> There's a new book out by Hagstrom called
> "The Warren Buffett Portfolio".

THE WARREN BUFFETT PORTFOLIO: MASTERING THE POWER OF THE FOCUS INVESTMENT STRATEGY
by*Robert G., Jr. Hagstrom*Hagstrom
Format:Hardcover,*246pp.
ISBN: 0471247669
Publisher: John Wiley & Sons, Inc.
Pub. date: April 1999
Other Formats:Analog Audio Cassette
Prologue
The Warren Buffett Portfolio
Mastering the Power of the Focus Investment Strategy
By Robert G. Hagstrom
John Wiley & Sons, Inc.

Copyright © 1999 Robert G. Hagstrom.
All rights reserved.
ISBN: 0-471-24766-9
Chapter One
Focus Investing
Robert, we just focus on a few outstanding companies.

We're focus investors.
—Warren Buffett
I remember that conversation with Warren Buffett as if it
happened yesterday. It was for me a defining moment, for
two reasons. First, it moved my thinking in a totally new direction;
and second, it gave a name to an approach to portfolio
management that I instinctively felt made wonderful sense but
that our industry had long overlooked. That approach is what we
now call focus investing, and it is the exact opposite of what most
people imagine that experienced investors do.

***

Hollywood has given us a visual cliché of a money manager at
work: talking into two phones at once, frantically taking notes
while trying to keep an eye on jittery computer screens that blink
and blip from all directions, slamming the keyboard whenever one
of those computer blinks shows a minuscule drop in stock price.

***

Warren Buffett, the quintessential focus investor, is as far
from that stereotype of frenzy as anything imaginable. The man
whom many consider the world's greatest investor is usually described
with words like "soft-spoken," "down-to-earth," and
"grandfatherly." He moves with the calm that is born of great confidence, yet his accomplishments and his performance
record are legendary. It is no accident that the entire investment
industry pays close attention to what he does. If Buffett characterizes
his approach as "focus investing," we would be wise to
learn what that means and how it is done.

***

Focus investing is a remarkably simple idea, and yet, like
most simple ideas, it rests on a complex foundation of interlocking
concepts. If we hold the idea up to the light and look closely
at all its facets, we find depth, substance, and solid thinking
below the bright clarity of the surface.

***

In this book, we will look closely at these interlocking concepts,
one at a time. For now, I hope merely to introduce you to
the core notion of focus investing. The goal of this overview
chapter mirrors the goal of the book: to give you a new way of thinking about investment decisions and managing investment
portfolios. Fair warning: this new way is, in all likelihood, the opposite
of what you have always been told about investing in the
stock market. It is as far from the usual way of thinking about
stocks as Warren Buffett is from that Hollywood cliché.

The essence of focus investing can be stated quite simply:

Choose a few stocks that are likely to produce above-average

returns over the long haul, concentrate the bulk of your

investments in those stocks, and have the fortitude to hold

steady during any short-term market gyrations.
***

No doubt that summary statement immediately raises all
sorts of questions in your mind:

***

How do I identify those above-average stocks?

***

How many is "a few"?

***

What do you mean by "concentrate"?

***

How long must I hold?

And, saved for last:

***

Why should I do this?
The full answers to those questions are found in the subsequent
chapters. Our work here is to construct an overview of the focus
process, beginning with the very sensible question of why you
should bother.

PORTFOLIO MANAGEMENT TODAY:
A CHOICE OF TWO
In its current state, portfolio management appears to be locked
into a tug-of-war between two competing strategies: active portfolio
management and index investing.

***

Active portfolio managers constantly buy and sell a great
number of common stocks. Their job is to try to keep their
clients satisfied, and that means consistently outperforming the
market so that on any given day, if a client applies the obvious
measuring stick—"How is my portfolio doing compared to the
market overall?"—the answer is positive and the client leaves her
money in the fund. To keep on top, active managers try to predict
what will happen with stocks in the coming six months and
continually churn the portfolio, hoping to take advantage of
their predictions. On average, today's common stock mutual
funds own more than one hundred stocks and generate turnover ratios of 80 percent.

