“One of the Investment Greats” Explains His Portfolio Strategy
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Finance & Accounting Nov 2, 2017

One of the Invest­ment Greats” Explains His Port­fo­lio Strategy

A Q&A with renowned investor Lou Simpson.

A man chooses flowers in a meadow

Lisa Röper

Based on insights from

Robert Korajczyk

Louis Simpson

From casu­al day­time traders to pro­fes­sion­al asset man­agers, every­one wants to know the secret to build­ing a strong port­fo­lio. What is the best way to pick a stock? When is it best to sell your shares, and when is it bet­ter to hold on? 

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Lou Simp­son, for­mer chief invest­ment offi­cer for Geico — a Berk­shire Hath­away sub­sidiary — and cur­rent Chair­man of SQ Advi­sors, has been called one of the invest­ment greats” 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 more than $4 bil­lion. Today he is also a senior fel­low and adjunct pro­fes­sor of finance at Kel­logg, and a mem­ber of the Advi­so­ry Coun­cil of Kellogg’s Asset Man­age­ment Practicum as well as a mem­ber of North­west­ern University’s Board of Trustees. 

Robert Kora­jczyk, a pro­fes­sor of finance at the Kel­logg School, sat down with Simp­son to dis­cuss his remark­ably suc­cess­ful invest­ment strategy. 

This inter­view has been edit­ed for length and clarity.

Robert Kora­jczyk: What would you say is the essence of your invest­ment philosophy? 

Lou 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. That’s some­thing any investor can access. 

If you’re a pro­fes­sion­al investor, the ques­tion is: How can you add val­ue? The more you trade, the hard­er it is to add val­ue because you’re absorb­ing a lot of trans­ac­tion costs, not to men­tion taxes. 

What we do is run a long-time-hori­zon port­fo­lio com­prised of ten to fif­teen stocks. Most of them are U.S.-based, and they all have sim­i­lar char­ac­ter­is­tics. Basi­cal­ly, they’re good busi­ness­es. They have a high return on cap­i­tal, con­sis­tent­ly good returns, and they’re run by lead­ers who want to cre­ate long-term val­ue for share­hold­ers while also treat­ing their stake­hold­ers right. 

Kora­jczyk: So you con­cen­trate your invest­ments in your very best ideas. 

Simp­son: You can only know so many com­pa­nies. If you’re man­ag­ing 50 or 100 posi­tions, the chances that you can add val­ue are much, much lower. 

So far, this year we bought one new posi­tion, and we’re look­ing pret­ty seri­ous­ly at one more. I don’t know what we’ll decide to do. Our turnover is 15, 20 per­cent. 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 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 twen­ti­eth 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. 

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. 

You can only know so many com­pa­nies. If you’re man­ag­ing 50 or 100 posi­tions, the chances that you can add val­ue are much, much low­er.” —Lou Simpson

Kora­jczyk: Are investors afraid to let the good ones run? 

Simp­son: 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. Of course, things can change. Ama­zon is chang­ing the retail busi­ness quite dramatically. 

Kora­jczyk: What is the cor­rect bal­ance between quan­ti­ta­tive and qual­i­ta­tive skills in your approach to investing? 

Simp­son: Well, I think you need a com­bi­na­tion of quan­ti­ta­tive and qual­i­ta­tive skills. Most peo­ple now have the quan­ti­ta­tive skills. The qual­i­ta­tive skills devel­op over time. 

But, as War­ren used to tell me, You’re bet­ter off being approx­i­mate­ly right than exact­ly wrong.” Every­one talks about mod­el­ing — and it’s prob­a­bly help­ful to do mod­el­ing — but if you can be approx­i­mate­ly right, you will do well. 

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? 

Kora­jczyk: It sounds like the qual­i­ta­tive skills can help you assess the down­side of hav­ing a con­cen­trat­ed port­fo­lio — name­ly, con­cen­trat­ed risk. What are some of the fac­tors you look at when you’re wor­ried an invest­ment might blow up and dam­age your portfolio? 

Simp­son: There are a few fac­tors that we look at. First, is this the busi­ness we thought it was? If you fig­ure out that a busi­ness is not what you thought it was, that’s a bad sign. 

The sec­ond fac­tor is the man­age­ment, which can also dif­fer from what you thought. Unfor­tu­nate­ly, a lot of man­age­ments are very short-term ori­ent­ed, and that can be anoth­er rea­son to sell. This goes back to the basic integri­ty and the focus of peo­ple in charge. 

The third fac­tor is an over­ly high val­u­a­tion, and this is often the most dif­fi­cult, because you’re invest­ing in some­thing you wouldn’t buy at cur­rent prices, but you don’t want to sell because it’s a real­ly good busi­ness and you think it’s ahead of itself on a price basis. It might be worth hold­ing on to it for a while. 

Kora­jczyk: My sense is that you and War­ren Buf­fett have very com­pat­i­ble invest­ment styles. Are there any inter­est­ing dif­fer­ences between you and Warren? 

Simp­son: The biggest dif­fer­ence between War­ren and me is that War­ren had a much hard­er job. He was man­ag­ing 20 times the amount of mon­ey we were. We were man­ag­ing five bil­lion. In equi­ties, he might have been man­ag­ing 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 focus and low turnover. It seems to be true that the more you trade, the low­er your returns.

Simp­son: Yes, I think there’s a strong cor­re­la­tion. There’s also a neg­a­tive cor­re­la­tion between the num­ber of peo­ple mak­ing the invest­ment deci­sions and the results. If you have a lot of peo­ple involved, you tend to have the least com­pe­tent per­son mak­ing the deci­sion, because you need consensus. 

One thing I say to peo­ple is if you real­ly don’t think that you can add val­ue — and most peo­ple can’t — then I think your base invest­ment case should be a pas­sive prod­uct with a low cost. 

Kora­jczyk: Is there a way for some­body to be an active investor, but only spend a few hours over the week­end doing research? 

Simp­son: 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 who have the right mind­set and maybe con­tacts, and cer­tain­ly luck, who could out­per­form the mar­ket. But if somebody’s going to invest using hot tips, or lis­ten­ing to CNBC, or invest­ing with so-called wealth man­agers at bro­ker­age firms, I think it’s a loser’s game for them. 

Featured Faculty

Robert Korajczyk

Harry G. Guthmann Distinguished Professor of Finance and Co-Director, Financial Institutions and Markets Research Center

Louis Simpson

Senior Fellow and Adjunct Professor of Finance

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