“One of the greatest investors” explains his portfolio strategy
Lou Simpson, former chief investment officer of Geico – a subsidiary of Berkshire Hathaway – and current chairman of SQ Advisors, has been called “one of the greats in investing” by none other than Berkshire Chairman and legendary investor Warren Buffett. At the time of his retirement from Geico in 2010, Simpson managed a portfolio valued at over $4 billion. Today, he is also a Senior Research Fellow and Assistant Professor of Finance at Kellogg, and a member of the Kellogg Asset Management Internship Advisory Board as well as a member of the Board of Trustees of Northwestern University.
Kellogg School finance professor Robert Korajczyk sat down with Simpson to discuss his remarkably successful investing strategy.
This interview has been edited for length and clarity.
Robert Korajczyk: In your opinion, what is the essence of your investment philosophy?
louis simpson: The essence is simplicity. The base case for investing in any area of the market is a passive product, such as an index fund. This is something that any investor can access.
If you are a professional investor, the question is: how can you add value? The more you trade, the harder it is to add value because you absorb a lot of transaction costs, not to mention taxes.
What we do is manage a long-term portfolio of ten to fifteen stocks. Most of them are based in the United States and they all have similar characteristics. Basically, they are good companies. They have a high return on capital, consistently good returns, and they’re run by leaders who want to create long-term shareholder value while treating their stakeholders well.
Korajczyk: This way, you focus your investments on your best ideas.
Simpsons: You can only know a limited number of companies. If you manage 50 or 100 positions, the chances that you can add value are much, much lower.
So far this year we have purchased one new post, and are seriously considering one more. I don’t know what we will decide to do. Our turnover is 15, 20%. Usually we add one or two things and get rid of one or two things.
Warren [Buffett] used to say you should think of investing like someone giving you a transport card with 20 punches. Each time you make a change, punch a hole in the card. Once you’ve made your twentieth change, you should stick with what you have. The point is just to be very careful with every decision you make. The more decisions you make, the more likely you are to make a bad decision.
One thing a lot of investors do is cut their flowers and water their weeds. They sell their winners and keep their losers, hoping the losers will even come back. Generally, it is more efficient to cut your weeds and water your flowers. Sell the things that haven’t worked and let the things that work run out.
Korajczyk: Are investors afraid to let the good slip away?
Simpsons: If I’ve made a mistake in managing investments, it’s selling great companies too soon. Because generally, if you have made good investments, they will last a long time. Of course, things can change. Amazon is radically changing retail.
Korajczyk: What is the right balance between quantitative and qualitative skills in your approach to investing?
Simpsons: Well, I think you need a combination of quantitative and qualitative skills. Most people now have the quantitative skills. Qualitative skills develop over time.
But, as Warren used to tell me, “It’s better to be almost right than exactly wrong.” Everyone talks about modeling – and modeling is probably worth doing – but if you can get roughly right, you’ll be fine.
For example, one thing you need to determine is: are the company’s executives honest? Are they integrated? Do they have a huge turnover? Do they treat their people badly? Does the CEO believe in managing the business for the long term or is he focused on consensus earnings in the next quarter?
Korajczyk: It seems that qualitative skills can help you assess the downsides of a concentrated portfolio, namely concentrated risk. What are some of the factors you look at when you’re worried about an investment blowing up and damaging your portfolio?
Simpsons: There are a few factors we look at. First of all, is this the company we thought it was? If you realize a business isn’t what you thought it was, that’s a bad sign.
The second factor is management, which may also differ from what you thought. Unfortunately, a lot of management is very short-term oriented, and that can be another reason to sell. This goes back to the basic integrity and orientation of those in charge.
The third factor is too high a valuation, and that’s often the most difficult, because you’re investing in something that you wouldn’t buy at current prices, but don’t want to sell because it’s a very good deal and you think it’s ahead of itself on a price basis. It might be worth keeping it for a while.
Korajczyk: I feel like you and Warren Buffett have very compatible investment styles. Is there anything interesting differences between you and warren?
Simpsons: The biggest difference between Warren and me is that Warren had a much tougher job. He managed 20 times more money than us. We were managing five billion. In shares, he could have managed 80, 90, 100 billion. So he was much more limited in what he could buy if he wanted to have a concentrated portfolio, which he did.
Korajczyk: You emphasize a long-term vision and a low turnover rate. It seems to be true that the more you trade, the lower your returns.
Simpsons: Yes, I think there is a strong correlation. There is also a negative correlation between the number of people making the investment decisions and the results. If you have a lot of people involved, it’s usually the least competent person who makes the decision, because you need consensus.
One thing I tell people is that if you really don’t think you can add value — and most people can’t — then I think your basic investment scenario should be a low cost passive product.
Korajczyk: Is there a way for someone to be an active investor, but only spend a few hours on the weekend doing research?
Simpsons: You probably could. But even among professionals who trade full time, the majority do not add value. Because, again, you have fees, you have transaction costs.
Yes, I think there are people with the right mindset and maybe contacts, and certainly lucky ones, who could outperform the market. But if someone is going to invest using sound advice, or listening to CNBC, or investing with so-called wealth managers at brokerage firms, I think it’s a losing game for them.