Rebecca Hotsko (02:00):

Robert, it’s great to have you here. You were on the We Study Billionaires show back in July of 2021 with Trey, and I’m really excited to have you on our show today. Because I’m the new host of the show and we have some new listeners, I wanted to go back to the roots of where The Investor’s Podcast Network started, which was founded on studying Warren Buffett’s investment strategy. You’ve written multiple books on Warren Buffett, so I thought that you’d be the perfect guest to have on to just help remind us of the core investing principles that make great investors. So to kick off today’s conversation, I’m curious to know, after you’ve written multiple books on Warren Buffett over the years, what do you think makes Warren Buffett one of the greatest investors of all time?

Robert Hagstrom (02:47):

Well, I think it can be summarized very simply and it’s that Warren has a totally different orientation to the stock market than what I observed 99% of the people do. By that, I think too many people spend too much time trying to guess stock prices and what stock prices will do in the short term, and Warren doesn’t think about the market in that way. He thinks about stock prices as being businesses, and he’s more focused on what’s going on with the business, the economics of the business, and the stock prices is almost an afterthought. He just doesn’t spend a whole lot of time thinking about markets, stock prices, sectors, things like that. He just wants to be a business owner and isolate some really great businesses for his portfolio, and that’s where he spends the vast majority of his time is being a business investor, not a stock picker.

Rebecca Hotsko (03:34):

Would you say that you think that’s one of the biggest mistakes you see newer investors make when trying to even just replicate someone else’s strategy is that they do it with maybe a short-term mindset?

Robert Hagstrom (03:47):

Well, Rebecca, it’s absolutely correct that the mindset of investors has shortened, time is compressed, turnover ratios have gone up, holding periods … I was looking at a graph not too long ago. Holding periods in the 1960s for average investors was around seven years. That is they would buy and hold a stock on average for about seven years. Today, the holding period for average investors is four months. So it’s very clear that people are trading stock prices as the primary method in the market as opposed to being business owners who buy businesses and watch the stock price go up over time as a reflection of the growth of the intrinsic value of the business. 

(04:26):

So Warren is in the latter camp. He’s a business owner, and he spends no time thinking about short-term markets and short-term stock prices, but it seems, Rebecca, the vast majority of investors today spend the vast majority of their time thinking about what’s going on in the market, what’s going to happen this week, next week, this quarter, next quarter, and not spending enough time thinking about what business they own. I think that’s the mistakes that people make that makes it very difficult for them to generate decent returns in the market.

Rebecca Hotsko (04:56):

I want to touch on his forever mentality with stocks in a bit, but first, I want to talk a bit about Warren Buffett’s method to investing. Your first couple of books on Warren Buffett were largely focused on his method and his process. So I’m just wondering if you can share some of your biggest learnings from studying his process over the years. If you had to boil down the key characteristics of his method, what would they be?

Robert Hagstrom (05:21):

Well, the first two books, it’s amazing. It was almost over 25 years ago. So the very first book was The Warren Buffett Way, which came out in ’94. I had written it as a way in which to think about a process that I thought would work for our investors at the time. Basically, I started learning from Warren Buffett in 1984 when I got in the business as a stock broker, and his methods and his processes really did resonate with me because I was a liberal arts major. I wasn’t an accounting major, finance major. I basically fell into the investment business backwards and went through training and a lot of stuff wasn’t making a lot of sense to me, but when I read the Berkshire Hathaway annual reports, the lessons there seemed to really connect with me psychologically and emotionally.

(06:07):

What he was doing at the time was basically spending … If you read a Berkshire Hathaway annual report, which is just basically talking about the business, the people that run the business. Well, first of all, what is the business? What are the products and services that they sell? What were the economics of the business? How much cash came out? What was the return on equity, return on capital? He talked about the management and how they allocated the capital. So it was a narrative, if you will, of investing, Rebecca, that spoke to me in a way that looking at just balance sheets and income statements and numbers didn’t strike a chord with me. 

(06:40):

So when we wrote the book, we basically wrote the book with the idea of all of these principles. We ended up calling them tenets. All of the tenets that Warren Buffett had talked about over the years, we wanted to know if, in fact, those tenets in which he talked about in the annual reports, did they line up with the companies that he owned? So we went back and looked at the very first investments, the Washington Post, Cap cities. We went into Geico. We went into Coca-Cola, Disney, American Express, all of them, and looked at those companies and, lo and behold, found that they did line up perfectly well with the way that he was talking about it in the annual reports. 

(07:17):

So we divided them into four categories, Rebecca. We talked about business tenets, we talked about financial tenets, we talked about management tenets, and we talked about market tenets or, basically, how to value the business. So that became the template. Basically, that’s all the Warren Buffett way was was a template that allowed you to apply that to a universe of stocks that if you did apply that, it would reduce those stocks down into a workable number that likely had a great number of them that would give you an above average return over the long term.

(07:49):

So the first book was all about how to think about stocks as businesses and think about what were the major tenets that you would look for in a business, and if those tenets were there, then you were upon a good investment opportunity. What I didn’t talk about in the book, Rebecca, was portfolio management. I think at that young age when I wrote the book, I was just so concerned about getting everything right about the stocks that I think in the portfolio management section, which was a paragraph, I said, “Oh, he buys and holds stocks forever. He doesn’t do a lot of trading.” 

(08:19):

So the second book that I wrote on Warren Buffett was called The Warren Buffett Portfolio was the very first book on focused investing. That’s what Warren called it. When I talked to him about the book, and this was 1998, he said, “Robert, we’re just focus investors. We just focus on a few stocks.” 

(08:35):

I said, “Well, that’s a great term.” I said, “Do you mind if I use this for the book?” 

(08:38):

He said, “Well, there’s nothing proprietary about the term focus, so go right ahead.” 

(08:42):

So it was called The Warren Buffett Portfolio: The Focus Investing Strategy or The Focus Portfolio Strategy. Today, they call that high active share. The academicians call it high active share to the degree that your portfolio’s different and it’s weighting and it’s number of stocks to the underlying index. You stand a much higher likelihood about performing the market if, and this is an important caveat, if you’re a good stock picker. 

