CHRIS DAVIS: IT’S ALL IN THE FAMILY TRANSCRIPT

May 9, 2014

Consuelo Mack: This week on WealthTrack, it’s all in the family! Third generation investor Chris Davis shares the investment lessons passed on from his grandfather, to his father, to him at the Davis funds family. The next generation Great Investor, Chris Davis is next on Consuelo Mack WealthTrack.

Hello and welcome to this edition of WealthTrack, I’m Consuelo Mack. When asked what he expected the market to do legendary financier J.P. Morgan replied: “it will fluctuate”. And so it has, quite a bit! Despite the oft quoted 12% annualized returns of the last fifty plus years, it turns out it is a market of extremes not means. As this chart reveals, which shows the frequency of years the S&P 500 has averaged certain types of annual returns since 1958, the market has never returned its 12% average and has rarely come within even 50 basis points or half a percentage point of it. The most frequent market returns have been at the extremes. In nearly 20 years the market experienced returns of less than 6% a year and in more than 20 years saw better than 18% results. No wonder investors get nervous!

Now the flip side is that despite these extremes the market has climbed inexorably higher over the years, exhibiting some reassuring predictability along the way. Take a look at this chart, courtesy of this week’s guest. Since 1928 there have been ten 10-year periods of poor market performance. Poor is defined as annualized returns of less than five percent. Each poor performance decade was followed by a 10-year stretch of much higher returns. Of interest to all of us, the last 10-years of subpar performance ended in 2011. As we have discussed on recent WealthTracks the biggest mistake investors make is not getting back into the market soon enough, to participate in those strong rebounds after a prolonged bear market.

This week’s guest wants investors to overcome that failing. He is Christopher Davis, a third generation Great Investor who is chairman of Davis Advisors, portfolio manager of the Davis Large Cap Portfolios, as well as co- manager of the firm’s flagship Davis New York Venture Fund among others. New York venture was started by his dad, Shelby M.C. Davis in 1969. Chris took over the reins in 1997. In his youth Davis also worked closely with his late grandfather, Shelby Cullom Davis who made a fortune in insurance and financial stocks. Chris was named Morningstar’s Domestic Stock Fund Manager of the year in 2005 and more recently The Motley Fool named Chris one of its current generation of Superinvestors.

I began the interview by asking Davis how he avoids the classic mistake of mistiming the market.

Chris Davis: Well, I think if you take one sort of generational lesson, it’s that stocks are ownership interest in businesses. And John Train had a wonderful quote, he used to say, “Investing is the art of the specific,” and when you start thinking about owning a business and what sorts of things will make that business more valuable over time, you really stop thinking about what’s going on in the Ukraine or what’s going to be the Fed’s next move. You start thinking about well, can that business open more stores? Can that business get new customers? Can that business enhance its competitive advantages? And once you do that, you stop thinking about all these unpredictable short-term forecasts and you start focusing on what you can have conviction in, which is, what are the competitive dynamics of that business? What will make that business more valuable?

Consuelo Mack: Are there any macro events that you do pay attention to on a regular basis?

Chris Davis: Well, I think you have to invest knowing that the world is an uncertain place; that terrible things and unexpected things will happen. Now of course, very positive unexpected things will happen, too, but nobody should invest with the view that if something happens, a geopolitical event, the formation of oil cartels, world wars, I mean, all of these things have happened during a period of time where the American businesses have still made progress decade after decade after decade. So you have to invest knowing that the world is uncertain, and when you do that you start thinking, well, am I owning a business that can withstand unpleasant, unpredictable events? Does it have too much debt? Does it rely on short-term financing? Is it something that couldn’t survive dislocation for some period of time? Well, when you invest knowing that that’s the world that we live in, then it becomes not about when to invest but what sorts of companies to invest in, and that to me is a much more useful way to think about risk management than trying to predict the unpredictable.

Consuelo Mack: And yet as an investor it’s one thing to say we invest in companies which you do long term. Then there’s the other aspect of that is you’re investing in these stocks as well of companies and stocks do go up and down, and stocks are affected. We just came through a major financial crisis, probably the worst financial crisis that you and I have had in our lifetimes in 2008 and 2009. How do you react to that? I mean, were there any lessons that you learned from that as an investor.