***

Index investing, on the other hand, is a buy-and-hold passive
approach. It involves assembling, and then holding, a broadly diversified
portfolio of common stocks deliberately designed to
mimic the behavior of a specific benchmark index, such as the
Standard & Poor's 500 Price Index (S&P 500).

***

Compared to active management, index investing is somewhat
new and far less common. Since the 1980s, when index
funds fully came into their own as a legitimate alternative strategy,
proponents of both approaches have waged combat to determine
which one will ultimately yield the higher investment
return. Active portfolio managers argue that, by virtue of their superior stock-picking skills, they can do better than any index.
Index strategists, for their part, have recent history on their side.
In a study that tracked results in a twenty-year period, from 1977
through 1997, the percentage of equity mutual funds that have
been able to beat the S&P 500 dropped dramatically, from 50 percent in the early years to barely 25 percent in the last four
years. Since 1997, the news is even worse. As of November 1998,
90 percent of actively managed funds were underperforming the
market (averaging 14 percent lower than the S&P 500), which
means that only 10 percent were doing better.

***

Active portfolio management, as commonly practiced today,
stands a very small chance of outperforming the S&P 500. Because
they frenetically buy and sell hundreds of stocks each year, institutional money managers have, in a sense, become the market. Their
basic theory is: Buy today whatever we predict can be sold soon at a
profit, regardless of what it is. The fatal flaw in that logic is that,
given the complex nature of the financial universe, predictions are impossible. (See Chapter 8 for a description of complex adaptive
systems.) Further complicating this shaky theoretical foundation is
the effect of the inherent costs that go with this high level of activity—costs that diminish the net returns to investors. When we factor
in these costs, it becomes apparent that the active money
management business has created its own downfall.

***

Indexing, because it does not trigger equivalent expenses, is
better than actively managed portfolios in many respects. But
even the best index fund, operating at its peak, will only net exactly
the returns of the overall market. Index investors can do no
worse than the market—and no better.

***

From the investor's point of view, the underlying attraction
of both strategies is the same: minimize risk through diversification.
By holding a large number of stocks representing many industries
and many sectors of the market, investors hope to create
a warm blanket of protection against the horrific loss that could
occur if they had all their money in one arena that suffered some
disaster. In a normal period (so the thinking goes), some stocks
in a diversified fund will go down and others will go up, and let's
keep our fingers crossed that the latter will compensate for the
former. The chances get better, active managers believe, as the number of stocks in the portfolio grows; ten is better than one,
and a hundred is better than ten.

***

An index fund, by definition, affords this kind of diversification
if the index it mirrors is also diversified, as they usually are.
The traditional stock mutual fund, with upward of a hundred
stocks constantly in motion, also offers diversification.

***

We have all heard this mantra of diversification for so long,
we have become intellectually numb to its inevitable consequence:
mediocre results. Although it is true that active and
index funds offer diversification, in general neither strategy
will yield exceptional returns. These are the questions intelligent investors must ask themselves: Am I satisfied with average
returns? Can I do better?

A NEW CHOICE
What does Warren Buffett say about this ongoing debate regarding
index versus active strategy? Given these two particular
choices, he would unhesitatingly pick indexing. Especially if he
were thinking of investors with a very low tolerance for risk, and
people who know very little about the economics of a business
but still want to participate in the long-term benefits of investing
in common stocks. "By periodically investing in an index fund,"
Buffett says in his inimitable style, "the know-nothing investor
can actually outperform most investment professionals."

***

Buffett, however, would be quick to point out that there is a
third alternative, a very different kind of active portfolio strategy
that significantly increases the odds of beating the index.
That alternative is focus investing.

FOCUS INVESTING: THE BIG PICTURE

"Find Outstanding Companies"
Over the years, Warren Buffett has developed a way of choosing the
companies he considers worthy places to put his money. His choice
rests on a notion of great common sense: if the company itself is
doing well and is managed by smart people, eventually its inherent value will be reflected in its stock price. Buffett thus devotes most
of his attention not to tracking share price but to analyzing the economics
of the underlying business and assessing its management.

