Click on the company name to jump to Hagstrom's comments on the stock.
AOL Time Warner
"Put all your eggs in one basket and --
watch that basket."
That morsel is doubly apt for this week's 10 Questions. For starters, fund manager Robert Hagstrom puts that idiom to work every day at his undefined Legg Mason Focus Trust fund, which holds a mere 18 eggs, er, stocks. Second, the quote comes from Samuel Clemens' legal sleuth Pudd'n'head Wilson, and Hagstrom -- a prolific author in his down time -- has a hot-off-the-presses book, "The Detective and the Investor". The purpose of the book: Instructing investors how to apply the methods of great fictional detectives to make better stock-picking decisions. It couldn't be timelier: If Sherlock Holmes had been around to sniff into WorldCom, Tyco and Enron's books, perhaps Wall Street would have avoided those massacres.
Hagstrom has played stock-market sleuth for years -- at the helm of the focus fund since its April 1995 inception. While concentrated funds' returns often provide as many twists and turns as a Poe mystery -- Legg Mason Focus is no exception, having had a rough 2000 -- Hagstrom's performance handily beats his peers and the broader market over the long haul. His five-year average annual return of 4.33% places him in the top 6% of the large-cap blend category, according to Morningstar.
It seems fitting that among Hagstrom's 18 stocks are three companies with such labyrinthine structures that much of Wall Street has shied away:
AOL Time Warner
. But Hagstrom thinks he has cracked all three cases and in the following pages, he lays out the compelling evidence. He also weighs in on other subjects, including Microsoft, winners and losers in the telecom sector, stocks he has sold, interest rate cuts, deflation risks and, of course, his new books.
The interview, like most worthy yarns, is stuffed with juicy information and, like all good authors, Hagstrom ties it all together in the end. We think investors will find it a most enriching read.
1. You have carved out an unusual niche for yourself in the literary-business marketplace, taking a liberal arts approach to investing -- first in "Latticework" (renamed "Investing -- the Last Liberal Art" for the paperback), now in "The Detective and the Investor." Whenever I recommend these books, people say, "Sounds interesting, but I don't see how it applies to real-world investing." Would you explain how you want readers to apply the lessons of these books to investing?
My books on Warren Buffett
"The Warren Buffett Way," "The Essential Buffett" and "The Warren Buffett Portfolio" are highly practical books, with highly practical solutions -- how-tos on solving investment problems. The two "liberal arts" books -- "Latticework" and "The Detective and the Investor" -- aim to teach investors how to broaden the way they think about investing, with the hope of becoming a more intuitive, crafty investor.
Fund: Legg Mason Focus Trust, manager since April 1995 inception
Assets Under Management: $86.2 million
One-Year Return: -1.73% (Top 3% of category)
Five-Year Return: 4.33% (Top 6%)
Top Three Holdings:
Expenses: 1.9%, no-load
Legg Mason Focus Web site
Source: Morningstar, Legg Mason
These books take up Charlie Munger's challenge to think of mental models. This was a highly theoretical notion to me until I started working with Bill Miller
manager of Legg Mason Value fund, which has topped the
for 12 years running, who was a walking edifice of mental models. He was a philosophy major in graduate school, and now he eats and breathes multidiscipline investing -- using biology, philosophy, psychology and other disciplines to examine an investing problem. What I began to recognize was that there are intuitive insights one can gain if you invest with a multidiscipline approach.
People try to reduce investing to a few fast-and-true metrics. But the markets have gotten smarter, the participants have gotten smarter. We all know and use the same data that by and large is being used by the rest of the market as well. When you're trying to figure out if markets misprice securities, you have to get past the obvious. Applying other disciplines can help you get an advantage over the rest of the market.
Regarding "The Detective and the Investor," I found that detective books are gifts to investors. What we've learned the past decade is that we can teach people about investing principles -- we can tell people how to be a Buffett investor, and they basically get it. Where we seem to lose people is in their behavior.
"The Detective and the Investor" is meant to help investors align their behavior to be consistent with optimal results. In the past decade, very smart people have behaved badly. They have taken short cuts; they have jumped to conclusions. Oftentimes, they take the first set of evidence -- akin to the chief of police in those detective books who always collars the wrong person based on limited evidence, and then gets corrected by the detective who does more probing analysis.
