Christopher Cullom Davis knows about being part of a fund family in more ways than one. His grandfather, Shelby Cullom Davis, made his fortune in the 1950s by buying reasonably priced growth stocks. Dad Shelby Davis continued that tradition when he founded Davis New York Venture Fund in 1969, the first mutual fund at Davis Advisors, the family's investment firm that now manages more than $40 billion in assets.
As a teenager, Chris Davis often accompanied his father on company research visits. During summers off from college, he worked at the family's New York offices as an analyst. "It was important to my father and grandfather that people judge me by my performance, not my name," says Davis. "So instead of paying me by the week, they paid $50 for each research report I produced."
Davis probably doesn't remember how many reports he produced or how much he made during his summers off from school. But as manager with Kenneth Feinberg of the $4 billion Selected American Shares and the $15 billion Davis New York Venture Fund, he is very aware of the performance microscope fund managers live under, whether or not they share the name of their predecessors. "As a mutual fund manager, your report card is out there every day," he says. "There is nowhere to hide when the going gets tough."
Although Davis didn't know it when he joined the firm in 1989 as an analyst, the going wouldn't really get tough for some time. In 1995, Davis' first full year as manager of Selected American, the fund shot out of the gate with a total return of 38%. In 1996 and 1997, its total returns of 30.74% and 37.32%, respectively, outpaced both the Standard & Poor's 500 Index and its Morningstar large-cap-value category average. Its strong performance continued into 2000. Davis' value orientation helped the fund sidestep the tech wreck that plagued its growth-at-any-price competitors.
But more recently, Selected American has felt the wrath of a bear market that has left few mutual funds unscathed. In 2001, its shares fell 11.17%, marking the first time during the younger Davis' tenure as manager that the fund lost money in any one calendar year. As of October 31, it was down more than 18% for 2002-still almost four percentage points ahead of the S&P 500 Index.
In conversations as well as shareholder reports, the 37-year-old Davis calls on his family's experience to put in perspective the devastation brought by his first full-fledged, claws-out bear market. A sign on his desk reflects the thoughts of his grandfather: "You make the most money in a bear market. You just don't realize it at the time." He recalls the challenges his father faced when he started a mutual fund just before the infamous bear market of the early 1970s. "By 1975, there were not many people who could see a reason to invest," he says. "But over the next five years, the stock market rose at a compound annual rate of 18%."
Davis sees some parallels to those cautious times today. "Three years ago, people didn't think much about stock market risk. Now, that's almost all they think about, even though we're buying stocks at substantially cheaper prices than we did then."
Yet he stops short of predicting a broad-based turnaround. The overall market, he says, is still "not outstandingly cheap. It's a market of individual stocks rather than a stock market." The triple threat of terrorism, war and a weak economic recovery remain prominent concerns.
Beyond facing the challenge of navigating a bear market, Chris Davis must also find a way to expand the family-run firm without succumbing to the bureaucratic decision-making process that bogs down many of his competitors. "Since the fund's communication and decision-making process is relatively informal-the portfolio managers don't believe in using a formal committee or meeting-driven process-there is a risk that, due to the larger team, their process may become more bureaucratic or less effective," writes Jeremy DeGroot, director of fund research at Litman/Gregory Research, in the firm's September No-Load Fund Analyst newsletter. Noting the firm's expanding advisory role for other funds and variable annuities, he adds, "We would be concerned if these engagements started to take significant time away from Davis and Feinberg's research responsibilities." Still, DeGroot considers the fund "an excellent larger-cap core holding," although he cautions that it may be more volatile than its benchmark over short-term periods because of its concentrated portfolio.
Growth Stocks In Disguise
That portfolio consists of stocks of larger companies selling at reasonable prices, or what Davis calls growth stocks in disguise. Consumer product and service companies, such as banking, insurance, food and beverage firms, dominate because of their reasonable valuations and the relative dependability of consumer disposable income.
Davis frequently prefers multi-national companies because they provide geographic diversity without the political, business and currency risks faced by companies in different countries, and he avoids cyclical companies such as autos, steel and metals because of their variable earnings record and poor returns. He'll usually hold a stock for several years, a discipline reflected in the fund's low portfolio turnover rate of about 20%.
Although talking to management has always been an important part of Davis' research process, the rash of corporate scandals has prompted him to assess manager quality under a harsher light than he once did. While he still talks to corporate managers regularly, he admits that isn't always enough to uncover just how bad a company's management is. "Sizing up managers is a qualitative art," he says. "Human nature and the nature of the scandals hasn't changed. But the scale of the problem is mind-boggling this time around."
Nowhere have corporate misdeeds been more publicized than at Tyco, which Davis began purchasing in 1999 during a widely publicized SEC investigation into the company's accounting practices. After some research, he concluded that the company's accounting practices were aggressive but not inappropriate. Two years later, however, he sold about half his position after he became uncomfortable with what he considered to be increasingly aggressive accounting practices.
Although the stock has fallen substantially since then, Davis thinks it's worth holding on to at this point. "Tyco has been dragged down with Enron, but it's still a business that produces a lot of cash," says Davis. "The company's reliance on short-term funding made it vulnerable to changes in perception, despite the reasonable strength of its underlying businesses." At the same time, he admits, "we were mistaken in not recognizing this vulnerability sooner."
The experience has taught Davis to watch for what he considers several key characteristics of managers likely to commit corporate malfeasance. "Tyco's managers were very promotional in nature and flamboyant spenders who lived a very lavish lifestyle. They were aggressive insider sellers and aggressive acquirers. And they were big users of debt. There are some good companies where the CEO has one or two of these characteristics. But when you see all of them, it definitely sends up some red flags."
Wariness of management doesn't keep him out of controversial stocks that get dragged down because of unfavorable publicity. He began buying Philip Morris in the late 1990s, when the stock sold at about $20 a share and litigation publicity had reached a peak. Although he says litigation remains a threat, the highly publicized awards from lawsuits brought by individuals are quietly whittled down to a fraction of their size after appeal. "This is a stock with a 6% dividend yield, a history of buying back shares, a strong international tobacco franchise, and a large stake in a successful food business," he says. "And it still trades at about six times earnings."
Longtime holdings with less controversial pasts but strong balance sheets and franchises include Diageo, the liquor manufacturer which owns brands such as Johnnie Walker, Smirnoff and Guinness, as well as United Parcel Service and Berkshire Hathaway. Out-of-the-spotlight companies with low profiles and reasonable valuations include Golden West Financial, a savings and loan, and reinsurer Transatlantic Holdings.
Lately, Davis has been adding to the fund's positions in commercial property insurer American International Group (AIG) and Chicago-based regional bank BankOne. AIG has been able to hike its premiums and sign on substantial new business because of terrorist concerns. BankOne enjoys one of the largest credit card operations in the country and remains "one of the best-managed financial services companies."