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- Herausgeber: John Wiley & Sons
- Kategorie: Fachliteratur
- Sprache: Englisch
Discover the secrets of the world's top concentrated value investors
Concentrated Investing: Strategies of the World's Greatest Concentrated Value Investors chronicles the virtually unknown—but wildly successful—value investors who have regularly and spectacularly blown away the results of even the world's top fund managers. Sharing the insights of these top value investors, expert authors Allen Benello, Michael van Biema, and Tobias Carlisle unveil the strategies that make concentrated value investing incredibly profitable, while at the same time showing how to mitigate risk over time. Highlighting the history and approaches of four top value investors, the authors tell the fascinating story of the investors who dare to tread where few others have, and the wildly-successful track records that have resulted.
Turning the notion of diversification on its head, concentrated value investors pick a small group of undervalued stocks and hold onto them through even the lean years. The approach has been championed by Warren Buffett, the best known value investor of our time, but a small group of lesser-known investors has also used this approach to achieve outstanding returns.
- Discover the success of Lou Simpson, a former GEICO investment manager and eventual successor to Warren Buffett at Berkshire Hathaway
- Read about Kristian Siem, described as "Norway's Warren Buffett," and the success he has had at Siem Industries
Concentrated Investing will quickly have you re-thinking the conventional wisdom related to diversification and learning from the top concentrated value investors the world has never heard of.
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Veröffentlichungsjahr: 2016
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Copyright © 2016 by Allen C. Benello, Michael van Biema, Tobias E. Carlisle. All rights reserved.
Published by John Wiley & Sons, Inc., Hoboken, New Jersey. Published simultaneously in Canada.
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Library of Congress Cataloging-in-Publication Data:
Names: Benello, Allen C., author. | Biema, Michael van. | Carlisle, Tobias E., 1979- author. Title: Concentrated investing : strategies of the world's greatest concentrated value investors / Allen C. Benello, Michael van Biema, Tobias E. Carlisle. Description: Hoboken : Wiley, 2016. | Includes index. Identifiers: LCCN 2016002290| ISBN 9781119012023 (hardback) | ISBN 9781119012054 (ePDF) | ISBN 9781119012047 (ePub) Subjects: LCSH: Capitalists and financiers--Biography. | Investments. | Portfolio management. Classification: LCC HG172.A2 .B454 2016 | DDC 332.6—dc23 LC record available at http://lccn.loc.gov/2016002290
To my wife Julie, and to my daughters Sophie and Avery.
—Allen Carpé Benello
To Lavinia, Fiamma, and Tristan—my earth, my flame, and my hunter.
—Michael van Biema
For Nick, Stell, and Tom.
—Tobias E. Carlisle
Contents
Preface
Acknowledgments
Introduction
Notes
Chapter 1 Lou Simpson: The Disciplined Investor: A Portrait of Concentration
“Unstoppable” GEICO
An Emerging Value Investor
Big, Concentrated Bets
Simpson’s Results at GEICO
Simpson, the Value Investor
Conservative, Concentrated
Notes
Chapter 2 John Maynard Keynes: Investor Philosopher: The Economics of Concentration
Celebrity Economist
Irrational Markets
The Investor
An Examination of Keynes’s Returns
A Study in Concentration
Notes
Chapter 3 Kelly, Shannon, and Thorp: Mathematical Investors: Concentration Quantified
Claude Shannon and Ed Thorp
Edward Thorp and Applied Kelly Theory
Notes
Chapter 4 Warren Buffett: The Kelly-Betting Value Investor: Portfolio Concentration for Value Investors
Closet Indexers
Kelly Bettin’ Value Investors
Notes
Chapter 5 Charlie Munger: Concentration’s Muse: Quality without Compromise
Blue Chip Stamps and See’s Candies
The Buffalo News
On Concentration
Notes
Chapter 6 Kristian Siem: The Industrialist: The Importance of Permanent Capital to the Long-Term Investor
The Jack-Up Rig Project
Diamond M Dragon and Common Brothers
Back to the Drilling Business
Norwegian Cruise Line
DSND Subsea
Siem on Valuation
Notes
Chapter 7 Grinnell College: The School of Concentration: Concentration and Long-Term Investing for Endowment
Grinnell under Gordon
The Modern Endowment
Notes
Chapter 8 Glenn Greenberg: The Iconoclast: Simple, Common Sense Research, and Tennis Shoes
The Family Business
Becoming a Money Mis-Manager
Arthur Ross’s Tennis Shoes
Greenberg’s Theory of Value
Concentration and Breakfast with Buffett
Notes
Chapter 9 Conclusion: The Concentrated Investor’s Temperament
Notes
About the Authors
Index
EULA
List of Tables
Chapter 1
Table 1.1
Chapter 2
Table 2.1
Table 2.2
Table 2.3
Chapter 3
Table 3.1
Chapter 4
Table 4.1
Table 4.2
Table 4.3
Table 4.4
Table 4.5
Chapter 5
Table 5.1
Chapter 6
Table 6.1
List of Illustrations
Chapter 2
Figure 2.1
Annotated Chart of Dow Jones Industrial Average (1921 to 1955)
Chapter 3
Figure 3.1
Shannon’s Demon Portfolio and Stock Price
Figure 3.2
Probability of Doubling and Quadrupling before Halving
Chapter 4
Figure 4.1
Chart of Average Arithmetic Annual Returns for Monte Carlo Portfolio Concentration Test in S&P 500 EW (1999 to 2014)
Figure 4.2
Logarithmic Performance Chart of Price-to-Book Value Portfolios (1929 to 2014)
Figure 4.3
Concentrated Combination Value Portfolios, Rolling Annual Rebalance (1963 to 2015)
Guide
Cover
Table of Contents
Preface
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Preface
Michael and I came up with the idea for this book while riding in a taxi on the way to a meeting with an investment manager. Michael interviews managers of value oriented funds regularly for his fund of funds business, and has met with at least a few hundred during the course of his career. On this particular occasion Michael asked me to come along to help evaluate a new manager, and I agreed to join him in between meetings of my own. As unlikely a place as it was to hatch the inspiration for this project, we were both puzzled by a strange paradox that we had observed over many years in the investment business: The returns generated by investors do not always correlate to their ability to analyze and understand companies.