(09:04):

So if you’re a good stock picker, you don’t want to own that many stocks. You just want to concentrate on your best bets. Warren says, “if you’re a know nothing investor, you don’t know a lot about investing, then you want to have a broadly diversified portfolio you want to index.” 

(09:17):

So it really was two parts. It was how to think about the individual stocks, and then once we had the individual stocks, how do we think about them in portfolio management? So as a way to wrap this up, after I wrote The Warren Buffett Way, people would come on the television networks and the cable news programs and they said, “Oh, we like to buy businesses that are simple and understandable, that have good favorable long-term prospects,” and I went, “Ah, business tenets, check.” 

(09:43):

“We like companies that generate a lot of cash, earn high returns on capital, high profit margins.” 

(09:48):

“Oh, financial tenets, check. They got that part right.” 

(09:51):

“We want management that thinks independently, that’s rational about how they allocate capital.” 

(09:56):

“Check. They got the management part right.” 

(09:58):

Then lastly, “Oh, we always buy it below intrinsic value.” 

(10:00):

I said, “That’s exactly the Warren Buffett way. This is perfect.”

(10:03):

Then I would look at their portfolio and they’d have a hundred stocks in the portfolio, and the turnover ratios was 100% percent per year, and I said, “Well, you’re talking the talk of Warren Buffett, but you’re not walking the part of Warren Buffett.” 

(10:14):

So that is what led us to write the portfolio management book. So it really is two parts. It is thinking about stocks as businesses. Then if you’re a business owner, how would you think about a collection of businesses? If you had great businesses, you wouldn’t want to trade them all the time. If you had great businesses, you’d want to hang onto them because that’s growing your net worth over time. So those are the two parts of the Warren Buffett approach, a stock selection approach, and a portfolio management approach.

Rebecca Hotsko (10:40):

There’s lots I want to unpack there. The one thing that you mentioned about concentration versus diversification I think was really interesting because Warren Buffett took a lot of concentrated bets during his career. However, on the other hand, as investors, we’re often told to diversify, so I liked your explanation of who should diversify and who should take concentrated bets, but I’m just curious to know, do you think that the concentration was key to his outsized returns in the long run, and can we get these outsized returns without taking more concentration?

Robert Hagstrom (11:15):

Well, I think that’s an excellent question. I think you’ve got the boundaries around it quite right. So let’s go back. If you can actually analyze companies and you think about them as businesses, you understand the cash, you understand the return on capital, you understand the competitive advantage period, how long this will last, you can actually do cash flow analysis and do dividend discount models, which are all, by the time you’re a freshman in college, you’ve that stuff figured out. If you can do that, then really, it’s in your best interest to own fewer stocks, not more stocks because you’re basically concentrating your bets on those things that have the highest probability of generating high returns over time. 

(11:53):

If you don’t have that confidence or you don’t have that insight about businesses and how to think about valuation and stuff like that, as Warren says, you’re a know nothing investor, then you want to diversify. Warren said there’s nothing wrong with indexing. It actually outperforms the vast majority of active managers. So there’s nothing wrong with it. You’ve just got to align your portfolio with your skillset, and you said if do have the skills to think about stocks as businesses and do good analysis, owning fewer stocks and holding them longer term is better than owning lots of stocks and turning them over, but if you don’t know, if you’re not a good business analyst, you don’t have that confidence level, then you certainly want to broadly diversify. 

(12:32):

Now, having said that, Rebecca, I would tell you over my career of doing this, I would talk about the tenets that Warren would use in investing and I’d say, “Well, if we go through this and everything, do you want to invest in the Warren Buffett way? Do you want to invest in stocks as businesses?” I tell you to this day, I still have not met one person who I ask that question and they say, “No, I don’t want to do this.” No. They say, “Yeah, this makes perfect sense. I want to invest like Warren Buffett. I want to think about stocks as businesses and I want to run my money exactly the same way. Let’s get started.” 

(13:04):

The problem is about two months later, I get phone calls or have meetings and people are all disheveled because something else is going on in the market. Maybe what they own is not performing very well. Maybe oil stocks are going up or financials are doing this. Different parts of the market are always going up and down at different parts of the time. Somehow another, they are so seduced into what’s happening most recently thinking that’s what they should be doing that they end up wanting to sell everything that they just bought to go buy something that has just gone up in price.

(13:34):

So that’s where they get off the track, and that’s where they end up losing money is chasing things that have gone up in price and selling things that go down in price because they want to be right all the time, and that’s a slippery slope that people fall into a trap. 

(13:49):

So I could say to you, Rebecca, there are three parts. There’s buying stocks as businesses, there’s running portfolios, there’s concentrated low turnover portfolios, and then there’s a psychological part, a philosophical, emotional part of being disconnected from the stock market, that it’s not your boss. The stock market is not your boss. It’s just there for you to get quotes and you can either agree or disagree, but at which time you let the stock market become the boss of you, then the game is up. You’re going to end up losing money over time.

Rebecca Hotsko (14:20):

That brought up a question. Like you said, when we’re thinking of investing in terms of a business mentality, we want to be business owners, often we might go to what we know best, so a niche that we’re an expert in. Maybe it’s a field we’ve worked in. I can see an issue where then we could only invest in companies, in one industry or sector, and then perhaps our portfolio becomes too concentrated in terms of a sector or industry because that’s what we know. Maybe those are the businesses we best understand. Is there anything that you would recommend in terms of how to just stay in your niche but then also diversify?

Robert Hagstrom (14:59):

You brought up an extremely, extremely important part, which is let’s say that you’re in the finance business or let’s make it easy. Maybe you’re in the food business. So you know food stocks extremely well, and you understand food processing, you understand the marketing of it, and stuff like that. As an investor, you don’t want to put a hundred cent on the dollar in the food business. You want to be diversified, but how much diversification do you need? Well, you might put, I don’t know, 10, 15, 20 percent in food stocks. Then you might put 10 to 20 percent in maybe entertainment, media entertainment type stocks, and then another 10 to 20 percent in maybe finance or things like that. 

(15:35):

It would be important for you to, obviously, know, understand what you’re investing in, but let’s think about Warren Buffett. So in his most concentrated positions, I guess he had one-third of his portfolio in Coca-Cola. That’s pretty big bet. He had big positions in media. Cap Cities and Washington Post were probably another 20, 30 percent. He had some finance stocks, American Express and Geico. So when we looked at the portfolios in the late ’80s and early ’90s, he got up to about a dozen stocks, but they probably were in about four different sectors of the market. 