Chris Davis: One of the most powerful lessons of the financial crisis in a way was resiliency. How many businesses continued to generate profits, generate revenues, generate growth through that period. In a funny way, here in New York we can think back to the events of 9/11 and what a dislocation that was, and yet here we are in this lesson of resiliency, you know, this enormous ability to come back to make progress. So what I would say is this is that the price fluctuations are there to serve you. They are not there to instruct you. They’re there so you can take advantage of them.

Consuelo Mack: One of the things that you’ve said in other interviews is that it’s not only your brain that’s important as an investor but your stomach is probably the second more important organ. Talk to me about how you handle your stomach.

Chris Davis: Well, I think there are certain tricks that you can work with as a way of framing the issues that can help. One is always to stretch out time periods, and the time period could be the period at which you look at price returns of stock. If you had taken a vacation in 2005 and came back today, you wouldn’t think there had been a huge dislocation. You would just sort of think the businesses have sort of flopped along, and you’ve earned some dividends along the way, and so the longer your time measurement horizon, the less you see that volatility. It shrinks in terms of noise, so that’s important.

Slowing down the decision making process. One of the things I tell investors all the time is usually it’s the case that when you want to get into the market, prices have already gone up a lot, and when you want to get out, prices have already gone down a lot. That’s usually the … so how do you fight that? Well, it’s easy to say, “Don’t do that”, but that’s like saying buy low, sell high…it sounds easy. But what you can do is average in. Systematic investing is such a powerful tool for minimizing the impact of emotions. I even had a family member who came into some money and was looking at what to do. I said, “I know you’re going to overreact. If you get invested today 100 percent and the market goes down tomorrow, you’re going to be calling me every week saying, “What am I doing? What should I do?” I said, “If instead you get in evenly, maybe over the next three years just do a certain amount every month, every quarter, every year, you’ll take your emotion out, and that way if the prices go down, you feel, well, I’ve only just got started. I don’t need to be nervous. If prices go up, you’re glad you got started.” Systematic investing works so well, and it’s just amazing that more people don’t do it, but of course through their 401(k) plans they are.

Consuelo Mack: Chris, as we said in the introduction to you, you’re the third generation Davis investor, and I know you worked with your grandfather. You worked with your dad. Where did this sensibility of investing in businesses and not stocks come from?

Chris Davis: You know, it really started with my grandfather. It’s an exciting story to us because we’re in the business. It’s not that titillating a story outside because it was really about his insights into the insurance industry. He was an insurance regulator, and one of the things he noticed was that these businesses that were growing as the soldiers came home from World War II and the baby boom was underway and the suburbs were being built, these soldiers were coming back, and they were buying life insurance, but the accounting for life insurance in those days was such that the big commission that the insurance companies paid upfront, the expenses of putting that policy onto the book meant that they reported a loss in the first year for each policy they sold, and so the companies that were growing the fastest looked like they were losing money, and this is where he developed this idea of owner earnings. He said, you know, if you own a business you have a much better understanding of what the true profits are than if you’re just looking at GAAP accounting or random financial statements, and so he really got at this idea of focusing on the business and the economics of the business, trying to look beyond perception, and I think the second big part of his insight was the quality of the people, that businesses are really collections of people, ideas and capital, and that focus of where a great manager can take a company over a generation, that’s something he really, really taught my dad and that my dad constantly reminded me of. Just watching where an entrepreneur can take a company over 30 or 40 years, it’s just fantastic. So those were the big insights I think.

Consuelo Mack: Who are the great managers now? Obviously you’ve been a long-term shareholder of Berkshire Hathaway, so Warren Buffett would be one of them, but everybody knows about Warren Buffett. So who are the other great managers that you’re investing with now at the Davis Funds?

Chris Davis: Well, one of the great books that all of your viewers should read is a book called The Outsiders, and what’s fascinating about it is it’s a profile of nine executives who ran businesses where they understood the capital allocation part of the business, and often that is misunderstood.

