A Visit with an Investing Legend
Morningstar analysts swap ideas with legendary bargain-hunter Lou Simpson.
Morningstar analysts swap ideas with legendary bargain-hunter Lou Simpson.
You'd think that anyone Warren Buffett proclaimed "a cinch to be inducted into the investment Hall of Fame" would be a household name. Think again.
For almost three decades Lou Simpson has managed insurer Geico's $4 billion-plus equity portfolio largely out of the limelight, amassing a nearly unrivaled record in the process. The Geico portfolio has topped the S&P 500 Index by an estimated 7% per annum during his tenure. It's not much of a stretch to call the 70-year-old Simpson one of the greatest investors of all time.
So imagine our delight at having the chance to pick Simpson's brain when he stopped by our Chicago office earlier this month. Although the discussion was wide-ranging, touching on the broader strokes of Simpson's philosophy--which shares a number of attributes in common with Morningstar's approach--as well as the finer points of the theses behind various investments he's made, he also imparted a few lessons.
Value Is in the Eye of the Beholder
Simpson disputed the notion that there's a stark divide separating growth and value stocks, saying such stocks were "joined at the hip." He reinforced that point by adding he'd always like to buy "growing businesses at value prices."
Although Simpson would not discuss individual stocks in the Geico portfolio, it became clear that he's no stranger to some of the market's faster-growing realms. For instance, he spoke admiringly of consumer-goods titan Nike (NKE) (a recent addition to our list of wide-moat stocks) and sounded notes of optimism on the health-care sector (which has been a fertile source of 5-star stocks in recent months).
Simpson's observation largely squares with our own research. Roughly one third of our 80 5-star stocks land in the growth column of the Morningstar style box, and in our book, many high-quality stocks remain cheap. To illustrate, while the typical wide-moat stock in our coverage universe is trading at a 2% discount to our fair value estimate, no-moat and narrow-moat stocks are fetching significant premiums. Not surprisingly, a number of dominant, steadily growing firms--including Dell , eBay (EBAY), Johnson & Johnson (JNJ), Medtronic (MDT), Procter & Gamble (PG), and Western Union (WU) to name a few--grace our list of 5-star stocks.
Know the "Bear Case"
Simpson repeatedly stressed the importance of understanding the negatives associated with a potential investment or, as he put it, knowing "why not to buy something." This, he felt, was one of the keys to validating a given investment idea, as it confers a much deeper understanding of the underlying businesses concerned.
There's not only a refreshing humility to this approach--demonstrating, as it does, a willingness to consider even the views of those you've trumped in the past--but also more than a whit of common sense in it. Uncertainty, Simpson clearly realizes, is as much a failure of will as imagination or insight. Thus, he forces himself to consider the flaws or holes in his logic like few other investors, scrubbing his investment thesis as he goes. Should an idea withstand such scrutiny, Simpson's process culminates with a high-conviction pick that he can add to the portfolio without reservation.
Stick to What You Know, But Never Stop Learning
Simpson referred numerous times to the prudence of staying within what he called his "circle of competence." For instance, he steers clear of most technology-related stocks for the simple reason that he has trouble understanding these businesses. Similarly, while a number of Geico's holdings operate overseas, Simpson has generally been reluctant to invest directly in companies that are domiciled abroad. The reason? He feels that he doesn't know these firms as well as their domestic counterparts.
Not that he's resting on his laurels. For instance, Simpson recounted a fact-finding trip he'd recently taken to India in order to learn more about that fast-developing economy. In addition, he sits on the board of technology firms SAIC (SAI) and VeriSign (VRSN), positions that no doubt afford him the opportunity to deepen his knowledge of that particular field.
Taken together with Simpson's aforementioned advice to seek opposing points of view, a fuller portrait emerges. Even in his eighth decade, Simpson remains every bit the student of his craft. He seeks out chances to learn (even if they take him halfway across the globe), and probes a diversity of viewpoints in order to arrive at investment decisions in the most circumspect way.
Patience Is a Virtue
Simpson bemoaned the short holding periods of many professional investors, observing that there seems to be a clear link between time horizon and investment outcome; the longer the time horizon, the better performance is likely to be, and vice versa.
This, too, makes good sense. For instance, once Simpson sinks his teeth into a particular stock, it can take him years to let go. Why? Given the sheer amount of legwork that Simpson does to validate an idea, and the voluminous knowledge of the underlying business that he accrues, he need not flee at the first sign of trouble like so many investors (many of whom fixate on the short term). Instead, if his thesis holds, Simpson simply bides his time. Consequently, the Geico portfolio's turnover ratio is a fraction of the typical stock mutual fund's.
The upshot isn't that investors should trade less frequently. It's that they should perform the sort of rigorous, fundamentals-based research needed to foster deep conviction in an idea. In that context, low portfolio turnover is simply the hallmark of a strong process.
Stocks Trump Bonds
Simpson doesn't spend much time evaluating the market from a top-down, macroeconomic perspective. Instead, he judges the state of things based on the relative scarcity of investment opportunities.
On that basis, Simpson reported that stocks, while not cheap in an absolute sense, aren't outrageously expensive either. He continues to see interesting individual opportunities, and he also thinks that stocks are a veritable bargain when compared with bonds.
This is largely consistent with what we're seeing. For instance, the typical stock in our coverage universe is trading at a modest premium to our fair value estimate (see our market-valuation graph). Nevertheless, bargains can be had, particularly as one gravitates toward larger, higher-quality, less-risky fare. Our 5-star list abounds with wide- and narrow-moat firms that pose average- or below-average risk.
Coming Full Circle
Simpson's philosophy leans heavily on many of the same tenets that inform our approach. He invests in businesses, not pieces of paper, burrows into the fundamentals of each firm to get a sense of what the future might hold, and tends to favor those with durable competitive advantages. Most of all, Simpson focuses unwaveringly on the long term and throws his high conviction behind each pick. (Geico's equity portfolio spans fewer than 20 stocks.)
Those similarities are a big reason why my colleague, Justin Fuller, considers Simpson's picks in putting together his "Ultimate Stock-Picker's Portfolio," which aggregates the holdings of some of the world's most-astute investors and overlays it with our equity analysis. If you're a Lou Simpson admirer or an acolyte-in-the-making, I'd strongly encourage you to give the "Ultimate" portfolio a look.
Jeffrey Ptak has a position in the following securities mentioned above: EBAY, JNJ, PG, WU. Find out about Morningstar’s editorial policies.