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Robert Hagstrom and Kunal Kapoor

Legg Mason manager Robert Hagstrom uses the value propositions of Warren Buffett to buy growth stocks.

Morningstar Advisor, 11/03/2008

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It's been a tough stretch for the investment team at Legg Mason. While the headlines have been filled with banter relating to the falling fortunes of the legendary Bill Miller, his colleague Robert Hagstrom has not had an easy go of it, either. Hagstrom, who manages the Legg Mason Growth Trust LMGTX and has written books about Warren Buffett, runs a concentrated portfolio that's lately been hit hard because of its financials exposure.

We visited Hagstrom on Aug. 25 at Legg Mason in Baltimore to see how his investing philosophy has led him to some of the market's most unloved areas--especially as a growth manager. We also spoke with him about the portfolio's exposure to areas such as technology, which has also struggled lately. The interview has been edited for clarity and length.

Kunal Kapoor: You're well-known for having written several books, and when a lot of people hear who you've written about--Warren Buffett--they're surprised to know that you run a growth fund.

Robert Hagstrom: We wrote The Warren Buffett Way back in 1994 and started the mutual fund in 1995. I was a sole proprietor, running a very small shop. It became very clear to me that you needed a lot of support to run a mutual fund well. We didn't have a marketing department. We didn't have client service. We were a 1-800 number.

I was good friends with Bill Miller, and he threw me a lifeline in late 1998. He asked if I'd come and run a growth fund for Legg Mason. I have a great respect for Bill, who I think is a great value investor, but Bill was making such a wonderful reputation off of identifying mispricing, or value propositions, in the growth space. For me, it was not that difficult to make the segue from Warren Buffett Way-land into Legg Mason, because Bill had already moved Buffett into the growth space and had done very well.

I really wanted to take the ideas of The Warren Buffett Way and move it into a new menu of stocks. Clearly, you could buy Warren Buffett stocks--the American Expresses, the Cokes, and the Gillettes--and follow the bread crumbs along the way. There are many great investors who have followed the Buffett approach and have done extremely well buying pretty much the same stocks that he did. In the book, I had already argued that these principles should apply to any part of the market--whether it's small cap, large cap, slower growing, rapidly growing. For myself, I really wanted to move into new areas in which Warren was not active to see how well I could do.

KK: Did you make some mental adjustments to accomplish that?PAGEBREAK

RH: I had to make a lot of mental adjustments, because those that follow Warren know his conservative style. I like to say that Warren buys "certainties at discounts." He wants high predictability of cash flows. When you go into the growth space--into technology, Internet, wireless communications, and others--the cone of uncertainty is a little wider than it is for soda pop and razor blades. It's harder to estimate cash flows out five and 10 years as you move into the Internet space and the technology space.

I had to get comfortable with knowing that my cash-flow estimates were going to have a wider potential outcome. The way I thought about it was that even though the cone was somewhat wide compared to Coke or Gillette, the payoff--if I was right--would certainly more than compensate me for that risk.

KK: But do you ask for an even larger discount before you buy?

RH: Sure. As you know, Warren doesn't think about equity risk premiums. He discounts it at the long bond rate. He's probably adjusted that up, but if you even think about a 10% discount rate, the riskier that the cash flows become, the greater the discount that you want. If you have something with high predictability, you need less of a discount to make that judgment.

KK: What are your biggest challenges in running this type of strategy?

RH: The uncertainties of the cash flows. When we went into the Internet space in the beginning, it was very difficult. The other thing is that in technology the business models are rapidly evolving, competition is more intense, and the certainties are not there always, so you really have to do an analytical judgment that's very challenging.

KK: It sounds like you are saying that sometimes it's hard to imagine the way growth may evolve. What do you do that other growth managers don't?

RH: We take a longer-term approach. We're looking for secular growth as opposed to cyclical growth. We're trying to think about how something may look three and five years from now. Internet was quite easy in that aspect; I didn't have to worry about it being a 18-month cycle. If you thought about how the Internet was evolving, it was clear that all of the Amazons, the e-Bays, the Googles, and the Yahoos were going to have a tremendous wind to their back and that secular growth forces were going to be strong for a long period of time.

That's the first thing that I think about as a growth manager. I'm trying to look for those landscapes that are going to be friendly for us for years. If I've got that working for me, it allows us to take the bumps. There's a lot of bounciness in this space, but if I have a high degree of confidence that the tail wind behind us will keep pushing the industry and the companies forward, we can take those bumps a little easier.PAGEBREAK

KK: Although I imagine a big challenge is that shareholders in your funds have the opposite reaction that you're having. How do you manage that?

RH: The late Bill Ruane, who started the Sequoia Fund SEQUX, gave me a great bit of advice. He said, "Robert, make sure you get the shareholders that you want, because if you don't, you constantly have to replace them and it's exhausting."

