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The War ren Buf fett Way
was published, we circled back
for more intense discussions about investing and the challenges of navi-
gating the economic landscape.
In the book, I pointed out that Buffett did not rely solely on low
P/E ratios to select stocks. The driving force in value creation was
owner earnings and a company’s ability to generate above-average
returns on capital. Sometimes a stock with a low P/E ratio did generate
cash and achieve high returns on capital and subsequently became a great
investment. Other times, a stock with a low P/E ratio consumed cash
2 0 6
A F T E R W O R D
Back then Microsoft was a $22 billion business that most value in-
vestors thought was significantly overvalued. By the end of 2003, Micro-
soft had grown to a $295 billion business. The company went up in price
over 1,000 percent, while the S&P 500 Index advanced 138 percent dur-
ing the same time period.
Was Microsoft a value stock in 1993? It certainly looks like it was,
yet no value investor would touch it. Is eBay a value stock today? We
obviously believe it is, but we will not know for certain for some years
to come. But one thing is clear to us: You cannot determine whether
eBay is a value stock by looking at its P/E any more than you could de-
termine Microsoft’s valuation by looking at its P/E.
At the heart of all Bill’s investment decisions is the requirement of
understanding a company’s business model. What are the value creators?
How does the company generate cash? What level of cash can a company
produce and what rate of growth can it expect to achieve? What is the
company’s return on capital? If it achieves a return above the cost of cap-
ital, the company is creating value. If it achieves a rate of return below
the cost of capital, the company is destroying value.
In the end, Bill’s analysis gives him a sense of what the business is
worth, based largely on the discounted present value of the company’s
future cash earnings. Although Bill’s fund owns companies that are dif-
ferent from those in Buffett’s Berkshire Hathaway portfolio, no one can
deny that they are approaching the investment process in the same way.
The only difference is that Bill has decided to take the investment phi-
losophy and apply it to the New Economy franchises that are rapidly
dominating the global economic landscape.
When Bill asked me to join Legg Mason Capital Management and
bring my fund along, it was clear to me our philosophical approach was
identical. The more important advantage of joining Bill’s team was that
now I was part of an organization that was dedicated to applying a
business-valuation approach to investing wherever value-creation op-
portunities appeared. I was no longer limited to looking at just the
stocks Buffett had purchased. The entire stock market was now open
for analysis. I guess you could say it forced me to expand my circle of
competence.
One of my earliest thinking errors in managing my fund was the
mistaken belief that because Buffett did not own high-tech com-
panies, these businesses must have been inherently unanalyzable. Yes,
A f t e r w o r d
2 0 7
these newly created businesses possessed more economic risk than
many of the companies Buffett owned. The economics of soda pop,
razor blades, carpets, paint, candy, and furniture are much easier to
predict than the economics of computer software, telecommunica-
tions, and the Internet.
But “diff icult to predict” is not the same as “impossible to ana-
lyze.” Certainly the economics of a technology company are more
variant than those of consumer nondurable businesses. But a thought-
ful study of how any business operates should still allow us to deter-
mine a range of valuation possibilities. And keeping with the Buffett
philosophy, it is not critical that we determine precisely what the
value of the company is, only that we are buying the company at a sig-
nif icant price discount (margin of safety) from the range of valuation
possibilities.
What some Buffettologists miss in their thinking is that the payoff
of being right in the analysis of technology companies more than
compensates for the risk. All we must do is analyze each stock as a
business, determine the value of the business and, to protect against
higher economic risk, demand a greater margin of safety in the pur-
chase price.
We should not forget that over the years many devotees of Warren
Buffett’s investment approach have taken his philosophy and applied it to
different parts of the stock market. Several prominent investors have
bought stocks not found anywhere in Berkshire’s portfolio. Others have
bought smaller-capitalization stocks. A few have taken Buffett’s approach
into the international market and purchased foreign securities. The im-
portant takeaway is this: Buffett’s investment approach is applicable to all
types of businesses, regardless of industry, regardless of market capitaliza-
tion, regardless of where the business is domiciled.
Since becoming part of Legg Mason Capital Management in 1998,
my growth fund has enjoyed a remarkable period of superior invest-
ment performance. The reason for this much better performance is not
that the philosophy or process changed, but that the philosophy and
process were applied to a larger universe of stocks. When portfolio
managers and analysts are willing to study all types of business models,
regardless of industry classif ication, the opportunity to exploit the mar-
ket’s periodic mispricing greatly expands, and this translates into better
returns for our shareholders.
2 0 8
A F T E R W O R D
This does not mean we do not have an occasional bad year, bad
quarter, or bad month. It simply means when you add up all the times
we lost money relative to the market, using any time period, the amount
of money we lost was smaller than the amount of money we made when
we outperformed the market.
In this respect, the record of this fund is not far different from other
focused portfolios. Think back to the performance of Charlie Munger,
Bill Ruane, and Lou Simpson. Each one achieved outstanding long-
term performance but endured periods of short-term underperfor-
mance. Each one employed a business valuation process to determine
whether stocks were mispriced. Each one ran concentrated, low-
turnover portfolios. The process they used enabled them to achieve su-
perior long-term results at the expense of a higher standard deviation.
Michael Mauboussin, the chief investment strategist at Legg Mason
Capital Management, conducted a study of the best-performing mutual
funds between 1992 and 2002.
1
He screened for funds that had one
manager during the period, had assets of at least $1 billion, and beat the
Standard & Poor’s 500 Index over the ten-year period. Thirty-one mu-
tual funds made the cut.
Then he looked at the process each manager used to beat the mar-
ket, and isolated four attributes that set this group apart from the ma-
jority of fund managers.
1.
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