Consuelo Mack: And explain the capital allocation part of the business that’s so important.

Chris Davis: Well, what we always say is if you own a business and the business produces earnings, at the end of each year you have some choices of what to do with those earnings. You could pay it out as a dividend. If your shares are under value, you could buy in stock. But of course if you’re running a business you have some other choices too, you could issue debt, you could buy other companies, you could issue shares.

Consuelo Mack: Reinvest in your business.

Chris Davis: You could build factories and so on, and what often happens is managers, when they’re in that role, want to just keep getting bigger, and they don’t think about the return that they’re getting when they buy another company. They just think about the fact that they’ll be bigger, and so a lot of value is destroyed by executives that think about size but not about value and value creation.

Consuelo Mack: Who was your favorite outlier?

Chris Davis: Well, I mean, of course Warren was, but when I think over time you think about companies like Leucadia which was not a household name, incredibly well run, enormous value creation. One of the things we’ve done at our company is we’ve thought of if you were going to write that book 15 years from now, who might be in it? And it’s a very interesting question. I mean, I love the companies we own because I think they combine decent businesses with thoughtful capital allocation, and there are some unusual ones.

Consuelo Mack: So let’s talk about some of the companies that you own that kind of exemplify that next generation of great managers that you want to invest in.

Chris Davis: Well, I’d divide the companies we own into a couple of categories. So we own companies where we think the business is very durable. The cash that they generate is predictable and that management can be trusted to do something sensible with it. Now these aren’t going to be galloping off enormous growth companies but our largest company, Bank of New York for example, would fit that category. And we think …

Consuelo Mack: Predictable earnings, Bank of New York.

Chris Davis: Predictable, durable business, 250 years old and it has the word “bank” in the name so people get nervous.

Consuelo Mack: Yes, it does, but it’s really not.

Chris Davis: It’s a processing company. If you think about the financial markets as if they were a city, what Bank of New York does is maintains the plumbing. It really is simply … it does custody and trust work and bond indentures and ADRs, and but all of these are processing.

Consuelo Mack: Boring but essential.

Chris Davis: Essential and all generate decent returns on capital. So generates this cash. It has enormous amounts of capital. It has very little credit risk and so that would be an example. My father used to call these boring but beautiful.

Consuelo Mack: Because the culture of Bank of New York is such that their successors, their management will have that sort of culture, boring but beautiful. That’s what you’re depending upon.

Chris Davis: Well, and not just that, Consuelo. They did the merger with Mellon and they did some other ill-timed mergers that I think sometimes you learn the lesson by touching the third rail.

Consuelo Mack: So that’s one kind of company. What’s the other kind? What are the other kinds?

Chris Davis: Well, I go from that’s our largest holding, so I should talk about our second largest.

Consuelo Mack: Google.

Chris Davis: And it’s Google. Now there you have the other side of it. You have a young management team. You know, I’m afraid they are younger than me.

Consuelo Mack: Very few are.

Chris Davis: With a fabulous, enormously protected competitive position, and with management that likely will be there for another 20 years or 30 years, and yet the valuation of the business is about 20 times earnings. Now when people talk about a multiple of earnings, what I always say to viewers, invert it. Think about it as an earnings yield. Right? So a 20 times earnings, if you turn that upside down, that means for every dollar …

Consuelo Mack: So not price/earnings but earnings over price.

Chris Davis: Exactly, and so what that means is when you buy the shares, the amount of earnings they generate relative to the price you pay is about five percent as a yield. So you think about that in a sense as your yield, and then the question is, are they doing sensible things with it? Now I think that they do understand competitively their businesses better than almost anybody I’ve seen. People like to say acquisitions are dangerous. We think acquisitions are dangerous, and yet they did a brilliant acquisition of YouTube and, of course, they bought the company that created the operating system, Android, for the vast majority of phones on earth. So they have been incredibly visionary and incredibly thoughtful about how they protect this competitive business, but if you were to say, is that a business that in 10 years from now is almost certain to be more profitable than it is? I would say so, and that’s unusual in technology. That’s one of the big changes in the world is that with the Internet there have been new blue chips created. I’d put Amazon in this category. We own just a little bit of Amazon, but without question Jeff Bezos is one of the great executives of a generation and has built one of the great companies, and I would defy anybody to give me a scenario where Amazon is a smaller company 10 years from now than it is today.

