Louis Simpson

Those familiar with Lou Simpson, Geico's head of investments and CEO of capital operations, know he has one of the best longterm investments record around. Simpson averaged annual returns of 24.7% for the 17-year period preceding Berkshire Hathaway's purchase of GEICO in 1996.

Here are his core investing principles from a 1987 article in the Washington Post:

1. Think independently. We try to be skeptical of conventional wisdom, he says, and try to avoid the waves of irrational behavior and emotion that periodically engulf Wall Street. We don't ignore unpopular companies. On the contrary, such situations often present the greatest opportunities.

2. Invest in high-return businesses that are fun for the shareholders. Over the long run, he explains, appreciation in share prices is most directly related to the return the company earns on its shareholders' investment. Cash flow, which is more difficult to manipulate than reported earnings, is a useful additional yardstick. 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.

3. Pay only a reasonable price, even for an excellent business. 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, he concludes, if the price is too high. The ratio of price to earnings and its inverse, the earnings yield, are useful guages in valuing a company, as is the ratio of price to free cash flow. A helpful comparison is the earnings yield of a company versus the return on a risk-free long-term United States Government obilgation.

4. Invest for the long term. Attempting to guess short-term swings in individual stocks, the stock market, or the economy, he argues, is not likely to produce consistently good results. Short-term developments are too unpredictable. On the other hand, shares of quality companies run for the shareholders stand an excellent chance of providing above-average returns to investors over the long term. Furthermore, moving in and out of stocks frequently has two major disadvantages that will substantially diminish results: transaction costs and taxes. Capital will grow more rapidly if earnings compound with as few interruptions for commissions and tax bites as possible.

5. Do not diversify excessively. An investor is not likely to obtain superior results by buying a broad cross-section of the market, he believes. The more diversification, the more 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.

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April 23, 2007

A Maestro of Investments in the Style of Buffett

By GERALDINE FABRIKANT

CHICAGO — Warren E. Buffett is hardly a man of mystery.

But when investors gather in Omaha in two weeks for the Berkshire Hathaway annual meeting, there will be a nagging question mark over the head of the 76-year-old chairman: who might someday replace him in each of the two roles he plays — chief executive of Berkshire Hathaway, and its chief investment officer?

A bit more is known about the choice of a future chief executive. Mr. Buffett has said there are three candidates from various Berkshire-owned companies. Buffett watchers speculate that the list includes David L. Sokol of MidAmerican Energy Holdings; Ajit Jain, head of the reinsurance division of Berkshire's National Indemnity Company; Tony Nicely, chief executive of Geico; Joseph P. Brandon, chairman of General Re; and Richard T. Santulli, founder of NetJets.

The bigger mystery is who will become the chief investment officer. Mr. Buffett says he does not know himself. On this point of succession, "frankly, we are not as well prepared," he wrote in his 2006 shareholder letter last month.

Here is a clue, though. He or she will probably be a lot like Louis Simpson.

Louis who?

Mr. Simpson, 70, has long overseen the investment portfolio of Geico, the insurance company Berkshire owns, which is now valued at more than $4 billion. He is also the only man other than Mr. Buffett who has managed stock investments in Berkshire's portfolio.

Mr. Buffett is a big fan. "He is the kind of person we are looking for: smart, classy, loyal," he said of Mr. Simpson in a telephone interview on Friday. But Mr. Simpson is just six years younger than Mr. Buffett, who has written that "for the long term, though, we need a different answer."

Applicants would do well to learn from Mr. Simpson, which is easier now that he has agreed to his first interview since Berkshire Hathaway gained total control of Geico in 1995.

In many ways, Mr. Simpson, whose title at Geico is chief executive for capital operations, is a lot like his boss. The two have the same general distaste for technology stocks. They both favor intensive research to find attractive companies to invest in, and they share a willingness to bet on returns from just a handful of stocks.

In terms of style, though, there are some major differences. Mr. Simpson, a deliberate, slow-talking executive, has maintained much lower visibility. "I have always felt I could do a better job in adding value by being somewhat removed from the circus and parimutuel atmosphere of the market," he said.

Mr. Simpson works in Chicago, where he moved from the La Jolla district of San Diego two years ago because his second wife, Kimberly, a chemical engineer, missed the energy of urban life.

Though he is already well-connected among Chicago's power brokers, he tends to describe people in terms like "fancy" if they are not the plain-spoken types that populate Berkshire's host of companies.

Mr. Simpson's work life is similarly low-key. On a recent spring day, he sat in his three-room office suite on North Michigan Avenue here, where he works with a small staff, explaining that it had been a particularly busy time.

