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Robert Hagstrom is the chief investment officer at EquityCompass Investment Management LLC. He has also authored 10 books, including the recent “Warren Buffett: Inside the Ultimate Money Mind” (Wiley 2021). We discussed value investing and Warren Buffett’s investing mindset.
—Charles Rotblut, CFA

You describe value as having progressed through three stages in your new book. Could you explain what those stages are?

If you think about value investing at its origin, it certainly involves Benjamin Graham. You would obviously go back to his 1934 classic, “Security Analysis,” but there is more interesting information pertaining to the years prior to when he wrote the book.

Graham had financial catastrophes twice in his life. His father died at a young age after his family had come over from Europe. So, his mother was left kind of financially desolate. The second one was Graham’s own fault. He had made some pretty good money in the 1920s, dodged the 1929 stock market crash but then tiptoed back into the market in 1930. He was hammered when the second down leg of the bear market occurred.

This led Graham to ask, “What do I need to do in the stock market to make money but to limit as much as possible my downside risk?” Graham basically wanted the bird in hand. He felt that if he was buying current assets, current earnings and current dividends at the lowest prices possible and the market went bad on him, his downside risk would be limited.

That was the first stage of value investing, and it flourished. It flourished in the 1930s, 1940s and 1950s, and then partially into the 1960s.

The strategy doesn’t put much of any emphasis on the future. It’s just trying to discount the here and now. But it worked extremely well, and Warren Buffett obviously embraced it enthusiastically. When Graham’s “The Intelligent Investor” came out in 1949, it motivated Buffett to go study with Graham.

Buffett ultimately got a job at the Graham Newman Corporation. He worked there from 1954 until 1956, then began his own partnership using the exact same methodologies that Graham used for so many decades. It worked out swimmingly well. If you look at the Buffett partnership, he outperformed the Dow Jones industrial average for 13 straight years: 1956 until 1969 when Buffett shut down the partnership.

Buffett bought Berkshire Hathaway Inc. (BRK.A) in 1965, took over the textile manufacturer in a proxy vote and began allocating the capital Berkshire Hathaway had by buying other businesses. Berkshire Hathaway would become Buffett’s conglomerate.

The methodology that he was using to pick stocks was the same methodology that he was using to pick businesses for Berkshire Hathaway. Buffett bought cheap companies, but they didn’t generate any cash. It finally dawned on him that the methods that he used to pick stocks with Graham were lousy methods to pick businesses that would generate cash that could be used to reinvest into other businesses.

Charlie Munger introduced Buffett to See’s Candies in the early 1970s. This basically set a lightbulb off for Buffett. When Buffett made his bid for See’s Candies, he thought he had grossly overpaid. It was a high price-to-book business—almost the antithesis of the Graham methodology. But Munger convinced Buffett that the cash coming out of this low capital-intensity business was going to be a home run for Berkshire Hathaway. It ultimately was one of the greatest investments that Berkshire Hathaway ever made. That experience of buying See’s Candies moved Buffett from stage one to stage two.

Stage two can be described as “Let’s buy better businesses with low capital-intensive needs that generate high cash and high returns on capital.” This pretty much began to drive the returns of Berkshire Hathaway from the 1970s into the 1980s and 1990s. Buffett made the pivot in Berkshire Hathaway to buying media companies, newspaper businesses, radio stations and television stations.

But the ultimate purchase for him was in the late 1980s when he bought Coca-Cola Co. (KO). Buffett put $1 billion of Berkshire Hathaway’s $3 billion portfolio into Coca-Cola. It was a high-multiple stock: a high price-earnings ratio, a high price-to-book ratio and a low dividend yield.

The pushback from the value camp was pretty fierce. Everybody said, “Warren, you’ve turned your back on the master. Graham would never have bought this stock. He’s rolling over in his grave. How dare you?” And of course, Coca-Cola went up 10 times over the 10 years versus a threefold increase for the S&P 500 index.

In 1988, Buffett outlined in the Berkshire Hathaway year-end report that value investing had nothing to do with accounting factors. It had nothing to do with high price-earnings ratios, low price-earnings ratios, high prices, low price-to-book values or dividend yields. It was all about the cash. It was all about the return on equity.

That moved us from stage one to stage two of value investing, which is value investing about buying companies that are selling at prices below the discounted present value of their future cash flows.

I wrote “The Warren Buffett Way” in 1994. Bill Miller admired it and he ultimately asked me to come and manage money for him at Legg Mason. Miller ran the famous Value Trust mutual fund, which outperformed the market for a still-standing record of 15 years in a row. I ran the growth trust fund.

