For much of his professional life, Chris Davis found himself thinking, with a degree of jealousy, of stories his grandfather would tell him about purchasing shares in companies like Johnson & Johnson for 12 times earnings with a 3.4% dividend back in the late 1940s and early 1950s.
Now that he could take advantage of a similar opportunity, it doesn't feel like the incredible bargain basement it was a half century ago. "The hardest thing is that every day the market tells you you're an idiot," Davis says. "We're nine years into what will almost certainly become the worst decade for stocks, including the 1930s (after the 20%-plus 1999 returns is replaced with 2009)."
After learning about investing from of his grandfather, a former New York state insurance commissioner, diplomat and an investor who parlayed $100,000 into $800 million, and his father, the legendary Shelby Davis, Chris Davis started in the business as an analyst in the middle of the 1982-1999 bull market in 1989. Until recently, he had never run money in this kind of environment. "My grandfather used to say you make most of your money in bear markets. You just don't realize it at the time," Davis recalls.
Many investors like to buy great companies for the long term, even if some are questioning that strategy today. But finding an attractive entry point is critical to generating positive returns over a decade.
Pick a company like Johnson & Johnson or Procter & Gamble that is growing at 10% a year and paying a 3% dividend, Davis says. "If you buy the stock at 10 times earnings and it goes to a 15 P/E over a decade, that's an 18% return," he notes. "If you buy it at 20 times earnings and the multiple goes to 15 over 10 years, your return is 6%."
Davis isn't about to call a bottom, something he considers a "terrible thing to do." People should be excited at the chance to buy stocks on the cheap, but if they truly were, equity markets would be a lot higher. At the same time, nobody has rung the proverbial bell or published a magazine cover proclaiming "The Death of Equities," as Business Week did in 1979.
Davis notes that when the magazine ran that cover story, the stock market had nearly doubled off its 1975 low, yet no one felt very good about it. Interviewed in late February, he says it's been a long time since he heard "a single rosy forecast for the next five or ten years."
What is so pervasive today is the chasm between risk and the perception of risk. Flying in airplanes in the pre-9/11 era was much riskier than it is today. People just didn't realize it.
Likewise, Davis observes that the safety of many small cars is greater than SUVs, despite what SUV marketers may tell you. "If a Toyota Camry collides with a Ford Explorer, you may have a better chance surviving in the Explorer, but more people die in Explorers than Camrys," he continues. "People drive faster in the rain in an Explorer but they don't brake any better." If you really wanted to reduce auto fatalities, he suggests putting a sharp steel spike on the driver's wheel.
The waves of selling triggered last fall by the collapse of Lehman Brothers struck him as irrational, as did the bull market capitulation that afflicted some normally rational investors in early 2000 when they stopped trying to fight the tidal wave and piled into Cisco Systems at $80 a share. Six months ago, giant institutions found themselves locked in illiquid hedge-fund and private-equity investments and some were forced to sell their publicly traded, blue-chip stocks-at any price. "It was pawnshop economics; sellers weren't asking what the underlying businesses were worth," Davis says. Fortunes, he continues, are made at times like this when there is very little visibility.
Over the last ten years, the Standard & Poor's 500 index has produced annual returns of between -2% and -3%, depending on what day one measures. Can it do that for another five or ten years?
"Possibly," Davis acknowledges. "But if you look at every ten-year period [when the S&P 500 was negative] and then look at the next ten years, the average annualized return was about 13%, and the worst was 7%. The idea that equities will underperform risk-free alternatives is a very low probability. People are paying an irrational premium for the perception of safety."
Davis Selected Advisors' two largest funds, the New York Venture Fund and the Davis Selected Fund, have a reputation as having a strong interest in financial shares. However, Davis explains their real objective is to find growth companies in disguise, which often leads them to financial companies.
A classic example is Progressive Insurance, an auto insurer that has grown at 18% to 20% for the last 20 years. "In almost any other industry it would normally trade at 20 to 30 times earnings, but Progressive trades at 12 times," Davis says.
All financials are not the same, as Davis is quick to point out. An investor who held a finance company, a retailer and a capital goods concern might think they have the foundation of a diversified portfolio, but if those companies happened to be Countrywide, Home Depot and Toll Brothers they would have been sadly disappointed in 2008.
