HOW SMART IS WARREN BUFFETT?

By JOHN ROTHCHILD

A friend of mine, who shares my weakness for making ill-fated investments, recently bought a share of Berkshire Hathaway. That's the flagship company of Warren Buffett, who recently surpassed Bill Gates as the nation's richest human. Like many of us, Buffett started with a modest bankroll, only he managed to turn his into $13 billion-plus. We've seen oil magnates, real estate moguls, shippers and robber barons at the top of the money heap, but Buffett is the first person to get there just by picking stocks.

While we've all been puttering around with our own portfolios, buying what Mario Gabelli likes, or last year's laggards in the Dow, we could have been sitting on a few shares of Berkshire Hathaway and turned $1,000 into $1 million. That's the return since 1969. I actually owned Berkshire for a stretch in the 1980s but sold it too soon. Buffett himself rarely sells too soon. A key element of his strategy is to buy companies at favorable prices and sit on them. It's the sitting part that Robert Hagstrom says most of us overlook.

Hagstrom is a Philadelphia investment adviser and longtime fan of Buffett's. While other Buffett buffs were waiting for their hero to write a book that explains how he does it, Hagstrom came out of nowhere as a replacement author. The publication last November of his book, The Warren Buffett Way, helped spark a sudden rise in the stock price of Berkshire Hathaway from $16,000 to a record $25,000 a share (this is no penny stock). Since Buffett owns 42% of Berkshire Hathaway, Hagstrom's effort made Buffett $2 billion richer, at least temporarily. This is the biggest favor ever done to a subject by a writer, and Hagstrom has never even met Buffett.

True to his instincts, the investor friend I mentioned earlier naturally waited for Hagstrom's readers to bid up Buffett's stock to an extravagant level before buying his first share. Had he read Hagstrom's book beforehand, he might have thought better of it because another of Buffett's rules is that you should pay sensible prices for things.

Hagstrom's detailed description of Buffett's modus operandi has caused a bit of confusion among Buffett followers. Inspired by the book, a number cruncher at Standard & Poor's took all the attributes of a Buffett-type investment (consistent profitability, high return on equity, etc.) and programmed a computer to spit out the names of the companies that qualified. Thirty did, but only two of those stocks are actually found in Buffett's portfolio at Berkshire Hathaway. As the Standard & Poor's computer sees it, most of Buffett's biggest holdings, with the exception of U.S. Tobacco and Coca-Cola, shouldn't be there. This poses a problem: If you want to invest like Buffett, do you buy the stocks he owns--or the stocks a computer says he ought to own?

I recently met up with Hagstrom in New York. He says we could argue all day about how Buffett picks stocks and what a computer thinks about it. A lot of good investors own good stocks, but what makes Buffett a great investor is that he owns only a few stocks and sticks with them. Eighty percent of the gains in Berkshire Hathaway have come from just six issues. Year after year he holds them, long after the rest of us would have got tired of seeing them on a brokerage statement. The last time Buffett disposed of a major position was 1986, when he dumped Handy & Harman, a precious-metals outfit, and Lear Siegler, an auto-parts manufacturer. Two years ago, he sold a third of his position in Capital Cities/ABC, and has since admitted that he made a mistake there.

Buying and holding wouldn't have worked with the clinkers in my portfolio, but Buffett doesn't have too many clinkers, except perhaps for USAir (another mistake he recently acknowledged). Neither, however, has he ever invested in the winningest stocks in the country. None of his holdings made the list of the top 50 performers over the past 20 years. So if he's the winningest investor without having owned the winningest stocks, something other than stock picking must have helped him.

Hagstrom has recently joined forces with Joan Lamm-Tennant, a professor of finance at Villanova, to test whether buying and holding make any difference on portfolios that are randomly selected by Villanova's computers. They tracked the performance of 3,000 fictional portfolios--some containing as few as 10 stocks, others as many as 150, going back 10 years. The upshot is that portfolios with the fewest stocks and the lowest turnover outperform portfolios with more stocks and a higher turnover. And that's without taking brokerage fees and taxes into account.

In a second test, they took randomly selected portfolios of 10 stocks each and compared results with the average mutual fund over a 10-year stretch. Apparently, the random portfolios do just as well as the funds. Perhaps this explains why funds can't come close to matching Buffett's record. Berkshire Hathaway resembles a fund, but since it isn't one, Buffett has the freedom to be boring.

Hagstrom's next step is to launch a mutual fund, Focus Trust, based on Buffett's principles. It's in registration and scheduled to be launched in April. The plan is to pick a few stocks that Buffett might want to own (though probably not the ones he does own) and hold onto them. The management fee will be very low, because with that strategy, the managers won't have much to do.