***

This is not to suggest that analyzing the company—uncovering
all the information that tells us its economic value—is particularly
easy. It does indeed take some work. But Buffett has often
remarked that doing this "homework" requires no more energy
than is expended in trying to stay on top of the market, and the results are infinitely more useful.

***

The analytical process that Buffett uses involves checking
each opportunity against a set of investment tenets, or fundamental
principles. These tenets, presented in depth in The Warren
Buffett Way and summarized on page 8, can be thought of as
a kind of tool belt. Each individual tenet is one analytical tool, and, in the aggregate, they provide a method for isolating the
companies with the best chance for high economic returns.

***

The Warren Buffett tenets, if followed closely, lead you inevitably
to good companies that make sense for a focus portfolio.
That is because you will have chosen companies with a long history
of superior performance and a stable management, and that
stability predicts a high probability of performing in the future
as they have in the past. And that is the heart of focus investing:
concentrating your investments in companies that have the highest
probability of above-average performance.

***

Probability theory, which comes to us from the science of
mathematics, is one of the underlying concepts that make up the
rationale for focus investing. In Chapter 6, you will learn more
about probability theory and how it applies to investing. For the
moment, try the mental exercise of thinking of "good companies"
as "high-probability events." Through your analysis, you have already
identified companies with a good history and, therefore,
good prospects for the future; now, take what you already know
and think about it in a different way—in terms of probabilities.

"Less Is More"
Remember Buffett's advice to a "know-nothing" investor, to stay
with index funds? What is more interesting for our purposes is
what he said next:

***

"If you are a know-something investor, able to understand
business economics and to find five to ten sensibly priced companies
that possess important long-term competitive advantages,
conventional diversification [broadly based active portfolios]
makes no sense for you."

***

What's wrong with conventional diversification? For one
thing, it greatly increases the chances that you will buy something
you don't know enough about. "Know-something" investors,
applying the Buffett tenets, would do better to focus
their attention on just a few companies—"five to ten," Buffett
suggests. Others who adhere to the focus philosophy have suggested
smaller numbers, even as low as three; for the average investor,
a legitimate case can be made for ten to fifteen. Thus, to
the earlier question, How many is "a few"? the short answer is: No
more than fifteen. More critical than determining the exact
number is understanding the general concept behind it. Focus investing falls apart if it is applied to a large portfolio with
dozens of stocks.

***

Warren Buffett often points to John Maynard Keynes, the
British economist, as a source of his ideas. In 1934, Keynes wrote
to a business associate: "It is a mistake to think one limits one's
risks by spreading too much between enterprises about which one
knows little and has no reason for special confidence....
One's knowledge and experience are definitely limited and there
are seldom more than two or three enterprises at any given time in
which I personally feel myself entitled to put full confidence."
Keynes's letter may be the first piece written about focus investing.

***

An even more profound influence was Philip Fisher, whose
impact on Buffett's thinking has been duly noted. Fisher, a
prominent investment counselor for nearly half a century, is the
author of two important books: Common Stocks and Uncommon
Profits and Paths to Wealth Through Common Stocks, both of which
Buffett admires greatly.

***

Phil Fisher was known for his focus portfolios; he always said
he preferred owning a small number of outstanding companies
that he understood well to owning a large number of average
ones, many of which he understood poorly. Fisher began his investment counseling business shortly after the 1929 stock market
crash, and he remembers how important it was to produce good
results. "Back then, there was no room for mistakes," he remembers.
"I knew the more I understood about the company the better
off I would be." As a general rule, Fisher limited his
portfolios to fewer than ten companies, of which three or four
often represented 75 percent of the total investment.

***

"It never seems to occur to [investors], much less their advisors,"
he wrote in Common Stocks in 1958, "that buying a company
without having sufficient knowledge of it may be even more dangerous
than having inadequate diversification." More than forty years later, Fisher, who today is ninety-one, has not changed his
mind. "Great stocks are extremely hard to find," he told me. "If
they weren't, then everyone would own them. I knew I wanted to
own the best or none at all."