In 2008, the Selected American Shares fund lost 39.4% of its value, not far from the S&P 500's 37% decline. But other funds with excellent long-term track records, like Dodge & Cox Stock Fund, fared much worse. Many gave back half their NAV or more to the merciless market.
Davis' funds take the long view and they are evaluated on 10-year performance figures. It so happens that Selected American Shares posted 10-year annualized total returns of 1.33%, but beating the S&P 500, which fell 1.38% over 10 years, isn't a source of satisfaction.
This equity market hasn't spared any of the few winners, and Davis is far too grounded in reality to take satisfaction from outperforming some former superstars. "About 43% of all managers in the top quintiles over the last decade were in the bottom quartile for a three-year period," he notes. In other words, gloat at your own risk.
Despite their funds' sizable setback last year, investors in Davis' funds managed to survive the worst of the subprime tsunami better than many others. Like survivors of a coal mine disaster, they managed to live to fight another day, while many rivals that saw more than half their capital vaporized remain trapped below the earth living off what oxygen rescuers can thread to them through various tunnels.
Going into 2008, Davis and his team knew that credit was too easy and they assumed there would be a downturn. Despite their financial exposure, they managed to sidestep the first six victims-Countrywide, Bear Stearns, Lehman, Fannie, Freddie and WaMu.
They weren't so lucky with AIG, once believed to be the strongest financial services firm on earth. It cost the fund 6% of its annual return last year. The fund also had a long-term investment in Merrill Lynch, which it had acquired at an average cost of $31 a share. Right after its acquisition by Bank of America was announced at $29 a share, the funds started selling. Say what you will about former Merrill CEO John Thain, but Davis notes he did "a masterful job" at convincing Bank of America to pay $29 a share.
The space on the wall between Davis' office and co-manager Kenneth Feinberg is reserved for documenting their mistakes. In fact, it's called The Mistake Wall.
In a ten-page letter to shareholders in February, the two portfolio managers devoted nearly two pages to discussing their AIG mistake, which cost investors three times more than any other. "We owe our shareholders an accounting of our mistakes," Davis says.
Condensing their explanation, Davis and Feinberg conceded that they-along with the entire AIG management team-vastly underestimated the destructive potential of a certain derivative known as a credit default swap (CDS) and how much collateral these contracts might require the insurer to post. Furthermore, they assumed that, since AIG was an insurance company, the classic run-on-the-bank scenario that brought down Bear Stearns and Lehman was not a life-threatening danger. But AIG had a big securities lending operation, and while they had huge cash reserves, regulations did not allow them to upstream the cash from subsidiaries to the parent.
Perfect storms clearly possess higher odds than the vast majority of investors thought. "Nouriel Roubini was right and we weren't," Davis says. "But the reaction that we should just raise cash doesn't make sense. It was like you are crazy if you don't own Cisco in 2000. Everyone wants to do today what they wish they had done a year ago."
Nonetheless, living through the last 18 months has, at times, been a learning experience, even for sophisticated investors. The idea that a triple-A-rated company like General Electric was almost unable to roll over a relatively small amount of short debt and saw its survival threatened stunned him. "We always assumed credit would be available to high-quality credits," he notes. This assumption, embedded in all of modern finance, now needs to be revisited.
While Davis' team members are meticulous students of accounting, they always viewed it as a way to provide different takes on reality rather than something that directly impacts reality. When rating agencies began to include equity prices, mark-to-market accounting and credit default swap spreads in their calculations, the game changed. Now a downgrade can make a company sell assets, even when there is no market for them. "Allowing the shameful explosion of the CDS market" as a place to speculate on companies' demise was a disgrace, Davis thinks.
Still, Davis, Feinberg and the rest of their portfolio management and research staff dodged more bullets than many mutual funds-for several reasons. As investors, they like to step back and look at investments in ways that give them a degree of detachment to avoid developing biases or getting locked into their convictions.
Speaking at a Morningstar conference several years ago, Davis flashed a PowerPoint shot of some of the metrics they consider important, then showed the numbers of two businesses that looked very similar. One happened to be a plastics manufacturer, while the other was a railroad.
