January 27, 2022

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Cash flow return is a useful metric as it cannot be manipulated, says star investor Simpson

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Warren Buffett is without a doubt one of the greatest investors of all time. But there are many more hidden gems like him who have achieved extraordinary success in their investment career. One such name is Lou Simpson, who is largely unknown even among the investing community.

Simpson quietly racked up a track record that bettered the S&P 500 by 6.8%. The former chief investment officer of GEICO, Simpson, produced a 20.3% return for the company over 25 years. Upon his retirement in 2010, Buffett praised him in Berkshire’s 2010 letter and said, “Simply put, Lou is one of the investment greats.”

At the time of his retirement from GEICO in 2010, Simpson managed a portfolio valued at more than $4 billion. He also served as a senior fellow and is an adjunct professor of finance at Kellogg, was a member of the Advisory Council of Kellogg’s Asset Management Practicum as well as a member of Northwestern University’s Board of Trustees.

Investment Strategy
Simpson developed his investment approach through trial and error and kept on evolving it over decades. Earlier in his career, long before being hired by GEICO, he was a growth investor often failing to predict whether that growth was being offered at a bargain price. His approach was to aim for spectacular returns from a few big performers. But after having his share of ups and downs, he realised that good long-run results came from buying companies with established high performance records that have low risk and are available at a low price.

Simpson shared the same investment philosophy as Buffett and Philip Fisher, which revolves around a few main tenants and is best described as concentrated, long-term bets in great businesses with great management at reasonable prices.

He says there is no mystery to his stock market success. Simpson searches daily newspapers, magazines, annual reports and newsletters for clues that might spark investment ideas. He uses computer screens to identify stocks that, on the basis of financial data, appear to be bargains.

Simpson left Geico in 2010 and started his own fund, SQ Advisers, in 2011. SQ Advisers, which now manages more than $3 billion, has a management strategy developed and implemented using Simpson’s investment principles as guidelines. Let’s look at some of these principles of this great investor.

Do your own analysis
Investors should obtain information on their own and do their own analysis before making an investment decision, he says. They shouldn’t let irrational behaviour and emotions get the better of them. Investors should be willing to consider unpopular and unloved companies as they often offer greatest opportunities, says the ex-CIO of GEICO.

“We try to be skeptical of conventional wisdom and try to avoid the waves of irrational behaviour and emotion that periodically engulf Wall Street. We don’t ignore unpopular companies. On the contrary, such situations often present the greatest opportunities,” he once said in an interview to a financial website.

Invest in high-return businesses run for the shareholders
Simpson is of the view that over the long run, share price appreciation is directly related to the return the company earns on its shareholders’ investment. He suggests investors look at the rate of return on shareholders’ money used within the business to identify superior businesses. 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 of 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, says the adjunct professor of finance. “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,” he says.

Pay only a reasonable price, even for an excellent business
Once a superior business has been identified, its shares should only be bought if the price is not excessive relative to its prospects, Simpson insists. “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 if the price is too high.”

Invest for the long term
Attempting to guess short-term swings in individual stocks, the stock market or the economy is not likely to produce consistently good results, says the Chairman of SQ Advisors. Hence, investors should look to invest for the long term as short-term developments are too unpredictable.

Do not diversify excessively.
Simpson, who was an instructor of economics at Princeton University earlier in his career, points out that investors are not likely to obtain superior results by buying a broad cross-section of the market. The more investors try to diversify their portfolio, the more their 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,” he says.

According to Simpson, one of the keys to successful investing is to make a relatively small number of investments. “One lesson I have learned is to make fewer decisions. Sometimes the best thing to do is to do nothing. The hardest thing to do is to sit with cash. It is very boring.”

Read as much as possible
Simpson insists investors should have a voracious appetite for financial newspapers, annual reports and industry reports. They should generally read five to eight hours a day if they want to be successful.

Buy quality business
Investors should look to buy quality businesses below intrinsic value, said Simpson, who has been a director of a number of publicly traded companies. “The essence of my investment philosophy is simplicity. Identifying a significant difference between the market value of a security and the intrinsic value of that security is what defines an investment opportunity,” he says.

Make wise decisions
Investors should make decisions very wisely as the more decisions they make, the higher the chances are that they will make a poor decision, says the former economics instructor.

Investors make the mistake of selling their winners and keep their losers, hoping the losers will come back even. Instead, he says, sell the things that didn’t work out, and let the things that are working out run. “One thing a lot of investors do is they cut their flowers and water their weeds. Generally, it’s more effective to cut your weeds and water your flowers. 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,” he says.

Develop both quantitative and qualitative skills
A combination of quantitative and qualitative skills is required to achieve success in investment. Investors have quantitative skills but have to develop qualitative skills over time, he says.

Be patient
Simpson points out that a lot of people don’t have the patience or temperament to really be investors. The stock market is like the weather and if investors don’t like the current conditions, all they have to do is wait for a while for things to get better. “If you cannot be patient, it is impossible to be a successful value investor. While being patient is a key attribute, you must also be capable of being aggressive and pouncing on an opportunity when the time is right. Patience and aggressiveness as desirable qualities for an investor may seem a bit odd to some people, but they are essential,” he adds.

Hence, according to one of the greatest investors of our time, dealing in a circle of competence, dealing with companies that investors have the ability to understand, being able to come up with a good analysis of a company’s value and earning power are fundamental for achieving success as a value investor.

(Disclaimer: This article is based on Lou Simpson’s various interviews)

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