Robert Hagstrom (03:52):
And so if we use that as a meta-theory temperament, what is temperament? And there’s so many individual parts to the temperament. So we began at the very first level when Warren was growing up with his dad, Howard Buffet, who was a remarkable human being, Republican Congressmen, a big force in Warren’s life, but it was actually Roger Lowenstein who had written a book called Buffett: The American Capitalist who linked Howard Buffett to the Emersonian philosophy of self-reliance and maybe argument that Warren himself had become so influenced by his dad’s philosophy of self-reliance. But that formed the initial building block of what a money mind here, which is to have confidence in your own decision-making and not having to rely on others for the decision to buy or sell things. The decision resides in yourself and having that self-reliance and that self-confidence is the cornerstone of a money mind.

Trey Lockerbie (04:48):
So you mentioned Emersonian, you’re talking about Ralph Waldo Emerson. Let’s dig into that a little bit on the critical thinking piece, self-reliance is somewhat self-explanatory, but when it comes to investing, are we talking about coming to different conclusions in other people based on the data available to everybody?

Robert Hagstrom (05:08):
I think there’s something to that, right? I think there’s something to that, but we’re always counseled by Warren’s advice that polling does not replace thinking you don’t want to be contrary. And just for the sake of being contrarian, sometimes he might be just right and sometimes it gets it wrong. And so self-reliance is really about coming to a conclusion based upon your own facts and reasoning that you believe the best course of action is, whatever it is. And you’re willing to make that bet make that investment. And the self-reliance part kicks in, obviously Trey, to your observation, when the market disagrees with you or other people disagree with you, prognosticators on television stations, say, do this, do that. And you’re doing something different. It is that self-reliance that, yes, you’ve got to figure it out yourself confident in your final decision making that you’re not swayed to do something differently just because the crowd is yelling at you to do something different.

Trey Lockerbie (06:04):
Yeah. I’m remembering this quote from Ben Graham, where he says “You are neither right nor wrong because the crowd agrees with you. You are right because your data and reasoning are right.”

Robert Hagstrom (06:14):
Very close to an Emersonian, thanks on that. And obviously, and further along in the book, Roger Lowenstein did a brilliant job with this is that the relationship between Warren and Ben Graham was nurtured in the beginning because Graham reminded him so much of his dad. So if you think about Graham’s attitude about investing, it was very Emersonian. It had that independence part to it. And he could relate to that because as an 11-year-old or a 10-year-old, as he grew up in the household with his dad, he was a GOP member. He was a Republican Congressman. Remember that what was called the old GOP right party, which was a libertarian-type stance, very Emersonian. So imagine of growing up for 10, 15 years in that household being creeks dad, or preached about the role of self-reliance and self-confidence, and then you go into Columbia University and here’s a guy that’s speaking to you in Emersonian language, the connection there was just immediate, that was forceful.

Trey Lockerbie (07:11):
Well, I’m glad you threw out the word reasoning because I want to talk about this point that Charlie Munger made back in 2010 at the Berkshire Shareholder Meeting, there was a question about what their theory is on life itself. And Charlie came out with this one-word answer, which was pragmatism. What is your revelation from pragmatism and reasoning and all these are rational approaches to investing?

Robert Hagstrom (07:37):
Well. There’s a lot, I remember it distinctly and funny. There’s so much written about Berkshire, Charlie, and Warren about rationality and how being rational in your decision-making process. And rationality is just understanding what works and what doesn’t work, and obviously do what works and avoid what doesn’t work. That’s the essence of rationality, but pragmatism is something that I think is very deeply woven throughout Warren and Charlie and Berkshire Hathaway, but it hasn’t gotten a lot of lip service other than that quote that you just read. But if you look at Berkshire Hathaway, you look at Warren Buffett, not only is rationality. So you start with self-reliance, you layer into the whole concept of rationality, which we know is so important, but pragmatism is what got him through what I call the evolutionary stages of value investing. So I think I have a quote in the book that says something “Rationality helps you become successful in investing, pragmatism is what helps you continue to be successful in investing.”

Robert Hagstrom (08:39):
And pragmatism as you know was the philosophy. William James was principle as you could go back to Charles Sanders Pierce before that, but James basically helped read the philosophy of how to achieve success by understanding cash value of ideas. And so instead of getting hung up on absolute, which is, I have a correspondence theory of truth, and I know exactly how the world works. If the world, in fact, changes and evolves, as we know it does, which we know markets do, then you want to be pragmatic in your viewpoint to always be open-minded to new ways in which to think about how to make money. And then as you well know, Trey, if you started with the Warren classic value investing with Ben Graham, then you go to Charlie Munger, buy a better business. The pragmatism was what moved him from classic value investing of hard book value, current earnings to stage two value investing, which was better businesses that generated cash and high returns on capital was the second level of value investing. And you could have only done that. Had you been pragmatic in your viewpoint about how to make money.

Trey Lockerbie (09:43):
Well, I’m glad you brought up the evolutionary stages of value investing because I think that this is very topical especially for me at the moment I was reading your book and it was just so funny because you lay out three stages to value investing. And I feel like I’ve been rounding the stage two and going to stage three in my own personal investing, but not really quite trying to put the pieces together about exactly what was happening, how my decision-making was leading me to certain conclusions. And you just laid it out so clearly in your book that you’re like, “Oh, here’s how it works in three stages.” And I’d love for you to layout the three stages for our audience and talk about how you came to those conclusions for yourself.

Robert Hagstrom (10:24):
Very quickly. It was Ben Graham was the essence of, and Ben Graham’s approach to value investing, which emphasized the here and now. I mean, it was about current book value, current earnings, current dividend yield. And he was so focused on making sure that you could value what was current and trying to buy that at a discount was the best way in which to ensure you couldn’t lose money because he had two episodes in his life. One when he was a young boy who lost his father, faced financial ruin then, his mother held the family together. And then later when he invested in 1929, he dodged that bullet but got back into the market in 1930, basically faced financial ruin for the second time. So the whole concept of security analysis and margin of safety focusing on the here and now is what’s called classic value investing stage one.

