Morningstar Advisor - Fall 2008 - (Page 50)

Morningstar Conversation coming up with most of the ideas and assigning them to the research department. All I want the analyst to do is tell me what the business is worth. Then I look at the model that they’ve put together to try to understand how they came to that conclusion. How are they weighting the outcomes? How do they think about margins? How are they thinking about sales and growth? We then discuss how they see the model versus how I see it, and we massage it to get the model to where I think it should be. KK: Let’s step back and talk about the market in general. RH: People are so fond of the baseball metaphors. Is it the third inning or the sixth inning? I don’t know. If you think we’ll get to the other side of the crisis, the question, right here today, is how do you think about making money from [the] change that will ultimately happen? Robert Hagstrom KK: No sports metaphors here. RH: Okay, no sports metaphors. Clearly, we’re in a very difficult period. If you think about oil, credit, and housing being kind of gale-force winds that are pushing on the capital markets, it’s very severe. think about valuation and not to focus on outcomes. Because outcomes vary from day to day, week to week, and so on, I think people who become outcome-focused are always trying to adapt their process to the outcome. They’re chasing their tails. If we concentrate on process and tease out what mispricing is, what valuation is, I think we’ll be fine. Just tell me what the business is worth. We do a lot of decision trades, which is basically capturing the cone. In the decision tree, you’re assigning a probability to this outcome, to this outcome, and to this outcome, and to a zero note in case of financials. It really is how do you weight all these potential outcomes. KK: That seems like a less precise way of attracted to precision models that can give you the decimal point that makes you comfortable? Yeah, I think people are attracted to that psychologically. Are you attracted to a model that has variant outcomes of different probabilities of which the weighted average outcome of those is the approximate value of something? That may be kind of loose for people to think about, but mathematically, it’s exactly the way in which I think about it. If you go back through the Buffett literature and the methodology, Buffett exactly works with approximations of different outcomes and weights them and gets a weighted average. As he says, I’m just trying to figure out what it’s approximately worth based upon these different scenarios and then buy them at a big discount. KK: Do you or the analysts surface ideas? But what I’ve been trying to think about and get my hands around is that if you went back to 1990-91 and read all the popular press, what would you have been thinking then? It was a horrible time: 300 bank failures, a Middle East war, major financial institutions on the brink, and the Resolution Trust Corp. You had massive deleveraging in this system. People said banks will never earn a decent profit. It was a very pessimistic period of time. Here’s the optimist in me: We will get to the other side of this mess. If we don’t think we will, then let’s just go get gold, and we’ll put it in the back yard and call it a day. But if you think we’ll get to the other side of the crisis, the question, right here today, is how do you think about making money from this change that will ultimately happen? The big challenge is that markets move before the bad news ends. In January 1991, the doing things. RH: Is it less precise than doing a P/E multiple? I’m trying to be, as Buffett says, “approximately right as opposed to precisely wrong.” Are you RH: We’re still primarily a portfolio-manager- driven system; the portfolio managers are 50 Morningstar Advisor Fall 2008

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Morningstar Advisor - Fall 2008 Contents New on MorningstarAdvisor.com Letter from the Editor Contributors Inbox Are You Preparing for Higher Taxes? State of Financials Oracles of Alabama Investment Briefs Managers’ Investment Secrets Revealed Conformity Becomes a Growing Concern at American Gimme Shelter Location, Location, Location Rooted in Buffett, Going for Growth Keeping Little Company Away from the Numbers Consumer Confidence What about Natural Gas? TIPS to Beat Back Inflation Investing in Hidden Assets Funds That Have an Edge Come Tax Time Mutual Fund Analyst Picks 50 Most Popular Equity ETFs Undervalued Stocks Most Popular Variable Annuities New at Morningstar One for You, 19 for Me

Morningstar Advisor - Fall 2008

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