Amidst Sensex volatility, Lou Simpson may have the answers

Lou Simpson asks investors to look at the return on capital; ROE or ROCE, but ideally both. Companies with consistently high ROE and ROCE rarely go wrong.

December 21, 2021 9:37 IST | India Infoline News Service
The markets have been extremely volatile and have corrected 11% from peak levels of mid-October. What does that mean for investors? Should they wait for a bounce or should they wait in the side-lines? Obviously, there are no simple answers; but in times of such market confusion, it is the voices of reason and sanity that you listen to.

Who exactly is Lou Simpson?

Unlike high profile money managers like Buffett, Peter Lynch, Paulson and Soros; not much has been heard or written about Lou Simpson. However, no less a person than Warren Buffett had specifically commended the performance of Lou Simpson as a disciplined money manager in his annual letter to shareholders of Berkshire Hathaway in 2004.

The proof of the pudding lies in the eating. Between 1980 and 2004, Lou Simpson averaged CAGR returns of 20% on his fund, which is 600 basis points more than what S&P index gave. This is not a flash in the pan but consistent performance over a quarter of a century. What stood out about Simpson was his ability to keep discipline and logic in volatile markets. Here is how investors can apply 6 of his key ideas in the current volatile markets.

Idea 1: Look at owning businesses not stocks

That is what many others said, but Simpson has persisted with this idea over 25 years. In fact, Simpson debunks the debate about value investing versus growth investing. According to Simpson, a value investor can also be a growth investor because when you buy something with above-average growth prospects at a discount; that is value buying. Growth is the key and as long as there is growth, the business is worth owning.

Lou Simpson asks investors to look at return on capital; ROE or ROCE, but ideally both. Companies with consistently high ROE and ROCE rarely go wrong. For investors to seriously understand ROE and ROCE and apply to investing strategy, they need to think like owners of the business than just owners of the stock. That is the principle that investors must follow in these markets. There is a business behind each stock, so check if you want to own it.

Idea 2: Great business at high prices are still awful

This is again a principle that investors must apply in the current market conditions. Even if the business is great, investors must ensure that they only pay a reasonable price. In fact, if you have an excellent business in mind, use this crash in the market to latch on to stocks that are suddenly trading 25-30% cheaper.

Lou Simpson offers the classic 25% principle. If you think that a stock is worth Rs1,000 in normal conditions and if you get the stock at Rs750, then it is a risk worth taking. You may not catch the bottom, but that is not the intent anyway. As long as you are getting a good stock at a much better price, it is worth the trouble. As Lou Simpson sums it up, “Being approximately right is a lot better than being precisely wrong”. The key takeaway is also that the same business can be a buy / sell / hold at different price points.

Idea 3: At the end of the day, markets are substantially rational

We have seen that time and again, although most investors may not have the courage or liquidity to buy when stocks are incredibly down. As a result, it is best that investors do not expend too much time trying to trade short term swings in the market. The point that Lou Simpson makes here is the price of a stock and the value of a stock are rarely the same.

However, in times of extreme optimism or extreme fear, the divergence becomes wider. That is what we have been seeing right now in the Indian markets. Mean reversion will eventually work. You should remember that trading on mean reversion can be dangerous (remember LTCM), but investing on mean reversion can be profitable.

Idea 4: Patience plus temperament is the divine secret of investing

Investing is a lot of mental strength and preparedness beyond just numbers and analysis. With the best of analysis and ideas, you can be an awful investor if you are low on patience and temperament. It is in markets like these that both these  attributes assume a lot more importance.

Lou Simpson says that patience and temperament can at times be contrary to each other. For example, patience may ask you to wait but temperament demand that you make the most of the current fall. In the current market conditions, just as investment action must be tempered by patience, so also patience must be coloured by some degree of aggression. That is the key to investing in these kind of market conditions.

Idea 5: Don’t own more than 10-15 stocks

In investing there is a difference between diversification and over-diversification. The former leads to reduction of risk and the latter just substitutes risk. That means if you want to achieve diversification then you don’t need to have more than 10-15 stocks in your portfolio. Beyond that, it is also too difficult to track and monitor the stocks.

Continuing on the subject of the portfolio size, the question is which 10 stocks to buy. Lou Simpson insists on the circle of competence. It is great to buy digital stocks at lower levels provided you are able to understand what would be the value triggers for these digital stocks. Rather, stick to stocks that are connected to your profession or expertise.

Idea 6: Make fewer decisions and analyse mistakes

These may appear like two different ideas but are connected. Investors often believe that they need to constantly trade in and out of the markets. Quite often, doing nothing can be profitable. It is tough to sit on cash, but many times it is worth the trouble. As Lou Simpson puts, if you are a good buyer and a lousy seller, you could be better off as an investor.

We often believe that post-mortems are pointless, but Simpson has a different take. As he puts it, you learn more from bad experiences than from good experiences. But that is only possible if you apply your thought to the bad experiences and try to figure out the reason.

Indian markets are in the midst of trying times. That is where rational voices of reason can add value to investors.

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