Now I'm pretty convinced that if it's going to be discovered, it's not going to be discovered on Wall Street, it's going to be discovered out in Santa Fe or at a think tank by a Nobel physicist.
DW: One of the great ironies I found in your book was that John Maynard Keynes, one of your focus portfolio investors, thought up a national income accounting equation, which tries to sum up in a neat algorithm what happens in the complex system of a national economy.
Hagstrom: It was dicey to throw Keynes in there, because he has a mixed record as to his abilities with economics and with investing, as I understand he had a tricky time being an investor, too. When he hit the Chest Fund period, he seemed to have gotten it all together, but in periods before that I think he was a little sloppy, and there was this period where he absolutely had no idea what he was doing and he blew up a lot of money.
DW: When it comes to economics, a lot of people think it's a hard science, that you can quantify everything. Ultimately, you're trying to quantify human behavior. People exhibit patterns, but you can't always make the linear projection from past data.
Hagstrom: I agree. I didn't really have a firm grasp of that until I went to work for Bill. In the last three years, in going to Santa Fe with Bill, and his becoming a partner in my limited partnership, he said, "Robert, you've got to start to think of this stuff." I guess Bill got turned on to this about the late 1980s, early 1990s, but really geared up in it in the 1993-1994-1995 time period. By the time he was really up on the curve, he said, "Let me take you by the hand, I'm going to show you something."
And I went "Oh my God." So I came late, but it's clear that what's going on at Santa Fe is really helping Bill think in very worldly ways. So now the trick is, we've got the stock selection process, the portfolio management process, and now [we need to] let Bill help us understand how to apply this to technology, how to understand complex adaptive systems, how to understand the Internet and how it affects business. I think Bill's absolutely right. It's not that [valuing Internet and technology-oriented] companies can't be done, it's just that you have to work with different models and think about things differently. Mike Mauboussin's influence is strong here, as well.
Buffett's not saying that it can't be done, but that he doesn't feel competent enough to do it at the level where he thinks he has a high win rate. I think he's being modest; he's got a Rolodex to kill for. He can look at a bank or an insurance company and say, "There are probably only five guys on the planet that can do it better than me, and I can be number one or two." Then he sees technology and he knows that there are many people that can do it better than he. In his rational mind, he doesn't want to play a game where he doesn't think he's going to be one of the best at it. So he says, "I'll pass."
That's how a rationalist behaves. They don't want to enter into games where they don't believe they're operating at the highest level. Why bother? It would be irrational to do that. I just wish Buffett would get up and get to it. It's not that he doesn't have the skills, he just hasn't gotten around to it. That's why we went to work with Bill [Legg Mason acquired Robert Hagstrom's fund advisory firm in June 1998]. Bill could fill in that piece, which is, "How do we take the Warren Buffett Way to the next level, how do we take this methodology and figure out technology and things like America Online?"Bill's the one that took the 2x4 and slammed me upside the head and said, "Would you please sell Disney and buy AOL?" To say that Bill's been instrumental in our performance and understanding is an understatement. Bill raises our intellectual benchmark. Just as we're looking for ways to raise our economic benchmark in the portfolio, we're looking for ways to raise our intellectual benchmark and he represents that.
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.
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.
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.
YC: People see Berkshire and Buffett interchangeably -- Buffett as Berkshire, Berkshire as Buffett. Do you think Berkshire can continue to be successful after Buffett is gone.
Hagstrom: Absolutely. I'll tell you two things that will happen. The day that Buffett does get hit by the proverbial bus, the stock price is going to go down big, and Bill Miller and I will be the biggest buyers of Berkshire Hathaway on that day. The one thing you recognize very quickly about Berkshire is its decentralized structure and that there are operating managers at every single level, including Ajit Jain in super-cat, Tony Nicely at GEICO, and Rich Santulli at Executive Jet -- all these guys are very good at managing businesses.
Warren does two things exceptionally well: He allocates capital and he sets executive compensation. My guess is that they've probably institutionalized the executive compensation. That part's probably figured out. The question is, who can allocate capital as well as Warren? Well, nobody can. But Lou Simpson is there and there are other people that can allocate capital at least above average. My sense is that Berkshire will surprise people on its upside after Warren's gone, because he's figured out how to make it keep going without him. But the market will massively misprice that stock and we'll be buying every damned share we can get our hands on, because that will probably be the one last fire sale on Berkshire Hathaway.