Consuelo Mack: Large does not necessarily mean quality to parrot what you said earlier.

Chris Davis: That’s true, so I would …

Consuelo Mack: And how profitable is Amazon and their business model?

Chris Davis: It’s a great question. I mean, this goes back to what I said about my grandfather and owner earnings. I think one of the very interesting things to think about is how much could Amazon earn if they were not reinvesting for growth? And so right now they earn very little money. Amazon is investing to protect and build their competitive advantage and build the value of the company over time. So we think it’s a very sensible thing to do, and so it is an unusual thing to look at our portfolio and see that we have stalwarts like Bank of New York, American Express, Wells Fargo, Berkshire Hathaway. These are sort of global leaders. They’re blue chip companies. People are comfortable with owning them, but we also have owned companies where we see them in a sense as the future blue chip companies. Some of them have higher growth rates like Google and in this case a little bit of Amazon, and they aren’t as well understood because of that. A lot of value investors won’t look at them, but what we believe is that growth is a component of value. Companies that grow profitably are more valuable than ones that don’t, and we don’t understand why investors try to create this distinction where they say it’s a strange thing for one investor to be simultaneously interested in United Health or American Express and at the same time see value in a company like Google.

Consuelo Mack: So those were two types of companies that you were just talking to. Was there a third type?

Chris Davis: Well, I think there’s always a type that we call “out of the spotlight”. These are companies that aren’t so well known. They aren’t household names but they’re often in dull businesses but with great economics, and there can be smaller companies, so we have this category that we call “out of the spotlight”, and you might have companies in there. Well, in New York like the Loews, the Tisch’s company.

Consuelo Mack: Conglomerate.

Consuelo Mack: Hotels and casinos.

Chris Davis: Hotels and Markel Insurance, companies like that, great records of long-term stewardship but not necessarily household names, and I would even give you one last category which is the category that’s hardest for all, and this is the category that we call “headline risk”. These are companies where your viewer hears that you own them, and they say, “Oh, god, that sounds so terrible. It sounds controversial,” and what we feel is over time investors should have the stomach to look at businesses when they’re under a cloud of controversy. So in the ‘90s it might have been in tobacco, for example.

Consuelo Mack: With all the litigation.

Chris Davis: People didn’t want to look at Philip Morris and yet it was an enormously great time to invest. Well, what about companies like Tyco when it went under its cloud?

Consuelo Mack: Your biggest headline risk company now is … ?

Chris Davis: Well, I would probably say it’s in the health insurance area. I think when you own a company like United Health, I think what happens is people say, “Well, what about Obamacare? What about what’s going on with nationalization of health care and so on?” There’s a lot of controversy. There’s a lot of misunderstanding. There’s a lot of regulatory risk, but I would also put in some of the financials. I mean, we own JPMorgan, and I think I’ve met Jamie Dimon maybe the year I started in this business when he was still the number two guy at a company called Commercial Credit.

Consuelo Mack: Your view of JPMorgan at this point as an investment?

Chris Davis: Oh, I have a very high regard for JPMorgan, very high regard for the management, for the necessity of what they do, for the thoughtfulness, and when you see these things like the London Whale that are very upsetting to people, one of the things that I found very reassuring about that was how well the company reacted. They got the news out as fast as they could. They communicated honestly with shareholders. I would say an interesting thing to recommend is annual reports, because most annual reports have become marketing documents. You know, there’s no sense reading them. They’re just written by an investor relations department, but every year there are a handful that are really worth reading. Well, of course, Berkshire’s is worth reading. I would highly recommend that every viewer read JPMorgan’s annual report, and you could go back and start the year that Jamie Dimon became CEO of Bank One and read his first annual report as a CEO and read every one since. It’s honest, thoughtful communication about the environment, about the businesses, about the strengths and weaknesses. So I’m very comfortable, but I would view that as a company full of headline risk, and so that sort of thing, when you think about annual reports as … and by the way, I would read Amazon’s.