With the initial idea for a book, and a set of interviews, Michael and I reached out to Bill Falloon at Wiley for help. Bill introduced Michael and me to Tobias Carlisle, the author of two other successful investment books, “Quantitative Value” and “Deep Value.” We found that they shared a very similar set of ideas about investing in general and about the theme for the book, concentrated investing, in particular. We hit it off immediately. Tobias agreed to come on board as a coauthor along with Michael and me. He has been instrumental in helping to take the raw interviews and put the investors and their flagship investments into their proper historical and theoretical context. He also helped to examine the strategy quantitatively to determine the drivers of outperformance: Was it a matter of selecting the right securities, or holding them in the right amounts?
I recall one individual, whom we’ll call Investor Number One, whose returns were decent, but who seemed to be totally off-base when it came to the highly subjective and trickier job of figuring out whether a company’s business and management were fundamentally attractive, or worth skipping over. He had made some notable blunders, on one occasion pounding the table to his colleagues about a soft goods company that was soon destined for bankruptcy. To me and a few others with whom I spoke at the time, it wasn’t difficult to comprehend that this company was not attractive and perhaps even precariously situated, so it left me scratching my head when I read his fund’s performance results, which seemed to have a way of levitating away from what must have been some costly errors.
On the other hand, another acquaintance whom we will call Investor Number Two was deeply insightful when discussing an industry or company and always grasped the investment case, for or against, with enviable precision and knowledge of the relevant facts. This second person’s returns, however, were decidedly lackluster. He somehow never managed to fully capitalize on his insights, which were tremendously valuable and, one would have thought, should have led to very outstanding returns.
This paradox got us thinking about the topics of security analysis and portfolio construction, and how they relate to returns. Apparently, analytical ability alone does not constitute a really good investor. Investor Number Two in the preceding example should have been doing better with his ideas, and just imagine what Investor Number One could have accomplished if he had been more analytically competent.
A lightbulb turned on when I realized the investors I admire the most (and this admiration comes only in part from the amazing success they’ve achieved) tend to share one characteristic: They are concentrated value investors. That is, they adhere to a concentrated approach to portfolio construction, holding a small number of securities as opposed to a broadly diversified portfolio. We set out to study the mathematical and statistical research that has been done by various academics on the subject of portfolio concentration, and to chronicle the methods and achievements of some of the people who have benefited from being concentrated value investors. Our first task was to approach Lou Simpson and Kristian Siem, two ultra-successful concentrated value investors who had never previously agreed to interviews on the mechanics of their investment style. As we completed their interviews, we began to compile material on the subject of portfolio concentration, a trail that ultimately reached back beyond the Kelly Formula to John Maynard Keynes.
In Concentrated Investing: Strategies of the World’s Greatest Concentrated Value Investors, we examine some of the methods these extraordinary individuals employ, providing the reader an insight into how they function and how they have managed to accomplish their returns. However, two very important caveats are necessary. First, concentrated investing is not for everyone. As Glenn Greenberg said, Peter Lynch (manager of the Fidelity Magellan Fund during its most successful period, earning truly amazing average annual returns during his tenure) was anything but a concentrated investor, owning a large number of securities in the fund. Furthermore, concentrated investing should only be undertaken by people who are prepared to do intensive research and analysis on their investments. People outside of the investment profession usually don’t have the time to do this, and are far better off with an index fund or finding a competent investment manager— preferably one who employs a focused approach.
The second caveat is more important, and applies to investment professionals and non-professionals alike (perhaps even more to professionals). It is summed up in an insightful and humbling quote from legendary martial artist Bruce Lee, which is as follows:
A goal is not always meant to be reached, it often serves simply as something to aim at.
Coming from one of the most disciplined and exacting athletes in the history of martial arts, this statement is illuminating. One can hardly imagine Bruce Lee trying to break a two-by-four with his fist and accepting, after a failed attempt, that this goal was not reachable. Evidently, beneath his hard-driving exterior, there was a more philosophical side. Similarly, in the context of this book, our intention is not to show that the great individuals profiled in the following chapters constitute the standard against which one should hold oneself, but to provide a road map with some concrete ideas on how to be a better investor. Not everyone should attempt to replicate their style or accomplishments. Rather, these profiles are a guidepost on the journey to successful investing.
With these caveats, we do believe that the average enterprising investor with the ability to perform in-depth fundamental analysis will be better off trimming the number of investments they hold and redistributing their capital into their top 10 or 15 ideas. To quote Bruce Lee a second time:
The successful warrior is the average man, with laser-like focus.
—Allen Carpé Benello
Acknowledgments
This book would not have been possible without the generous facilitation and support of Louis A. Simpson. In addition, we are the beneficiaries of a great deal of assistance in the production of the manuscript for Concentrated Investing. We’d like to thank the interviewees Lou Simpson, Charlie Munger, Kristian Siem, Glenn Greenberg, and Jim Gordon. Finally, we appreciate the assistance of the team at Wiley Finance, most especially Bill Falloon, Susan Cerra, and Meg Freeborn, who provided guidance and advice along the way.