Robert Hagstrom (11:14):
And that’s what drove Warren for so many years. There’s no doubt about it. But when he then took control of Berkshire Hathaway in 1965, using that methodology to pick businesses for Berkshire Hathaway found out, although they might’ve been a good stock investment for a short period of time, they weren’t a good long-term business investment. And we go back and look at Dempster Mill and the retail stores and things like that. Even Berkshire Hathaway, the textile business, cheap businesses, cheap stocks, but not good long-term businesses that you want to buy and hold. And so the second stage moves you off the current assessment of book value, the current assessment of current earnings, and gets into the concept of what will be the future cash flows? Because you began to understand that when he was running Berkshire Hathaway, he needed cash. He needed to get to compound and conglomerate, which was the whole strategy of why he took it over.

Robert Hagstrom (12:06):
He needed cash from these businesses to buy more businesses. We call it the penny weighing machine concept and he needed cash from those businesses. So it pivoted, he had to pivot, I guess, how he thought about stock investing from how he began to understand how businesses were generating cash. He then applied those same lessons to stocks and ultimately allowed him to move to stage two. And the brilliant move of putting one-third of his net worth in Coca-Cola in 1988, which at the time looked at not to be a value investment. There was a high PE stock higher than the market, higher price to book below-average dividend yield. Everybody thought he had turned his back on this master Ben Graham, but the stock went up 10 times in 10 years when the S&P went up three times. So without a value proposition yet it was. So there’s a line that Warren always used. “I’m a better investor because I’m a business person and I’m a better business person because I’m an investor.” It was linking those two models together that allowed him to get to the stage two level of value investment.

Trey Lockerbie (13:06):
I love that example. And you just covered it a little bit with the Coca-Cola, obviously, See’s Candy with somewhat of a similar scenario that caused him to make that evolution. What about Apple? I mean, because is that stage three? Can you walk us through stage three and maybe what he’s seeing there?

Robert Hagstrom (13:22):
Apple, there’s no doubt it’s back up See’s basically helped him understand the value of paying off for something that generated a lot of cash, at the time he thought he overpaid for See’s Candy, and Charlie was nudging him along saying, “Look, we’re okay. It’s going to be fine. Not a capital-intensive business, a lot of cash.” And Warren was reluctant to make the investment ultimately did so. And it kind of go back and do the math. It may be one of the greatest investments that he ever made considering how little money he had to put back into See’s over the years and how much cash came out of it. It really is a phenomenal investment return for Berkshire Hathaway. So See’s gave him that tangible experience of paying up for something that generated a lot of cash with low capital investment need.

Robert Hagstrom (14:07):
There’s no doubt. And he said it in the annual reports and he said it publicly that See’s helped him understand and appreciate his investment in Coca-Cola. So then we get to Apple and Apple is more of a hybrid. It’s both a stage two and a stage three, but I’ll call it stage three. And we’ll talk about in a second, but he began to understand the consumer products business, if you will, and whether it’s Coca-Cola or this thing called a cell phone. And it was clear to him that this cell phone that Apple had, was extremely valuable. You talked about the ubiquity 80-year-olds use an Apple phone and seven-year-olds use Apple phones and nobody wants to give up their Apple phone. And if you go back and do the math on it, it really is a phenomenal business, a handset manufacturer that I think the time he was buying it, they had 13, 14, 15% market share, but were getting 85% of the profits.

Robert Hagstrom (14:56):
So people were willing to pay a premium price for their Apple phones and very rarely change the manufacturers. So he began to recognize that this really was quite a phenomenal investment. But what happened, I think, was the stage three level of value investing begins to embrace what’s called network economics, which is as you become a part of a technology environment if you will, or a technology ecosystem, whether it’s through software, enterprise software, whether it is through search, whether it is through entertainment or whether it’s through this telephone, you get connected to a network economics. And in this case, the iOS system that links your phone to your laptop, to your iPad, to, Apple Pay to Apple Health, everything is connected together. You get used to doing something it’s called a kind of a lock-in effect pathway. As you get used to doing something technologically in a very hesitant to want to learn, to do anything else.

Robert Hagstrom (15:53):
So it has a positive feedback loop, networks then get bigger, the bigger they get, the more valuable they get and you don’t want to change. And that lock-in feature is as good a mode feature as you could ever see. So I was fortunate to have management with Bill Miller for 14 years at like Mason and Bill phenomenal guy, one of the great investors of all time. And he was the very first value investor to actually apply valuation methodology to technology stocks. And this goes back to Dell computer in the ’90s, in AOL, and eventually Amazon and Google that we made investments in over the years. So I had the benefit of understanding the value of technology companies by managing money with Bill Miller. But then you could see Warren coming around to it in 2016. And it was a combination of buying a phenomenal consumer products company that was enveloped and this network economic, which is a moat life system with high margins, low capital intensity needs.

Robert Hagstrom (16:51):
And it’s just been a home run. I mean, imagine, he’s 86 years old, but $36 billion into a new investment and makes $100 billion. If that’s not pragmatism I don’t know what is, that’s the perfect, perfect image of someone who is pragmatic about how to think about investing, would be Warren buying Apple is 86 years old. Phenomenal.

Trey Lockerbie (17:13):
All right. So stage one, we’re focusing on the here and now, what can I buy this business for, for what it has today? Stage two, we’re projecting out the cashflow, discounting it back to today, and then stage three, wrap this up in a bow here. How do you define stage three exactly?

Robert Hagstrom (17:31):
Well, phase three is largely, there’s two things going on. Not so much changing economics. We’re still looking at cash. We’re still looking at return on capital. It’s just that these new business models, network economic models. And so if you think about whether it’s Facebook or Google or Amazon or Apple, or you go into the enterprise software business, Microsoft, whatever. You get, this kind of lock-in feature that people adopt these services and become very, very comfortable with it, with the positive feedback loop and the resistance to want to change that it really becomes a phenomenal business, but this is the misnomer. It’s not only do they capture the customer and as the network itself starts to get big, more and more people are attracted to that network, which gets bigger, the bigger it gets, the more attractive it becomes. And it’s an idea of network effect, that bigger it gets more valuable, the more valuable it gets, the more cash it generates, the higher returns on its invested capital if it doesn’t need a lot of capital to grow.

