Unlike all other CEOs of Warren Buffett's Berkshire Hathaway diverse business empire, who make annual shipments of excess capital and retained earnings to Omaha--Lou Simpson of GEICO Insurance keeps his retained earnings and float and makes his own independent investment decisions. Louis A. Simpson has become a superinvestor in his own right, and appears positioned to take over Berkshire if something were to happen to Buffett and Charlie Munger.
Simpson downplays the liklihood of ever becoming Buffett's successor. First of all, he is only six years younger than Buffett. Simpson says, I don't even think about it. I see myself as a potential back-up. Warren is Berkshire and as long as Warren is around he will be running Berkshire. He as dedicated his life to it and he's the best person to do it. Of course, taking over from Buffett would be no easy responsibility--not only because of the responsibility to manage over US$75 billion in assets, but to work under the shadow of such a renowned legend.
Simpson was born in Chicago in 1936 and initially enrolled in Northwestern University to study engineering, but soon transferred to Ohio Wesleyan University and changed majors to accounting and econimics. He later received a masters degree in economics from Princeton. His first job was with Chicago investment firm Stein, Roe & Farnham in 1962. In 1969, he left to join Los Angeles-based Shareholders Management, an aggressive growth fund. The market tumbled almost immediately, and Simpson learned a lifelong lesson about the importance of considering both valuation and growth when choosing investments. In 1971 he became vice president of Western Asset Management, and was promoted to President in 1976.
In 1979, GEICO's chairman, John J. Byrne, Jr., was looking for a new chief investment officer, and Simpson was one of the four final candidates. Since Buffett at that time already owned about 30% of GEICO, Byrne send the four candidates to Omaha for Buffett interviews. After Simpson left Buffett's office, he phoned Byrne and said, Stop the search,. That's the guy. Simpson's official title was senior vice president and chief investment officer.
Given free rein by his new employers, Simpson switched from bonds to utility, energy, and industrial stocks, and also increased GEICO�s holdings in food packaging and banking companies. Common stocks soon came to represent 32% of the company's portfolio, versus just 12% when he took over. Although his first-year return of 23.7% on equities was well below the market average of 32.3%, in 1982, when the US market's gain was 21.4%, GEICCO's was 45.8%. During the 17 years between his joining the company and its being sold to Berkshire Hathaway in 1996, Simpson achieved average annual returns of 24.7% (versus S&P's 17.8%), beat the S&P Index in 12 of 17 years, and increased GEICO's portfolio value from US$280 million to $1.1 billion.
Focused Investing
Simpson had $2.5 billion in just 7 stocks in 1996. By contrast, the average large-cap value mutual fund owns 86 stocks. Warren Buffett is renowned for following a concentrated approach that puts over 70% of Berkshire common stock holdings in just 4 stocks. Lou Simpson is the same. To quote Simpson, If we could find 15 positions that we really had confidence in, we'd be in 15 positions. We'll never be in 100 positions because we're never going to know 100 companies that well. I think the merits of a concentrated portfolio are: You live by the sword, you die by the sword. If you're right, you're going to add value. If you're going to add value, you're going to have to look different than the market. That means either being concentrated, or, if you're not concentrated in a number of issues, you�re concentrated in types of businesses or industries.
Stock Selections
It begins with research. Once Lou Simpson has identified a possible stock purchase, a meeting with company executives is arranged. One of the things I have learned over the years, Simpson says, is how important management is in building or subtracting from value. We will try to see a senior person, and prefer to visit the company at their office, almost like kicking the tires. You can have all the written information in the world, but I think it is important to figure out how senior people in the company think. Given his status ($2.5 billion under his control and billions more available) and the fact that Simpson can make a substantial investment on behalf of GEICO, a company�s executives are, more often than not, agreeable to meeting. If they are not agreeable, he doesn't invest in the company.