I was there front-and-center when Miller was starting to pivot from the Buffett-like stocks. While we still owned Berkshire Hathaway, Miller was moving into new stocks like Dell Technologies Inc. (DELL), AOL and Amazon.com Inc. (AMZN). He was making a lot of money and we were doing extremely well, but Miller was being called out—just like Buffett had been called out about buying Coca-Cola. Jim Cramer claimed that Miller was not a value investor.

Miller publicly wrote back and accused critics of missing a key point: These were great businesses. They generated cash in excess of the operating needs and had tremendously high returns on invested capital.

Dell, for instance, was a PC manufacturer. The PC manufacturers, like Gateway, HP Inc. (HPQ) and IBM Corp. (IBM), could be bought at nine times earnings and sold at 12 times earnings. When Miller started buying Dell, it was trading at nine times earnings. When Dell got to 12 times earnings, he held on to his shares. The stock became the largest holding in the Value Trust portfolio, trading at 45 times earnings. Everybody thought Miller had lost his mind. But then, he walked them through exactly what was going on at Dell from a business standpoint.

Dell was a negative working capital story. In the old days before the internet, customers called a 1-800 number and outlined what they wanted. Dell would charge the credit card at that moment. This gave Dell the cash from that sale and enabled it to expand the business because it didn’t ultimately have to pay for the computer’s components for 30, 60 or 90 days. Dell was basically growing on the backs of accounts receivable, meaning their customers’ order flow. This allowed them to expand the business with very little capital as long as the sales kept coming in.

Dell became the very first company to ever generate 100% return on invested capital. Dell was growing at a double-digit rate, generating 100% return on capital and it ultimately became the single best-performing stock in the 1990s. I think it went up 10,000% in the decade of the 1990s. Miller got 8,000% of that increase.

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Then Miller moved onto AOL, Amazon and Google and stocks like that. In addition to his understanding of Dell, the illumination for owning Amazon, AOL and Google really came from his work at the Santa Fe Institute. Miller had been introduced to the Santa Fe Institute from John Reed at Citigroup. Citigroup underwrote an economic conference in 1987 that began to explore economics from a different angle; not as a diminishing returns business but as an increasing returns business based on network economics.

Network economics is a positive feedback loop in which what is bigger continues to get bigger. As more people join a network, the network becomes more profitable and more valuable. It became an increasing-return economic story and one that favored low capital-intensive businesses as well.

Networks became the new moat. Miller figured this out pretty quickly. We were able to move to stage three of value investing, which is network economics and positive feedback loops. The moat is defined by path dependency, lock-in of users and customers, things of that nature. Desirable business models are low capital intensive and have high returns on capital.

That was the third stage of value investing. Now, in the book we talk about how Buffett got ahold of Apple Inc. (AAPL) in 2016, but it was actually Ted Weschler who made the initial purchase for Berkshire Hathaway. At the time in 2015, the market was discounting prospects for no growth in Apple.

The App Store was growing double-digits and had low capital-intensive needs, had network effects. The moats were all there. Ultimately, it was well understood even back in 2016 and 2017 that Apple was going to become almost 50% service and 50% hardware. The service business was worth much more than people were discounting. Buffett put in a big chunk of Berkshire Hathaway money, ultimately $36 billion. So, Buffett finally got to the third stage of value investing. But it was Bill Miller who certainly was the trailblazer for that.

You’ve studied Buffett extensively, but I don’t think most people realize how much Buffett thought about investing and making money early on in his life.

First of all, Buffett always talks about the ovarian lottery. He was lucky to be born in the U.S. You know, if he had been born in Africa, he likely wouldn’t have been a billionaire. He also had a wonderful dad. People have mentioned his father, Howard Buffett, and I go into more detail about the philosophical underpinnings of him in my new book. Warren’s dad was a wonderful teacher. He was a libertarian at heart, an Emersonian philosopher.

Warren was born in 1930. Take yourself back to 1938, 1939 and 1940 when Warren was eight, nine and 10 years old. There was no television. There were no smartphones, no internet and no video games. There was a radio. Sometimes you could listen to programs at night. If you were lucky enough, you went to a Saturday afternoon matinee in downtown Omaha. But most of the time, you were conversing and reading.

Buffett was extremely fortunate to have grown up in a household where his parents engaged him and talked about self-reliance and philosophy. His dad was also in the brokerage business. So, Buffett had a leg up, if you will, by hanging out with his dad, particularly on the weekends. In those days, the markets were open on Saturday. He would go down to his dad’s brokerage business, and there are stories about one of the stockbroker firms on the first floor letting him mark the board with stock prices.

Buffett was immersed in the stock market at a much earlier age than most people. There’s no doubt about it. He brought a book home from the library, right before he bought his first stock. The book was “One Thousand Ways to Make $1000” by F.C. Minaker.