We try to get the message out. We emphasize over and over that we're not concerned with short-term performance, no matter how much it is a driving force in how people make decisions. We talk about the fact that 95% of my net worth in the stock market is in this fund. I'm doing everything in this fund so that my family will benefit along with you. But as you know, Kunal, it resonates with some people and they get it. And others say, "Yeah, it makes sense," but then they have trouble with the volatility.

KK: A lot of the Legg Mason funds have underperformed recently, and you guys have lost some prominent accounts. How's morale at the firm?

RH: Morale, believe it or not, is high. Bill has built this organization for the past 25 years with a belief that valuation wins out. You go through periods where value may not matter, but ultimately, valuation wins out. If it doesn't, then we need to close up the Berkshire Hathaway annual reports and Ben Graham and put them away. But clearly, valuation and contrarian strategies have been miserable strategies to follow the past two to three years, whereas momentum strategies have worked.

KK: But some value managers have done fairly well during this time.

RH: Yes, and I congratulate them, because they did one or two things well that we didn't. We underestimated the severity of the credit contraction in the housing market. We believed the system would self-correct. So being overweight in financials certainly wasn't the right call. Second, we had no energy exposure. We knew at the time that commodities were moving, and we knew that there was probably a period of excess return in commodities relative to the market, but maybe we have too much Buffett DNA in our system. Commodities are tricky. They earn the excess return for a very short period of time. Then, supply and demand come into balance, and they earn below the cost of capital and they're miserable investments. This cycle turned into a "supercycle" and lasted much longer than we recognized.

We've been thinking about energy extremely hard. We recently had an "energy summit" here for three days and brought in a lot of experts--Daniel Yergin [Pulitzer Prize-winning author of The Prize: The Epic Quest for Oil, Money, and Power], a lot of guys from the Santa Fe Institute--to look at renewables and alternative energy sources, trying to get an idea about this supercycle that we've gone through. Does it moderate and come back down, or are we now in a new secular phase? Which energy will be an above-average performer, not just for two or three years but for 10?PAGEBREAK

KK: You guys have done a lot to beef up your analyst ranks. When you go through a market like this with a stay-the-course philosophy, how do you keep younger analysts focused on it?

RH: One of the things that we constantly are trying to get the analysts to understand is process outcome. I want to make sure that we're following the right process of how to think about valuation and not to focus on outcomes. Because outcomes vary from day to day, week to week, and so on, I think people who become outcome-focused are always trying to adapt their process to the outcome. They're chasing their tails. If we concentrate on process and tease out what mispricing is, what valuation is, I think we'll be fine. Just tell me what the business is worth. We do a lot of decision trades, which is basically capturing the cone. In the decision tree, you're assigning a probability to this outcome, to this outcome, and to this outcome, and to a zero note in case of financials. It really is how do you weight all these potential outcomes.

KK: That seems like a less precise way of doing things.

RH: Is it less precise than doing a P/E multiple? I'm trying to be, as Buffett says, "approximately right as opposed to precisely wrong." Are you attracted to precision models that can give you the decimal point that makes you comfortable? Yeah, I think people are attracted to that psychologically. Are you attracted to a model that has variant outcomes of different probabilities of which the weighted average outcome of those is the approximate value of something? That may be kind of loose for people to think about, but mathematically, it's exactly the way in which I think about it. If you go back through the Buffett literature and the methodology, Buffett exactly works with approximations of different outcomes and weights them and gets a weighted average. As he says, I'm just trying to figure out what it's approximately worth based upon these different scenarios and then buy them at a big discount.

KK: Do you or the analysts surface ideas?

RH: We're still primarily a portfolio-manager-driven system; the portfolio managers are coming up with most of the ideas and assigning them to the research department. All I want the analyst to do is tell me what the business is worth. Then I look at the model that they've put together to try to understand how they came to that conclusion. How are they weighting the outcomes? How do they think about margins? How are they thinking about sales and growth? We then discuss how they see the model versus how I see it, and we massage it to get the model to where I think it should be.

KK: Let's step back and talk about the market in general.PAGEBREAK

RH: People are so fond of the baseball metaphors. Is it the third inning or the sixth inning? I don't know.

KK: No sports metaphors here.

RH: Okay, no sports metaphors. Clearly, we're in a very difficult period. If you think about oil, credit, and housing being kind of gale-force winds that are pushing on the capital markets, it's very severe.

But what I've been trying to think about and get my hands around is that if you went back to 1990-91 and read all the popular press, what would you have been thinking then? It was a horrible time: 300 bank failures, a Middle East war, major financial institutions on the brink, and the Resolution Trust Corp. You had massive deleveraging in this system. People said banks will never earn a decent profit. It was a very pessimistic period of time.