Introduction
Conscientious employment, and a very good mind, will outperform a brilliant mind that doesn’t know its own limits.
—Charlie Munger1
Concentration value investing is a little-known method of portfolio construction used by famous value investors Warren Buffett, Charlie Munger, long-time Berkshire Hathaway lieutenant Lou Simpson, and others profiled in this book to generate outsized returns. A controversial subject, the idea of portfolio concentration has been championed by Buffett and Munger for years, although it moves in and out of fashion with rising and falling markets. When times are good, portfolio concentration is popular because it magnifies gains; when times are bad, it’s often abandoned—after the fact—because it magnifies volatility. Concentration has been out of favor since 2008, when investment managers began in earnest to avoid what they perceive as a risky business practice.
It is time to re-visit the subject of bet sizing and portfolio concentration as a means to achieve superior long-term investment results. We will start by examining some of the academic research on concentration versus diversification on long-term investment results. One central feature of the discussion surrounding concentration is the Kelly Formula, which provides a mathematical framework for maximizing returns by calculating the position size for a given investment within a portfolio using probability (i.e., the chance of winning versus losing) and risk versus reward (i.e., the potential gain versus the potential loss) as variables. The Holy Grail for any investor is a security with a high probability of winning and also a large potential gain compared to the potential loss. Given favorable inputs, the Kelly Formula can produce surprisingly large position sizes, far larger than the typical position size found in mutual funds or other actively managed investment products. In addition, some academic studies point to the diminishing advantages of portfolio diversification above a surprisingly small number of individual investments, provided each investment is adequately diversified (no overlapping industries, etc.). Also, portfolios with a relatively smaller number of securities (10 to 15) will produce results that vary greatly from the results of a given broadly diversified index. To the extent that investors seek to outperform an index, smaller portfolios can facilitate that goal, although concentration can be a double-edged sword.
Investors can employ the traditional value investing methodology of fundamental security analysis to identify potential investments with favorable Kelly Formula inputs (a high probability of winning, and a high risk/reward relationship), in order to maximize the chances of significant outperformance, as opposed to significant underperformance, with a concentrated portfolio.
We have unparalleled access to investors in Warren Buffett’s inner circle. Interviews with several highly successful investors who have achieved their success employing a concentrated approach to portfolio management over the long term (at least 10 to 30 years) will be incorporated throughout this book. One common feature of these investors is that they have had permanent sources of capital, which has changed their behavior by allowing them to endure greater volatility in their returns. Most people seek to avoid volatility in general because they perceive increased variance as an increase in risk. The investors we examine, however, tend to be variance seekers. At the same time, however, they are able to produce returns with low downside volatility compared to the underlying markets in which they invest.
This book profiles eight investors with differing takes on the concentration investment style. The investors and the endowment interviewed are contemporary. One of the investors profiled, Maynard Keynes, is now a historical figure, but was the early adopter of many of the ideas that came to be held by his successors. The purpose of the book is to tease out the principles that have resulted in their remarkable returns. Though they operated through different periods of time, all have compounded their portfolios in the mid-to-high teens over very long periods—defined as more than 20 years. The investors in this book are rare in that they all have either permanent or semi-permanent sources of capital. We hypothesize that this is an important factor in allowing them to practice their focused style of investment. The book also puts forward a mathematical framework, the Kelly Criterion, for sizing investment “bets” within a portfolio. The conclusion of both the profiles of these great investors and of the Kelly Criterion is remarkably coincident.
Modern portfolio theory would have us believe that markets are efficient and that attempts to beat market performance are both foolhardy and expensive in terms of return. Yet the fact remains that there is at least a small cadre of active managers who have beaten the market by a significant margin over prolonged periods. This book and the investors profiled in it agree with the proponents of efficient market theory on two points:
Markets are mostly efficient.
They should be treated as efficient if you are, as Charlie Munger puts it, a “know-nothing” investor.
In other words, it requires a lot of hard work and a significant amount of knowledge to produce market-beating returns. If you do not have this, it is to your benefit to diversify and index. If, however, you possess knowledge and the capability for hard work as well as a few other characteristics outlined in the book, it is to your benefit to focus your energies on a small number of investments. The degree of focus is a stylistic choice and cannot be prescribed for any given individual, but the investors in this book concentrate on anywhere from 5 to 20 individual securities. The larger the number, the more the benefits of diversification, the lower the volatility of the portfolio, but also, in most cases, the lower the long-term returns. The trade-off between larger bets and more volatility is an individual choice, but both the Kelly Formula and the participants in the book point to the advantages of larger bets and more concentrated portfolios. In fact, the reader will probably be quite surprised by how large the bets can be calculated to be. Once again, placing bets of significant size depends on appropriately skewed probabilities, and these types of probabilities are uncommon, but both the mathematics and the investors argue for large bets when situations with unusual risk/return arise. It is important to note that the risk referred to here is the risk of permanent loss of capital and not the more commonly used academic metric of volatility. The investors in this book are willing to suffer through periods of temporary (but significant) loss of capital in an attempt to find opportunities where the probability of the permanent loss of capital is small. In other words, they attempt to find situations that offer a strong margin of safety where one’s principal is protected either by assets or by a strong franchise and an unlevered balance sheet.
