206 AFTERWORD
Back then Microsoft was a $22 billion business that most value in-
vestors thought was signif icantly 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,