(16:07):

I think at one time Warren said you need no more than 20 stocks as a way to do it. So if you think about 20 stocks, put 5% into 20 stocks and you might have four or five sectors. That’s plenty of diversification, plenty of diversification, and that will give you more protection than if you owned one or two stocks and put 50% in each stock. So there is a happy medium between owning every sector and owning hundreds of stocks like an index fund does and owning one or two stocks, which would be highly risky. Owning 15 to 20 stocks in four different sectors, to me, if you’ve done the analysis and you’re confident in what you’re owning, that’s plenty of diversification in my mind for somebody, but your point is well-taken, which is don’t get down just to one industry and don’t get down just to one or two stocks. That’s taking too much risk.

Rebecca Hotsko (16:57):

So I want to go back to Warren Buffet’s investment method and his forever mentality with stocks. So Buffett has a quote, “If you aren’t willing to own a stock for 10 years, don’t even think about owning it for 10 minutes.” He is known to have a very long time horizon and stick to his conviction, and I’m sure that these stocks have fluctuated a lot during his time horizon. So can you just speak a bit about the importance of these two things and how you think it contributed to his success?

Robert Hagstrom (17:25):

Well, what he’s doing is these compounding money, and people, really, when they think about investing, don’t really think about the mathematics of compounding. That is, let’s say we own a stock, we bought it at a good value, it’s slightly undervalued or fair value, and it’s compounding. It’s return on capital, let’s just say 15%. Okay. 15% is okay. There’s stocks that do 20, 30, and 40, but a 15% return on investing capital doubles your money every five years, and that’s a 15% average annual return, just in very simple math. 

(17:54):

What he’s trying to do is generate those types of returns by owning a company for five years that can generate a return on capital at 15% because over time, the stock price will equate, as Ben Graham said, in the long run it’s a weighing machine. Stock prices end up calibrating to the economics of what you own. If Warren has Coca-Cola, he’s generating a 15 to 20 percent return on capital, and he owns it for five years, he’s doubled his money. If he owns it for 10 years, he’s tripled his money. That’s the way that he thinks about it. 

(18:22):

Most people don’t think about compounding their underlying value or their underlying intrinsic value. They think about the trading profits of what they’re doing and those trading profits, oftentimes the odds on them are no better than 50/50. So you’re winning half the time, you’re losing half the time. When you’re doing all that trading, not to even mention costs and taxes and things like that, at the end of the day, you’re not compounding money at a very high rate. So trading often, with its wins and its losses and its expenses, probably underperform something that’s compounding money at 15 to 20 percent per year or doubling every five years.

(18:58):

So Warren thinks about compounding his intrinsic value, his net worth over five years at a 15% rate, and that works out swimmingly well if you have the patience to let it work out because the compounding is a wonderful, wonderful wealth builder over time, but it’s not going to show itself in the first three months or six months after you bought it. You’re seeing things on the market go up and they’re going up 10% and 15% and 20 and you’re like, “I want to buy this, and then I got to sell this to buy that,” and you’re doing all this buying and selling and buying and selling, and by the time you end up tabulating your wins and losses at the end of the year, you find out had you just left it alone in a year or two, you would’ve made a lot more money than all this frenetic activity of buying and selling over the time. 

(19:40):

So once again, a different orientation. I can’t stress enough, Rebecca, that when he looks at the market, it’s a totally, totally different viewpoint, orientation, thought process than what most people do when they look at the stock market.

Rebecca Hotsko (19:54):

Another notable thing that made Warren Buffett successful is that he stuck to his conviction. He was very self-reliant even if the market was telling him he was wrong, but I guess on the flip side of that, there are going to be times when you are wrong about an investment, and I’m just wondering, how should investors think about navigating this dilemma of sticking to their conviction and I guess risk maybe holding on to a losing stock for too long instead of coming to terms with the fact that maybe they were wrong about this one?

Robert Hagstrom (20:27):

Yes. Self-confidence is critical for investment success because you have to have a sense of confidence that allows you to stay the course when the market may be heading in a different direction or it’s rewarding stocks that you don’t own and you feel left out and stuff like that. So self-confidence is huge. The Emersonian idea of self-confidence is a bellwether of how Warren has been successful over the years, but as they say, self-confidence or conviction or stubbornness can sometimes get you in trouble if and when you should be making different decisions, you should have sold something, but you held on it because you felt that you were smarter than everybody else, so you weren’t going to be flushed out of it.

(21:10):

Why did Warren make decisions to sell something when he was wrong? He was wrong in the airlines. He was wrong in IBM years ago. He makes mistakes and he moves on. The answer is facts. When the facts change, as John Maynard Keynes said, “When the facts change, I change. What do you do?” 

(21:27):

What you have to look at is the underlying facts. If your thesis on why you own something was because the sales and the revenues and the cash were going to go up over three to five years, and you look at your track record here of the economics of your business and it’s not doing that, the facts have changed. So then you have to make a decision, “Am I wrong? Is the market wrong or is the market right and I’m wrong?” You really have to be honest with yourself that if the facts are overwhelmingly evident that your thesis now is wrong, you have to sell and move on. 

(21:59):

We’re not going to be perfect. Warren Buffett is not perfect. None of the great investors that we study are 100% perfect. They make mistakes, but what they do is when they make a mistake, they admit it and they take the loss and they move on and they reallocate the capital again. So there’s a difference between being stubborn and being flexible in your thinking that when the facts change, you’ve got to change your portfolio. So there’s a fine line between the two.

Rebecca Hotsko (22:24):

That brings up another question for me. So we often talk about Buffet’s successes and we try and learn from those, but I think it’s also important to learn from mistakes. So can you talk a bit about some of his biggest mistakes and what we can learn from them? You touched it on there, but I’d love to dive a bit deeper.

Robert Hagstrom (22:46):

So with the airlines, airlines were tricky. When he bought them the first time around, they weren’t the kind of industry sector that they became in the years later. So there was a time where they basically began to sell seats on airlines below the cost of running the airline in order to generate cash flow to stay out of the doghouse, but if you do that over time, then you’re eventually going to go out of business anyway that when you sell something below the cost of production, you can only do that. It’ll get cash in the door, but it’s not going to last very long if it’s below your cost of production. 