The investors in this book come from very different backgrounds ranging from an English major to an economist, but somehow they ended up in quite similar places in terms of their general investment philosophy. The singular trait that unites these investors, and separates this group from the herd of investors who try their luck on the stock market is temperament. Asked in 2011 whether intelligence or discipline was more important for successful investors, Buffett responded that temperament is key:2
The good news I can tell you is that to be a great investor you don’t have to have a terrific IQ. If you’ve got 160 IQ, sell 30 points to somebody else because you won’t need it in investing. What you do need is the right temperament. You need to be able to detach yourself from the views of others or the opinions of others.
You need to be able to look at the facts about a business, about an industry, and evaluate a business unaffected by what other people think. That is very difficult for most people. Most people have, sometimes, a herd mentality, which can, under certain circumstances, develop into delusional behavior. You saw that in the Internet craze and so on.
. . .
The ones that have the edge are the ones who really have the temperament to look at a business, look at an industry and not care what the person next to them thinks about it, not care what they read about it in the newspaper, not care what they hear about it on the television, not listen to people who say, “This is going to happen,” or, “That’s going to happen.” You have to come to your own conclusions, and you have to do it based on facts that are available. If you don’t have enough facts to reach a conclusion, you forget it. You go on to the next one. You have to also have the willingness to walk away from things that other people think are very simple. A lot of people don’t have that. I don’t know why it is. I’ve been asked a lot of times whether that was something that you’re born with or something you learn. I’m not sure I know the answer. Temperament’s important.
Munger says of Buffett’s theory:3
He’s being extreme of course; the IQ points are helpful. He’s right in the sense that you can’t [teach] temperament. Conscientious employment, and a very good mind, will outperform a brilliant mind that doesn’t know its own limits.
In the next chapter we meet Lou Simpson, the man Warren Buffett has described as “one of the investment greats.”4
Notes
1
. Charles Munger, interview, February 23, 2012.
2
. “A Class Apart: Warren Buffett and B-School Students,” NDTV, May 24, 2011,
https://www.youtube.com/watch?v=4xinbuOPt7c
, as discussed in Shane Parrish, “What Makes Warren Buffett a Great Investor? Intelligence or Discipline?”
Farnam Street Blog
, April 19, 2014.
3
. Charles Munger, interview, February 23, 2012.
4
. Warren Buffett, “Chairman’s Letter,” Berkshire Hathaway, Inc., 2010.
CHAPTER 1Lou Simpson: The Disciplined Investor: A Portrait of Concentration
Stop the music.
—Warren Buffett to Jack Byrne, chairman of GEICO, after meeting Lou Simpson in 19791
In 1979, GEICO, an auto insurance company based in Washington, DC, that had been brought close to bankruptcy just three years earlier was searching for a new chief investment officer. The company’s recent near-death experience, and the perception of insurance companies’ investment efforts as hidebound, and highly risk-averse, had made the search difficult. The recruiter, Lee Getz, vice chairman of Russell Reynolds, did find a candidate who later turned it down because his wife refused to move to Washington.2 Lamenting his lack of success in filling the position in over a year, Getz told his friend Lou Simpson about the little insurance company with big problems that no one wanted to tackle. He asked Simpson, the chief executive of California-based investment firm Western Asset Management, if he was interested in the job. Simpson was reluctant.3 Western Asset Management had been a subsidiary of a big California bank holding company. Simpson was sick of politicking within the confines of bank bureaucracy, and didn’t have any great desire to repeat the experience in an insurance company. He also knew that GEICO had almost gone belly up just three years earlier.
As a favor, Getz asked Simpson to interview with the company’s chairman, John “Jack” Byrne Jr., the man who had almost single-handedly pulled GEICO back from the brink of insolvency.4 Simpson agreed if only to help out an old friend. He traveled to Washington to meet with Byrne, who Simpson judged as being “a very, very smart guy,” but also a micro-manager involved in everything GEICO did.5 Simpson found the role interesting, but not compelling. He craved autonomy, and Byrne, who had just saved GEICO, seemed unlikely to grant it. Byrne called Simpson back for a second interview. Though he had reservations he dutifully traveled back to Washington. In the second interview, Byrne told Simpson, “We’re really interested in you. But the one hoop you’re going to have to go through is to meet with Warren Buffett.”6 With about 20 percent of GEICO, Buffett was the largest shareholder through Berkshire Hathaway. Byrne said, “Warren thinks we need a new investment person. The person before was really not up to the job.”7 Though Buffett didn’t yet have a high profile, Simpson had read about the Nebraska-based value investor who was just renewing a longstanding interest in GEICO.
“Unstoppable” GEICO
Buffett has a storied 65-year association with GEICO, beginning in 1951 as a 20-year-old graduate student in Benjamin Graham’s value investing class at Columbia. He recounted the first 45 years of that association in his 1995 Chairman’s Letter following Berkshire’s purchase of the half of GEICO it didn’t own.8 It was then the seventh-largest auto insurer in the United States, with about 3.7 million cars insured (in 2015, it is second, with 12 million policies in force). Buffett attended Columbia University’s graduate business school between 1950 and 1951 because he wanted to study under Graham, the great value investor and investment philosopher, who was a professor there. Seeking to learn all he could about his hero, he found that Graham was the chairman of Government Employees Insurance Company, to Buffett “an unknown company in an unfamiliar industry.”9 A librarian referred him to Best’s Fire and Casualty insurance manual—a large compendium of insurers—where he learned that GEICO was based in Washington, DC.