This is one area where Simpson disagrees somewhat with his boss, Mr. Buffett, and famed value investor Ben Graham. Instead, he follows legendary investor Phil Fisher and the qualitative approach to investing. Graham believe primarily in quantitative analysis: By studying the numbers, a wise investor can determine the best investment. In fact, Graham wrote that visiting management, also known as qualitative analysis, might subject an investor to management's salesmanship and charm. Buffett initially follow Graham's investing methods closely, but over time evolved into a blend of Graham and Fisher (with the help of close confidant and partner, Charlie Munger) with remarkable results. With a serious demeanor, straight talk, and down-to-business approach, few if any managers would have the ability to charm Simpson.
Lou Simpson has three qualities that are admired by Warren Buffett: intellect, character, and temperament. Buffett on Simpson, Temperament is what causes smart people not to function well. His temperament probably isn't different than mine. We both tend to do rational things. Our emotions don't get in the way of our intellect. As Charlie Munger says, I would argue that good stock-picking records are held by people who are a little cranky and are willing to bet against the herd. Lou just has that mind-set and that's what impressed us. Buffett and Simpson are not people-intensive but thought-intensive. They are not trading intensive but reading-intensive.
Lou Simpson manages his portfolio according to five basic principles. He outlined these timeless principles in GEICO's 1986 annual report, and he explained them at greater length in an interview with the Washington Post the following year:
1. Think independently. We try to be skeptical of conventional wisdom, he says, and try to avoid the waves of irrational behavior and emotion that periodically engulf Wall Street. We don't ignore unpopular companies. On the contrary, such situations often present the greatest opportunities.
2. Invest in high-return businesses that are fun for the shareholders. Over the long run, he explains, appreciation in share prices is most directly related to the return the company earns on its shareholders' investment. Cash flow, which is more difficult to manipulate than reported earnings, is a useful additional yardstick. We ask the following questions in evaluating management: Does management have a substantial stake in the stock of the company? Is management straightforward in dealings with the owners? Is management willing to divest unprofitable operations? Does management use excess cash to repurchase shares? The last may be the most important. Managers who run a profitable business often use excess cash to expand into less profitable endeavors. Repurchase of shares is in many cases a much more advantageous use of surplus resources.
3. Pay only a reasonable price, even for an excellent business. We try to be disciplined in the price we pay for ownership even in a demonstrably superior business. Even the world's greatest business is not a good investment, he concludes, if the price is too high. The ratio of price to earnings and its inverse, the earnings yield, are useful guages in valuing a company, as is the ratio of price to free cash flow. A helpful comparison is the earnings yield of a company versus the return on a risk-free long-term United States Government obilgation.
4. Invest for the long term. Attempting to guess short-term swings in individual stocks, the stock market, or the economy, he argues, is not likely to produce consistently good results. Short-term developments are too unpredictable. On the other hand, shares of quality companies run for the shareholders stand an excellent chance of providing above-average returns to investors over the long term. Furthermore, moving in and out of stocks frequently has two major disadvantages that will substantially diminish results: transaction costs and taxes. Capital will grow more rapidly if earnings compound with as few interruptions for commissions and tax bites as possible.
5. Do not diversify excessively. An investor is not likely to obtain superior results by buying a broad cross-section of the market, he believes. The more diversification, the more performance is likely to be average, at best. We concentrate our holdings in a few companies that meet our investment criteria. Good investment ideas--that is, companies that meet our criteria--are difficult to find. When we think we have found one, we make a large commitment. The five largest holdings at GEICO account for more than 50 percent of the stock portfolio.
Buffett, also quoted by the Washington Post, Lou has made me a lot of money. Under today's circumstances, he is the best I know. He has done a lot better than I have done in the last few years. He has seen opportunities I have missed. We have $700 million of our own net worth of $2.4 billion invested in GEICO's operations, and I have no say whatsoever in how Lou manages the investments. He sticks to his principles. Most people on Wall Street don't have principles to begin with. And if they have them, they don't stick to them.
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