(23:14):

So in the first years when he bought US Air many, many years ago, he thought this could be a really good business, but when management began to sell below the cost of production to generate cash flow to stay in business, that ended up being a very bad decision. When the math added itself up, he knew he was in trouble and he had to sell and move on. 

(23:31):

Then later, the business consolidated into the big four, so you think about United Airlines, American airlines, Delta, and Southwest. Then the industry became interesting and it was like the steel business had consolidated and you go back and study the steel business. Once it consolidates into three, four major players, it can have a tendency to be a very, very profitable business. 

(23:55):

Now, what then became interesting is that he was a very big investor in the airlines and prior to the pandemic, significant investing, and when the pandemic hit, he sold the stocks immediately, and that ended up being the wrong decision, but in hindsight, it actually was a thoughtful decision because at the time, Berkshire Hathaway being almost a half a trillion dollars and had a hundred billion dollars in cash, he felt that at the time that when the pandemic hit and the airlines were about to go bankrupt because nobody was getting on airplanes, the government would turn to him as an owner and say, “Okay. You keep these businesses afloat,” and didn’t want to be on the hook for 10, 20, 30, 40, 50 billion dollars to support these businesses that couldn’t operate during a global pandemic. 

(24:37):

So he sold those businesses. The government eventually then lent them money, which has been paid back over time, and those stocks actually went to higher prices than they did when he sold them. So it’s a tricky time when you go through these types of episodes and markets like we did with the global pandemic. I can’t say that he was wrong in making that decision, but it ended up being a decision that he made that cost him a lot of money, but I understand why he did that. 

(25:04):

He made mistakes on IBM. He bought IBM I think because he felt at the time not only was it generating a lot of cash, it was increasing the dividends. Each and every year, they had a good, solid business, where they were running software programs for the states and for local governments. These guys didn’t like to change their software providers, but he missed the evolution of the cloud computing and how that would undercut the business at IBM and, ultimately, he had to sell that business. 

(25:31):

So there are mistakes that are made. Some of them are ones that you didn’t see. Some of them are ones that you should have seen that you didn’t, but once again, let’s go back. When you make a mistake, admit it, move on. The problem is if you’re stubborn in it and you’re so overly confident in it and unwilling to be flexible in your thinking, that’s where you could end up losing lots and lots of more money. I’m not sure that was the best explanation you were looking for, but mistakes happen in investing. 

(25:57):

Better just to admit it and move on, but if you’ve done your work correctly and you have 10 stocks, maybe two don’t work out, eight do, and of those eight you do want to have the self-confidence while the facts are in your favor, they’re in your favor, the economics are producing what you thought they would produce, if the market’s not rewarding it immediately, no need to sell if the facts still substantiate while you own it. When the facts change, you got to go. If the facts don’t change, hang in there. That I think is the key.

Rebecca Hotsko (26:27):

I think that is what makes stock picking so hard is that you could buy a great company and things can still happen and you also have to be right on the timing. So that brings up a question that I have because when an investor is picking stocks using a value investing approach, you not only have to be right about the company, but also in the timing or the convergence of the current price to its intrinsic value. So how did Warren Buffett think about that convergence piece or the timing aspect of that? Because like you just talked about, you can invest in a great company, but things can happen and the timing can be off.

Robert Hagstrom (27:06):

Well, I’m going to push back on you, Rebecca, just a little bit. One of my favorite sayings from Warren Buffett is, “I don’t know time, I know price.” What he meant was that he knows when something is mispriced. He cannot predict with certainty when the market will correct that. Now, I would agree with you, Rebecca, that if you’ve got a mispriced security and your timing is really good, the payoff will come sooner, not later, but if you’ve got a mispriced security and it’s mispriced, and let’s say it’s undervalued by 50%, and you don’t know that if you’re going to get paid this month, next month, this quarter, next quarter, this year, next year, but you know you’ve got a double ahead of you, does it really matter that the market corrects it this month, next month, this quarter, next quarter, this year, next year? If you’re absolutely certain that things are mispriced like that, knowing that you could compound it 15%, the timing of it becomes less critical than the fact that you’re quite certain that something’s undervalue. 

(28:04):

So my example. Today, so I’m a growth investor. My argument was that I thought that Warren Buffett was a great growth investor. He just understood valuation because if you go back and look at the companies that he bought in the late ’80s and ’90s, they were all growth stocks. Things like Cap Cities, things like Coca-Cola was a high multiple stock. American Express was a high multiple stock. So I made the argument that I thought he was a great growth investor but understood valuation. 

(28:27):

If we look at the market today, the sector that is down the most today is the growth sector, and particularly in the technology. If you look at the NASDAQ, the NASDAQ’s down probably 25%. We had a little bump in the second half of June going into July, August, and now NASDAQ’s down 26% year to date. There are a lot of great quality growth stocks that are down in price today, and they went down in price because the market began to sell long duration assets. 

(28:55):

When interest rates go up and interest rates have been going up as the fed’s resolve now is to break the back of inflation, and in order to do that, they have to raise rates to slow the economy, to recalibrate supply and demand. So the market began to sell growth indiscriminately. It was just a one track decision. Interest rates go up, sell growth stocks. Growth stocks and long duration assets like long-term bonds, they’re worth less when interest rates go up. That’s correct. They’re worth less, but they’re not worthless, and the market has priced many high quality growth companies down 50%, 60%.

(29:29):

Without a doubt, there is no doubt in anyone’s mind that does fundamental analysis that the most mispriced part of the market right now is growth stocks. What they don’t know is when interest rates will stop going up and when interest rates stop going up, then growth stocks will do better. We saw that in the second half of June when it was thought that interest rates had peaked and just all of a sudden the best performing stocks over the six week period of time were growth stocks.

(29:53):

So we know growth stocks, generally speaking, in aggregate are the most mispriced part of the market. I simply don’t know when they’re going to start to go up, but I do know they’re the most mispriced. So having a portfolio of high quality growth stocks today that are easily down 50%, that could double over the next three to five years will outperform the market, no doubt in my mind. The market will not go up 15% per year for the next five years. It just doesn’t have the economic wherewithal to do that in GDP and earnings and things like that, but the mispricing in the growth market is so severe right now. There’s no doubt that is the market of the highest excess returns going forward. I just don’t know the timing, but I’m okay with that. 

