Chris Davis is the portfolio manager of Davis Financial Fund. He joined Davis Advisors in 1989 and currently the firm manages more than $60 billion in several asset classes. Chris Davis has more than 21 years experience in investment management and securities research. Furthermore, he is portfolio manager of Davis Large Cap Value Portfolios.
Chris Davis and his team's investment philosophy is based on picking up long-term, well-managed businesses at value prices and hold them for a long time to allow compounding. Davis Advisors applies the Davis Investment Discipline which supports the principle that stocks are long-term economic interests. Based on this premise, the firm considers that two questions should be answered: What kind of business is wanted and how much is it worth?
To answer the first question, the Davis Advisors team figures out the characteristics a company must have to see if it can create value over long periods of time. These characteristics include proven management, financially strong business models and sustainable competitive advantages. The idea, according to the firm, is to identify the categories where these characteristics fall.
Let's start with proven management. According to Davis Advisors, this means that a company must have built first-class management teams. These teams are made up of individuals who see themselves as owner-operators and take into account operation and strategic implications upon decision-making. They allocate capital on a daily basis and do their best to improve shareholders' value. These individuals should act as partners.
The company should also apply strong business models. A strong business model is a durable model that can be sustained in good and bad times. Davis Advisors focuses on companies that generate important cash flows from products and services that do not easily become obsolete, earn high returns on capital and are well positioned.
Finally, Davis Advisors screens the company's sustainable competitive advantages. The purpose of these advantages is to preserve superior economics. Types of advantages include a recognized brand, a dominant or growing share in the market, a profit model, a cost structure, intellectual property, among others.
All this information enables Chris Davis and his team to answer the first question. Now what about price? Once all the above information has been screened, it is necessary to wait for an opportunity in which the company's stock price is at a discount. Purchasing undervalued stock provides margins of safety that can improve return while reducing risk. Davis Advisors' method includes:
Owner earnings refer to the excess of cash generated by a business after reinvesting. The amount of exceeding cash should enable the company to maintain its capacity and competitive advantages. Owner earnings are calculated through an analysis of income statements and adjustments. Finally, the firm considers if the company is over-earning or under-earnings vis-Ă -vis full market cycles.
Enterprise value considers account equity, debt and off-balance sheet liabilities as well as adjustments. It is the purchase price to be paid for the business. The other factor is owner earnings yield. This is a standardized method through which an investor can notice if a stock is interesting or not according to the risk-free rate and the earnings yield offered by other potential investments. This factor jointly with Owner Earnings enables an investor to value a business. The formula involves dividing Owner Earnings by Enterprise value to calculate the initial return that could be obtained if the business is purchased at today´s prices.
The last factor is Reinvestment Rates. They are growth rate assumptions based on organic growth and assumptions on ROC.
Now, let's look at Chris Davis' top buys:
Walt Disney Co (DIS, Financial): Disney is a company that operates in different areas and posts strong numbers year over year. Actually, last year the company reported a 21 percent increase in net income and 7 percent in revenue. The company's EPS for the last quarter was 59 cents, which is 31% higher than a year ago.
Lately, the company has made investments in emerging markets such as Russia, India and China to open a TV channel in Russia, a Disney Resort in China and pick up stock from the biggest TV Empire in India. The purpose of these investments was to boost growth.
Now, the company is engaged in opening new resorts and parks across the world and continues profiting from its resorts, cruises, movies and TV channels. Most importantly, the company is shareholder-friendly. It issues dividends although it issues them at a low yield (1.52%). However, it is permanently raising their payout ratio. For instance, last year it increased dividends from 40 cents to 60 cents. Besides, the company keeps buying back shares every quarter, which helps boost the prices. The stock currently trades at $39.44 and it's been up by 76% in the last three years.
Disney is a very profitable business and posts strong growth. Chris Davis decided to bet on it because it is a company that has been trading in the market for decades and despite certain headwinds, it has always been able to keep its position.
