Concentrated Investing. Carlisle Tobias E.

72

      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.73 In addition to Buffett’s view on investing, Simpson would also ask Buffett about companies that he thought he knew something about.74 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.75 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.76

      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.77 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.”78

      The story stuck with Simpson, helping him avoid trading and to focus on developing a long-term investment perspective.79 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.”80 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.81 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.82 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.83 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.84 He took a large position because he assessed the Baby Bells as offering an unusually good risk/reward ratio.85 Admiring Simpson’s bet, Byrne remarked, “It was a very big hit on a very large amount of money.”86

      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.”87 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.”88 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.”89 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.”90

      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.91 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.”92 While he disclaims any ability to predict macro factors, he has looked at valuation levels of the market as a whole.93 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.”94 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.”95

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

73

Lou Simpson, interview, June 8, 2011.

74

Ibid.

75

Geraldine Fabrikant, “A Maestro of Investments in the Style of Buffett,” New York Times, April 23, 2007.

76

Lou Simpson, interview, June 8, 2011.

77

Ibid.

78

Ibid.

79

Ibid.

80

Ibid.

81

Ibid.

82

David Barboza, “GEICO Chief May Be Heir to an Legend,” New York Times, April 29, 1997.

83

Lou Simpson, interview, June 8, 2011.

84

Ibid.

85

Miles Weiss, “Buffett Stock Picker Simpson Opens Florida Firm after Retiring from GEICO,” Bloomberg, January 20, 2011.

86

Ibid.

87

Lou Simpson, interview, June 8, 2011.

88

Ibid.

89

Zachary A. Goldfarb, David Cho, and Binyamin Appelbaum, “Treasury to Rescue Fannie and Freddie,” Washington Post, September 7, 2008.

90

Lou Simpson, interview, June 8, 2011.

91

Ibid.

92

Ibid.

93

Ibid.

94

Ibid.

95

Ibid.