Here's the optimist in me: We will get to the other side of this mess. If we don't think we will, then let's just go get gold, and we'll put it in the back yard and call it a day. But if you think we'll get to the other side of the crisis, the question, right here today, is how do you think about making money from this change that will ultimately happen?

The big challenge is that markets move before the bad news ends. In January 1991, the big-cap bank index took off. It was up 47% right there in 1991 and almost 100% within 18 months. The news was horrible in 1991. The news was even worse in 1992. Charge-offs and delinquencies and capital raises were still extended in 1992, but the market took off. As you well know, Kunal, being a student of markets, is that when you get a bull market recovery coming out of a bear market, it's the first few months that could be two thirds of the advance of the market. So we're really trying to position the portfolio today for our payoff 12 to 24 months from now. Is that the right call for this quarter, next quarter? I have no idea, but I do have a strong sense that we've got the portfolio right for the payoff in the next 12 to 24 months. Do we have it right? That question is all that I need to worry about.

KK: I have to ask you about Yahoo YHOO. You voted against Carl Icahn in his proxy fight against management. The result of that was the takeover bid by Microsoft MSFT. Discuss your view of Yahoo. Is it a growth company?

RH: I do think it's a growth company. The way in which I think about growth is that if you can grow at least 10% in sales, earnings, or cash flows over a three- to five-year forecast period then you qualify as a growth stock for me. Yahoo definitely can do that. Even at its most pessimistic scenarios, it's going to grow cash flow at a double-digit rate. The question is, is it going to grow 10%, 11%, or 12%, or is it going to grow at 18%, 20%, and 25%. If everything works well, it's a high teens, low-20% grower. If it doesn't work out well, I still think you can go up to 11%, 12%, and that's what the market's wrestling with right now.PAGEBREAK

Yahoo has been an incredible roller-coaster ride. It was the largest position in the portfolio at the end of last year, when nobody liked Yahoo. They were going to go through a big technology and content spend. I think the stock was at $21, $22. The stock dropped to $19 after the fourth quarter, and then Steve Ballmer made the bid and the stock went to the high $20s. It didn't quite cross the $31 bid. We sold a third of the position at that time because it went through 10% of the portfolio, which is where we typically back a stock down.

We thought $31 was an attractive price, but we didn't think it gave us full value for our shares. If it all worked out well and [Yahoo CEO] Jerry [Yang] nailed this thing and the search improved and he could stop losing position to Google GOOG, we thought the stock was a $40 stock. That's the reason why we bet it the way we did. But we also thought, even if it doesn't do well, margins would improve because they quit spending money and it really just becomes a cash-flow generator. We thought that was a $35, $36 number. At $31, we thought, "Yeah, that's interesting, but if you really want us to take the bird in hand now, then it's got to be $35, $36, and we'll give up the $40."

KK: I hear you on that, but why not take the bid at a time when the market's down and reinvest it into other ideas where the potential payoff was high?

RH: We did take a third of the position of the portfolio off, but we still thought even at $30--maybe we played the hand too long, but I thought that Microsoft needed Yahoo more than Yahoo needed Microsoft. If Microsoft had any chance of being a player in this space, particularly how I think desktop software is going to work years from now, they needed to go to an advertising-based model. The only way you can go to an advertising-based model is you better have a lot of eyeballs falling through there, and when you look at the Microsoft Internet space versus the Yahoo Internet space, it was like, this is a no-brainer.

If we consummate the deal, Microsoft would be No. 2 in global search with almost 30% global share, No. 1 in ad display, and No. 2 and No. 3 in video. I thought that this is just too good for them not to do it. And obviously, egos got involved. There's a lot of issues there and the deal ultimately came apart, but to this day, I still say that Microsoft needs Yahoo more than Yahoo needs Microsoft.

Now, I like the point you raised. We owned Amazon AMZN. Go back to 2006, and it'd gone through a two- to three-year period of big technology and content spending. Margins were down, everybody's kind of depressed about Amazon. Everybody's saying that the only reason why they can sell new products is that they keep cutting prices, blah, blah, blah. It's the No. 1 position in the portfolio at the end of 2006 as a $25 stock. In 2007, it's up 175%, and it was the reason why we beat the market last year. A big win for us.PAGEBREAK

I thought to myself, "Well, what would you have done if Amazon was $25 and Wal-Mart WMT offered to buy it at $42. Would you have taken it?" Had I taken it, I would have left a lot of money on the table. If you really thought about what Amazon was going to be able to accomplish on the other side of its technology and content spend, that was worth a lot more. If you had offered me 60% on Amazon at the end of 2006 and I had accepted it, that would have been the wrong decision to make. In many ways, we thought about Yahoo and Amazon as being similar. If a big technology and content spend works, it's going to be worth a lot more. If it doesn't work, it will still be worth more because the margins are going to get higher.

