How Can ‘Scandal’ Provide the Best Opportunities – Christopher Davis

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Christopher Davis is a portfolio manager for the Davis Large Cap Value Portfolios.

According to Amazon, the Davis Dynasty begins in 1947, the year Shelby Davis quit his job as a state bureaucrat and, armed with $50,000 of his wife’s money, took the plunge into stock investing.

By the time he died in 1994, he had multiplied his wife’s original stake 8,000 times! The story continues with his son, Shelby, who established one of the most successful funds of the past thirty years.

The final characters in this enthralling family saga are grandsons Christopher and Andrew.

The family’s history is chronicled in a book called, The Davis Dynasty: Fifty Years of Successful Investing on Wall Street.

Davis has continued his family’s success at the Davis Funds and he’s one investor all value investors should follow.

Back in 2006, Davis did an interview with Wealthtrack, where he provided investors with some great tips on how to avoid the underperformance trap, and how scandal can provide the best opportunities.

Let’s see what he had to say…

Here is an excerpt from the 2006 interview that Davis gave to Consuelo Mack at Wealthtrack.

Let’s take a look…

Christopher Davis has value in his blood. He is the third generation to lead the firm that bears his name… Chris co-manages the family’s highly-rated flagship fund, Davis NY Venture and its no load equivalent, Selected American Shares…Davis and his firm have recently been chosen to manage the well regarded Clipper fund, as well. In a recent interview I asked Chris to describe what value investing means, and how he does it.

CHRIS DAVIS: Well, I always think that value investing is sort of a redundancy. I mean, investing is a process of buying a business today that you think will be worth more in the future, so you’re buying it because you think it is undervalued. Now growth, which people sometimes think is the opposite of value, growth is actually a component of value.

We all would want to own a business that grows profitably over time, it would be more valuable. So value investing shouldn’t stand out as a separate school compared to growth, but instead maybe as a shorthand for reflecting on firms that do their own research, that do fundamental work, and really think about trying to determine independently the value of the businesses they invest in.

CONSUELO MACK: So what are the characteristics that you think really differentiate yourself from the rest of the pack?

CHRIS DAVIS: Well, we look at the characteristics that somebody would look for if they were buying a business in their neighborhood. In other words, if they were buying the entire company, they would think about things like, well, what sort of business is it? Is it a good business, is it a profitable business, is it a business that can grow over time?

What is the competitive landscape looking like? They would also spend time looking at who’s going to run the business? Do they have an honest partner who’s going to manage that business day to day? Those sorts of characteristics are important, but what else would they ask? Well, they’d ask, how much do I pay?

Because obviously a business that might be very attractive to buy for a hundred thousand dollars, might be a terrible investment if you paid a million dollars. And yet somehow people don’t necessarily see those two questions as so closely related. What kind of businesses do you want to own, and how much do you pay for them?

Well, if you’re buying the neighborhood dry cleaning business, that seems obvious, and yet it’s the same principle if you’re buying a share of a global business, like General Electric Corporation or American International Group, it’s the same discipline of, what if we bought the whole business? What do we pay versus what do we get? Do we get value for money?

CONSUELO MACK: And what are the kind of key criteria for value for money? What are the kinds of things that you look for, I mean aside from the management you just talked about, and whether it’s a good business, but what are the kind of key financial markers that you look for?

CHRIS DAVIS: Well, we think a lot about how much the business earns relative to what we pay for it. Now people say, oh, you must just mean the PE ratio. Well, yes, except that GAP earnings can be wildly overstated or understated. In other words, GAP earnings are…

CONSUELO MACK: General Accounting Principal earnings.

CHRIS DAVIS: Exactly. What are reported, when a company reports their earnings, they report GAP earnings. Now, when a company reports its earnings to the tax authorities, it chooses accounting policies that reduce current income, and that’s perfectly legal, and obviously in the company’s interest, so they make esoteric decisions to expense things that they could capitalize, or accelerate depreciation, just the way any normal person does on their own tax return, within the law.

When companies report their GAP net income they often feel they have an incentive to do the opposite, to choose accounting policies that make current earnings look as high as possible. The truth is usually in between, so it’s not just a PE ratio, you have to look through the numbers, look through the footnotes, look at the cash flow statements, and try to really understand how much cash does that business produce, relative to what you pay to buy it?

So, in a sense I would call that maybe an adjusted PE, you want to look at dividend … capital reinvestment. Is that a management that is going to reinvest your share holders’ equity, your retained earnings, at good rates of return, or are they going to build an empire to themselves? Those questions for a long term investor are going to be critically important.

CONSUELO MACK: One of the other kind of hallmarks of the Davis Funds is that you do not shy away from controversy or scandal, and you’ve made some sizable investments in companies in the past, I mean Tyco, for instance, that have had real … that have been under the spotlight as, you know, associated with scandals.

So how do you see kind of beneath the scandal, to see whether or not it’s a company that you want to get involved in, even though it might decline in price for, you know, a number of months, if not a year or so?

CHRIS DAVIS: Well, the Chairman of Wal-Mart, Lee Scott, he was talking about another subject, but he made a very powerful comment. He said, you can’t do what everybody else does and expect a different result. Now, the only way to add value as an investor is if you feel that there is some reason that a stock is mispriced.

Now the reason that it would be mispriced if you were a buyer, is if it was worth more than everybody else thinks it’s worth. So you have to look for what are the sort of circumstances that would cause such a mispricing? Well, one of them is fear. When people are afraid to own a company, it’s in the headlines, it’s scandal ridden, they want it out of the portfolio, they don’t want to see it, they know it must be bad.

