10 Questions With Legg Mason Focus Trust's Robert Hagstrom

3. Given your interest in detectives, I find it interesting that you have three "black box" companies among the 18 holdings in Legg Mason Focus -- AOL Time Warner, Tyco and General Electric. In your book, you say solving a mystery is similar to determining is a stock is priced correctly. Let's apply some sleuthing techniques to AOL. How have you been able to determine the stock's value when its statements are so thorny, its tentacles are so wide, its revenue-recognition policies are under investigation by the SEC and its Internet operations are seen by many as an albatross?

In fairness, we got AOL Time Warner(AOL Quote) right in early 1998 and 1999, but we got it wrong in 2000. Obviously, we were wrong when we didn't sell in 2000. We assumed the growth and ad rates at AOL would be sustainable, we underestimated the economic slowdown. But we started buying again after the markets sent it down so much early this year. So, essentially, we were right, wrong and right again. (Laughs.)

What you have to do with AOL is separate the parts, try to determine their worth individually, then build up a sum of the parts again and see what you have. With these accounting questions, you almost have to put them off the ledger for a moment and determine each section is worth, and see if there's a value here despite the risk.

AOL is in the low teens [it closed Friday at $15.34]. If you do a sum-of-the-parts evaluation, any reasonable analysis shows that the market assumes Internet operations are going to zero, with zero subscribers. We just don't see this -- we don't expect a negative growth rate.

Based on our analysis, even with very below-average growth rates, we think AOL is trading at a 30% discount to its value.

4. Your No. 6 holding is a new one, Tyco -- investors would've benefited from Sherlock Holmes probing Kozlowski & Co. When did you take your stake in Tyco, and why do you like it?

We think Tyco(TYC Quote) is a significantly underpriced stock. We bought it right when [new CEO Edward] Breen showed up [in July].

With Tyco, you had two things to consider. First, you had to separate the accounting issues and put that in one box. In the second box, you had to look at the individual businesses and determine what their economic power was after removing the headline risks and Dennis Kozlowski. We assigned the worst operating margins and the worst growth rates for the businesses relative to their peer groups. It looked to us that Tyco's total earnings power was somewhere in the vicinity of $1.50 to $2 a share -- that's using conservative projections.

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Now, when the stock starts getting down to $14, $13, $12, $11, you have a stock at five, six, seven times earnings! That's a pretty comfortable margin of safety and you can use that to offset the risks of the accounting box.

Also, we didn't think the operating numbers were wrong -- we knew there would be charge-offs and the like. We thought liquidity would be fine after CIT got sold. The issues with Kozlowski were at the CEO level, not the operating level. Some people assumed, incorrectly, that if the CEO was corrupt, everything down to the last employee was corrupt. And that just did not happen.

We see this as a $22-$23 stock -- and that's being conservative, in our opinion. [Tyco closed Friday at $15.48.]

There's not a great deal of mispricing in the markets -- the market gets it right more than wrong. As an investor, you have to go where there is mispricing in the extreme. This is obviously a company where mispricing is extreme. When you have headline risks and earnings risks like you had at Tyco, this is where investors typically make bad decisions. So we were attracted to this stock from a psychological standpoint, because psychological pressure invites mispricing.