***

Ken Fisher, the son of Phil Fisher, is also a successful money
manager. He summarizes his father's philosophy this way: "My
dad's investment approach is based on an unusual but insightful
notion that less is more."

"Put Big Bets on
High-Probability Events"
Fisher's influence on Buffett can also be seen in his belief that
when you encounter a strong opportunity, the only reasonable
course is to make a large investment. Like all great investors,
Fisher was very disciplined. In his drive to understand as much
as possible about a company, he made countless field trips to
visit companies he was interested in. If he liked what he saw, he
did not hesitate to invest a significant amount of money in the
company. Ken Fisher points out, "My dad saw what it meant to
have a large position in something that paid off."

***

Today, Warren Buffett echoes that thinking: "With each investment
you make, you should have the courage and the conviction
to place at least 10 percent of your net worth in that stock."

***

You can see why Buffett says the ideal portfolio should contain
no more than ten stocks, if each is to receive 10 percent. Yet
focus investing is not a simple matter of finding ten good stocks
and dividing your investment pool equally among them. Even
though all the stocks in a focus portfolio are high-probability events, some will inevitably be higher than others and should be
allocated a greater proportion of the investment.

***

Blackjack players understand this tactic intuitively: When
the odds are strongly in your favor, put down a big bet. In the
eyes of many pundits, investors and gamblers have much in
common, perhaps because both draw from the same science:
mathematics. Along with probability theory, mathematics provides
another piece of the focus investing rationale: the Kelly Optimization Model. The Kelly model is represented in a formula
that uses probability to calculate optimization—in this
case, optimal investment proportion. (The model, along with
the fascinating story of how it was originally derived, is presented
in Chapter 6.)

***

I cannot say with certainty whether Warren Buffett had optimization
theory in mind when he bought American Express stock
in late 1963, but the purchase is a clear example of the concept—and
of Buffett's boldness. During the 1950s and 1960s, Buffett
served as general partner in a limited investment partnership in
Omaha, Nebraska, where he still lives. The partnership was allowed
to take large positions in the portfolio when profitable opportunities
arose, and, in 1963, one such opportunity came along.
During the infamous Tino de Angelis salad oil scandal, the American
Express share price dropped from $65 to $35 when it was
thought the company would be held liable for millions of dollars
of fraudulent warehouse receipts. Warren invested $13 million—a
whopping 40 percent of his partnership's assets—in ownership of close to 5 percent of the shares outstanding of American Express.
Over the next two years, the share price tripled, and the Buffett
partnership walked away with a $20 million profit.

"Be Patient"
Focus investing is the antithesis of a broadly diversified, high-turnover
approach. Among all active strategies, focus investing
stands the best chance of outperforming an index return over
time, but it requires investors to patiently hold their portfolio
even when it appears that other strategies are marching ahead.
In shorter periods, we realize that changes in interest rates,
inflation, or the near-term expectation for a company's earnings
can affect share prices. But as the time horizon lengthens, the
trend-line economics of the underlying business will increasingly
dominate its share price.

***

How long is that ideal time line? As you might imagine, there
is no hard and fast rule (although Buffett would probably say
that any span shorter than five years is a fool's theory). The goal
is not zero turnover; that would be foolish in the opposite direction
because it would prevent you from taking advantage of
something better when it comes along. I suggest that, as a general
rule of thumb, we should be thinking of a turnover rate between
10 and 20 percent. A 10 percent turnover rate suggests
that you would hold the stock for ten years, and a 20 percent rate implies a five-year period.

"Don't Panic over Price Changes"
Price volatility is a necessary by-product of focus investing. In a
traditional active portfolio, broad diversification has the effect
of averaging out the inevitable shifts in the prices of individual
stocks. Active portfolio managers know all too well what happens
when investors open their monthly statement and see, in cold
black and white, a drop in the dollar value of their holdings.
Even those who understand intellectually that such dips are part
of the normal course of events may react emotionally and fall
into panic.