That sort of scandal can create terrific opportunities. Businesses, many businesses, are very durable, and yet they get tarred with the taint of scandal, the valuation goes down, and you have an opportunity to buy what my grandfather called a growth company in disguise.

You know, a company that’s disguised by the scandal, and companies, as I say, are very durable. Remember in the early ’90s, when everybody thought Citicorp was going to go bankrupt? I think it was trading at a split adjusted probably a dollar or two dollars a share. When Warren Buffett in the late ’90s, they said, oh, he’s lost it, he doesn’t understand the Internet …

CONSUELO MACK: Right.

CHRIS DAVIS: You know, these sorts of opportunities. They don’t have to be big scandals like Tyco was, they can be indifference or cynicism, but any reason that a business might get mispriced, those are the sorts of opportunities we look for, and as you said, scandal is often the best. When it’s in the headlines, it’s in the price, that’s … we want to look for things that can get better.

CONSUELO MACK: Now, one of the other things that really separates the Davis Funds’ approach from many others as well is that the average equity fund, stock fund, has a pretty high turnover rate, and yours is low relative to your competitors. So you tend to take big positions in stocks, and stay with them for a number of years.

So you actually … you don’t mind riding a stock up or down? I mean, you know, do you trade within these stocks? I mean, how do you handle the kind of volatility so that you’re actually keeping a position in some of the stocks that you hold?

CHRIS DAVIS: Well, they say, and Ben Graham famously said, in the short term, the market’s a voting machine. In the long term it’s a winning machine. And what he meant by that is prices fluctuate in the short term, and by short term I don’t just mean one year, it can be two years, three years … (Overlap)

CONSUELO MACK: Right.

CHRIS DAVIS: The prices fluctuate based on psychology, and we all know psychology is inherently unpredictable. There’s nobody I know that’s gotten rich making a forecast about what the market’s going to do next year, or one year later, or one … and swinging in and out of the market trying to time these things. But in the long term, it’s a weighing machine. It weighs the value of the business.

So if a company builds its value over time, and you didn’t overpay for it in the beginning, then time is your friend. The business becomes more valuable, and of course from an after tax point of view, it’s even more glorious, because you’re deferring that gain longer and longer versus trading in and out and having to pay taxes and commissions every time you do.

So we think doing research, buying good businesses where time is your friend, that you can own for the long term, we think that that’s the way that has worked for us over a long period of time, and it makes sense. We haven’t heard a lot of other investment philosophies that make sense. Rotating into this sector, high turnover, high cost, high taxes, doesn’t make sense to us.

You know, we eat our own cooking. So we’re the largest share holders in the funds that we manage, so those things really matter to us.

CONSUELO MACK: There is a chart showing some statistics that we got from Jack Bogel, the founder of Vanguard, from his research center, showing how the market has performed over the last 20 years, versus the average equity fund, which has performed more poorly than the market, underperformed the market, and versus the average individual invested in those equity funds, how much worse the individual investor has performed over the last 20 years.

Explain that underperformance. We call it the underperformance trap that individual investors find themselves in, and how we can get out of it.

CHRIS DAVIS: Well, Jack Bogel has done a great service to investors by getting this data out. The first gap, which is the funds underperforming, that tends to be driven by costs and turnover. You know, the average mutual fund has turnover of over a hundred percent. That means they buy … (Overlap)

CONSUELO MACK: A year. Right, right.

CHRIS DAVIS: A year, every year they’re buying and selling and buying and selling. You think of all those commission costs plus the high management fees and all of the expenses that are built into that … (Overlap)

CONSUELO MACK: And capital gains taxes.

CHRIS DAVIS: And taxes, especially if you tax effect the numbers, that’s the first gap. Now that’s how my partners and I judge our results. How did we do relative to the market over time? We want to beat the market over a long period of time, and we’ve been fortunate that we have over, I think every ten year period since 1969, that’s how we keep …

But the second gap, and this is where Jack’s really done a valuable service, is he’s emphasized that second gap is just as important. The average investor getting in and out of funds, has incurred another cost.

CONSUELO MACK: Well, what is that cost? It’s not commissions, that’s in the first one. The cost is the timing of their own investment decisions. What happens is they get in, they want to chase whatever has worked in the last few years. So they want what’s hot, what’s already gone up. Well, this is hugely destructive. Now there are other reasons.

They might react to the general environment. Remember when the market was near its peak, people were pouring money into funds. When the market was near its low, people were taking money out. Well, the result is that, however the funds did for that period, the investors in the funds did worse, because they were more in when things were overvalued, and fewer in when they were undervalued.

That is a very powerful trap. final question.

This particular period of time, we’ve just come out of a period of time when the last five years, Index funds, for instance the S&P 500, has not done well as an investment. So if these things go in cycles, what kind of a, you know, what do you think, who’s going to do better? Are actively managed funds going to tend to do better, or Index funds in the next five year period? (Overlap)

CHRIS DAVIS: Well, it’s hard to say, but if I had to guess, I would say that the typical pattern is that an investment strategy becomes most fashionable at exactly the worst time to go into that investment strategy. And I think in a way the peak of Indexing, for this part of the cycle, may have been in the late ’90s and into the last several years, and we may be in a period where active managers do for this decade in general do better, provided their fees are reasonable, their turnover’s low, and remember, share holders should be looking at after tax returns, if they’re taxable.

And so we think that with those provisions, I wouldn’t say all active managers will do, there are many that have outrageous fees, but in general, I think that we’re in a period where it’s going to be easier, and it has been easier to beat the Index over this sort of period than when the Index is marching ahead, as it did in the ’80s and ’90s.

CONSUELO MACK: Chris Davis, Davis Funds, thank you so much for being with us.

CHRIS DAVIS: Thank you, Consuelo.

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