The Warren Buffett Way

By Robert G. Hagstrom

Published by John Wiley & Sons

October 2004; $24.95US/$35.99CAN; 0-471-64811-6

A decade has passed since the book that introduced Warren Buffett to the world -- The Warren Buffett Way by Robert Hagstrom -- first appeared. Since then, Buffett has solidified his reputation as the greatest investor of all time -- quietly amassing a multibillion-dollar fortune, despite the wild fluctuation of the markets.

Although Buffett has claimed time and again that what he does is not beyond anybody else's competence, some people still do not understand how this value investing legend can consistently perform so well. That's where Robert Hagstrom and the Second Edition of The Warren Buffett Way come in. This completely revised and updated look at the Oracle of Omaha encompasses Buffett's numerous investments and accomplishments over the past ten years, as well as the timeless and highly successful investment strategies and techniques he has always used to come out a market winner.

Rather than presenting Buffett's strategies by stock purchases -- as he did in the first edition -- Hagstrom makes "Buffett's Way" more accessible to you, the individual investor, by presenting Buffett's basic tenets of investing and illuminating these principles with relevant and up-to-date examples from Buffett's investments, including common stocks, private companies, and high-yield bonds.

Standing far above the market madness, this timely guide distills the wisdom and insight of the world's greatest investor. It skillfully . . .

• Presents a brief history of Buffett from boyhood to Berkshire Hathaway, and reveals the individuals and events that shaped his investing philosophy


• Outlines the business, management, finance, and value tenets that make up the core of Buffett's investing approach


• Examines Buffett's ongoing process of managing a portfolio from knowing which stocks to hold, and for how long, to deciding if, when, and how to cash out some investments and move into others


• Discusses the psychology of money and how Buffett uses this concept to avoid common investment mistakes and recognize other people's mistakes in time to profit from them

Change is constant, but the investment principles outlined in this book have remained the same. In an environment that seems to favor the speculator over the investor, Buffett's investment advice has proven, time and again, to be a safe harbor for millions of lost investors. No one understands Warren Buffett like Robert Hagstrom, and in the Second Edition of The Warren Buffett Way, Hagstrom will help you -- whether you're a seasoned investor or just getting started -- understand and employ the investment strategies that have made Buffett so successful for over five decades.

Author

Robert G. Hagstrom is Senior Vice President of Legg Mason Capital Management and the portfolio manager of the Legg Mason Growth Trust. He is a member of the CFA Institute and the Financial Analysts of Philadelphia. The Warren Buffett Way sold more than 1,000,000 copies worldwide and spent twenty-one weeks on the New York Times bestseller list. Robert lives with his family in Villanova, Pennsylvania.

Excerpt

The following is an excerpt from the book The Warren Buffett Way, Second Edition

by Robert G. Hagstrom

Published by John Wiley & Sons; October 2004; $24.95US/$35.99CAN; 0-471-64811-6

Copyright © 2004 Robert G. Hagstrom

Status Quo: A Choice of Two

The current state of portfolio management, as practiced by everyone else, appears to be locked into a tug-of-war between two competing strategies -- active portfolio management and index investing.

Active portfolio managers are constantly at work buying and selling a great number of common stocks. Their job is to try to keep their clients satisfied. That means consistently outperforming the market so that on any given day should a client apply the obvious measuring stick -- how is my portfolio doing compared with the market overall -- the answer will be positive and the client will leave 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.

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. The simplest and by far the most common way to achieve this is through an indexed mutual fund.

Proponents of both approaches have long waged combat to prove 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 number of equity mutual funds that have been able to beat the Standard & Poor's 500 Index dropped dramatically, from 50 percent in the early years to barely 25 percent in the final four years. And 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 index. For one thing, it is grounded in a very shaky premise: 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 complexity of the financial universe, predictions are impossible. Second, this high level of activity comes with transaction 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 you exactly the returns of the overall market. Index investors can do no worse than the market, and also no better.

Intelligent investors must ask themselves: Am I satisfied with average? Can I do better?

A New Choice

Given a choice between active and index approaches, Warren Buffett would unhesitatingly pick indexing. This is especially true for investors with a very low tolerance for risk, and for 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," he says in inimitable Buffett 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

Reduced to its essence, focus investing means this: 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.

The following sections describe the separate elements in the process.

"Find Outstanding Companies"

Over the years, Warren Buffett has developed a way of determining which companies are worthy places to put his money; it rests on a notion of great common sense: If the company is doing well and is managed by smart people, eventually its stock price will reflect its inherent value. 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.

The Buffett tenets, described in earlier chapters, can be thought of as 4, a kind of tool belt. Each 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. Buffett uses his tool belt to find companies with a long history of superior performance and a stable management, and that stability means they have 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 with the highest probability of above-average performance.

"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. Philip Fisher, who was known for his focus portfolios, although he didn't use the term, profoundly influenced Buffett's thinking in this area. Fisher always said he preferred owning a small number of outstanding companies that he understood well to a large number of average ones, many of which he understood poorly.

"Know-something" investors, applying the Buffett tenets, would do better to focus their attention on just a few companies. How many is a few? Even the high priests of modern finance have discovered that, on average, just fifteen stocks gives you 85 percent diversification. For the average investor, a legitimate case can be made for ten to twenty. Focus investing falls apart if it is applied to a large portfolio with dozens of stocks.

*endnotes have been omitted

Copyright © 2004 Robert G. Hagstrom

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