Consuelo Mack: So Jeff is really a creative thinker.

Chris Davis: And one of the interesting things is in every annual report he reprints his first letter to shareholders from 1998. It’s an outstanding pledge of these are the principles of how we will run the company, and he has really stuck by those.

Consuelo Mack: Let’s talk about how you are judged at the Davis Funds from outside investors, and one of the things that you want is returns in excess of the S&P 500, and if you look at your Venture Fund, for instance, which started in 1969, since inception and through many, many periods it has had excess returns to the S&P 500. You’ve just come through a period of time where it has not, for instance, the last ten years and five years. Last year, 2013, you did once again surpass the S&P 500. Why have you underperformed your benchmark, and also how do you handle that?

Chris Davis: Well, of course, when times are good we used to always put in our annual reports, we’d always say periods of underperformance are inevitable. We will go through bad periods, but of course when you’re doing very well, that just sounds modest. When you’re not doing so well, it sounds defensive like you’re making excuses. We don’t want to make excuses. You know, our money is invested alongside our clients, so we eat our own cooking, and so we are aligned. We have complete incentive system to generate the results over time. So when we lag an index, we know we will go through periods of that. It’s part of active management. You have to be willing to look different, and that means sometimes that looking different will lead to periods of underperformance. Now in our case, it was exacerbated by the financial crisis. We’ve always had some …

Consuelo Mack: Because you had heavy investments in financials.

Chris Davis: We did, and amazingly virtually all of them came through not only unscathed but are generating record profits. American Express, Berkshire, Wells Fargo, JPMorgan, but we also had a big holding in AIG, and that was a catastrophic loss.

Consuelo Mack: Right, and that really hurt you. So that legacy is still …

Chris Davis: That legacy is still in the numbers. So we have to grind through that. I mean, that is just the fact of it, but I would say that we do have a high degree of conviction that the performance of the businesses we own has been better than the performance of the stock prices of the businesses we own. So the value of the businesses over the last decade have grown more than the stock prices.

Consuelo Mack: And that’s what matters to you.

Chris Davis: And that gives us a lot of confidence about the future.

Consuelo Mack: Last question, one investment for a long-term diversified portfolio. What would you have us all own some of in a diversified portfolio?

Chris Davis: Well, I’m going to cheat and say the two that we spoke about because, you know, we ….

Consuelo Mack: Bank of New York and Google.

Chris Davis: We have low turnover. We’re going to own these for a long time, and so I feel it would be wrong for me to talk about my tenth largest holding. I should talk about the ones that I own the most of, and I like that as a pairing. I think they’re both wonderful leaders in totally different industries.

Consuelo Mack: Chris Davis, such a treat to have you back on WealthTrack. Thanks so much for joining us.

Chris Davis: Thank you so much, Consuelo.

Consuelo Mack: At the close of every WealthTrack we try to give you one suggestion to help you build and protect your wealth over the long term. This week’s action point follows Chris Davis’ advice to invest systematically. Most of us do it automatically in a 401 k plan where money is deducted from our regular paycheck and invested. But any investing outside of that is subject to market timing and the state of our emotions towards the market. Davis recommends investing equal amounts of money at regular intervals, very month or quarter for instance, which will insure that we are automatically purchasing more shares in down markets and fewer shares in up markets. This kind of disciplined approach can save us from the classic mistake of buying high and selling low.

Next week we will introduce you to a new Great Investor for us. Chuck Akre will explains how he finds “compounding machines,” companies that produce high rates of returns for shareholders in his five- star rated Akre Focus Fund.

In the meantime on our website we will have more of our interview with Chris Davis in our extra feature and in our new WealthTrack Women section our team of award winning women financial advisors will share specific steps they take with their female clients to develop a financial plan.

Have a wonderful Mother’s Day weekend and make the week ahead a profitable and a productive one.

 


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