By Glen Arnold
Geico is probably the best investment Warren Buffett ever made. Much is due to the terrific performance of the insurer’s underwriters. But what turbocharged his return is the investment record of GEICO’s chief investment officer.
Lou Simpson’s record at Geico from 1979 to 2010 rivals that of Buffett at Berkshire Hathaway (NYS:BRK.A) (NYS:BRK.B) , but he remains little-known, except by true Buffett fans.
Despite their different investment choices, Simpson, now 81 years old, and Buffett in many ways have similar investment philosophies. Buffett so admired Simpson that he suggested at one time that the Geico CIO could step in should something happen to himself and Charlie Munger. For his part, Simpson said his smaller portfolio gave him an advantage over Buffett. While they were both running concentrated portfolios of less than 15 to 20 shares (often seven companies or less), Buffett had to manage up to $40 billion whereas Simpson usually had less than $4 billion.
Like Buffett, Simpson developed his investment approach through trial and error, evolving over decades. Earlier in his career, long before being hired by Geico, he was a “growth investor” often failing to properly consider whether that growth was being offered at a reasonable price. He was aiming for spectacular returns from a few star performers, hoping that he had guessed the future correctly.
But through bitter experience he learned that good long-run results come from buying companies with established high performance (rather than mere promises of future riches) with low risk and at a low price.
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Today, many people can crunch the company’s numbers and determine whether the share price looks cheap. But they need to be equally sharp in judging qualitative factors, he told an audience at Northwestern University’s Kellogg School of Management in November 2017.
“As Warren used to tell me, “You’re better off being approximately right than exactly wrong.” For example, one thing you need to determine is: Are the company’s leaders honest? Do they have integrity? Do they have huge turnover? Do they treat their people poorly? Does the CEO believe in running the business for the long term, or is he or she focused on the next quarter’s consensus earnings?”
Buffett highlighted Simpson’s impressive performance data from 1980 through 2004 in his 2004 letter to shareholders . Most fund managers would consider themselves well ahead of the pack if they delivered an annual average outperformance of a mere 1 percentage point; Simpson outperformed by a stunning 6.8% percentage points over a 25-year span.
Geico’s equity portfolio gained an average of 20.3% a year, compared to the S&P 500’s 13.5% (S&P:SPX) . Put another way, a $10,000 investment compounded at a 13.5% annual rate becomes $237,081 after 25 years; at a 20.3% annual rate, it becomes $1,015,408.
Of course, all investors have years where they underperform the market; Simpson underperformed for three years in a row. As a value investor, Simpson was out of step with the irrational exuberance of the late 1990s dot-com boom. But he stuck to his principles and delivered great results in the years following the 2000 crash.
Here are five key principles that helped Simpson in his quest for outperformance.
Read (all day if you can)
Simpson has a voracious appetite for financial newspapers, other intelligent press, annual reports, industry reports, and generally reads five to eight hours a day. He, like Buffett, is not trading-intensive but reading-intensive and thought-intensive
Be skeptical of conventional wisdom. Obtain your own information and do your own analysis. Don’t get caught up in waves of irrational behavior and emotion. Be willing to consider unpopular and unloved companies as they often offer the greatest opportunities.
Make few investments. Hold them for a long time.
Simpson continues to invest through SQ Advisors, where he is chairman. Good investment ideas — companies that meet his investment criteria — are hard to find. So when he finds one, he makes a large commitment.
Typically, SQ Advisors adds just one or two investments a year to a portfolio of 10 to 15 stocks and drops one or two, he told that Northwestern audience. And sometimes the best plan is to do nothing.
SQ Advisors’ holdings
|Company||Ticker||Industry||Shares held as of March 31 (thousands)||Value as of March 31 ($millions)||Total return - 2018 through May 25|
|Allison Transmission Holdings Inc.||(NYS:ALSN)||Trucks/Construction/Farm Machinery||8,899||$347.6||0%|
|Brookfield Asset Management Inc. Class A||(TSE:CA:BAM.A)||Investment Managers||8,839||$344.7||-4%|
|Charles Schwab Corp.||(NYS:SCHW)||Investment Banks/Brokers||5,960||$311.2||12%|
|CarMax, Inc.||(NYS:KMX)||Specialty Stores||4,948||$306.5||5%|
|Liberty Global PLC Class C||(NAS:LBTYK)||Cable/Satellite TV||9,573||$291.3||-18%|
|Cable One Inc.||(NYS:CABO)||Cable/Satellite TV||365||$250.7||-6%|
|Apple Inc.||(NAS:AAPL)||Telecommunications Equipment||1,209||$202.8||12%|
|Sensata Technologies Holding PLC||(NYS:ST)||Electronic Equipment/Instruments||3,880||$201.0||2%|
|Tyler Technologies Inc.||(NYS:TYL)||Data Processing Services||878||$185.3||29%|
|Charter Communications Inc. Class A||(NAS:CHTR)||Cable/Satellite TV||625||$194.4||-20%|
|Berkshire Hathaway Inc. Class B||(NYS:BRK.B)||Multi-Line Insurance||798||$159.1||-2%|
|Liberty Broadband Corp. Class C||(NAS:LBRDK)||Specialty Telecommunications||1,596||$136.8||-16%|
|Axalta Coating Systems Ltd.||(NYS:AXTA)||Industrial Specialties||32||$0.971||0%|
|SBA Communications Corp. Class A||(NAS:SBAC)||Real Estate Investment Trusts||5||$0.876||-3%|
|Hexcel Corp.||(NYS:HXL)||Aerospace & Defense||5||$0.339||16%|
|Source: SEC 13-F filing for March 31, 2018 ; FactSet|
Simpson admits that mastering inactivity is difficult to do because it “is very boring”, but it is often the right thing to do.
“Warren used to say you should think of investing as somebody giving you a fare card with 20 punches. Each time you make a change, punch a hole in the card. Once you have made your 20th change, you have to stick with what you own. The point is just to be very careful with each decision you make. The more decisions you make, the higher the chances are that you will make a poor decision,” he said at Northwestern.
Buy at a reasonable price
Look at the rate of return on shareholders’ money used within the business. If it is high and sustainable given the strategic position of the company and the quality of management, then there is a good chance of long-run appreciation in the share price. Cash-flow return, rather than profit return, can be a useful additional metric given that it is more difficult to manipulate than profit.
Once a superior business has been identified then its shares should only be bought if the price is not excessive relative to its prospects. Simpson uses indicators such as earnings yield. He also uses the ratio of price to free cash flow.
Sell your mistakes and hold the successes
Investors have a tendency to hold on to losing shares — they might come back, and who wants to crystallize a loss? — while selling early those that are performing well.
Simpson summed up his opposition to these notions this way during his talk at Northwestern: “One thing a lot of investors do is they cut their flowers and water their weeds. They sell their winners and keep their losers, hoping the losers will come back even. Generally, it’s more effective to cut your weeds and water your flowers. Sell the things that didn’t work out, and let the things that are working out run…If I’ve made one mistake in the course of managing investments it was selling really good companies too soon. Because generally, if you’ve made good investments, they will last for a long time.”
Glen Arnold is an investor and the author of “The Deals of Warren Buffett Vol 1: The First $100 Million.”
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