10 Questions With Legg Mason Focus Trust's Robert Hagstrom

8. In "The Detective and the Investor," you mention that a one-metric approach to selling a stock is short-sighted. You also discuss the perils of holding a stock for too long. Can you detail your sell discipline on the Focus fund, possibly providing an example of a recent decision to unload a holding?

When you analyze a stock -- examining all the parts, taking a multifactored approach to determining value -- you get a sense of what the stock is worth. However you go about it, you're reaching some assessment of what the approximate value is.

To the degree that the market closes that gap between the stock price and what that stock is worth, that becomes our sell strategy. So, if the gap goes to 50% to 30% to 10%, then you start selling.

Wal-Mart(WMT Quote), Home Depot(HD Quote), Minnesota Mining(MMM Quote), Merck(MRK Quote) -- these are stocks that we have sold recently because they have reached proper valuation levels.

Let me add, these are all fine companies -- I have no beef with any of them. They just aren't values any more.

Honeywell(HON Quote) [the No. 17 holding in Legg Mason Focus] looks like it's closing the gap. We lighten as the gap closes.

9. Your fund has turned in great performance since its inception, with the exception of 2000 -- when you were at the bottom 99% of your category. Did you learn any lessons from that year, or was the downturn a short-term anomaly in which you simply had to stick to your guns and charge ahead?

I think we learned three valuable lessons from 2000.

The first one is simply part of the nature of focused investing. The research on focused investing is pretty clear. It has the highest probability of generating excess returns -- to make a few highly concentrated bets is the best way to compound money. But it comes with the burden of higher standard deviation. But, of course, Buffett defines risk not by the stock's bounciness but by the underlying asset's performance.

So the first lesson is Focus funds have higher standard deviation. All in my peer group -- (MFOCX Quote)Marsico Focus, (symbol Quote)Longleaf Partners, (CFIMX Quote)Clipper Focus, (JAVLX Quote)Janus Twenty, (SEQUX Quote)Sequoia, (WOGSX Quote)White Oak -- have had at least one pretty ugly year during the past five years relative to the S&P 500.

Focus Up, Focus Down As the year-by-year returns indicate, Legg Mason Focus Trust's concentrated portfolio means a bumpier ride at times. But over the long haul, the ride has paid off: Hagstrom's management puts the fund's five-year performance in the top 5% of the large-cap blend category.
	1996	1997	1998	1999	2000	2001	2002*
Total return %	17.1	29.1	41.5	18.6	-22.5	-6.6	-9.6
+/- Category	-4.1	1.6	19.8	-1.1	-17.3	5.6	11.7
+/- Index	-5.8	-4.3	12.9	-2.5	-13.4	5.3	12.2
% Rank in Category	81	46	1	60	99	11	4
*Through October 2002. Source: Morningstar

The second lesson we learned was: We didn't move fast enough. As the market gets smarter, the magnitude of stock change is larger but the speed at which it corrects is getting faster. You're getting these huge shifts, which create opportunities, but the markets are closing those opportunities faster.

Essentially, we should've sold faster. Growing up in the Buffett world and in the 1980s and 1990s, the quick sells were the wrong sells. You wanted to buy and hold back then. In 2000, we realized we were wrong on the expectation side regarding some technology companies. We saw the problem coming and thought we could sell it down, but the market beat us to it.

The third lesson we learned is that the market is more efficient -- mispricings are going to occur on things like headline risk and earnings risk. Most valuations on companies are probably right. When things get mispriced, you have to act a little quicker.