Robert Hagstrom (18:31):
So what becomes phenomenal about stage three is understanding they are significant moat businesses. How Warren talks about moats. “I want a business that can withstand competition, that continues to earn high returns on invested capita for a very, very long period of time.” Well, that’s what you’re looking at right now. Now the difference is this with Coca Cola, you could see the cash, Roberto Goizueta who was the CEO that turned around Coca Cola in the late ’80s, got rid of all the underperforming businesses at Coca Cola, reallocated that capital to syrup business, which is the best performing business at Coca Cola, highest returns on capital and with the excess cash began to buy back stock.

Robert Hagstrom (19:10):
So even though you were paying a higher multiple for that cash than you would have under a Ben Graham model, cash was right there. It was readily seen readily available. With the network economic businesses, the slippery part of it is the cash is not coming down to the bottom lot. It’s not going through the income statement to the EPS. Now today I would point out Google is trading at a market multiple on cash flow. And so by Facebook’s pretty cheaper on cash flow. The mystery stock has always been Amazon, right? Bill and I started buying Amazon, we bought it in ’98, we got it ’97 in the IPO, we doubled sold it. We bought it again in ’99, went through the technology crash and came out on the other side and it’s become one of the most valuable companies next to Apple in the world.

Robert Hagstrom (19:56):
And rarely reports any E, so PE is always 50 to 100 times earnings. But if you pull back the layers on the company and Jeff Bezos walks you through it perfectly, you can look at the online retailing, the PoD computing, AWS, you can look at the advertising business, they’ll walk you right down that’s function from here are the revenues, here are the operating expenses. And so you get to what’s called an operating cashflow statement, got operations, is cash flow after paying for all the expenses of operating the business and the cashflow on Amazon this past quarter, before reinvestment back into the company, was equal to Procter & Gamble. So the cash was there, but Jeff Whiteley makes the decision that he has this cash. “So what should I do with this cash? Should I drop it to the bottom line, pay a corporate tax on it, or perhaps should I pay it out in a dividend or should I put it back into the business?”

Robert Hagstrom (20:52):
Well, Amazon is earning a 100% return on invested capital. One of the highest return on invested capital in the history of capitalism. Dell computer was the very first one to ever do it. And its top line is growing at 20%. What would a rational person expect Jeff Bezos to do? If I have a business growing at 20% per year, earns 100% return on invested capital, that generates an operating free cash flow of 3%. I want you to put it right back into the business. And I want you to compound that over time. And that’s exactly what he’s been doing for the last 20, some odd years, instead of bringing it down to the bottom line. So you can actually see it, it’s there. It’s just that he reinvested before he gets to the bottom line on a GAAP-reported basis.

Trey Lockerbie (21:34):
Yeah. And it seems like there’s a new phenomenon. I guess what I’m trying to wrap my head around is it only internet companies that have this advantage or are there others like Apple, as you mentioned is consumer. And I do think humans are forced into this kind of recurring decision-making process where they don’t want to make new decisions. So they stick with the status quo. What you’re talking about sounds a lot like instead of the law of diminishing returns over time, there’s this law of incremental returns.

Robert Hagstrom (22:04):
Yeah. It’s increasing returns, economics, Brian Arthur, an economist kind of walks you through that. The switching cost is what prevents people from wanting to change product, whether it’s software or handset. Do I want to go learn a different phone, like an Android phone or a Samsung or something like that? No, I mean, I’m very happy with my Apple phone for me to go and do a new phone and change everything over software and learn different ways in which to do things is a real pain for me. And so I am mentally locked into wanting, just to keep doing this technology the same way. Now there’s also financial costs, switching costs, and it’s more prevalent in software. So if you had a Microsoft operating system all through your corporation and you wanted to change it for some reason, that’s a very expensive proposition to do it switching costs.

Robert Hagstrom (22:50):
In addition to you have to retrain everybody how to use it. So switching costs become part of the moat. Past dependent, I liked doing it this way. I don’t want to learn how to do it any other way as a moat-type business. Now, what becomes phenomenal about this and Warren talks about it in the annual meeting is that he and Charlie didn’t wrap their hands around how something could turn into hundreds of billions, if not trillions of dollars with so little capital involved. And that’s the essence of network economics, different than brick and mortar, which Ben Graham started with. So if you go back to Rockefeller and Carnegie and Mellon, for them to grow the business, they had to build more brick and mortar. They had to make the physical hard book value of the business, go up for it to get bigger.

Robert Hagstrom (23:32):
Then you go into stage two, which was media, newspapers, network, television, cable news. And then you get into the soda business, consumer durable. It was not as capital-intensive as the Rockefeller Carnegie brick and mortar world of manufacturing. So less capital-intensive, but then you get to the stage three level. It’s just phenomenal how little capital is required to build something that could be hundreds of billions of dollars in market cap generating billions of dollars in free cash flow each every year. It was just very hard to get your head around it. And so they were late. So, Warren says, “I was foolish not to a bought Amazon.” He actually owned the convertible bonds at one time, he met Jeff Bezos. I said it was brilliant. I mean, think about a guy that actually built the world’s largest online retailing business from scratch.

Robert Hagstrom (24:20):
And as Warren said, just to have done one global leader business it’s Herculean, well, he’s done three. He’s not only the world’s largest online retailer. He’s the world’s largest cloud computing with AWS. And now is the world’s largest advertising media business through advertising sales, through Amazon Prime, and others. So he’s done it three times, but at the same time, Warren was just really struggled to get his hands wrapped around it. Charlie was like, “Amazon didn’t bother me, Google it. We should have had Google.” And they tell the story about they own Geico. And they looked down on the expense line and they look at all these millions of dollars that get sent into Google and they go, “What are we spending all this money to Google for?” And someone explained to them, “When you do a search for insurance on internet and someone clicks on Geico, we have to send them a nickel every time they do it, or whatever the amount of money you get.”

Robert Hagstrom (25:08):
And they said, “Well, we keep spending a lot more money.” They go “Well because more and more people are using the internet to search for insurance.” And so, Charlie was really kind of like missed that he missed Google. And then at the end of the day, he said, “Well, maybe Apple is our tome, maybe, we didn’t get Amazon, we didn’t get Google, but we got Apple.” And that certainly has been a home run. I mean, think about it 36 billion to 136 billion. That’s 20% of the market value of the business. That’s a pretty good investment in four years. That’s pretty good.