***

The more diversified the portfolio, the less the chances that
any one share-price change will tilt the monthly statement. It is
indeed true that broad diversification is a source of great comfort
to many investors because it smooths out the bumps along
the way. It is also true that a smooth ride is flat. When, in the interests
of avoiding unpleasantness, you average out all the ups
and downs, what you get is average results.

***

Focus investing pursues above-average results. As we will see
in Chapter 3, there is strong evidence, both in academic research
and actual case histories, that the pursuit is successful.
There can be no doubt, however, that the ride is bumpy. Focus
investors tolerate the bumpiness because they know that, in the
long run, the underlying economics of the companies will more
than compensate for any short-term price fluctuations.

***

Buffett is a master bump ignorer. So is his longtime friend
and colleague Charlie Munger, the vice chairman of Berkshire
Hathaway. The many fans who devour Berkshire's remarkable
annual reports know that the two men support and reinforce
each other with complementary and sometimes indistinguishable
ideas. Munger's attitudes and philosophy have influenced Buffett every bit as much as Buffett has influenced Munger.

***

In the 1960s and 1970s, Munger ran an investment partnership
in which, like Buffett at about the same time, he had the
freedom to make big bets in the portfolio. His intellectual reasoning
for his decisions during those years echoes the principles
of focus investing.

***

"Back in the 1960s, I actually took a compound interest rate
table," explained Charlie, "and I made various assumptions
about what kind of edge I might have in reference to the behavior
of common stocks generally." (OID) Charlie worked
through several scenarios, including the number of stocks he
would need in the portfolio and what kind of volatility he could
expect. It was a straightforward calculation.

***

"I knew from being a poker player that you have to bet heavily
when you've got huge odds in your favor," Charlie said. He
concluded that as long as he could handle the price volatility,
owning as few as three stocks would be plenty. "I knew I could
handle the bumps psychologically," he said, "because I was
raised by people who believe in handling bumps. So I was an ideal person to adopt my own methodology." (OID)

***

Maybe you also come from a long line of people who can
handle bumps. But even if you were not born so lucky, you can
acquire some of their traits. The first step is to consciously decide
to change how you think and behave. Acquiring new habits
and thought patterns does not happen overnight, but gradually
teaching yourself not to panic and not to act rashly in response to the vagaries of the market is certainly doable.

***

You may find some comfort in learning more about the psychology
of investing (see Chapter 7); social scientists, working in
a field called behavioral finance, have begun to seriously investigate
the psychological aspects of the investment phenomenon.
You may also find it helpful to use a different measuring stick for evaluating success. If watching stock prices fall gives you heart
failure, perhaps it is time to embrace another way of measuring
performance, a way that is less immediately piercing but equally
valid (even more valid, Buffett would say). That new measurement involves the concept of economic benchmarking, presented in
Chapter 4.

Focus investing, as we said earlier, is a simple idea that draws its
vigor from several interconnecting principles of logic, mathematics,
and psychology. With the broad overview of those principles
that has been introduced in this chapter, we can now
rephrase the basic idea, using wording that incorporates concrete
guidelines.

***

In summary, the process of focus investing involves these
actions:

* Using the tenets of the Warren Buffett Way, choose a few

(ten to fifteen) outstanding companies that have achieved

above-average returns in the past and that you believe have

a high probability of continuing their past strong performance

into the future.
* Allocate your investment funds proportionately, placing

the biggest bets on the highest-probability events.
* As long as things don't deteriorate, leave the portfolio

largely intact for at least five years (longer is better), and

teach yourself to ride through the bumps of price volatility

with equanimity.
A LATTICEWORK OF MODELS
Warren Buffett did not invent focus investing. The fundamental
rationale was originally articulated more than fifty years ago by
John Maynard Keynes. What Buffett did, with stunning success,
was apply the rationale, even before he gave it its name. The
question that fascinates me is why Wall Street, noted for its unabashed
willingness to copy success, has so far disregarded focus
investing as a legitimate approach.

