Improving on The Warren Buffett Way


By Robert Barker Books for Warren Buffett wanna-bes make up a whole subcategory of the get-rich genre. No one is more prolific here than Robert Hagstrom, whose 1994 The Warren Buffett Way has done plenty to popularize the Sage of Omaha's investing principles. In 1999, he followed that with The Warren Buffett Portfolio, and this spring, he's bringing out The Essential Buffett: Investment Principles for the New Economy (Wiley, $27.95).

What separates Hagstrom from other Buffettologists is that he's also practicing the principles in real time, via his $173 million mutual fund, Legg Mason Focus (FOCTX). Over its nearly six years, however, the returns are hardly Buffettesque: Through Jan. 31, the fund returned 16.3% a year on average, vs. 17.8% for the average comparable fund and 20.5% for the Standard & Poor's 500-stock index, according to Morningstar. The fund suffered an especially damaging 2000, losing 22.5%.

As of Feb. 14, Hagstrom's fund is up 3.6% for 2001. To find out what's in the new book -- and the fund -- I reached Hagstrom by phone recently at his suburban Philadelphia office. Here are edited excerpts of our chat:

Q: Why do we need another Buffett book?

A: Good question. I think there were two primary reasons. One, there was a growing sense that there really needed to be one book that looked at both stock selection as well as portfolio management. When I wrote The Warren Buffett Way in '94, it was exclusively on how Warren Buffett picks stocks.

Q: And then?

A: We realized soon thereafter that there were two other very important issues that we didn't address very well in The Warren Buffett Way. We addressed them very well in The Warren Buffett Portfolio -- the issue of portfolio management, something that we called focused investing...and the second was...how do you deal with the emotional/psychological issues that come along with being a focused investor? [Focused investors concentrate on a few, carefully picked stocks, so they have to be able to stomach wild swings in their portfolios.]

Q: Why another book?

A: We got more and more people saying, gee, I wish you would've put [all of this] into one book.... And the second important reason...was to include a chapter in the end that showed how three other prominent investors are using Buffett's principles in areas in which Buffett doesn't.

Q: For example?

A: We have [Legg Mason Value Fund's (LMNVX)] Bill Miller, who uses the Buffett principles [with] technology [stocks].... We have [Longleaf Partners Fund's (LLPFX)] Mason Hawkins showing how he applies the Buffett principles to international stocks. And Wally Weitz, who runs Weitz Value Fund (WVALX)...applies the Buffett principles in the mid-cap area.

Q: Now, in your own fund, 1998 was a very good year, '99 pretty good, and last year, you went in opposite directions from Buffett's own fund-like company, Berkshire Hathaway (BRK.A), which was up 28.6% last year. What happened?

A: Well, first of all, we don't correlate at all to Berkshire. If you look at what we own, we do have Berkshire Hathaway in our portfolio.

Q: It's a big holding, isn't it?

A: It's about 8%. And we have American Express (AXP), which is about 7%. But that's it. The other 85% of the portfolio are things that Warren does not own. And the answer is that we made a conscious decision in 1998 to...apply the Buffett principles to technology.

Q: A bum bet in 2000. Which of your tech holdings really hurt?

A: Oh, gosh, about everything that was tech. There was nobody that didn't hurt us. Gateway (GTW) was probably the biggest.

Q: That was your No. 1 holding?

A: That was our No. 1 holding. It went down [75%].

Q: What's your feeling about it now that [founder] Ted Waitt has taken over again?

A: Oh, we love it. We like the company. We certainly like and admire Ted Waitt. It was just a macro change in the behavior of the consumers to basically just quit buying computers, which, when it became self-evident in [the fall], it was too late.

Q: What's Gateway's competitive advantage vs. other peddlers of PCs?

A: I think you have to look at Gateway...as a complement with Dell (DELL). Now they don't have efficiencies [that Dell enjoys] because of their Country stores. But they're moving into areas which Dell would like to be in, which is the beyond-the-box strategies: services, ISP business with [America Online], and things of that nature.