F.C. Minaker was a woman, but she hid her identity through F.C. Minaker because women weren’t writing business books in those days. One of the stories in her book was about penny-weighing machines. In those days, you’d go into a drug store or a food store and, as you were waiting in line, right next to the checkout line would be a weighing machine. If you dropped a penny in, it would tell you how much you weighed.

A gentleman named Harry Larson noticed people were dropping pennies left and right into the machine and weighing themselves. So, he went up to the owner of the drug store, and said, “What’s the story of this machine?” The store owner responded by saying, “Well, I don’t own the machine. I lease it from a guy who owns it and I get 25% of the pennies and he gets 75%. But, you know, every month I’m getting $20 out of this thing.”

Larson responds, “Well, wait a minute, every month, people are putting in pennies and you’ve got a revenue share with it, but you’re still getting $20 a month for nothing other than leaving this machine in your store?” The store owner says, “Yes.” So, Larson takes his savings and buys three penny-weighing machines. He puts them around town and then ultimately buys another 70 penny-weighing machines with the proceeds of his first three. He ended up having a tremendous living until the fad passed.

This was the compounding effect that Buffett talked about wanting Berkshire Hathaway to possess. Buffett was looking for penny-weighing machines.

Buffett wanted to buy a machine that would generate pennies that would allow him to go buy another machine that would generate pennies to go buy another machine that would go generate pennies. Buffett thought about Berkshire Hathaway as that place; he wanted to buy a business that generated cash and would allow him to go buy the next business and allowed him to go out and buy another business.

And so, Buffett learned that story at an early age. He kind of took a mental detour when he worked with Graham after reading “The Intelligent Investor” and was not so much focused on the cash compounding of penny-weighing machines. He was still doing factor-based analysis. But make no mistake, when Buffett shifted gears from the Graham methodology to the Munger “buy a better business that generates cash” model, it was the penny-weighing machine story that he read as a young man that influenced him.

Incidentally, Buffett still has a penny-weighing machine in the Berkshire Hathaway lobby. He actually sent me a picture of it after I sent him the book.

Another thing that is underappreciated is Buffett’s capital allocation skills. He has been one of the world’s greatest capital allocators.

Yes, he has been.

The story of the money mind came from the 2017 Berkshire Hathaway shareholder meeting. During it, a question was asked about capital allocation. I was at this meeting when a shareholder asked Buffett, “After you and Charlie are no longer on the diocese, how do we think about capital allocation?”

It was obviously a question about succession. Buffett came out right away and said, “You know, any person who’s going to sit in the chair of CEO at Berkshire Hathaway has to have this money mind.”

I’ve never heard that term before. I thought to myself, “Well, wait a minute. This is a new term. What is money mind?” Buffett went on to talk about money mind as basically having the ability to optimize the allocation of capital, meaning to be very thoughtful about how you think about the allocation of capital.

Without question, Buffett will go down in history as someone who took this little textile business that was worth $20 million, $30 million or $40 million in the 1960s and built it into a half-a-trillion-dollar business because of his ability to allocate capital. Berkshire Hathaway is a penny-weighing machine.

When it comes to Berkshire Hathaway, people will ask, “How long will the company last?” Well, we know that the next person who steps in will be someone who’s going to be a great capital allocator, but the essence of Berkshire Hathaway is that it’s not dependent upon any kind of technology or a drug or anything that may fade in the future. Berkshire Hathaway’s whole essence is about capital allocation, which will never go out of style. Capital allocation is something we’ll be doing 100 years from now.

Is there anything you think people get wrong about Buffett based on your observations over the years?

I’m glad you asked that question because we are doing a lot of writing on this topic right now for commentaries. Even though he’s on CNBC, even though he’s a celebrity in the world of the stock market, even though he’s probably one of the most popular positive role models anyone could think about that is associated to the stock market, I don’t think people really comprehend or recognize how little he pays attention to the stock market.

Buffett is the Lebron James of the stock market, the Michael Jordan, the Tiger Woods. He is the poster child of the stock market, and what a positive role model he is. But if you looked at the number of hours each week that he spends thinking about the stock market, watching the stock market, listening to the stock market, reading people who pontificate about the stock market, it is a fraction of his time. Buffett is spending 80%, 90%, 95% of his time thinking about businesses and analyzing businesses independently and separately from what’s going on in the stock market.

It’s only then that he will take a peek at what’s going on in the stock market to say, “Well, what would be the price of this business if I were to buy it today? What is the market pricing this business at?”

So we’re trying to get our clients to recognize that even though the market is front-and-center in our minds—we think about it every day, our phones have our stock prices, we’re totally consumed with market information—it is how many hours each week that Buffett is not thinking about the stock market and thinking about businesses that has been the greatest contributor to his success over time in my judgment.