DW: That's a funny thing, the assumption that in running his business, Warren Buffett is an uber genius, but when it comes to planning his succession, all of a sudden he's a dummy. That's a poor assumption, I think.
Hagstrom: A very poor assumption. He's very passionate about the Buffett Foundation and he really wants to leave money and devote that to two principal causes. My sense is that he hasn't thought this all the way through just to see his net worth plummet by three-quarters just because he didn't figure out how to make this thing work. My guess is that the market misprices it, but it'll be just fine.
DW: If I could jump on NASCAR for a second, I just wanted to say that The NASCAR Way was my favorite book, because I knew nothing about NASCAR before reading it. It was the most eye-opening to something I didn't know. International Speedway (Nasdaq: ISCA) and Action Performance (Nasdaq: ACTN) are top ten five positions?
Hagstrom: It's gotten down now. They're both about 5% positions. The reason is pricing on them. International Speedway is up probably 50% for us and the stock's now almost heading to 50 times earnings and it's a little ahead of itself. We want to own this stock, but we haven't [added to it]. As funds have come in, it's started to drop back down [in its weighting]. We love the business… we think International Speedway is great and we want to own it ten years from now. I think the France family is wonderful. I understand the returns on the business very well. I think NASCAR has still got a lot more to grow. At this price, the probabilities of beating the market over the next two years are probably not as high.
DW: It has probably already earned its 1999.
Hagstrom: Right. I don't want to let loose of the stock and have to re-buy it again.
DW: Now, something happened earlier this year that justifies some of that move up from around $40.
Hagstrom: The TV rights deal. That number doesn't hit until 2002. I think the market's already heavily discounting that. France down at Talladega said that he thought the $300-$400 million number for TV rights was probably right. So if you take the $400 million high-end number, and discount it back, that may be in the price right now.
DW: Do you think there's a positive feedback loop there, where you've now got this national package and that sucks in more people?
Hagstrom: I think things that make that more lucrative is if Fox gets in the game and wants to get in heavily, then that number will go higher. It depends upon how aggressive NBC gets. You figure CBS and ABC are going to be there, because they had 80-90% of the package and NBC just had a little bit. If Fox gets into this game in a big way -- because they run out of stuff after football and need something to carry them in the spring -- if the advertising revenues that the salesmen can start charging for each 30-second spot start to go up much faster, that number can change.
The thing where it ran into a little bit of a problem, and it's just probably catching up, is that the salesmen at ESPN and CBS have a Rolodex of people who they want to sell ads to, and they kept calling the same people at GM, Budweiser, and the like. When they tried to call somebody else that wasn't a typical NASCAR advertiser, there was some resistance to advertising on the sport, even though the demographics were there and the ratings were there. So what David Hall at TNN and CBS was saying was, "Our salesmen are having trouble bringing in more revenue, even though we've got the ratings and demographics; it's still the typical beer, auto, oil Rolodex that drives the advertising dollars for these things and we've got to figure out how to get Avon and that."
DW: And now 3Com is advertising. The one big insight I got from The NASCAR Way -- and I thought the book had many good insights -- that made it worth many more times its cover price, is your discussion of the loyalty factor and how much more loyal NASCAR fans are to the sponsors. If you're selling ads and marketing, you know what that means.
Hagstrom: Sponsorship-based marketing is huge and it's one thing I learned by doing the research. From what I get from the advertisers in the consumer products area that spend on TV, newspapers, and magazines is that they're very frustrated. They don't know what the return is and they're not sure they're getting their money's worth. The one thing about sponsorship-based marketing is that they know they're getting their money's worth and it's a high return investment. They can see the translation very quickly into product sales, whether they do a regional test or other ways. They want to allocate more money to sponsorship-based marketing because it's effective.
The only thing I see disruptive to that is how well the Internet works for advertising. That's the ultimate -- getting the message to you at your PC, where it gets one-on-one with the consumer, which is the most effective an advertising message can get. It comes to me, specifically on the product and the kind of message that will stimulate me to make that purchase. But my sense is that will probably be a number of years.