(30:33):

I’ve been doing this for 22 years. I’ve had periods where I look like a hero and periods I look like a goat, and it has most to do with the short-term predilections of the market, not necessarily the economics of what I own. So that’s a long-winded answer for you, Rebecca, is that, yeah, if you get the timing right, good for you, but predicting the timing is almost impossible. It’s a coin flip. You’re just better off positioning your portfolio and things that are mispriced, things that are undervalued, and if you’ve got that part right, and can double money over five years, that’s going to be a good rate of return for you and a good sensible rate of return, and that will beat the S&P and probably beat the NASDAQ over the next several years. Going up 15% per year will be a hell of a rate of return, and there are many stocks out there that can do that right now.

Rebecca Hotsko (31:20):

So I think another piece of it, a Buffett advice that I think is extremely useful for beginner investors is, “Don’t follow the crowd.” I think this one is especially important in the modern age where we are constantly consuming information. We’re able to look up different people’s opinions on forums, YouTube, podcasts. I think sometimes it’s hard to block out the noise of the crowd and not let it impact your own analysis or assessment of a stock. So can you speak a bit on this point and why Buffett stress the best way to invest is to ignore the crowd and just focus on your own analysis?

Robert Hagstrom (31:56):

Yeah, that’s a wonderful question as well, and there are a lot of parts to this, Rebecca. You’re right. Once again, independent thinking, right? You don’t want to be beholding to the crowd that you’re only right when the crowd is with you and you’re wrong when the crowd is against you. As Warren Buffett once said, “Polling does not replace thinking.” Sometimes when the market goes up, you’re right to go with the market when the market’s going up. Sometimes the market gets it right and you go with it. There are other times it goes up and it shouldn’t be going up or it’s going down and it shouldn’t be going down and you want to take the other side of that, but it has nothing to do with the polling or, like you said, listening to YouTube or listening to the prognosticators, and jumping on a bandwagon because everybody tells you it’s time to sell or things like that.

(32:36):

You’ve got to make those decisions independently of what’s going on, but you shouldn’t just always fade what’s working. If it’s going down, there could be opportunity for you like there is now in growth stocks. So for me, and I think there’s a great bet to be made and things that people don’t want to own, so I’m willing to take the other side of the trade. At the same time, you could argue things that are going up the most right now, things like utilities, things like food stocks, things like energy are the most expensive part of the market. People are gravitating to that because it seems to be working right now when growth is not working. So I will fade that. I will fade that. I’m not putting money there. We’re not investing there. We don’t think the future rates of return very well. 

(33:19):

So let’s fast forward to 2023. Interest rates have probably peaked. Inflation has definitely rolled over. The fed is more probably inclined to cut rates than to raise rates. What’s going to do the best there? Well, obviously, the growth stocks. The growth stocks that are down 50%, that have the highest future rate of return are just waiting for that inflection point where interest rates aren’t going to keep going up. Inflation is broke. Once inflation peaks and starts to move down, interest rates will cap and start to move down, and then growth stocks will be the best performing sector. That’s pretty simple to figure out. 

(33:50):

When that happens, I am not going to sell growth stocks in the first few months of a growth stock rally. As long as they’re undervalued, as long as they’re still growing sales at high rates, earn high returns on invested capital and is still undervalued, I’m very happy to hang on to stocks for multiple years. I have a 25 stock portfolio. I have 14 stocks in my portfolio that I’ve held for eight years. We’ve changed the weights at different times, but 14 stocks in that portfolio over eight years tells you I’m not doing a lot of buying and selling. I’ll change the weights, but I’m not doing a lot of buying and selling. My average turnover ratio is 13%, which is close to an eight-year average holding period. 

(34:25):

So there’s times when you want to fade what the market is doing. There’s some times you want to go along with it when it’s going, but you don’t know whether you’re right or wrong unless you have the facts at hand. So polling doesn’t replace thinking. Contrarianism is an interesting way to think about investing because it can set you up for opportunities, but sometimes the market’s right, and when it’s going up, it should be going up, and when it’s going down, it should be going down, but you won’t know that if you don’t do your own independent thinking.

Rebecca Hotsko (34:52):

That was interesting to hear your take on that because I’ve heard a lot of investors and just people that I’ve watched recently say that utilities, energy stocks, those defensive plays are in right now, but then to your point, there’s a point where those are just over bought, and now they’re overpriced because everyone flooded into them. So I guess investors always just have to be thinking really critical about even if it was perhaps undervalued over the past 10 years, if everyone flooded into it, maybe it is overpriced now.

Robert Hagstrom (35:24):

Yeah. I’ll give you a quick story that may help people. So we were managing money during the pandemic, and being a growth manager, growth stocks did extremely well during 2020 because they were businesses that could continue to grow, many of them technology, internet-based, which we’re doing extremely well. So I think we were up 38% in 2020. It was a really great year for us. Towards the end of the year, it became very clear to me that the growth stocks were becoming fully priced. We weren’t selling growth stocks, but we weren’t aggressively pounding the table saying everybody should jump in and buy growth. 

(35:55):

Now, at the beginning, during March when the pandemic hit and the market fell out of bed, went down 40%, we definitely slammed the table and said, “Growth is the most mispriced. Get it.” Well, by the end of 2020, growth had repriced. What had gone down the most that year were dividend paying stocks, value stocks, dividend paying stocks, and they had gone down in priced because everybody was convinced that we had already had the worst recession since the great depression, and it was likely that if the pandemic didn’t resolve itself, which it ultimately did, that we could potentially have another great depression. 

(36:27):

So what did people do? They just sold everything that had to do with dividend stocks because they felt these companies had no choice but to cut dividends in order to stay alive. At the end of 2020, I banged the table and said, “Look, the most mispriced part of the market is not the growth market anymore. It is the dividend paying stocks.” You could not give a dividend paying stock away in 2020. You could look at these high quality value stocks. You could look at them. They had dividend yields, four, five, and six percent. They’d been around for decades and decades. They weren’t growth stocks, but they were good solid businesses. You could not give a dividend stock away. 