***

In 1995, we launched Legg Mason Focus Trust, only the second
mutual fund to purposely own fifteen (or fewer) stocks.
(The first was Sequoia Fund; its story is told in Chapter 3.) Focus
Trust has given me the invaluable experience of managing a
focus portfolio. Over the past four years, I have had the opportunity
to interact with shareholders, consultants, analysts, other portfolio managers, and the financial media, and what I have
learned has led me to believe that focus investors operate in a
world far different from the one that dominates the investment
industry. The simple truth is, they think differently.

***

Charlie Munger helped me to understand this pattern of
thinking by using the very powerful metaphor of a latticework
of models. In 1995, Munger delivered a lecture entitled "Investment
Expertise as a Subdivision of Elementary, Worldly Wisdom"
to Professor Guilford Babcock's class at the University of
Southern California School of Business. The lecture, which was covered in OID, was particularly fun for Charlie because it centered
around a topic that he considers especially important:
how people achieve true understanding, or what he calls
"worldly wisdom."

***

A simple exercise of compiling and quoting facts and figures
is not enough. Rather, Munger explains, wisdom is very much
about how facts align and combine. He believes that the only
way to achieve wisdom is to be able to hang life's experience
across a broad cross-section of mental models. "You've got to have models in your head," he explained, "and you've got to
array your experience—both vicarious and direct—on this latticework
of models." (OID)

***

The first rule to learn, says Charlie, is that you must carry
multiple models in your mind. Not only do you need more than a
few, but you need to embrace models from several different
disciplines. Becoming a successful investor, he explains, requires a multidiscipline approach to your thinking.

***

That approach will put you in a different place from almost
everyone else, Charlie points out, because the world is not multidiscipline.
Business professors typically don't include physics in
their lectures, and physics teachers don't include biology, and biology teachers don't include mathematics, and mathematicians
rarely include psychology in their coursework. According to
Charlie, we must ignore these "intellectual jurisdictional boundaries"
and include all models in our latticework design.

***

"I think it is undeniably true that the human brain must work
in models," says Charlie. "The trick is to have your brain work
better than the other person's brain because it understands the
most fundamental models—the ones that will do the most work
per unit."
***

It is clear to me that focus investing does not fit neatly within
the narrowly constructed models popularized and used in our
investment culture. To receive the full benefit of the focus approach,
we will have to add a few more concepts, a few more
models, to our thinking. You will never be content with investing
until you understand the behavior models that come from psychology.
You will not know how to optimize a portfolio without
learning the model of statistical probabilities. And it is likely you
will never appreciate the folly of predicting markets until you understand the model of complex adaptive systems.

***

This investigation need not be overwhelming. "You don't
have to become a huge expert in any one of these fields," explains
Charlie. "All you have to do is take the really big ideas
and learn them early and learn them well." (OID) The exciting
part to this exercise, Charlie points out, is the insight that is
possible when several models combine and begin operating in
the same direction.

***

The most detailed model that focus investors have to learn is
the model for picking stocks, and many of you are already familiar
with that from The Warren Buffett Way. From here, we need to
add just a few more simple models to complete our education: to understand how to assemble those stocks into a portfolio, and
how to manage that portfolio so that it yields maximum results
well into the future. But we are not alone. We have Warren's and
Charlie's wisdom to guide us, and we have their accumulated experience at Berkshire Hathaway. Typically, these two visionaries
credit not themselves personally but their organization, which
they describe as a "didactic enterprise teaching the right systems
of thought, of which the chief lessons are that a few big ideas really work." (OID)

***

"Berkshire is basically a very old-fashioned kind of place,"
Charlie Munger said, "and we try to exert discipline to stay that
way. I don't mean old-fashioned stupid. I mean the eternal verities:
basic mathematics, basic horse sense, basic fear, basic diagnosis
of human nature making possible predictions regarding
human behavior. If you just do that with a certain amount of discipline,
I think it's likely to work out quite well." (OID)