Trey Lockerbie (25:38):
Not bad. And yeah, it’s just interesting to hear you lay this out in the book because I know for myself, I’ve been having a hard time wrapping my head around that stage three concept. I understand it in theory but actually applying the value methods that I’ve learned to something like that like an Apple or Amazon has been tough. And I think it’s tough for a lot of value investors. And I think it might be because a lot of value investors look at someone like Warren Buffet and they immediately associate him with Ben Graham, rightly so, but a lot of people forget that Buffet was actually a student of Phil Fisher as well. And I’d love to just hear you touch on how important that was, that element of Warren Buffett’s success.

Robert Hagstrom (26:22):
Yeah, I appreciate you bringing that up because the original Warren, by the way, in 1994, we did eliminate the influence of Phil Fisher. And I thought it was quite large. I think there’s an ancient quote. And it was late six days that I think Warren said “I’m 85% Ben Graham and 15% Phil Fisher,” if you would have fast-forwarded that to the 1980s, it might’ve been more 50/50 because Phil Fisher continues to play a very increasing role. And we talk about it in the book that when it became clear to Warren and managing Berkshire Hathaway, that Ben Graham didn’t have the roadmap for him to understanding how to add stocks or businesses to Berkshire Hathaway. It was at that time that Phil Fisher came out with Common Stocks and Uncommon Profits. And it was a book that Warren read had an influence on him.

Robert Hagstrom (27:09):
Warren went to see Phil Fisher meet with him and Phil Fisher began to talk about the attractiveness of great businesses and how you might think about owning these great businesses as opposed to cheap. What do you call cigar but stocks there’s a different way was to do it. So when he was leaving the Graham methodology, not the Graham temperament. So remember margin of safety is still a very big deal. I mean, those are the three right words, temperament how Graham came about temperament. But if you look at the two chapters that he thinks are the most valuable pieces of Ben Graham’s work is chapter eight and chapter 20 in intelligent investor. That’s the core essence of Ben Graham, but now we need some new methodology about how to think about stocks and businesses because they’re one and the same.

Robert Hagstrom (27:57):
And Phil Fisher writes this book. And I think it helped Warren begin to think about things. Now, the timing of it was brilliant because Charlie comes on the scene about the same time. They meet late ’50s, ’59, ’60 Charlie starts an investment partnership in ’62, they become friends. They have similar investments, they stay in contact. And so Phil Fisher was the Ben Graham teacher he needed at the time. At the same time, Charlie shows up as a friendly co-investor in similar stocks that then led to this beautiful marriage of Berkshire Hathaway. So Phil Fisher was a very big deal for Warren that came at the right time, in the right place.

Robert Hagstrom (28:37):
Now, what Phil Fisher didn’t provide Warren was how to value stock. There’s nothing about valuation in Phil Fisher’s work. And he then turned to John Burr Williams, that theory of investment value, and got to the dividend discount model that resonated with Warren because it was all about clipping coupons and discounting the coupons and how you think about that. So he now had the two pieces that he needed. He had the kind of Phil Fisher, Charlie Munger architecture about how to think about great companies and management and things of that nature. Now we had John Burr Williams on valuation. So he now could leave the Ben Graham stage one world that lead on margin of safety, not leaving behind temperament, but now he could move from stage one to stage two. He had everything that he needed to make that leap.

Trey Lockerbie (29:20):
And to make the leap to stage three as you highlighted, an investor needs to essentially shift their valuation methodology from GAAP accounting to the economic earnings of adjusted cash flow and return on capital. So adjusted cash flow and return on capital, that emphasis on that, as you mentioned with Jeff Bezos, and that’s why a lot of companies look expensive from a GAAP accounting perspective, but they might actually be cheap if you take what you call more of a business owner mindset. So provide some color around what you mean by a business owner mindset.

Robert Hagstrom (29:55):
Warren says GAAP earnings is where you start, not where you stop because he talks about how GAAP earnings doesn’t think smartly about capital reinvestment and how much capital reinvestment has to go on. So he introduced the concept of owner earnings and trying to get to what he said. It was a business person’s earnings like you’ve got your revenues, you got your expenses, you bring it back down to the bottom line, but you got to put money back into the company to keep it operating after that. And then so there’s not as much cash as some of these companies as GAAP might lead you to believe when you get to operating cashflow or owner earnings after capital reinvestment, you begin to understand that the beauty of your investment or the lack of beauty of your investment, what you keyed on Trey though, is I think something that I haven’t emphasized enough and maybe it hasn’t been emphasized enough by others is the changing valuation of changing returns on capital.

Robert Hagstrom (30:49):
All right. So we know if we aren’t above the cost of capital, we create value. If we aren’t below the cost of capital, we’re destroying shareholder value. All right? So that’s 101 about return on capital. What hasn’t been, I think discussed enough is what would you pay for something that earns 100% return on capital, versus 50% return on capital, versus 20% return on capital? If the cost is 10? So our cost of capital is 10. Let’s just leave that out as opportunity costs to be in the markets 10%, and I’m earning 20% versus an opportunity cost of 10. That would mean that I’m adding value to my portfolio. What would you pay for something that’s doing a 50% return on capital? What would you pay for something turning 100% return on capital? Then it’s about the sustainability, right? How long can I do it?

Robert Hagstrom (31:33):
Then add to that, not only the return on capital but what’s the sales growth? So if I’m earning really high returns on invested capital that through network economics and network effects, looks to be long-lasting, then put a sales growth number on that. I’m growing at 10% with a high return on invested capital. What would I pay for that? If I’m earning 20% on a high return on invested capital business, this going to last for a long period of time. What would I pay for that? If you actually start to do the math, the numbers are this mind-boggling, what you would pay for something that generates 100% return on capital. This is growing at 20% per year, that could last for five or 10 years. And if the numbers are just mind-blowing the guy that’s done to work on this, and I have such high regard and actually worked with him for a time at like Mason Capital Management, Michael Mauboussin.