On a Saturday in January 1951, Buffett took the early train to Washington and headed for GEICO’s downtown headquarters. The building was closed for the weekend, but he frantically pounded on the door until a custodian appeared. He asked the puzzled janitor if there was anyone in the office the young Buffett could talk to. The man said he’d seen one man working on the sixth floor—Lorimer Davidson, assistant to the president and founder, Leo Goodwin, Sr. Buffett knocked on his door and introduced himself. Davidson, a former investment banker who had led a round of funding for GEICO before joining it, spent the afternoon describing to Buffett the intricacies of the insurance industry and the factors that help one insurer succeed over the others.10
Davidson taught Buffett that GEICO was the very model of an insurer built to succeed. Formed in 1936, at the height of the Great Depression by Goodwin and his wife Lillian, GEICO was set up to be low-cost from the get go.11 Goodwin had been an executive at the United Services Automobile Association (USAA), an auto insurer founded to insure military personnel, and a pioneer in the direct marketing of insurance. He had seen data that showed federal government employees and enlisted military officers tended to be financially stable, and also low-risk drivers. Those two attributes, he surmised, would mean that premiums were paid on time, with lower and infrequent claims. Agents were typically used to provide professional advice for more complex business insurance requirements. Auto insurance, though it was mandatory and expensive, was also relatively simple. Most consumers would know what they required in an auto policy.12 Goodwin reasoned that GEICO could cut out the agents and market directly to consumers, thereby minimizing distribution costs, just as USAA had. Those two insights—direct selling that bypassed agents to financially secure, low-risk policyholders—put GEICO in a very favorable cost position relative to its competitors. Later, Buffett would write that there was “nothing esoteric” about its success: its competitive strength flowed directly from its position as the industry low-cost operator.13 GEICO’s method of selling—direct marketing—gave it an enormous cost advantage over competitors that sold through agents, a form of distribution so ingrained in the business of these insurers that it was impossible for them to give it up.14 Low costs permitted low prices, low prices attracted and retained good policyholders, and this virtuous cycle drove GEICO’s success.15 GEICO was superbly managed under the Goodwins. It grew volumes rapidly, and did so while maintaining unusually high profitability. When Leo Goodwin retired in 1958, he named Davidson, the man whom the 20-year-old Buffett had met on that Saturday in January 1951, as his successor.16 The transition was a smooth one, and GEICO’s prosperity continued with Davidson in the chief executive role. Volumes grew such that, by 1964, GEICO had more than 1 million policies in force.17 Between its formation in 1936 and 1975, it captured 4 percent of the auto market, and grew to be the nation’s fourth largest auto insurer.18 It looked, in Buffett’s estimation, “unstoppable.”19
But GEICO was struck by a double whammy in the 1970s. First, Davidson retired in 1970, and then both Leo and Lillian Goodwin passed away. Without a rudder, it seemed to stray from the principles that had made it successful.20 When real-time access to computerized driving records became available throughout the United States in 1974, GEICO moved beyond its traditional government employee constituency to begin insuring the general public.21 By 1975, it was clear that it had expanded far too aggressively during a difficult recession.22 Actuaries had also made serious errors in estimating GEICO’s claims costs and reserving for losses. This faulty cost information caused it to underprice its policies, and lose an enormous amount of money.23 Weak management, bad investment choices, and years of rapid expansion took their toll.24 In 1976, GEICO stood on the brink of failure.
It was saved from collapse when Jack Byrne was appointed chief executive in 1976. Byrne took drastic remedial measures.25 He organized a consortium of 45 insurance companies to take over a quarter of GEICO’s policies.26 To pay the remaining claims, he had GEICO undertake a stock offering that severely diluted existing stockholders.27 The stock price was savaged. From its peak, it fell more than 95 percent.28 Believing that Byrne could rescue GEICO, and that, despite its problems, it maintained its fundamental competitive advantage as a low-cost auto insurer, Buffett plunged into the market in the second half of 1976, buying a very large initial interest for Berkshire.29 Byrne put it on a path to insuring only “government employee”-style policyholders from a much wider pool of potential insureds, and improving its reserving and pricing discipline. Though the company shrank significantly in the first few years of Byrne’s tenure, Berkshire kept buying, making purchases at particularly opportune times. By 1979, GEICO had taken a step back from the precipice, but it was only half the size that it had been. While the business maintained its inherent competitive advantage—its rock-bottom operating costs—and Byrne had reserving and pricing under control, it was clear that GEICO needed help on the investment side. After searching for over a year without luck, and being turned down by the first good prospect, Byrne had whittled the field down considerably from the initial candidates. Simpson was one.30 And a meeting with Buffett stood in the way.
On a Saturday morning in the summer of 1979, Simpson traveled to Omaha to meet with Buffett in his office. In the meeting Buffett said, “I think maybe the most important question is, what do you own in your personal portfolio?”31 Simpson told him, but Buffett didn’t give away whether he was impressed or not. After talking for two to three hours, Buffett drove Simpson to the airport where they met Joe Rosenfield. Rosenfield was a good friend of Buffett’s, and an impressive investor in his own right: He would almost single-handedly steer little Grinnell College’s $11 million endowment into a $1 billion behemoth, one of the biggest per student for any private liberal arts school in the country.32 Simpson and Rosenfield discovered they were both big-time Chicago Cubs fans, and spent the time chatting about the team (Rosenfield would go on to acquire 3 percent of the Cubs, and, in his seventies, vowed not to die until they won a World Series).33 After visiting with Buffett and Rosenfield, Simpson flew back to Los Angeles. Evidently Buffett found the stocks in Simpson’s personal portfolio acceptable because he wasted no time. He called Byrne straight after the interview, and told him, “Stop the music. That’s the fella.”34 Byrne called Simpson to offer him the job, and upped the compensation package.35 Though his wife was skeptical about leaving California, Simpson persuaded her, saying, “I think this is an interesting opportunity and I really don’t want to stay where I am.”36 Simpson accepted, and the family began preparing to move to Washington, DC.