Bill Miller says in ten years we're all going to have a DNA card that has our genetic make-up. Well, in ten years we're probably going to have a genetic advertising make-up, and the advertisers are going to know that. That's what makes the Internet exciting. It could be a competition for sponsorship. That's what makes newspapers, magazines, and TV scary, because this one-size-fits-all advertising model just isn't going to work. You go to Procter & Gamble and talk to those people, and they're dying for the Internet to win. Why? Look how much money they're spending and they don't know what they're getting for it. They've got one message out there on the TV or one message in the newspaper. Obviously, not everybody is effected by that message. Some are and some aren't. They don't know that. Sponsorship-based marketing is huge.
DW: Back to Berkshire, why doesn't every general equity fund own a big slug of Berkshire?
Hagstrom: It used to be that there wasn't a research report on it, so the analysts couldn't figure out if they should buy it or sell it. But now Alice Schroeder at PaineWebber has the detailed report, so that can't be the answer. The misperception is also there that you're just buying a mutual fund, and that's obviously wrong. There are some institutional reasons why people can't buy stocks without dividends, so that holds back a number of people. It's not in the S&P 500, so that holds back some people. There's a lot of money that tracks the S&P 500.
If they solve the S&P issue and we get a couple more analysts following Berkshire Hathaway and more information gets out about what Berkshire is, as opposed to what it isn't, it seems to me that stuff breaks down. And clearly an $80,000 share price doesn't help. It doesn't matter, but it intimidates those that want to put it in the portfolio. It's never been an institutional holding. I think the reason why the stock is still working out sideways is there's still a rotational shift out of GenRe. You talk to the specialist [at the NYSE], he still says there's some old GenRe guys still coming out of the stock.
DW: The last comment I had for you is that I want to put a vote in for your next book. I think it should be The Charlie Munger Way.
Hagstrom: Well, apparently Janet Lowe is doing a biography.
YC: With his help?
Hagstrom: Well, she apparently beat him down. He basically gave in and said, "You're going to do it anyway, I guess I'd better pipe in there." She's a good writer. I think the next book is, and this is very much off the record…
* * *
Just a note on the last question -- I believe it's impossible to figure out Warren Buffett and Berkshire Hathaway of today without knowing something about Charlie Munger. It would probably go too far to call Munger a Renaissance Man, but he's pretty much the modern equivalent. That's one of the reasons why Hagstrom's book goes into psychology and behavioral finance, probabilities analysis, and discussions of topics like complex adaptive systems or economic profit. Because the team of Warren Buffett and Charlie Munger have done so well in looking at the world from a multi-disciplined viewpoint, it would be pointless to analyze what they do from a fixed, doctrinaire standpoint. At some points, common modes in their approach and Hagstrom's approach are going to meet, and that's where you're going to hit on some elemental truths in what goes on with Berkshire Hathaway. You can see this to be the case where Hagstrom compares super-catastrophe insurance underwriting to focus investing, a conclusion with which Charlie Munger smilingly agreed.
There is no single answer to figuring out what makes Berkshire Hathaway, Warren Buffett, and Charlie Munger tick. There are objective facts that have to be identified and processed, but like a problem in geometry, there's more than one way to do a proof. The thinking process of Charlie Munger is imbued with the influences of many different disciplines and the conclusions he comes to are arrived at through using models from all these different disciplines. Those who want to understand Warren Buffett by clinging to a couple known and obvious influences in his life, such as Ben Graham, are going to miss the boat. Ben Graham was an enormously complex individual who was an accomplished scholar in a number of areas of life. It's probably no surprise that Buffett's Vice-Chairman and 40-year friend, Charlie Munger, exhibits these same characteristics. Rather than deviating from the known patois of Berkshire Hathaway discourse, I believe Robert Hagstrom actually introduces the reader to a style of thinking that is elemental to Berkshire. As Charlie Munger said at the annual meeting this year, The Warren Buffett Portfolio makes a real contribution. I agree wholeheartedly.
-- Dale Wettlaufer
I have nothing to add.
-- Yi-Hsin Chang (in Mungerian fashion)
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