2. In "The Detective and the Investor," you hold up three fictional detectives as exemplary sleuths that investors should emulate: Poe's C. Auguste Dupin, Conan's Sherlock Holmes, and Chesterton's Father Brown. Can you elaborate on the habits that investors should emulate from each of these three detectives?
The three great analytical detectives have some overlapping attributes, but I felt there was enough differentiation to make it worthwhile to study them individually.
Poe's Dupin -- the first detective in literary history, he first appeared in 1841 -- imparts two key lessons. First, he is a skeptic. His key attribute is a willingness to question conventional wisdom -- I can't think of a more important thing for investors to do. If you agree with the market and with conventional wisdom, you are never really going to generate market-beating returns. You have to have a sense of skepticism about what the market is saying.
The second attribute investors can pick up from Dupin is the ability to conduct your own thorough investigation. As Buffett says, holding does not replace thinking. You have to conduct a thorough, continuing investigation of your investments.
Sherlock Holmes, the first great scientific detective, introduces what I call a set of habits of mind that help the investor drill down into a more fine detail. Holmes offers four lessons for investors. First, he approaches every investigation with an objective and unemotional perspective, without prejudice. This is often the opposite with investors -- they usually come to a stock, or think about selling a stock, based on some positive or negative feeling. It's very difficult to approach investing scientifically and with emotional detachment, but Holmes teaches that is exactly what investors need to do.
The second thing Holmes teaches us is to pay attention to the tiniest details. The financial scandals of the past year or so illustrate how the problems that can sink a company are often contained in a little footnote in a lengthy 10Q or 10K. Those investors that did gained additional insights into those companies.
Our third investing lesson from Holmes is: When contrary information crops up, you have to have a willingness to go where the facts take you. Let the facts lead you. Again, that's very hard for investors to do. The fourth thing we learn from Holmes is to apply a process of logical reasoning to all you learn. Holmes was a great reasoning detective. If he were an investor today, he would be an expert at running models -- examining things like return on invested capitol, for instance, and processing this information as part of a bigger picture.
Father Brown is the hardest one to get your arms around because he works on intuition -- in contrast to Sherlock Holmes, who discounts intuition. But it's also important to realize that intuition has value. Intuition is a sophisticated form of cross-indexing, taking what you know from multiple disciplines to give you a better sense of a stock. People who don't take a multidiscipline approach rarely use intuition effectively.
Father Brown is also student of psychology -- he has a great understanding of human nature, which he uses in his decision-making process. He teaches investors to become students of psychology. Given the disastrous decisions investors have made the past few years, it's not a coincidence that a behavioral-finance expert won the Nobel this year.
Lastly from Brown, we learn to seek alternative explanations -- is there another way to look at this investment?
If you can find someone who fuses all of these detective traits, my guess is you have a pretty damn good investor.
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
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?
is a significantly underpriced stock. We bought it right when
new CEO Edward Breen showed up
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.
5. Let's talk about General Electric, your No. 7 holding, and what Father Brown might call "cultivating the understanding of intangible." Some intangibles include GE Capital's exposure to troubled industries, such as telecom and insurance. How comfortable are you with the company's ability to manage the intangibles?
after 9/11 -- it's kind of run back and forth a bit.
I'm not sure to what degree GE Finance's exposure risk is overstated. Everybody is exposed -- any financial-services company that has lending businesses has some risk in this environment. As pessimism rises in this market, people think there's voodoo behind the curtain, and I'm not so worried about that at GE.
Chief Executive Jeff Immelt is a pretty good guy -- his decision to make it more transparent is a starting step in helping to understand the company's worth. It's a starting step.
The greatest story with GE is the underlying notion that the larger companies over smaller companies have a greater opportunity to benefit from productivity gains. GE has numerous ways to benefit from gains in productivity. Big companies like GE are able to dictate terms with their suppliers, and we think the company is in a strong position going forward.
The stock's about 30%-40% off its 52-week high. What kind of upside do you see?
Probably about that much. I think GE is 30% undervalued here -- it's not a home run. Tyco is probably 50% or more, but GE also offers less risk and more predictability.
GE closed at $25.10 Friday.
Speaking of telecom exposure, Legg Mason Focus has an 18.7% sector weighting in telecom -- more solid names like Nextel, your No. 1 holding. What do you see for the battered sector going forward?
I don't even know if the negative aspects of the "telecom" label applies to companies like
-- three stocks we own.
To me, Nokia is the Dell of the industry. Nextel was an amazingly cheap stock at four or five bucks
it fell to $2.50 in July and closed at $13 Friday.