An Emerging Value Investor
Lou has never been one to advertise his talents. But I will: Simply put, Lou is one of the investment greats.
—Warren Buffett, “2010 Berkshire Hathaway Letter to Shareholders”
Louis A. Simpson was born in Chicago, Illinois, in 1936. He grew up an only child in the Chicago suburb of Highland Park.37 At the end of his college freshman year at Northwestern University in 1955, he went to see the school guidance counselor. After subjecting Simpson to the usual barrage of tests, the counselor told the 18-year-old that he had an aptitude for numbers and financial concepts.38 Simpson, who had been studying first engineering and then pre-med, transferred to Ohio Wesleyan with a double major in economics and accounting. Three years later he graduated with high honors and was offered a Woodrow Wilson National Fellowship to study labor economics at Princeton. He received his MA from Princeton in two years, and began to work on his doctorate, researching the market for engineers. Simpson was offered the opportunity to teach full time as an instructor of economics, teaching the basic courses of accounting and finance, even though he had never taken a formal course in finance. At the first faculty meeting, the provost told the junior faculty members that only 10 percent would proceed to get tenure. Now married and with his first child, Simpson realized that the very long odds of tenure meant that teaching was an unlikely path to financial security.
While teaching full time, Simpson started writing letters and interviewing for positions in investment management firms and investment banks. He’d always had an interest in investments and managed his own tiny stock portfolio as a teenager, which was unusual at the time. A firm in Chicago, Stein Roe & Farnham—then perhaps the largest independent investment firm between New York, Boston, and the West Coast (today it has disappeared)—had a partner who was a Princeton graduate who conducted the interviews at the campus. He and Simpson hit it off. The deciding factor for Simpson was that Stein Roe was prepared to offer him $100 a month more than any firm in New York. So in 1962, he dropped out of doctoral studies at Princeton University to return to Chicago.39 He was 25, and working in his first full-time job as a portfolio manager at Stein Roe.40
At Stein Roe, Simpson managed separate accounts, beginning with individuals and gradually moving toward institutions. Stein Roe did offer mutual funds, though Simpson did not work on them. The strategy for the separate accounts was narrowly confined. An investment committee created a model portfolio, and the separate accounts were expected to follow it. Simpson followed the model portfolio, but had a tendency to concentrate the managed accounts more than the model portfolio dictated.41 He stayed seven-and-a-half years with Stein Roe, and was made a partner. He was concerned that the partners were much more interested in the size of their slice of the pie than in trying to grow the whole pie.42 He told a good friend from Princeton that he was open to making a change. The friend introduced him to Shareholders Management, a mutual fund management firm in Los Angeles.43 Shareholders Management was headed by “fund wizard” Fred Carr, a darling of the market during the go-go years in the 1960s, when the fad was for performance mutual funds.44 Shareholders Management was one of the hottest. Under Carr’s guidance, Shareholders’ Enterprise Fund had soared 159 percent from 1967 to 1969, and the fund’s assets had ballooned more than fiftyfold, to $1.7 billion.45 Carr was a “gunslinger,” a market timer who dove in and out of the shares of small, rapidly growing stocks.46 A Business Week magazine profile in 1969 said of Carr that he “may just be the best portfolio manager in the U.S.”47 Carr offered Simpson a role not managing the hot mutual funds, but the separate accounts. Simpson would have to take a cut in base salary, but received a substantial option package. He accepted, and so in 1969, he became one of the first partners to leave Stein Roe.48
Simpson moved his family, now with three children, to Los Angeles to join Shareholders Management under Carr. While Shareholders Management had been for several years regarded by the market as an unusually gifted investment team, all was not as it seemed. Carr had bought a lot of “letter stock”—stock not registered with Securities and Exchange Commission (SEC), which cannot be sold to the public, meaning that it is extremely illiquid—for the Enterprise Fund. This strategy had done very well as the market ran up, but the long bull market soon collapsed, and investors in Carr’s Enterprise Fund were slammed, leading to large-scale redemptions. Compounding the problem, there was virtually no market for sales of the unregistered letter stock needed to meet the redemptions. Simpson’s timing was unlucky. He had joined in September 1969, the absolute top of Shareholders Management’s run. One month after his arrival, the losses in the Enterprise Fund were so bad that Carr was forced to resign, and cashed in his equity in the funds as he left.49 Though he had been hired to run managed accounts, Simpson was tasked with managing part of the Enterprise Fund. He quickly found that he didn’t fit into the Shareholders’ culture. “I viewed myself an investor, and they were trading-oriented,” he says.50 At lunch one day, one of the firm’s lawyers asked Simpson, “Do you realize how screwed up this place is? They’ve done things that are not on the up and up, and, if you want to maintain your reputation, it would be a good idea to leave.”51 Simpson resigned shortly after. He had been at Shareholders’ Management for just five months. He was 33, with three children, and he had just moved to Los Angeles. Though he had some opportunities in Chicago, he decided to see what was available on the West Coast.