KK: Do you think Microsoft will come back for Yahoo?

RH: Yes. I can't imagine how Microsoft can get this done without Yahoo. Think about Microsoft's revenues and earnings that come from selling software. Let's just talk about desktop. The day Google gave that away for free I imagine Gates and Ballmer fainted in Seattle, because that's a lot of their business that you're giving away for free.

The writing is on the wall for a lot of software: It's going to be given away, if not for free then at much lower prices and subsidized by advertising dollars. If you believe that, then Microsoft has a lot more economic risk than Yahoo does. Remember, Yahoo has 400 million registered users. There's about 200 million people who go through that site every day. You don't think that has value to advertisers. They just have to do a better job of monetizing it, that's all.

KK: What are some other interesting positions in your portfolio?

RH: About 25% of the portfolio now is in engineering/construction, as it relates to electricity in the national grid system. Years ago, when we were doing a risk analysis on Google, we asked Google managers what they thought their biggest risk was. I hoped that they would say Yahoo, but they said electricity. That's odd, I thought at the time. It seemed to be working there fine. But they said the grid was very fragile and dependability was not high. If the electricity on their servers goes out, they have no revenues, so they moved their servers to high-dependable grid systems.

In 2006, I started doing a big read on the state of the national grid system and electricity. I found out that it's in dire need of both upgrade and repair. We've got to build new electric power facilities. Old ones that have been around for 50 years are coming offline. That really opened up my mind. Then, there is transmission and distribution. You make electricity, but you've got to distribute it with power poles and the lines and the connectors, and that's a big business. We've got about 9% of our portfolio just in transmission distribution.

KK: What are some stocks?PAGEBREAK

RH: Quanta Services PWR is the largest labor force that works for utility companies. General Cable BGC makes the copper line. Thomas & Betts TNB makes the connectors to which the lines connect. You can follow the value chain all the way down. And it's a secular business that's not going to have a lot of economic sensitivity. If you talk to the electric utilities, they say that it doesn't matter if we have a recession or not. We've got to improve the grid. We've got to make this investment. Capital is set aside to do it.

We had made a lot of money in alternatives last year in solar and others. Their prices had gotten high, and we sold, but I recognized that for every solar farm that goes up, for every wind farm that goes up, you still have to have a transmission and distribution system put in. Our companies will be the beneficiaries of solar farms and wind farms. What you will see over the next three to five years is that the demand for electricity is rising faster than the supply is able to give it. We have to address it. There's going to be more build-out of electric power transmission and distribution, and that's a big part of the portfolio.

KK: There doesn't seem to be a lot of exposure directly to the consumer in the portfolio.

RH: No, other than the fact that you might argue that the Internet stocks are consumer-discretionary because they're ad-supported businesses. Amazon certainly would be a consumer-related stock, but we're not overwhelmed with consumer-direct purchases.

KK: But you're not necessarily making a comment on consumer itself, are you?

RH: I'm somewhat agnostic on consumer. It has had a good run for 20 years, but there's some debt and leverage to work through. Consumer is important to the economy, undoubtedly, but I think people have a tendency to think about this in black and white. Either consumers are spending or they spend zero. It doesn't work like that. Either they're spending a lot or they're spending less, but there's always some consumer spending.

I think you also have to think globally. I know that the G7 economies are slowing down, but I'm not yet a believer that the emerging-market economies are going to go into recession. They were growing at 7% to 10%, so maybe they grow 4% to 6%, but they'll grow four or five times faster than we're growing in the G7. I think there's a lot of opportunity internationally.

KK: Who are a couple of guys who aren't named Warren and Bill whom you admire on the investing side?PAGEBREAK

RH: Chris Davis has done a great job at his shop. Another guy that I like is Tom Russo, who runs Gardner Russo & Gardner. You have to tip your hat to David Winters. I've known David for a number of years, and he's starting the Wintergreen Fund WGRNX and it looks like from a global perspective he has done very well.

KK: Do you study other investors?

RH: Oh, sure. In this business, if you're not looking at what the other smart people are doing, shame on you. I'm not so egotistical that I don't want to know what other smart people are doing, so absolutely. Part of our research intelligence is looking at the smartest people in the world and finding out what they're doing. What are they buying? What are they selling? Per chance they see something that we don't want to see. It's a very competitive landscape.

On the value side, there are obviously some high-quality guys that we're seeing. On the growth side--the problem is that it's very hard for me to find growth investors. There are some growth numbers out there that are staggeringly good, but when I look at the portfolio and the portfolio turnover rate is 100%, 200%, 400%--they're obviously doing something different than me and the processes are technically oriented, momentum-oriented. We have done less well relative to our growth peers because we're more valuation-centric.

Kunal Kapoor is president and chief investment officer of Morningstar Investment Services (http://www.mp.morningstar.com).

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