Portfolio Head Goes the Buffett Way

Portfolio manager Robert G. Hagstrom Jr. has spent more than three years immersed in the money-making tenets and strategies of famed investor Warren E. Buffett.

In 1994 he wrote a best-selling book, "The Warren Buffett Way," and in 1995 he set up Focus Trust Fund, which mimics Mr. Buffett's wildly successful investment vehicle, Berkshire Hathaway Inc.

But when it comes to bank stocks, Mr. Hagstrom, who is 40, is more rigid than his famous mentor in Omaha. He doesn't like them.

Mr. Hagstrom, who started the $8 million Focus Fund two years ago, focuses 25% of its portfolio on financial stocks. And he is indirectly a stakeholder in Wells Fargo & Co. and several other banks through his holdings in Berkshire Hathaway.

Yet he has no problems saying he is "slightly prejudiced against banks." His stance is firm, even after acknowledging that banks have enjoyed strong earnings and that their stocks were a prime driver of last year's huge market rally.

Mr. Buffett's market strategy is based on investing in "businesses that make sense," said Mr. Hagstrom, whose own fund is headquartered in Wayne, Pa.

More specifically, Mr. Hagstrom says, Mr. Buffett aims to invest in businesses that are easy to understand, are backed by a consistent operating history, and enjoy favorable long-term business prospects.

Moreover, the ideal company from Mr. Buffett's perspective also ought to be under a management team that "genuinely and accurately" disclosures its earnings, he adds.

As Mr. Hagstrom sees it, banks have no consistent operating history because of the cyclicality in both their earnings and stock performance, said Mr. Hagstrom.

Furthermore, banking is a business where "you have to have an incredible trust in the loan officers and managers of the bank," Mr. Hagstrom added. "So here is a situation where your balance sheet is leveraged almost 90% and one slip can wipe out your equity. We have seen that before."

Another drawback, as he sees it, is that banks-with the exception of Wells Fargo & Co.-don't have what Mr. Buffett calls "share of mind," or brand awareness, explains, Mr. Hagstrom.

"When most people see golden arches, they think of McDonalds, or when they think of the phrase "don't leave home without it, they think of American Express," said Mr. Hagstrom. "But I can't name too many corporate emblems when I think of banks."

Mr. Hagstrom recognizes that some bank stock investors will profit from the rapidly consolidating industry. But at the same time he notes that banks commit one of Mr. Warren Buffett's cardinal no-no's, which is to pay too much to buy each other.

"The thinking is that they can pay a premium on the front end and because of the cost savings and increased efficiencies it all washes," said Mr. Hagstrom. "The smarter thing to do is to pay fair value for the business and then improve it."

When banks buy other banks at premiums to the seller's market price and use stock as the currency, the shares of the acquiring bank fall, while the shares of the one being acquired rise, he added. continued Mr. Hagstrom.

"To me the net gain is minimal." asserted Mr. Hagstrom, who nevertheless admits without hesitation that he "has missed some opportunities by not buying bank stocks."

And specifically, "Wells Fargo was one that we missed." Its return on equity was 30% and, regarding its merger with First Interstate, "they are wringing the hell out of the inefficiencies," Mr. Hagstrom said.

He speaks avidly of American Express Co., a stock which makes up 11% of his portfolio. The company is generating a 20% of return on equity, has strong margins and has smaller losses on its credit cards than its competitors, he said. Mr. Hagstrom also has a substantial stake in Federal National Mortgage Association, or Fannie Mae.

Mr. Hagstrom notes that banks do not dominate Mr. Buffett's portfolio either.

Indeed. At Berkshire Hathaway's heavily attended annual shareholder meeting earlier this month, banks were notably absent from Mr. Buffett's speech on his holding company's performance.

And according to the Berkshire Hathaway's 1996 annual report, PNC Bank no longer is among Mr. Buffett's bigger holdings.

Even if Mr. Buffett's interest in banks were to suddenly swell, Mr. Hagstrom is doubtful that his position on the industry would change much.

"I'm sure there are good quality banks, I just don't think that that particular fishing hole is stocked with great catches," he said. "We are going to other ponds where we think the fishing is better."

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