(37:01):

Two years later, what is the best performing category in the market? Value stocks. The S&P low vol, high dividend index is the best performing sector in the market today with positive returns. So dividends have worked out swimmingly well over the last two years, but to your point, now they’re the most expensive part of the market, just like growth stocks were at the end of 2020. 

(37:21):

So the thinking should be not that, “Oh, I should own these dividend value stocks of utilities and foods and energy because they don’t go down, and when the market goes down, they stay up,” and stuff like that. Well, that’s yesterday’s game. That game’s over. They should be looking at themselves and saying, “What is the most mispriced part of the market?” I’m here to tell you the high quality growth market is the most mispriced part of the market. Nobody wants it. You could not give a gross stock away. Try to give Google away today, Amazon, any of these stock. Nobody wants to own these stocks, but they’re, without a doubt, the most mispriced part of the market. 

(37:54):

So do I know when it’s going to happen? No, but I know two years from now these growth stocks are going to substantially outperform the value side of the market. We’re very happy to own those stocks knowing that we’ll get paid over the next couple years. I just don’t know if we’ll get paid in the fourth quarter or some time next year, but we’re going to get paid and we’ll do very well with it.

Rebecca Hotsko (38:12):

So when you talk about the growth stocks, are you mostly referring to large cap like tech stocks that you think are the most drastically undervalued right now?

Robert Hagstrom (38:24):

Yeah. Aswath Damodaran, he’s a finance professor at NYU and considered to be the leading dean academic on valuation. He had an interesting interview the other day. He said, “Old tech is probably the most mispriced part of the market,” and I thought to myself, “Well, what is he talking about? Is he talking about Intel or IBM or Cisco?” In my mind, they are the old tech, but he was referring to old tech today as being Apple and Amazon and Google, and many of those stocks, and the new growth, the new growth or the new technology would be the Ubers and the Airbnbs, and things like that. 

(39:02):

So he said, “The new tech is not necessarily mispriced, but the old tech is mispriced,” and he was referring to the Googles and the Amazons and the Apples and things like that. As a matter of fact he said, “I’d rather own Apple than Coca-Cola today.” So Coca-Cola’s gone up with a dividend stock. It’s been a safe stock to own over the last couple years. He said, “I’d rather own Apple than Google,” but he was also pointing out, which is true, that Apple’s probably the single greatest cash-generating business in the history of capitalism. I think in the last 10 years it’s bought back over 500 billion dollars worth of stock, which if you add that up, that’s more stock than 494 companies in the S&P 500. So it’s a wonderful, wonderful business. 

(39:39):

As you know, Warren started buying it in 2016. We started buying it in 2014, we got to jump on it, but it’s a wonderful company. Today, it is the most mispriced part of the market, not Coca-Cola, but everybody wants to own Coca-Cola. Why? Because Coca-Cola doesn’t go down, and they don’t want to own Apple. Why? Because Apple is down with Google and Amazon and everybody else, that part of the tech market, which is quality.

(40:01):

Apple’s been around for 20 some odd years. Amazon came to the market in ’98. Google came to the market in 2002. These companies are two decades old now. They have hundreds of billions of dollars in cash on their balance sheets. They’ve got dominant positions in their industry. Their gross sale is at a double digit rate, and nobody wants them. Why? Because they go down when interest rates go up, but the old tech, which is the Amazons, Googles, Apples, that group, I would put ServiceNow in there, Salesforce, guys like that are the mispriced part of the market. 

(40:30):

The new tech, which are the companies that came out during 2020 and during the pandemic, some of that stuff probably still could correct a little bit. Now, Uber will still be here 20 years from now. Airbnb will be here 20 years from now, but they’re not as mispriced as the old tech guys are like the Googles. So it’s an interesting way in which to think about it.

Rebecca Hotsko (40:51):

So recently we’ve had on a few guests talk about why paying attention to macroeconomic data matters for investing in your investment process, but Buffett took an opposite stance to this. He didn’t ignore it completely, but can you talk a bit about why Buffett didn’t really like to include a lot of macroeconomic data in his investment analysis?

Robert Hagstrom (41:13):

Well, you’ve got it quite right. I think the saying that we have here is that we’re macro aware but macro agnostic. So I want to understand what’s going on in the economy. I want to understand what’s going on with inflation as it impacts profit margins. I certainly want to understand what’s going on in interest rates as interest rates, as Warren said, are probably the single most important indicator of how to think about valuation because they’re the anchor of how you think about dividend discount models, but we’re macro agnostic when it comes to making decisions about our portfolio. Why?

(41:41):

Well, if I’ve got a great business at a great price that earns high returns on invested capital, has a huge total addressable market, can do this for the next 10, 15, 20 years, do I really care whether interest rates are going up or down or the economy is growing slow or growing rapidly? There’s never a bad time to value a great business at a good price.

(41:59):

Oftentimes, you don’t get great businesses at good price unless you’re in a poor macro environment. So that’s a circular argument. Yes, I’m aware of what’s going on in the economy. Yes, I know why growth stocks are going down. Yes, I know why interest rates are going up. Yes, I understand that, but it doesn’t stop me if I see something that I like quite a lot and that I plan to own for the next three, five, 10 years. What’s going on in the economy? 

(42:25):

Warren’s the same way. He says, “I’m going to own these things for 10 years.” If I can get it when the economy is decelerating or accelerating, it doesn’t matter. If you look at all his purchases, he’s been on both sides of the macro ledger times when the economy’s doing well and times when the economy’s doing poor. When the market gives you good businesses, great businesses at good prices, you buy them. You don’t wait for the economy to get better to buy them. You buy them. That’s what you do.

(42:49):

So it’s very important as a business owner, once again, put that business owner hat on. If someone said to you in the middle of a recession, “Hey, I’ve got a really great business. I’m going to give it to you at a very cheap price. Are you interested?” a business owner said, “Yeah, I’m interested right now. Let’s buy it.” They don’t wait for things to improve before they then say, “Okay. Let’s buy it,” because by then the stock price is already up and you’ve got it. So we’re macro aware of what’s going on out there, but we’re macro agnostic when it comes to making decisions in the portfolio.