Busy, though, is relative. There were no researchers running around, no Bloomberg terminals, and no interruptions. "We are sort of the polar opposites of a lot of investors," Mr. Simpson said. "We do a lot of thinking and not a lot of acting. A lot of investors do a lot of acting, and not a lot of thinking."

He does not crow about Geico's performance except to say that "it has been very, very good," and he is disarmingly honest about investments that have not worked out.

"Pier 1 was a horrible mistake," he acknowledged. "It was our own doing. They were totally out of touch fashion-wise, and it was a disaster."

Such mistakes notwithstanding, his track record has even led Mr. Buffett to brag about him periodically. In 2004, the only time that Berkshire ever stated Geico's performance separately, Mr. Simpson over 24 years had posted a 20 percent average annual gain, surpassing the Standard & Poor's 500-stock index by 6.8 percentage points.

Since 2004, Geico's results have been somewhat better than the S.& P. index, he said, declining to be specific. In 2005, the S.& P. was up 4.9 percent, compounded. In 2006, it rose 15.8 percent.

"He has an amazing record," Mr. Buffett said in the interview. "He does not make a lot of noise about it. He is a very sensible, sound, decent guy."

To find stocks, Mr. Simpson does not read analysts' reports. "They have their own agenda," he said.

Nor does he search data on the Bloomberg terminal for ideas. "If I have the Bloomberg on, I find I am looking at what the market is doing," he said. "I am looking at every news story. I really like to be the one who is parsing the information, rather than having a lot of irrelevant information thrown at me."

Sometimes he speaks with Mr. Buffett several times a week and sometimes not for a month or two. Mr. Simpson makes his own decisions and essentially works alone.

"The more people you have, the more difficult it is to do well," he said. "You have to satisfy everybody. If you have a limited number of decision makers, they are more likely to agree."

It is hard to know which stocks are Geico's and which are Mr. Buffett's picks. Mr. Simpson holds about 10 major positions: According to filings with the Maryland Insurance Administration, they are in American Standard, Nike, Comcast, Costco Wholesale, First Data, Home Depot, ServiceMaster and UnitedHealth Group (he bought it after the stock-option scandal). Geico's biggest position is Tesco of Britain, a stock also owned by Berkshire Hathaway.

Mr. Simpson found Nike, one of Geico's most successful holdings, through a stake in the rival Reebok. He had hired a journalist-turned researcher, and the researcher thought that Reebok was the "cat's meow," Mr. Simpson recalled, adding: "Paul Fireman ran the company, but not particularly well. The more we got into it, the more I saw the really quality company with the franchise and sports brand was Nike. It was truly a worldwide brand that did not have a lot of penetration in growing parts of the world such as Asia."

Thomas Russo, a partner in Gardner Russo & Gardner, also studied that industry for investors. Geico "did an enormous amount of research," he said. "They wanted to understand the management questions," adding, "We were researching companies in that same sector, and we had a pretty good idea of what was going on."

Mr. Simpson, who grew up in Chicago and has three sons, began his investing career at Stein Roe & Farnham. During a heady investment period in the late 1960s, he learned the perils of market timing when he worked for Shareholders Management, then a hot fund company run by Fred Carr. But when the market turned, Shareholders' Enterprise Fund took a nose dive, and there were substantial redemptions. Mr. Simpson resigned. "I viewed myself an investor, and they were trading-oriented," he said.

From there, he joined Western Asset Management where he rose to chief executive. Still, that firm basically followed analysts' recommendations.

It was not until Geico's chairman, John J. Byrne, called him in 1979 to become its chief investment officer that Mr. Simpson found a niche where he could put his own ideas to work. Berkshire Hathaway was already a shareholder in Geico, and Mr. Byrne sent several candidates to see Mr. Buffett about the management job. After a four-hour interview with Mr. Simpson, Mr. Buffett called Mr. Byrne. "Stop the search," Mr. Bryne recalled him saying. "That's the fellow."

Mr. Simpson's compensation has not been disclosed since Berkshire took over Geico in 1995. At that time, he received a moderate salary and a bonus based on how much the portfolio outperformed the S.& P. 500. He said that structure had not changed.

Mr. Buffett has noted that Mr. Simpson could probably make more money elsewhere. Mr. Simpson says he is not tempted.

Does the fact that Mr. Buffett seeks a younger heir for the long term upset him?

"If he would have asked me to take over the investments for Berkshire, I certainly would have done it," Mr. Simpson said, "but I certainly did not seek it out or wait for it to happen."

That kind of patience has proved to be its own reward. "Lou can keep running money as long as he wants," Mr. Buffett said.