After a brief search, Simpson settled on United California Bank to help start an investment management business and be second-in-command in the investment area. That new business was eventually spun out into a separate company called Western Asset Management, and became a subsidiary of Western Bank Corporation.52 Simpson stayed at Western Asset Management for nine years as head of portfolio management, and then director of research.53 Western Asset Management was successful, but Simpson found it difficult to operate in a big banking environment. The chairman of Western Bank Corporation wanted to make him CEO of Western Asset Management, but said he would only do it if Simpson promised to stay on. The chairman forced the resignation of the former chief executive, and Simpson was made the new chief executive of Western Asset Management. Though he stayed on for three years, he found the management role chafed him. He yearned to do something entrepreneurial. Friends of his wanted to set up some kind of investment management company with him, but he wasn’t sure.54 The experience with Shareholders Management had a transformative effect on Simpson, wholly changing his perspective on investment.55 Shareholders Management taught him about the importance of business risk, and started him on the road to value investing.56 During his time at Western Asset Management he was able to think, developing his investment philosophy, both on a personal and a company basis. He began to embrace value investing. His philosophy evolved dramatically when he ran the research department and he moved toward a more concentrated value investment approach. And then GEICO came calling.
Big, Concentrated Bets
In the 1970s, most insurance companies held a broad portfolio of bonds, counting on diversification to minimize risk, and little in the way of stocks. They also held a high proportion of the portfolio in government bonds, which, during the period of high inflation in the 1970s, had led to sizable losses for most portfolios.57 Before Simpson arrived in 1979, GEICO was no exception. He would radically change GEICO’s course. The agreement Simpson had struck with Byrne allowed the new investment chief to put up to 30 percent of GEICO’s assets in stocks.58 At the time, most property and casualty insurers limited stock holdings to about 10 percent of assets.59 The agreement also allowed him to hold concentrated positions.60 Simpson went to work as soon as he arrived, slashing the company’s bond holdings and rebuilding the stock portfolio in a limited number of names.61
Wary of Byrne’s reputation for micromanagement, Simpson had made it clear he was to be solely responsible for managing GEICO’s investments. “The more people you have making decisions, the more difficult it is to do well,” he said.62 “You have to satisfy everybody.”63 Neither Buffett nor Byrne were to interfere with the portfolio.64
Simpson’s instincts about Byrne were right. After he had been at GEICO for more than a year, he went away for a week on vacation. Byrne took the opportunity to buy some stocks for the portfolio. When Simpson returned, he immediately sold Byrne’s positions. Byrne asked, “Why would you do that? They were good ideas.”65
Simpson replied, “If I’m going to be responsible for the portfolio, I’m going to make all the decisions.”66 From then on, Simpson made his own decisions, essentially working autonomously.67 Describing the arrangement in 2004, Buffett wrote,
You may be surprised to learn that Lou does not necessarily inform me about what he is doing. When Charlie and I assign responsibility, we truly hand over the baton—and we give it to Lou just as we do to our operating managers. Therefore, I typically learn of Lou’s transactions about ten days after the end of each month. Sometimes, it should be added, I silently disagree with his decisions. But he’s usually right. [emphasis Buffett’s]68
Simpson did, however, regularly speak to Buffett about his investing philosophy. Simpson was impressed by Buffett’s encyclopedic knowledge of businesses and numbers, and his long list of contacts.69 In addition to Buffett’s view on investing, Simpson would also ask Buffett about companies that he thought he knew something about.70 Over time, Simpson and Buffett fell into a routine. Buffett would call Simpson, or Simpson would call Buffett. Initially as often as several times a week, as time went on, the men might let a month or two go by before the two talked, but they always stayed in regular contact.71 Though both operated independently, GEICO and Berkshire did have several common positions. They tended not to overlap because GEICO had a significant size advantage. Where Buffett needed to take positions of more than $1 billion to generate a return meaningful relative to the Berkshire portfolio worth many billions, GEICO could take much smaller positions given its smaller portfolio size. Simpson found several larger ideas he wanted to buy for GEICO, but if he learned Berkshire was already buying the stock, he stood back to allow Berkshire to complete its buying.72
When he first arrived at GEICO, Simpson found a group of investment people who did not share his investment approach but thought he would try to work with them for a while. He asked Buffett to come to GEICO twice a year to spend an hour with the investment team. During one of these talks, Buffett told a story that left an impression on Simpson.73 Buffett said, “Suppose somebody gives you a card with 20 punches, and each time you make an investment move you have to punch the card. Once you have had 20 punches, you’re going to have to sit forever with what you have.”74
The story stuck with Simpson, helping him avoid trading and to focus on developing a long-term investment perspective.75 Simpson says, “I never did a lot of trading but the story really did highlight that you need to have a lot of conviction in what you’re doing because you only have so many shots and you better be confident on the shots that you take.”76 Heeding Buffett’s advice, Simpson gradually concentrated larger and larger sums of money into just a handful of companies. In 1982, GEICO had about $280 million of common stock in 33 companies. Simpson cut it to 20, then to 15, and then, over time, to between 8 and 15 names.77 At the end of 1995, just before Berkshire’s acquisition of GEICO ended separate disclosures of the insurer’s portfolio, Simpson had $1.1 billion invested in just 10 stocks.78 Simpson was willing to concentrate positions in a single sector. At one time GEICO owned five or six electric utilities, which Simpson regarded as a single, big position.79 In the early 1980s, GEICO took a huge bet on three of the “Baby Bells,” the nickname given to the independent regional telephone companies spun out from AT&T, Inc., following the U.S. Department of Justice’s antitrust lawsuit filed in 1974. Simpson also regarded those holdings as one position.80 He took a large position because he assessed the Baby Bells as offering an unusually good risk/reward ratio.81 Admiring Simpson’s bet, Byrne remarked, “It was a very big hit on a very large amount of money.”82