Rebecca Hotsko (43:19):

One thing I want to touch on that you mentioned there is how Buffett, how and when he assessed the price of a company and these price multiples in his investment process. So I think often investors get wrapped up in price and these multiples and they may rule out an investment before looking at the business fundamentals. The price you pay is obviously very important, but can you talk a bit about why this wasn’t the first thing that Buffett focused on?

Robert Hagstrom (43:47):

Well, price is not value. I mean, sometimes it is and sometimes it isn’t, but you don’t start with price. You start with what is it worth, then you look at the price. Too many people, I think, look at the price and see the price is going up and say, “Oh, it must be worth a lot. I should buy it,” or “The price is going down. Oh, there must be something wrong with that. I should sell it.” Price is not value. Value is the discounted present value of the future of cash flows accentuated by the returns on investing capital. Companies that earn above the cost of capital that have cash flow or worth more than companies that earn below the cost of capital that have cash flow. So it’s a dual mandate for you there to understand value. 

(44:21):

You understand what the value is first, and then you look at the stock price. If there’s a big enough gap there between what you own valued as a business owner would value it and what the market is willing to sell it for you, there’s your arbitrage. That’s the excess returns that you make. So we never look at price first. As a matter of fact, Warren and Ben Graham both said, “I think investors will do extremely well if stock prices were only published maybe once a month.” They didn’t look at them all. It probably would help you out extremely well. People are too, too focused on ever changing stock prices as some indication of value. 

(44:55):

There are lots of reasons why stocks go up and down every day, every week, every month, every year that have nothing to do with value. I think I wrote this in the last book. Just think about all the different strategies that are in place in the market. Not all of them are business-driven strategies like Warren Buffett and what we do. I mean, there’s arbitrage out there. There’s options moving. There’s people making macro bets on stocks right now. There’s lots of reasons, quantitative strategies. There’s lots of reasons why stock prices go up and down that have nothing to do with business valuation. Once you understand that there’s a difference between business valuation and what stock prices are doing and you find that moment when you can arbitrage that difference, boy, that’s where the big money is made. 

(45:36):

Then I’ll give you one last off, and I don’t know why we’re still in this business of determining that value is based on price-earnings ratio. There’s nothing written in any academic textbook ever that says that price-earnings ratios are value. They’re not. Price-earnings ratios are nothing more than the market’s expectation for the stock. A high PE is market telling you that they have high expectations. They have a lot of optimism about a company. A low PE is basically saying the market is very pessimistic about the outlook for this company. Whether it’s undervalued or overvalued has nothing to do with price-earnings multiple. It has everything to do with cash and return on invested capital. 

(46:10):

Today, you will find people that says, “Oh, the stock is too expensive because the price-earnings ratio is high.” There’s no evidence, whatsoever, that price-earnings ratio is value. So you’ve got to get that figured out too, right? Warren wrote that in 1992 when he introduced John Burr Williams, the dividend discount model as being the moniker of value. He turned away from Ben Graham, who had been preaching low PE Investing for 60 years and said, “Nope, that’s not it. No, it’s the dividend discount model that John Burr Williams introduced in 1938,” four years after Graham wrote security analysis, and he says, “Value has nothing to do with whether the PE is high, the price to book is high. There’s no dividends or they’re low price-earnings, and low price to book and high dividend yield. That has nothing to do with value. 

(46:49):

So if you’re going to be a value investor buying businesses, get off this PE wagon and do the actual work because if you ask a business owner, “What is the most important thing as a business owner?” they will tell you this. Number one, how much cash is coming out of this? If I didn’t have the stock market to worry about, and I wanted to buy the grocery store down the street or the gas station or a donut shop, I would ask, “How much money did you make this month? How much cash did you put in your pocket as the business owner?” Then I would determine how much capital I have to put in to run it, and do I get a rate of return on that capital from my cash that’s better than what I could get if I put it in the savings account at the bank. 

(47:24):

When you think about it from those terms, boy, then the market starts to make a lot of sense to you, and it makes even more sense when it behaves foolishly because the gap between what the market is pricing and what you understand is business value is so glaringly wide that you can fall out of bed and know exactly what you’re supposed to do tomorrow.

Rebecca Hotsko (47:42):

I think that was a really great reminder for all of us. So I’m wondering if you can talk a bit about what you’re primarily looking at then when you’re finding these companies to invest in. What metrics or ratios are you paying most attention to if it isn’t the price multiples?

Robert Hagstrom (48:01):

Yeah. It’s cash. So what we’ll do, very, very simplistically stake is we’ll take EPS, the earnings of the company. We will then add back the non-cash charges, so in GAAP accounting, which is gap is called Generally Accepted Accounting principles. It’s not saying the viably inspired accounting principles. It’s just these are generally accepted. You take your EPS and then you add back the non-cash charges.

(48:24):

So in GAAP accounting, you reduce your earnings by the amount of amortization and depreciation. So we add those back, but then we subtract maintenance capital expenditures, what is monies that we have to put back into the business to get the same rate of return, to get the same amount of cash, and we get what Warren calls as owner earnings, which is the cash that the owner of the business can put in their pocket at the end of the year. So that’s important. Then we try to figure out how much capital is in the business, and then we get a percentage return of that cash over the capital invested. 

(48:54):

So for us, we’re looking for returns on capital better than 10%. Why 10%? Well, that’s the opportunity cost for investing in the stock market. Average returns in the market over time are roughly 10%. So if I can’t earn above 10% on my stock investments as a return on capital, my opportunity cost to lending money to the stock market, I’m not interested. Why would I lend money to the stock market to get a 5% rate of return or lend it to a company that gets a 5% rate of return when the average return in the market is 10? 

(49:22):

So we look at cash and then we look at its return on invested capital. If we get good cash, and then we’ve got returns on capital above our opportunity cost to capital, then I’m very interested. Then as a growth investor, the additive is sales growth because once you earn above the cost of capital, sales growth then becomes the throttle for intrinsic value. The faster you grow, the faster you grow your intrinsic value. So once you earn above the cost of capital, it is how fast you can grow, then how long can you grow it? That gets into the competitive advantage period. That gets into the moat, what Warren talks about how long can we earn those excess rates of return. Then you begin to think about, “Can Amazon, as the world’s largest retail director, distributor of retail products, how long can it do this at these rates of return? It’s the largest, AWS cloud computing business, how long can it do it? How long can it earn these rates of return?”