Robert Hagstrom (32:20):
Michael Mauboussin has written several books. He’s extremely talented, thoughtful, professor, adjunct professors at Columbia University teaching security analysis. And he’s done the work on what multiple would you pay for different levels of return on capital and growth rates? And all I can tell you is you think that maybe 50 times or 70 times earnings for Amazon is expensive, without understanding the return on capital and without understanding the sales growth and without understanding the competitive advantage period of how long this will last 40 and 50 times earnings, it’s going to look extremely, extremely cheap five and 10 years from now, just by that compounding effect. haven’t done enough work to eliminate what returns on capital to me. So it’s not only Amazon, look at Google, look at Microsoft, look at Facebook, but then let’s go even further, start to look at this enterprise software business, which are kind of like Microsoft, right?

Robert Hagstrom (33:13):
Not heavy capital investment needs, not heavy capital reinvestment needs, cash generation, lock-in effect, growing global markets. The other things that people forget is that this is not a domestic business. I mean, we’re talking about a business that’s going to be reaching around the world 7.8 billion people on the planet earth and this reaches everywhere and can be done rapidly because it’s not capital-intensive, I don’t have to build a lot of brick and mortar in Asia to make this work. And I don’t think people fully appreciate how valuable this is. But if you drill down into Michael Mauboussin and you drill down to some others who think about return on capital, cash and sales growth and how that comes together, these things look very cheap to me.

Trey Lockerbie (33:57):
I want to talk about your background a little bit, as you just alluded to, you’ve obviously had a long career in active management, and you talk about this in your book that you say not all active management is bad, and there’s a huge debate obviously around this has been going on for a long time, about active versus passive. Talk to us about where you stand on the subject today.

Robert Hagstrom (34:18):
When we wrote The Warren Buffett Portfolio, after we wrote The Warren Buffett Way, when I wrote The Warren Buffett Way, I didn’t even talk about portfolio management. I think I said something like Warren holds stocks for a long period of time. He doesn’t own a lot of stocks on the whole, but that was the essence of portfolio management. All I was interested in was getting the methodology down about how he thought about stocks and it was clearly written in the reports. I just organized it in such a way that would help people understand what the major tenants were in the subtenants and how it lines up with the companies that Warren purchased. But the portfolio management part was really illuminating. And when we wrote the book in ’99. We began to look at focus investors, not only Warren Buffet, we looked at Charlie Munger, we looked at Louis Samson, we looked at Sequoyah Fund, we looked at John Maynard Keynes and began to look at these guys and go in, they’re concentrated low turnover and they’re generating some really strong returns.

Robert Hagstrom (35:05):
Problems that we saw was variance was high. Volatility was high. Drawdowns were high, periodic underperformance was kind of high relative to our broadly diversified portfolio. Well past that then, so we talked about focus investing. We thought that was the most optimal approach. And we did some very elementary things like took 3,000 stocks and you divide them up to different portfolio sizes of 250 stocks, 150 and 15, the 15 stock portfolios had a higher percentage win rate of beating the market than the 250 stocks. So you a working hypothesis here, but it was really Martijn Cremers and Petajisto who began to write about high active share investing. So they didn’t call it focus investing, they call it high active share. High active share is equivalent to how different your portfolio is from the market.

Robert Hagstrom (35:51):
If you have a portfolio that has nothing in common with the benchmark, your high active shares is 100%, because you have nothing in common. If you’re totally identical to the benchmark, your high active share is zero because you are the index. What Cremers and Petajisto discovered was that portfolios over a high active share, 80% or higher, actually it seemed to have a pretty damn good track record of beating the market, and companies’ portfolios with low active share that were closet indexers were not doing very well. And then there was another Professor Parrott at Rutgers that basically looked at turnover ratios and found out, well, if you control for turnover ratios, it is even more glaring, which is high active share and low turnover really gets a big return. And broadly diversified portfolios with high turnover rate, sort of just abysmal. It’s just horrible.

Robert Hagstrom (36:37):
So then you begin to say, okay, rationality would say, “I should own a high active share, low turnover portfolio. And I should have avoid broadly diversified high turnover ratio.” But then you look at the industry of portfolio management, 90 some odd percent of all portfolios are broadly diversified with turnover ratios. And you kind of look at the math. You go you can’t get there from here. And the number of high active share low turnover portfolios are very small. And actually have been going down since the late 1980s, which then begs the question what’s going on here. It’s so much complicated, but not too complicated. We write it in the chapter. It’s not that active management doesn’t work. It’s the strategies used by most active managers that doesn’t work is that there’s psychological reasons why people don’t like high active share, big bed portfolios because of price volatility of price variance.

Robert Hagstrom (37:24):
And we know about prospect theory and loss aversion, how people overweight losses relative to gains. But Warren divorced himself about thinking about price changes as being a gauge of whether I’m doing well or not. It was economic returns. And so if you could actually look at the economic returns of high active shareholder turnover portfolio, they can not be returned to a pretty stable. It’s just that the prices were going all over the place and Warren divorced himself from thinking about price change as being a reflection of progress. And everybody else thinks about price change as their performance indicators. So if the prices going up, I feel good at the prices are going down I feel bad. And so what portfolio management does at all costs just tries to reduce the possibility that things can go down in price.

Robert Hagstrom (38:05):
And that was the whole essence of modern portfolio theory. And we’ve walked through the book about how Harry Martin, with this about high active share portfolios, concentrated portfolios believed in broadly diversified portfolio, for some unexplainable reason we go into in the book, don’t know why, but he decided as a young kid in college looking for a master’s thesis decided “I think I’ll call risks, price variance no evidence but it is,” but he just said, “Let’s call risks, price variance.” Even though Ben Graham said, “It’s not price variance, it is capital loss.” And the whole essence of modern portfolio theory began as an exercise on how to reduce price volatility, price variance, and Sharpe got in there and did broadly diversified and CAPM and all that having to do with price volatility. And got into this world.

