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Hagstrom: The One Tech Industry with the Highest Potential

Bridget B. Hughes, CFA

Bridget Hughes: Hi. I'm Bridget Hughes with Morningstar, and we are here today with Robert Hagstrom of Legg Mason Capital Management Growth Trust. Robert, thanks for joining us today.

Robert Hagstrom: Bridget, nice to see you.

Hughes: I've read your latest quarterly commentary, and in that you talk about positioning the fund in the high-quality growth stocks that you undertook about a year or so ago. Is that still how the portfolio is positioned?

Hagstrom: Yes. We made the investment in high-quality stocks at the end of '08. It actually worked out relatively well in '09, even though I think the high-quality growth stocks have not yet reset to what we think is fair value. So the fund, yes, is still very much a large-cap, high-quality growth portfolio.

Hughes: Let's talk about interest rates. Most people expect interest rates to increase. Now you talked about your portfolio in terms of duration. Can you explain?

Hagstrom: Well, it's a novel concept. Think about a bond manger. Think about a fixed-income manager. And they think about duration--how many short-term bonds versus long-term bonds.

And when interest rates rise, they all know that they need to shorten their maturity so they are not harmed by the rise in interest rates.

We've looked at the research on how this might affect stock portfolios. There is some good academic research here.

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And what is interesting is that when interest rates rise, typically, the sensitivity of the portfolio is much higher in high P/E stocks--what is typically growth stocks. You think about them as long duration assets.

So if you think that interest rates are going to rise, you want to start to shorten the duration of your portfolio. You want to move into higher free cash flow companies that act more like short-term bonds than long-term bonds.

We don't have a forecast about interest rates this year, but if interest rates were to start to rise, you would want to favor the short duration, high-free-cash flow stocks.

Hughes: And as a growth manager, though, you are always thinking about the secular growth trends that are out there. What is one of the trends that you are most excited about today?

Hagstrom: If you said to me the one area in technology that probably has the highest growth rate potential over the next many years, it is going to be in cloud computing.

It is a new concept where you can outsource your computer needs, whether it be software, e-mail, the servers that you use. All this now can be done by other companies, whether it is Amazon, believe it or not, Amazon.com.

A company that we own, Rackspace, is in this business. Microsoft is in the business. And IBM is coming in. Hewlett-Packard is going to come in.

There is going to be a day where there will be very few companies that will actually run their servers and softwares in-house. It will be much cheaper to outsource it to someone else, and it will be lower cost for you to do so.

That is a huge business, Bridget, that is going to last for many years, and it is global.

It is something that is not only going to happen here in the U.S. but across the globe, and it is going to last for many, many, many years. So this is going to be a very exciting secular growth story to come.

Hughes: OK. And how do you see that playing out already in Amazon?

Hagstrom: Well, the fastest ramp...It's interesting. We had a very bad recession last year; the worst recession since the Great Depression.

Cloud computing actually grew 28% year over year. Amazon had tremendous growth rates in their cloud computing division. Rack Space grew over 30%.

What we are seeing in cloud computing is that smaller businesses are adopting cloud computing first, and they are going to the smaller providers.

It is going to be a while before the Fortune 1000 companies do it, but it will come. They will get there. And then the Microsofts, and IBMs, and HPs will benefit as well.

Hughes: OK. Well, thank you so much Robert, and thank you for coming in.