(50:11):

If that adds up to it, they can do it for a long period of time at very high rates of return on capital, then it’s like, “Okay. Boy, this is really a great investment.” Then you got to do the math. You do a dividend discount model. You discount those cash flows at 10%. You do a reasonable expectation of sales growth over five and 10 years, and you look at what the model says something like this would be approximately worth, not perfectly worth, approximately what is its worth. Then you look at the price and if there’s a big enough gap between approximately what you think it’s worth and the current price of what the market will sell it for, then that’s your excess rate of return, and that’s what we do.

Rebecca Hotsko (50:48):

So for the discount rate, that is one of the single most important things that can change your entire intrinsic model. So I’m curious to know, you mentioned 10% there, is that the hurdle rate that you use in your investment process?

Robert Hagstrom (51:04):

Yeah. That’s what we use. Now, in modern portfolio theory, so everybody goes to business school and gets their degrees in finance and stuff like that, modern portfolio theory tells you it’s the risk rate of return plus the equity risk premium, equity risk premium being the volatility of the market up and beyond the risk free rate. So people have a tendency to say, “Okay. When interest rates were one and a half percent or even one percent they were over the last couple of years and the equity risk premium was four, five, six percent, you add those two together and maybe you were discounting cash flows at six percent, well, we thought that that was unreasonably low, that interest rates wouldn’t stay that low forever. So we kept discounting at 10.”

(51:41):

Today, the discount rate now with the tenure today at three and a quarter, equity risk premium at four and a half, five, we’re getting discounts at eight, almost 30, 40, 50 percent higher than what they were a year or two ago. As those interest rates have moved up, you can see stock prices have moved down. We continue to discount at 10%. Some people say that’s just too high based upon the interest rate market. 

(52:04):

I go, “Well, maybe so, but what I have done is built in a margin of safety, an additional buffer, which is if I’m wrong on interest rates and they keep going up or I’m wrong on stock market volatility and it goes higher, I still just think across the board, discounting my cash flows at 10% is the most conservative manner in which to think about value.” Then whatever volatility and the interest rates do in the interim between that, I don’t have to fine-tooth it. I don’t have to thread the needle so tightly that we do. 

(52:32):

So I don’t discount at modern portfolio theory metrics. I discount at the market opportunity metrics, and the market has basically afforded investors at 10% rate of return. That’s my opportunity cost. If I’m going to lend money to the stock market, I’m going to expect to get 10% back on my money, and that’s our opportunity cost, and that’s what we discount cash flows at.

Rebecca Hotsko (52:52):

I think that was such a helpful explanation. I have done two levels of the CFA, so I know that they go into detail about discount rates, and it’s based on what is the market giving you, but I like that approach so much more where it’s like, “What do you want to get from the market?” and if it doesn’t meet 10%, 15%, whatever your hurdle rate is, you shouldn’t invest in it because I think that’s where a lot of Investor’s get hung up on is what rate to use.

Robert Hagstrom (53:19):

Yeah. Let me give you a piece of advice. When it comes to answering that question, Rebecca, don’t answer it the way that I did. Answer it the way that textbooks tell you to do it because that’s going to be the right answer for that test. I got my CFA in 1992. I don’t think I could even pass today’s CFA if you even ask me. There’s so much on there that I go, “I don’t need to know this,” but as a business investor, I know what I need to know, and that’s what moved me.

(53:42):

I think the CFA is a great, great designation to have. There’s a lot of interesting stuff in there that you need to know and need to demonstrate a working knowledge of, but there’s some stuff that’s not relative to being a business owner, and if you’re going to be a business owner/investor, not everybody’s going to do this, but if you’re going to be a business owner/investor, there’s some things you’ll pivot from that are being taught at the CFA, but as long as you’re taking the test, make sure you answer it the way they tell you to answer it.

Rebecca Hotsko (54:09):

Exactly. I think it’s really good advice that investing, it should just be simple. Often, if you take a lot of formal education, it makes it you go into depth in a lot of these concepts, but when you go to apply it, sometimes simple is just almost better, but thank you so much for joining me today, Robert. This was excellent. I know that I learnt a tremendous amount today. Before we close out the episode, where can the audience go to connect with you, learn more about you, and maybe pick up your books?

Robert Hagstrom (54:40):

Great. Well, thank you so much. I appreciate that. I’m the chief investment officer of a money management business called EquityCompass. We’re a wholly owned affiliate of Stifel Financial. I’ve been here for eight years after working at Lake Mason for, God, almost 20 years and moved over here. So we have a website, www.equitycompass, all one word, .com. On there, you can read some of my commentaries. You can look at my portfolio at Global Leaders Portfolio. As far as the book’s concerned, just go to amazon.com, look up Warren Buffett Way, look up Robert Hagstrom, and there will be the list of books. We wrote a book called Investing: The Last Liberal Art, which is now in its second edition, which is how to think about investing from a multi-discipline way of biology and philosophy and psychology and math and things like that, which has been very popular. So there are more books on there not just about Warren Buffett, but about philosophy and different things that you might find interesting.

Rebecca Hotsko (55:36):

All right. I hope you enjoyed today’s episode. Make sure to subscribe to the show on your favorite podcast app so that you never miss a new episode. If you’ve been enjoying the podcast, I’d really appreciate it if you left us a rating or review. This really helps support us and is the best way to help new people discover the show. If you haven’t already, be sure to check out our website, theinvestorspodcast.com. There’s a ton of useful educational resources on there, as well as our TIP finance tool, which is a great tool to help you manage your own stock portfolio. With that, I will see you again next time.

Outro (56:13):

Thank you for listening to TIP. Make sure to subscribe to We Study Billionaires by The Investor’s Podcast Network. Every Wednesday, we teach you about Bitcoin, and every Saturday, we study billionaires and the financial markets. To access our show notes, transcripts or courses, go to theinvestorspodcast.com. This show is for entertainment purposes only. Before making any decision, consultant professional. This show is copyrighted by The Investor’s Podcast Network. Written permission must be granted before syndication or rebroadcasting.