Robert Hagstrom (38:51):
And if you look at it, and I don’t mean to go along with Trey, the first 30 years of modern portfolio theory taught by Markowitz, Sharpe and Formal, no one cared, no one had any, didn’t even move the needle. It wasn’t until after the ’73, ’74 bear market, where we blew up all this money, pejoratively, that people said, “Listen, I want something other than blowing up money.” And these professors at universities stuck up their hand and said, “I’ve got something that will dampen price volatility, that will reduce drawdown. Would you like to invest in that?” And everybody said, “Yeah, that’s great. That’s what I want to invest in.”

Robert Hagstrom (39:25):
And we built this machine that became modern portfolio theory that became the standard approach to money management. That’s basically overtaken money management. So now money management is the standard approach of broadly diversified, low price variants, high turnover ratios with high expenses that can’t beat the market, but it makes you feel good, I guess, because there’s not a lot of volatility to it, but then you’re mad when you don’t beat the market. So everybody goes to index invest, along with an answer is there is a way to beat the market. It is academically proven the caveat being, if you’re going to run high active share, low turnover portfolios, you’d better be a good stock picker because you’re making very big bets on very few stocks and you better understand what you’re investing in. That’s the caveat.

Trey Lockerbie (40:08):
Got it. Yeah. And I remember talking about this a little bit with Joel Greenblatt, who started obviously with a very concentrated portfolio at first, if I’m understanding it correctly, what you’re saying is essentially, that it’s hard to run a concentrated portfolio because the volatility is there. There’s a lot of swings that can happen in a very concentrated portfolio, but sometimes the volatility is the price you pay for performance over time. And if you diversify and have high turnover, is it that these funds are just wanting to make it look like they’re doing their job again, if we’re going back to pragmatism, how has it lasted this long?

Robert Hagstrom (40:41):
I think one thing that we haven’t talked about and needs to be talking about is the compensation practices, the portfolio management or asset management firms. If they changed their compensation practices, not to reward short-term performance, and change it to long-term performance, it would be interesting how people would construct a portfolio. So for example, Todd and Ted, in fact for Hathaway get an annual salary of base salary, and it’s a good one, but their biggest money is made over a rolling three-year average relative to the S&P 500. So if 90% of my compensation was based upon how I could outperform the market over the next three to five years, I guarantee you people would be running high, active share portfolios, but because people are paid largely based upon assets under management. And if you had a lot of assets this year relative to whether you even beat the market you did in the market, you still get a big paycheck.

Robert Hagstrom (41:29):
Your primary motive is just not to lose money and you’re more likely to lose lots of money if you underperformed by a wide gap than if you modestly underperformed by a small gap, the amount of money that’s going to leave will be less. And so that’s a very big deal because most investors equate price with value. If the price is going up they think it’s more valuable, if the price is going down they think it’s less valuable. So if you’re concentrated, low turnover portfolio has a drawdown, which is going to have from time to time. They think it’s less valuable. They take money out. And if you’re compensated on assets, there goes your job. If we change that though, you begin to wonder if people would begin to behave differently. But we do have a section in the book because Charlie Munger asked the question.

Robert Hagstrom (42:14):
He says, “If what we do at Berkshire Hathaway,” and they talked about loose cents, then he talked about these other great Sequoyah Funding then. “What are we doing, if what we’re doing in money management is really that good and outperforming, why don’t more people imitate us, what’s going on here? It’s not taught at university, it’s not imitated by these large money management shops, what’s going on here?” And I think part of it is what I’ve said is that there is a seeding to a client’s wish to have a smooth ride versus a bouncy ride, which is what active share does.

Robert Hagstrom (42:44):
They’re trying to avoid big drawdowns, which we know from prospect theory makes people very nervous. But the other thing is that if you have built an investment management practice and let’s say all your schooling, your education, and your entire, asset management businesses, depended upon broadly diversified, low various portfolios. And you’re not doing very well. You’re not going to decide, you know what? Everything that I’ve told you was wrong. Everything that I discussed with how to make money doesn’t make any sense. You can see where the economics incentives might continue to perpetuate bad behavior versus taking the rational, optimal approach. Change your behavior.

Trey Lockerbie (43:23):
Yes. Charlie would say, “Show me an incentive and I’ll show you the result.”

Robert Hagstrom (43:27):
But at the same time, to this point, Cremers writes about this. He says, “You can change the incentives, but you still have to have people show up to do it.” And so you have to match the portfolio with a client who gets it, right? Who understands that “If I want to outperform the market, I have to do high active shareable turnover portfolios. And yes, I have to understand that my batting average might be 50%.” I mean, we looked at focus investors like Charlie and all that, their batting average was 40, 50%, 60%, the rest of the time they’re underperforming. So how do you feel about underperforming on a short-term basis? Well, Warren says “That is a matter. It is my look-through earnings, the economic progress of my business, that you should be focused on, not on the price, which is secondary. And you have to change the way in which people calculate their progress by economic returns versus price return.”

Trey Lockerbie (44:15):
I want to shift gears a little bit. I heard a funny quote recently that said something to the effect of, “If you think you learn a lot by reading a book, try writing one.” So I’m curious, you’ve written a few books now. I’m really curious to hear what you learned from writing this book for yourself that you didn’t already know maybe.

Robert Hagstrom (44:33):
It goes back to my mom, she always used to say, “If you write it down, you’ll remember it.” And I guarantee you, if you write a book, you really become quite proficient at what you’re writing. And so if you really want to be best in class, on a topic, or you want to become really quite proficient and thought well of, and how you’re explaining something by writing a book, it not only gives you credibility, but you actually become much better at it because you’re so immersed in it by writing, doing the research, doing the footnotes and the bibliographies and reading things that by the time you put down a book, or by the time you’ve written a book, you should have a very high level of being able to explain it. And so I do think that there’s something to that. And to this point that you write books, you also teach and to the degree that you teach, you become better at it too.

Robert Hagstrom (45:19):
And there’s a lot of work that’s been done about how teachers, the more they teach their subjects, the better there are at it. And it’s all intertwined. So everything that I’ve ever done has worked to getting me to be smarter about what I was curious about. Curious about how Warren thought about stocks. Well, I could have just kind of thought about it and passed on, or just read a couple of articles and passed on, or I could have actually written a book about it. And I got a lot smarter about it. I was the one to think about portfolio management. Well, let’s write a book. We get really smart about portfolio management. How does Charlie think about the Latticework of Mental Models in achieving worldly wisdom? We wrote a book called Investing: The Last Liberal Art, where we went through the actual disciplines of physics and biology and philosophy and psychology and social sciences and all down the road.

