Renowned investor Warren Buffett does not suffer fools gladly, and has a short list of other money managers whom he admires greatly. One of these is longtime right-hand man Charlie Munger at Berkshire Hathaway. Another is Lou Simpson, the "third mastermind" who made investment decisions at Berkshire, as GuruFocus styled him. Buffett has called Simpson, per GuruFocus, "a cinch to be inducted into the investment Hall of Fame," and "a top-notch investor with an outstanding long-term record."

Like Buffett, Simpson is a value investor who prefers to manage a concentrated portfolio. MarketWatch reports that his firm SQ Advisors held just 15 stocks as of March 31. Among them are these six, with their upside potential as implied by the consensus price targets from securities analysts:

Stock Ticker Upside Potential
Brookfield Asset Management Inc. BAM 16%
Liberty Global PLC LBTYK 37%
Charter Communications inc. CHTR 36%
Berkshire Hathaway Inc. Class B BRK.B 19%
Liberty Broadband Corp. LBRDK 44%
SBA Communications Corp. SBAC 16%

Source: FactSet, as reported by MarketWatch on June 13.

Why Buffett Admires Simpson

When Berkshire was finalizing its purchase of giant insurance company GEICO in 1996. Simpson was its CEO of capital operations. Impressed by his track record, Buffettt kept him on as chief investment officer (CIO), a post that he held when he first joined GEICO in 1979, after stints as an economics instructor at Princeton University, CEO of Western Asset Management, and a partner at Stein Roe and Farnham.

From 1980 to 2004, Simpson delivered an average annual return of 20.3%, versus 13.5% for the S&P 500 Index (SPX), per GuruFocus. He posted negative returns in only three years, and returns below double digits in just four years. After retiring from GEICO in 2010, Simpson founded his own investment firm, SQ Advisors.

Investment Philosophy

In a 2010 interview quoted by GuruFocus, Simpson described his investment approach as "eclectic," with these key elements:

  • "I try to read all company documents carefully."
  • "We try to talk to competitors."
  • "We try to find people more knowledgeable about the business than we are."
  • "We do not rely on Wall Street-generated research."
  • "We do our own research."
  • "We try to meet with top management."

In their recent article, MarketWatch summarized the key metrics that SQ Advisors uses to evaluate stocks, based on comments by Simpson:

However, these are not hard-and-fast screens used by Simpson. MarketWatch found that 7 of the 15 stocks in his portfolio lag their industry peers in a variation on ROIC called return on corporate capital (ROCC), while data limitations prevented calculations for one other. Regarding price to free cash flow, 10 of the 15 had higher valuations than the S&P 500 average, if you also include three stocks with negative free cash flow.

Applying Simpson's Methods

Using data from FactSet Research Systems, MarketWatch found that the ratio of price to free cash flow is 20.4 for the S&P 500, based on share prices as of June 8, and excluding companies with negative cash flow. Among the six stocks above, Liberty Global stands out as the cheapest, with a ratio of 5.7, and Brookfield is second, at 13.1.

Return on corporate capital (ROCC) equals annual net income plus interest expense and income taxes, divided by the ending balance of total assets minus total liabilities, but it excludes interest bearing debt from total liabilities. MarketWatch made comparisons by industry since some industries are more capital intensive than others, and used 5-year averages. 

The ROCC standouts were Berkshire, which was compared to fire, marine and casualty insurers, and wireless tower owner SBA Communications, compared to other real estate investment trusts (REITs). However, since Berkshire is a multi-industry conglomerate that also has a large investment portfolio, comparing it to pure insurance companies is not methodologically pure.

Copying Buffett

Given the phenomenal success enjoyed by Buffett, many investors try to imitate his methods. His fundamental rules for investors are: only invest within your circle of competence; understand that buying stock makes you an owner; and buy stocks that sell well below their intrinsic value. As an owner, he believes that you should invest for the long run, ignoring short-term market fluctuations. Additionally, Buffett advises against buying stocks on margin. (For more, see also: Buffett's 3 Best Rules For Stock Investing.)

Meanwhile, various analysts and investment managers take the additional step of identifying specific stocks that might be Buffett's next targets, based on his criteria. A team at Credit Suisse has done just that recently. (For more, see also: 5 Stock Picks That Would Attract Warren Buffett.)