Q: So, you still own both and figure you've got PCs covered that way?

A: Yeah, that's how we look at it. We think that both are very attractive, and both are fighting for different shares of the market. And they have competitive advantages where they're much better than Compaq (CPQ) and IBM (IBM), which are not direct sellers.

Q: Now Mason Hawkins, whom you examine in your new book, and his colleagues down in Memphis at Longleaf Funds have taken a big position in AT&T (T), I gather. Some people might call that a tech stock. Are you in AT&T, too?

A: No. We actually owned WorldCom (WCOM), in the interests of full disclosure, and did very badly with it. And I don't think we did a very good job in telecommunications. I think telecommunications is a very, very difficult business and a very difficult industry. But I'll defer to Mason, and he obviously has some insight. He's a very good stock picker, and there may be something at these prices, which intrigues him.

Q: What have you added to the portfolio recently?

A: Applied Materials (AMAT).

Q: The semiconductor-equipment company?

A: Yes. We added it at the beginning of the year. Right around $50 a share. If you look at it, although it's a capital-goods company, which falls out of the brand-specific type things that Warren promotes, it's a company that controls 60% of its market, almost. Does 60%, 70% of its sales overseas. Gets 20% return on equity and 25% return on capital. Tremendous cash earnings. Once there is growth back in the economy, Applied Materials will probably double from here.

Q: What else are you buying?

A: J.P. Morgan Chase (JPM). We sold our American International Group (AIG) between $95 and $100, which appeared to be the smarter thing to do. We loved the company. It was just that [with] 30-some-odd times earnings, our valuation metrics were stretched. So, we sold AIG and bought J.P. Morgan Chase.

Q: Where did you buy that?

A: Oh, right around $50. We've [also] added FleetBoston Financial (FBF), right at these [recent] prices. We haven't made any money on them yet. And we started another small position in Philips Electronics (PHG).

Q: What's your expectation on Philips?

A: We think it's a 15%-type grower over the long term. And we think the stock is probably worth something like $65 to $70.

Q: You held America Online. Now that it has merged into AOL Time Warner (AOL), what do you make of the assertion that it's an incomparable company -- one of a kind?

A: Well, I think it's not untrue, when you look at how those pieces are put together. We very much like the merger between the companies [even though] there is execution risk in putting [them] together, as there would be with any two large companies.

The things they need to achieve to reach their stated goals are multiple in nature, and so any time that you have multiple things that have to occur with two large businesses that you're putting together, it increases execution risk. But when you look at the competitive nature of media and entertainment on a global scale, it's tough to find anybody that's in the same category.

Q: So, when CEO Jerry Levin says cash flow even after capital spending is going to double this year and then grow at a 50% compound annual rate over the next several years, that doesn't sound outlandish to you?

A: Well, we don't model it that way. That's not outlandish. That's a very aggressive target. We model it down at 15%, 20%, and 25% [growth], and are very happy with the valuation numbers we come up with after that.... There's a big cash savings of $1 billion-plus from putting these two businesses together, and that's helpful.

Q: The Essential Buffett discusses looking at a company's cash return. Why is that important?

A: What Buffett was trying to do is get you to focus on [the question], just what are the cash earnings of the business? As opposed to just the reported earnings per share, which was kind of an [accountants'] number. So, how much cash comes out of this company?

Capital-intensive businesses generally consume more cash than what's reported in the EPS. Companies that aren't capital-intensive, that have some pricing power that can generally raise sales without having to necessarily add on more equipment to do so, can generate more cash than what's reported in an EPS number.

Q: Because they don't have to keep plowing it back into the business?

A: Sure. The company that you want is obviously one that generates a lot of cash. Barker covers personal finance in his Barker Portfolio column for BusinessWeek. His barker.online column appears every Friday, only on BW Online.

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