"WARREN BUFFETT… PATTED ME ON THE BUTT"

Robert Hagstrom may well be the Buffett head of Buffett heads. He founded a mutual fund based on Warren Buffett’s investment philosophies, owns three decades’ worth of Berkshire Hathaway Inc. annual reports, and next month will release his second book about the chairman of the legendary holding company.

Mr. Hagstrom’s fanaticism has paid off, too. His first book, “The Warren Buffett Way: Investment Strategies of the World’s Greatest Investor,” published in 1994, landed on the New York Times best-seller list. Some 600,000 copies sold in 12 languages.

And his fund, which had attracted just $11.5 million in the three years following its April 1995 inception, recently ballooned to $110 million, thanks largely to another legendary investor and Warren Buffet follower: Bill Miller.

Mr. Miller, of course, manages the Legg Mason Value Trust fund and has the distinction of having beaten Standard & Poor’s 500 stock index for the last eight years. He was key in persuading Legg Mason shareholders to acquire Mr. Hagstrom’s fund; doubtless they’re glad.

The newly renamed Legg Mason Focus Trust returned 41.5% in 1998, and its three-year average annual return is 28.9%. So far in 1999, it’s up 14%, making Mr. Hagstrom’s passion for Buffett-like investing seem very rational, indeed.

Q How would you categorize your fund? Is it under the growth umbrella?

A I don’t think we can be identified as value or growth. We have the luxury of going small-cap, mid-cap or large-cap. We own international as well as domestic. So we’re basically an unconstrained portfolio that’s seeking out the best businesses in the world, regardless of style, market cap or country domicile.

Q How do you go about finding the best businesses, then?

A We have to have some understanding of what the company is trying to achieve and some understanding of its economic model. We also have to feel they’re in a competitive position to win the game. Typically, we like some operating history, so we can see how a company has performed in different economic environments.

Q Berkshire Hathaway is a $30 billion portfolio of seven stocks. Is Focus Trust similarly concentrated?

A We’ve always owned between 10 and 15. Today, with 14, we believe we have the fewest stocks in any mutual fund over $100 million.

Q What’s your biggest holding? Uh, let me guess: Berkshire Hathaway?

A Yes. In fact last summer we boosted our investment in Berkshire Hathaway from 10% to 24.9%, which is as high as we can go according to the Securities and Exchange Commission law on non-diversified funds.

The stock, which was trading at $82,000 last year, popped when Berkshire purchased General Re, the largest U.S. reinsurer, for $16 billion. It fell to $70,000, then $65,000, and when the market corrected last year, it fell further to $56,000. So it basically corrected 30% in market value and, knowing the company as we do, we thought it was just an incredible buy.

We also have about 7% bets on the Federal Home Loan Mortgage Association (Freddie Mac), American Express Co. Inc., Citigroup and America Online Inc. Close to 60% of the portfolio is sunk in those five names.

Q America Online? Warren Buffett isn’t known for investing in technology. Explain yourself.

A The merger with Legg Mason created more than a distribution opportunity; it provided us the chance to raise our intellectual benchmark.

One of the quickest ways to do that is to work with someone who is talented in areas that you aren’t. Bill Miller allows me to understand how the Warren Buffett way applies to companies like America Online, Dell, Gateway and other companies that might have slipped through traditional value measures.

Q How do you gauge what is and isn’t a value?

A As Warren says, value is value. Whatever the value is is the value of the business — whether you’re liquidating the value of the company and have some sense of what the parts are worth, or you’re buying the future cash flows of a business.

Q How deep does this enchantment with Mr. Buffett really run?

A My first job was as a retail broker at Legg Mason, and on my first day of training class, we were asked to read a Berkshire annual report. I was floored. The guy is brilliant; he’s witty, and he teaches you how to think about investing.

He was immediately the guy I wanted to emulate, so I started collecting anything and everything about him. If he bought a stock, I’d buy the annual report to figure out what interested him about that particular company.

Q Have you ever sought guidance from the man himself?

A No. We have a professional relationship, and he’s a wonderful individual. When I was writing my first book, he patted me on the butt and said, “Go get ’em, boy.” But we don’t exchange business information.

Q The success of your book was a testament to Mr. Buffett’s popularity, but modeling your fund on his tenets didn’t help it much at the outset. Why?

A We had an 800 number and a best-seller. And like Kevin Costner in “Field of Dreams,” I kind of built it thinking everybody would show up. But we didn’t have salespeople, we didn’t have a marketing staff and we didn’t have a 12b-1 program. So, I struck a deal with Bill Miller to go with Legg Mason. They had 1,000 brokers and 100 offices throughout the mid-Atlantic and the Eastern Seaboard.

Q Does Mr. Miller have some say about what goes into and out of your fund?

A No. We work together through Legg Mason’s advisory group with three other fund managers. The five of us meet weekly and talk and travel together, so there’s a lot of cross-intellectual leverage between the groups.

Bill’s gift is to be somewhat Socratic in the way he leads the team. He asks questions, and the answers help you understand businesses in ways you might not have understood them before.

Q Have you sold anything this year based on those insights?

A We sold Johnson & Johnson and bought Gateway.

Johnson & Johnson is a great company and does generate high returns on equity. But if you looked at where the business was going, it was trading at 30 times earnings but growing at between 10% and 11% and return on equity was starting to trend downward.

Gateway, meanwhile, was growing between 30% and 35% yearly. Its p/e ratio at the time of purchase, in January, was more like 20. And its return on capital was heading to 50% and growing fast.

Q So, you’re a technology bull. Any other sectors?

A Consumer stocks will always do well. I own Avon, McDonald’s Corp. and Harley-Davidson.

McDonald’s and Avon are very much plays for incremental return on investment dollars overseas. As the companies move more than 50% of their businesses abroad, returns on foreign capital become twice and three times what they are in U.S. capital.

Harley Davidson is a company that knows how to rationally allocate its capital. It’s sold off both its side-panel truck and recreational vehicle divisions to direct money back into its most profitable division, motorcycles. We like that.

Q You like financial services, too. Why?

A I know everyone is sick of hearing about them, but I think financial services are becoming businesses of increasing returns.

As the businesses get bigger, they increasingly find themselves in positions with which it’s difficult for others to compete. And, because of their technology base, we can actually drive volume through them without necessarily increasing the amount of capital required to run them. The only capital expense of companies like Citigroup, American Express and Freddie Mac right now is maintaining their technology, and that may well be the case for the next decade.

Q Last question: Berkshire Hathaway returned just 2.5% last year, so how do you feel about beating the master?

A Performance should never be judged on one year alone. Warren has been compounding money at a rate of 23% since 1967. We still have some catching up to do.

Vitae

Robert Hagstrom, 42, portfolio manager, Legg Mason Inc., Baltimore.

Legg Mason Focus Trust: (assets, $62.7 million) year to date, 14%; 1998, 41.5%; 1997, 29.11%; 1996 (April 16, 1996 inception) 16.5%.

Standard & Poor’s 500 stock index: year to date, 5.8%; 1998, 28.6%; 1997, 33.4%, 1996, 22.9%.

Personal: BA and MA, Villanova University; author of “The Warren Buffett Way: Investment Strategies of the World’s Greatest Investor.”