As a colleague of mine said, just because there has been a boom and bust in telecommunications doesn't mean we're going back to jungle drums and tin cans. That said, you have to pick and choose your opportunities. We don't own
-- there are highly problematic issues surrounding these companies. But the companies we do own, we feel pretty comfortable with.
6. Another big holding for you is Microsoft. What do you think about its decision to forego dividends and the legal challenges it faces?
I don't think I have anything intelligent to say about the legal landscape regarding
Microsoft is a pretty dominant business, obviously. Regarding the dividend issue: To me, their $30 billion cash hoard is an insurance hedge against competition. They can put together a portfolio of "call options" -- acquisitions, new business initiatives. Holding the cash is a way to ensure that if the landscape changes, they can put that cash to work to remain dominant and survive in that landscape. Microsoft is a company that wants to dominate your desktop at work and home --control all entertainment and household functions as well as office functions.
The stock has been a great performer. When you strip out the cash and their equity investments, Microsoft has had a 200% return on investment capital -- that is just astonishing.
The stock should be valued at $65 of $70, so the gap is narrowing. As it works back into the mid-$50s, it's probably only undervalued by about 15%.
The stock closed Friday at $55.10.
7. Two other new holdings in your fund are Liberty Media and USA Interactive. What do you like about these two companies?
Chairman John Malone and
Chairman and CEO Barry Diller are phenomenal managers. They are two of the most forward-looking and shareholder-friendly guys you want to be associated with.
I am also a very big believer that an area of high-returning assets are the Internet-content players. There are tremendous global opportunities here, triple-digit return on invested capital possibilities.
USA Interactive is a very good business. It's a bit complex, but Diller has done a great job positioning the company.
Malone's company, on the other hand, is probably one of the simplest businesses to examine. Based on our evaluations, Liberty Media's stock is 50% undervalued -- it's probably worth $15, it's now at about $9.
It closed Friday at $8.82.
How do you factor in a company's management into your valuation?
Management is a weighting or tipping-point issue for us after we determine the company's value. In a case like Tyco, even though we had new management, the margin of safety with that stock became huge.
In cases where you have extraordinary management -- shareholder-friendly, honest and smart leaders -- you are willing to accept a smaller margin of safety. A 25% discount to value is acceptable when you have great managers like Malone and Diller.
We always look for great managers, but oftentimes the market has found them as well.
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.
-- 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.
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 --
White Oak -- have had at least one pretty ugly year during the past five years relative to the S&P 500.
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.
10. What do you make of the current political/economic environment -- GOP control of Congress and the White House, another interest rate cut by the Fed, this one a half-percentage point -- and how much does this play into your investment strategy?
We are an offensive portfolio. We generally take the position that the future is going to be relatively bright. We think a GOP-controlled Washington is a little more positive for the markets in the long term, whether it will be new tax structure or more corporate-friendly initiatives. That's just my opinion -- it's a long-term positive.
The 50-basis-point rate cut is more short-term interesting. It confirms our theory that the Fed has to be very aggressive and overshoot if the risk of deflationary environment is present. This follows the book on how central-bank policy is used to fight deflation. It's pretty easy to stop inflation. But it's much more problematic to stop a deflationary spiral. Even if there's a 10%-20% chance, it's very difficult to stop once it gets going.
Are those the percentage odds you place on deflation?
We put the risk of a deflationary spiral at about 20%. Bridgewater Associates is at 40%. We've been running the fund under the assumption that there will be low nominal GDP growth ahead. Pricing is going to be more difficult going forward.
There really is no inflation in the system, so the Fed tried to buy some more insurance against a deflationary spiral -- they figure they can take measures to curtail inflation next year if it rears its head. I think the market is still trying to figure the 50-basis-point cut, too.
But I don't think it's as much as trying to stave off deflation risk. They appear more concerned about the unwillingness of companies to spend money -- for the first time, it cited geopolitical risks as a factor in the lack of spending.
One more question: What is the next book? Examining what Poe's Tell-Tale Heart teaches us about investor psychology?
I'm going to spend some time reading. (Laughs.)
The detective book took two years and it was written during a pretty exhausting two-year period -- what with Sept. 11 and the market downturn.
I'd like to expand further into areas that are not finance-centric -- maybe psychology or biology, get investors to think about things in different ways.
But first, I'll spend the holidays reading. Relax a little.
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