Online Exclusive Q&A

When it comes to return on invested capital, how should investors look at it? Because it does vary by the type of industry or sector you’re looking at.

We go through this in the book. Modern Portfolio theory has its own version of risk. Your equity cost of capital is a function of the volatility of the stock—called the equity risk premium, plus the risk-free rate equals the cost of equity capital.

We always struggled with that, and really felt that that was not a proper way in which to think about it. Munger used to talk about that your equity cost of capital is your opportunity cost. That is, you’re investing in the stock market. What is your expected return? What do you think you should earn from the stock market? What would be the opportunity cost of that return if you didn’t invest in the stock market?

It’s two sides of the same coin. Let’s just say for the sake of argument, your historical return is 10%. That’s your cost of capital. To lend money to the stock market, you’re expecting a 10% rate of return.

So, your equity cost is your opportunity cost, or 10%. Your debt is the stated coupon interest rate offered by bonds or the current yield. Your weighted average cost of capital then is the weighted average return of the cost of the debt capital plus 10% for the equity capital.

It became really well-known then that intrinsic value was a function of earning returns above that cost of capital. If you earned above the cost of capital, you generated returns that would grow intrinsic value. If the rates of return were below the cost of capital, then you were destroying shareholder value. So, you’ve got to figure out the cost of capital.

We really don’t try to get too scientific about it. Our cost of capital for companies is the equity return. Now I will adjust the margin of safety, meaning what kind of discount I’m looking for in a company. If there’s high uncertainty, I want a bigger margin of safety. If there’s low uncertainty, I don’t need as much margin of safety.

That gets to another question. Graham’s margin of safety was buying below tangible book value. But now we’re dealing with intangibles like the network effect. How do we define margin of safety?

Where Graham had it right and then had it wrong was that he felt that if you bought something below hard book value and the business didn’t work out, you could sell the assets to somebody. If you had hard asset value and you bought it below hard asset value, there would always be someone around that would buy your asset.

Now, what Buffett found out when he went around trying to sell really junky companies was that nobody was willing to pay the stated book value. While book value might be what you think is a fair market value for those businesses, book value is really what someone is willing to pay for those assets. For a lot of those poor returning businesses for economic returning businesses, their book values were much lower than what is on the financial statements.

But your point about intangible is extremely important because the reason why the returns on capital are so high for software businesses and network economic businesses is because the value creation of those businesses is the intellectual capital, the software and things of that nature that are considered intangible.

The intangible assets that are creating the most value for these new economic businesses are not showing up in the book value. They are being expensed on the income statement. You end up with a high-multiple stock because all the intangible values are being expensed on the income statement. At the same time, your book value is not growing. So, you end up with high price to book and high price to earnings. Those investors who have the insight can say that the investment of intangible assets has greatly increased in the return on capital and the intrinsic value of the business.

So to your original point, how should we think about intangibles? There’s a growing belief that we need to be calculating and segregating out intangible assets. Maybe not so much to change it from an income statement to the balance sheet item, but basically to tabulate how much investment intangibles have accrued to the company. This would get you a better sense of what has been the total investment in the company. In some ways, you could take that number and add it to your capital. Your returns on capital would end up being lower but still probably very much higher than your cost of capital.

In terms of discounted cash flow, there are a lot of variables that influence the formula’s output. Any suggestions on how an individual investor can make a reasonable assumption for calculating discounted cash flow?

The way we did it in “The Warren Buffett Way”—and I think it’s still a sensible way—is to take straight net income and add back depreciation and amortization to it. Then you deduct capital expenditures. So, it’s net income plus depreciation and amortization, subtracting out your baseline capital reinvestment needs. This gives you the best cash flow operating needs.

Now, an interesting side note. Amazon, when Jeff Bezos was running the company, he would walk you through the online retailing, AWS and the advertising business. He would give you all the revenues of all those three different businesses. He would then take out the operating expenses of all of those three businesses to get what was called an operating free cash flow yield.

It was kind of a pretax operating cash flow. What we discovered—and other analysts have verified—is that the free cash flow of Amazon on an operating basis is higher than Procter & Gamble.

Amazon makes a ton of money. It’s just that at the end of the day when they’re sitting on the pile of cash called operating free cash flow yield, Bezos then did exactly what you’re supposed to do, which is if you’re earning a 100% return on capital, you just put the money back in as fast as you can. You don’t care about earnings per share. You want to continue to compound the intrinsic value of that business as fast as you can because that’s growing the intrinsic value of the business.

You have to do a little work as an investor to noodle out the free cash flow yield. But if you get there, a lot of companies look much different than what they do just on an earnings per share basis.

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