Scrambling various metrics might prove an interesting intellectual exercise, but what was the point? The point was that numbers tell only part of the story, as CEOs have been heard to quip that they can drive fleets of trucks through the holes in generally accepted accounting principles.
Any advisor who owns his or her own firm knows that there are legitimate ways to make their business look more or less profitable, and those opportunities are magnified at huge public companies. Davis and his team expend a great deal of effort trying to get at "the underlying reality," examining such adjustments as pension income/expense, depreciation versus maintenance capital spending, nonrecurring charge-offs, inventory and mark-to-market adjustments, tax rates and the cost of equity compensation.
Davis' team likes to break their portfolio into four components. They label the first group camels, because these are companies that can spend an eternity in the desert without water, or rather capital. This list includes Procter & Gamble, Costco, Microsoft and Altria.
Another holding in this category is Google. Davis watched the company's profits and shares soar in the years immediately after its IPO.
During that period, they also heard executives at auto insurers like Progressive and Geico enthuse about the efficiency of using Google as an advertising vehicle. When Google shares dropped more than 50% from their all-time high last year and at less than 12 times their estimate of "owner earnings," Davis' team purchased it.
The second part of their portfolio centers on companies that tend to be disciplined, opportunistic and well-positioned to take advantage of sudden changes in the capital markets. Some of these companies like Dun & Bradstreet and Loew's Corp. are also disciplined share repurchasers. Davis notes that in an environment characterized by severe dislocations like those of the last six months, many managements get scared and back off stock buybacks at just the wrong moment.
The third group focuses on companies that operate in areas where headline risk is the highest. Not surprisingly, this group is heavy on financial services and includes Progressive Insurance and Bank of New York Mellon, which is fundamentally more of a transaction processor than a bank, as well as such franchise financials as JP Morgan, Wells Fargo and American Express.
Straddling groups two and three is Berkshire Hathaway. "The headlines on Berkshire are likely to get worse, but they went into this crisis with $50 billion in cash and they are well-positioned to take advantage of this crisis," Davis says. Recently, his funds joined with Berkshire to invest in senior securities in two companies whose equity they already own, Sealed Air and Harley Davidson. The securities yield 12% and 15%, respectively.
The final group revolves around companies positioned to benefit from the powerful emergence of a global middle class. "The odds of China growing at 7% or 8% for the next decade are still pretty high," Davis says. Energy stocks like Occidental, ConocoPhillips, EOG and Devon dominate this group. Davis hasn't bought any oil service companies yet, "but we are looking."
Does Davis worry about the rise of the anti-Wall Street, pseudo-populist, anti-business environment in the wake of the most severe collapse of the financial system in 80 years? Of course. "People hear that and say, 'I won't invest,'" he says. "The opportunity to invest comes about because of things like this."
The odds are strong that taxes will be higher, inflation will be higher, while productivity and profit margins will be lower. Between 1975 and 1980, America experienced high unemployment, double-digit inflation and declining respect around the world, but also in those years, stock prices nearly doubled while small-cap stocks sparkled.
Looking into the next decade, Davis thinks it's a "near certainty" the environment for equities will be superior to the last decade. "The question isn't what is going to happen; it's what is discounted," he says.
The conventional wisdom that private equity funds and hedge funds are the only logical buyers for toxic assets and other opportunities that may arise from the crisis leaves him irked. "Why doesn't anyone ever mention public equity?" he asks.
Davis won't draw a direct correlation between the headfirst rush of institutional investors into alternative investments over the last decade and the subpar returns so many of them experienced. But he is quick to note that the result was a move to less liquidity, higher fees and more leverage, all of which reduced returns and exacerbated the subprime debacle.
Ultimately, his firm's goal is to create a portfolio that can compound over a generation, a portfolio with offensive and defensive elements. He is also acutely aware that his shareholders differ from those of hedge funds, as when his barber asked him if knew how many haircuts it would take him to recoup the $1,000 he lost in Davis' fund.
"What we do has life-changing consequences for our shareholders," he reflects, noting that advisors deal with these issues on a constant basis. "If you are wired with a stewardship gene, you feel terrible right now."