Simpson would take those big bets only when he thought the odds were well in his favor. He regards GEICO’s single biggest winner as the Federal Home Loan Mortgage Corporation, known as “Freddie Mac.”83 Freddie Mac is a government-sponsored enterprise created in 1970 to expand the secondary market for mortgages in the United States. It buys mortgages on the secondary market, pools them, and sells them as a mortgage-backed security to investors on the open market. It operates in a duopoly with the Federal National Mortgage Association, commonly known as “Fannie Mae.” When GEICO bought into Freddie Mac, it was not a public company. While Fannie Mae was then public, Freddie Mac was only semi-public, with a small market in its stock, and the bulk owned by savings and loans associations. Simpson found it trading exceedingly cheaply, between three and four times its earnings. In addition to its manifest cheapness, Simpson was attracted to its franchise, which it owed to its status as a duopoly with Fannie Mae. Buffett had already bought up to his limit, and was restricted by regulation from buying more because Berkshire owned Wesco, which was a Thrift Bank. Simpson thought Freddie Mac was one of the best opportunities he’d ever seen, and in the mid to late 1980s, he took an enormous position for GEICO. He finally sold the position during 2004 and 2005, three years before Freddie Mac ran into trouble. GEICO sold out not because Simpson regarded Freddie Mac stock as being “horribly expensive,” but because he saw the business “taking on more risk, increasing leverage, and buying lower and lower quality mortgages to make the targets set by Wall Street analysts who thought Freddie Mac should be able to compound its earnings 15 percent a year.”84 Simpson says that, while GEICO’s reasons for selling turned out to be correct, he had no idea Freddie Mac would melt down completely. (In 2008, the Federal Housing Finance Agency put both Fannie Mae and Freddie Mac under conservatorship, equivalent to bankruptcy for a privately owned business. The action was described as “one of the most sweeping government interventions in private financial markets in decades.”85 As of the date of writing, they remain in conservatorship.) For GEICO, Freddie Mac was a very successful investment. “After we bought it,” says Simpson, “it went on a very, very big run, returning 10 to 15 times GEICO’s investment.”86
Simpson also invested GEICO in a number of merger arbitrage deals, an investment strategy in which an investor, typically, simultaneously buys and sells the stocks of two merging companies in order to profit when the companies actually merge.87 Simpson, however, chose only to invest on the long side of these deals since he felt he could capture enough of the arbitrage that way. Simpson recalls that the 1980s, with the explosion of contested mergers and acquisition, were a particularly good time for merger arbitrage. GEICO invested in several of the food company takeovers after the deal was announced hoping that another bidder would top the offer. In the heated market, they often did. GEICO’s returns from merger arbitrage were excellent, in line with or even a little bit better than the remainder of the portfolio. As the decade wound on, however, Simpson became increasingly concerned that the takeovers were getting too heated, and he didn’t know if the market could sustain the torrid pace. Simpson believes he got lucky by declaring victory before GEICO had a disaster. After he stopped investing in merger arbitrage, there were many broken mergers in the lead up to the crash of 1987, and “we were darn lucky that we didn’t get a few bum deals.”88 While he disclaims any ability to predict macro factors, he has looked at valuation levels of the market as a whole.89 In 1987, before the crash, he also moved GEICO’s portfolio to approximately 50 percent in cash because he thought the valuation of the market was “outrageous.”90 Simpson says that the huge cash position “helped us for a while and then it hurt us,” because “we probably didn’t get back into the market as fast as we could have.”91
Simpson’s Results at GEICO
[W]e try to exert a Ted Williams kind of discipline. In his book The Science of Hitting, Ted explains that he carved the strike zone into 77 cells, each the size of a baseball. Swinging only at balls in his “best” cell, he knew, would allow him to bat .400; reaching for balls in his “worst” spot, the low outside corner of the strike zone, would reduce him to .230. In other words, waiting for the fat pitch would mean a trip to the Hall of Fame; swinging indiscriminately would mean a ticket to the minors.
—Warren Buffett, “1997 Berkshire Hathaway Letter to Shareholders”
In 1980, his first year at the helm of GEICO’s investment portfolio, Simpson returned 23.7 percent.92 A great return in almost any other year, that year it was just below the market average, which returned 32.3 percent. Over the next two years, however, he beat the market handsomely, racking up a 45 percent return in 1983, far above the market’s 21 percent gain. By then, almost a third of GEICO’s portfolio was invested in stocks, up from just 12 percent when Simpson started. Byrne later noted, “We gave him a broad, unfettered pasture to work in, and we allowed him to put an unusual percent of the company’s assets into equities. And Lou just knocked the cover off the ball for us.”93 Simpson was head of investments for GEICO for 31 years from 1979 until his retirement from GEICO in 2010, aged 74, by which time he was president and co-chief executive officer of GEICO Corporation.94 His record over that long period is extraordinary, trouncing market averages and most investment managers’ performance. Simpson says of his time at GEICO, “Over the years we put together a good record. At one time we were hitting on all cylinders and I think there was a period of five, six, seven, eight years where we were outperforming by over 15 percent a year. But over a 25-year period, and this was in the Berkshire Report, our over performance was 6.8 percent a year.”95
Buffett first mentioned Simpson in passing in a letter to the shareholders of Berkshire in 1982, describing him as “the best investment manager in the property-casualty business.”96 From that heady start, he became increasingly effusive about Simpson as time wore on. He detailed Simpson’s record in the 2004 report, writing, “Take a look at the facing page to see why Lou is a cinch to be inducted into the investment Hall of Fame.”97 Under the heading “Portrait of a Disciplined Investor Lou Simpson,” Buffett set out Simpson’s extraordinary record, reproduced here in Table 1.1.
Table 1.1 “Portrait of a Disciplined Investor Lou Simpson” from Buffett’s 2004 Berkshire Hathaway “Chairman’s Letter”
Year
1980
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