Robert Hagstrom (46:03):
And then you can tease out. So if you write it down, you’re going to get a lot smarter. Now I’m not saying that everybody needs to go out and write a book, but I’m telling you, if you do write a book, you’re going to get really quite good at what you’re trying to explain. So I think your question was great, what did I learn by writing this last book? Okay. Well, I said upfront, I was embarrassed and humbled that after writing about Warren Buffet for 25 years, I think I discounted what was equally the most important part of being successful in a Warren Buffet approach which was temperament, The Money Mind. And I write in the book that all I did was focused on methods. All I wanted to do is learn how to swing the bat like Warren Buffet. If you want to learn how to play golf, like Tiger Woods, you learn how to swing like Tiger Woods or whatever you do, you’re following the mechanics and the method.

Robert Hagstrom (46:46):
And I thought that’s all that was needed. But I did discover over time that people struggled with the Warren Bucket methodology. I’ve never met anybody who disagreed with it. I’ve never met anybody who said, that’s not smart. That’s smart. Do you want to invest like that? And those that did it, absolutely I’m going to invest like this. And a good many of them were successful, but some of them struggled. And some of them really were stressed about the volatility and the variants and the drawdowns and the underperformance. And the more that they stressed about it, the more I sharpen my pencil to tell them, this is a really good investment. This is really smart. You should actually own this and not sell it and we’re going to be okay. And I kept just pounding the method and the method and the method.

Robert Hagstrom (47:24):
What I realized was without having the temperament. And we talked about self-reliance and rationality and pragmatism, which all leads to stoicism. We didn’t talk about that. But Ben Graham was a grit stoic. And if you think about the really great investors, they have a stoic attitude towards markets. If you build that, that money mind architecture, that philosophical background, about how to think about markets independently. That is the reinforcement that you need. When you have a drawdown of the portfolio, or you have price variance, or you’re out of step with the market. Having that money mind architecture is a steel reinforcement, the backbone that you need in order to navigate through markets when they’re not shining on you. So if you’re 50/50 on a market on a monthly quarterly, annual basis of beating the market, underperforming the market, they can be psychologically kind of tough because if you think prospect area, you’re going to weight losses twice, as much as gains. If you’re losing half the time, psychologically, you already beat up about it.

Robert Hagstrom (48:24):
But I would say this, what makes high active share portfolios work is that it’s not a frequency argument. It’s not how many times you win less how many times you lose, it’s how much money you make when you win. That’s how much money you get back when you lose. And so it’s a frequency versus magnitude, but there was between batting average and slugging percentage. And people that get to understand that. And it’s psychologically reinforced themselves with that self-reliance rationality, pragmatism, stoicism, and that all intertwined. Then you’re in much better shape. And then I would say this, we write a section of the book about, we make reference to Rod Serling, Twilight Zone. You’re probably too young trying to watch Twilight saying growing up, but it’s the fifth dimension, an alternate dimension, no Warren basically… You think is all the celebrity of him being in the stock market.

Robert Hagstrom (49:12):
He really operates in an alternative universe. He really doesn’t think about the stock market that much. It doesn’t absorb him 24/7, even though he says he has CNBC on, he says, he turns the sound off and only looks at the headlines every once in a while, he’s operating in an investment zone. If you will, of stocks as businesses EPIs, the stock market did not exist. 99% of the people operate in a market zone, which is all they can see are the greens and the reds that are flashing on the screen and all the people that are pontificating about what you should do and what you shouldn’t do and why, things like that.

Robert Hagstrom (49:44):
Warren doesn’t even live in that world. He lives in an alternative world and more people live in the market zone, they live in the investment zone. And if you’re going to be very successful at the Warren Buffet way, methodology, the money mind aspects of it, you really find yourself being divorced from the market zone and you go live in the investment zone and it’s a much easier friendlier place to live in. In the investment zone than it is the markets zone, but you can’t get to the investment zone if you don’t have the money mind in my judgment.

Trey Lockerbie (50:12):
That’s a conclusion I’ve made for myself wherein, when I discovered Warren Buffet, I came the investing and I’ve stayed for the philosophy. That’s what I love about investing so much is it’s really philosophy at the end of the day and psychology and a number of other things as you highlighted. One thing, I’d love your opinion on, it sounds like when Warren Buffet talks about the money mind, it sounds like you either have it or you don’t. Right? Do you believe this? Do you think it’s teachable? Do you think if you read enough books, if you study stoicism, is it something that you will grasp ultimately? Or is it something that you’re inherently born with?

Robert Hagstrom (50:44):
I think both, I mean, clearly Warren, the DNA worked really well. Some people are really wired very well for this type of investing. Bill Miller was the kind of guy that’s just perfectly wired as Warren Buffet, as Charlie Munger, they talk about it. But at the same time, both Warren and Charlie talks about it is teachable. Rationality is something that can be learned. So I remember one of the first reviews of the Warren Buffet Way back then. And I won’t tell you the name of the reviewer, you’re going to a nice guy. He said, “Yeah, it was a good book, but really just because you want to play piano like Mozart, if you study Mozart, you’re not going to play the piano like Mozart.” Well, I always felt that that was kind of a stupid argument. I never said that if you read the Warren Buffet Way that you were going to achieve the same returns, play the piano the same way as Warren Buffet.

Robert Hagstrom (51:26):
I said, if you basically studied the message, you’re likely to improve your way in which to invest, right? So you may not actually be able to perfect it. You may not actually be able to achieve identical returns. But if you follow this outline, that’s a good chance that you may do better than what you’ve done in the past. And we took the same approach with The Money Mind. I said, look, reading this book. It’s not going to give you the same money mind as Warren Buffet. But if you were to study the aspects of a money mind and the architecture of the money mind and we’re able to embrace part of it and continue to use it as a learning tool over time, will you be psychologically, emotionally, and philosophically better at investing than had you not read the book and the answer’s yes.

Robert Hagstrom (52:09):
It should be yet. So it’s kind of like, yeah. I mean, there’s some people that just seem to fit the mold really, really well. And Warren is one of those guys, and then there’s the rest of us like me, that didn’t fit the mold well, but are trying, that are studying and trying to reach out and trying to figure this stuff out. And I do feel after having read this book, I have a much better sense of the philosophical, psychological, emotional aspects of investing that I did not have before I wrote the book. So it was 25 years after writing The Warren Buffet Way. I’m humbled to tell you I didn’t have it all figured out.

Trey Lockerbie (52:47):
Well, we’ve talked a lot about Warren Buffet. I want to just end by talking a little bit more about Robert Hagstrom. You mentioned earlier about Warren’s quote saying he’s 85% Graham, 15% Phil Fisher, maybe it’s 50/50 as the ’80s. After all of this research. And you’ve run your own successful fund and invested along Bill Miller and a few others. I’m going to pose the same question to you. How do you quantify your approach these days after? Is it 90% Buffet, is it 50%? Who else do you incorporate in your own practice?

Robert Hagstrom (53:18):
That’s a great question. God, how do you think about, I’ve never been asked that question. Someone said to me, “Robert, you wrote your dissertation on Buffet by writing The Warren Buffet Way. And you got your practicals by managing money with Bill Miller. If you can’t outperform the market, shame on you.” And that’s true, right? So you can’t dismiss Graham. You can’t dismiss Phil Fisher, but Warren is a huge part of my life, a huge part of my investment life, which was able for me to equate stocks as businesses. And it’s Carol Loomis said, we were back and forth with Carol Loomis, she edited the Berkshire Hathaway and reports and just a wonderful journalist who’s written for seven decades. It seems like. And she said, “It’s all reduced to stocks as businesses.” And I remember when I became immersed in Warren Buffet is that I was a liberal arts major, political science major and getting into the stock brokerage business in the 1984 always thought I made a terrible mistake.

Robert Hagstrom (54:11):
Didn’t understand finance, didn’t understand accounting, thought this was it. Was in a training program the night before our last day. And I had planned to resign the next day from my training program going this isn’t for me. I happen to read this annual report of Berkshire Hathaway, which I’d never heard of written by a guy named Warren Buffett, which I’d never heard of, and then read it in my hotel room that night. And it was the proverbial light goes on, it’s adaptation, you get it, that stocks are businesses. So yeah, it’s a Warren Buffet, absolutely it’s huge. Cannot underestimate how much Bill Miller has influenced me. So to be able to work alongside Bill Miller and understand not only evaluation for technology, go through Dell, go through Amazon, go through Google at the feet with Bill Miller and it’s going to make you much smarter, but he did so much more for me.

Robert Hagstrom (54:56):
I mean, he took me to the Santa Fe Institute and helped me understand complex adaptive systems and year after year of going out there and meeting all these great scientists, including Brian Arthur and Murray Gell-Mann and just tremendous. And then the academics that we’ve been able to interface with, like Michael Mauboussin. I guess it would be a troche of Warren and Bill huge. And then being able to, at the same time, a continuous learning attitude of surrounding yourself with the smartest academics that you can. That’s a pretty good definition. So I don’t think there’s a Robert Hagstrom in there. I think there’s three major inputs in my life and I’m an amalgamation of all those put together.

Trey Lockerbie (55:38):
I love that, a great answer. In the spirit of continuous learning. That sounds like the key to success ultimately is just continuously learning and taking on a wide range of subjects. And that’s what I’ve taken away from Buffet and Charlie. And from this book that you just recently read. So thank you for expanding my knowledge by writing it. And I’ve really enjoyed this conversation. I’d love to just give you an opportunity before I let you go to off to the books you’ve written, where they can find them. If people can find you online, any other endeavors you’re working on, feel free to share.

Robert Hagstrom (56:09):
Good books are all in the amazon.com and again Amazon selling 80% of the books in the world today. So the Warren Buffet Way’s now in the third edition, what I’m most proud about Warren Buffet Way is the international sales. It’s now an 18 foreign languages. We sell more books overseas than we do in the U.S. about Warren Buffett. That’s the celebrity of Warren Buffett. He is just worshiped overseas. Charlie’s just been a phenomenal influence. If you want to talk about waking up each day with a spirit of adventure and curiosity, to want to be able to study anything anywhere. And it doesn’t have to be finance and accounting, to pick up a history book, pick up a science book, to pick up anything, to see if you can distill something out of there that will make you smarter.

Robert Hagstrom (56:52):
Charlie gave me that when he did the Latticework of Mental Models and that is a blessing that he gave me that has enriched my life in so many ways and will enrich my life to my dying day. Because each day I wake up with, “Hey, let’s go figure out something new. Let’s go study something new.” So as Charlie says, “Reading is the answer to it.” I’ve been so blessed and so lucky to have had so many great influences. Warren says, “Pick your heroes, make sure you pick your heroes and pick the right heroes.” I’ve picked, Warren and Charlie and Bill Miller and some others. And my life is so much more enriched, so much better forward. So I always wish people continued success, but read, read, read, and don’t stop being curious about things. And remember, pragmatism is what makes you successful next year, not just this year.

Trey Lockerbie (57:40):
Well, Robert, this was such a pleasure and I know your time is so valuable. I really appreciate you taking the time to join us today and talk to us and educate our audience. I really cannot encourage people enough to go read this book. I highly enjoyed it. And personally having read a lot of Warren Buffet S books, this is one of my favorites, so really enjoyed it. And this conversation didn’t disappoint. So Robert, let’s do it again sometime soon. I appreciate it.

Robert Hagstrom (58:03):
I look forward it, Trey you were terrific. Great, great conversation. Thanks for the invitation. I look forward to seeing you again.

Trey Lockerbie (58:09):
All right, everybody. That’s all we had for you this week. If you’re loving the show, go ahead and follow us on your favorite podcast app. So you get these episodes automatically every week, and if you haven’t already done so go to theinvestorspodcast.com, check out all the tools we have there, or just simply Google TIP Finance. Go ahead and follow me on Twitter @treylockerbie and reach out with feedback would love to hear from you. And with that, we’ll see you again next time.

Outro (58:32):
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