Wells Fargo & Co (WFC, Financial): Wells Fargo is the largest U.S. financial based on market capitalization. In the fourth quarter it reported a 20% increase in profits, surpassing analysts' estimates. Net income rose to $4.11 billion or $0.73 cents per share exceeding the $3.41 billion or 61 cents reported in the fourth quarter of 2010.
Most importantly, the company is willing to increase dividends to return more capital to shareholders. Its current quarterly dividend stands at 12 cents per share. At the beginning of 2011 it sat at five cents per share.
Wells Fargo clearly outperforms other large banks in the United States. Although it lost 11 percent in 2011, it is one of the banks with highest market value surpassing JP Morgan by $20 billion.
Wells Fargo is facing certain problems, though. Lately, it has faced litigation losses from claims by RMBS investors. Its exposure in this area has been driven by the acquisition of Wachovia three years ago. Wells Fargo has set aside $2.04 billion for credit losses and reported $2.64 billion in net loan writedowns.
Despite the litigation problems Wells Fargo is facing, Chris Davis also saw that the company is a leader in online banking, where customers tend to be more profitable than traditional banking clients, so it can easily improve its situation.
Bank of New York Mellon (BK, Financial): BK is the oldest bank in America and it is the only one that has been rated AAA by Moody's. Its customer base is made up of other financial institutions, governmental agencies and high net worth individuals. BK has a very strong 14.0% Tier 1 capital ratio and a 16.1% total capital ratio.
In 2011, BK reported a profit of $2.645 billion. Although it severely suffered from the 2008-2009 economic crisis, during which it reported a loss of $978 million and the dividend was cut from $0.96 to $0.51, it has regained its position in the market. Now the bank has started to recover, has recovered its strength, has stabilized loan loss provisions and earnings rose. Unfortunately, in October 2011, the DOJ filed a lawsuit against BK alleging price manipulations against clients and claimed $2 billion in illegal profits. The issue is still unresolved. BK has also been affected by the severe drop in Investment Management revenues, driven by the uncertainty regarding the European crisis and the plummeting of the U.S. market. This segment accounts for 75% of BK's NOI. Wells Fargo is extremely sensitive to markets.
In terms of quarter results, Bank of New York Mellon is trading at less than $20 per share. It is clearly undervalued. It severely dropped after reaching a peak of $50. This situation can be attributed to the litigation problems it is facing, the banks' general situation which has worsen and the global financial uncertainties. Chris Davis invested in Bank of New York Mellon because, although the stock is 31% below book value and 62% off its high price, it is considered a speculative buy.
In terms of future expectations, BK should be able to reach $3 per share and P/E should improve too. At 16-18.0X and $3.25 per share BK would trade at $52.80-58.50. The dividend rate, which currently sits at $0.52 per share with a stock trading at $19 and providing a yield of 2.7%, should go up with the increase in earnings.
Charles Schwab Corp (SCHW, Financial): Charles Schwab Corporation is a financial services company that offers retail brokerage and banking services through its investor services segment and independent advisor, retirement plan, and other corporate services through its institutional services segment. Its primary subsidiaries are securities broker-dealer Charles Schwab & Co., Charles Schwab bank, and investment advisor Charles Schwab Investment Management.
Financially speaking, the company is performing well. Its fundamentals remain in steady improvement as well as revenues, which have gained strength. Earnings are benefiting from management's efforts to increase clients’ database. However, cash holdings decreased to pre-crisis levels and profitability metrics have been affected by fee cuts. Nevertheless, analysts consider that in the long term this situation will be important from a competitive viewpoint.
Now, the company is focused on rising interest rates to let earnings grow. As most of the company's income is driven by interest revenue and asset management, the company is not price dependent.
By the end of 2011, Charles Schwab acquired optionsXpress Holdings Inc. to enhance the company´s options and futures. The company expects to generate revenues of $60 million and costs of about $20 million in the first full year of combined operation.
Chris Davis was attracted to the company because it has a comfortable capital position. Most importantly, as regards dividends, the company keeps its payout ratio of 20 to 30%. Management supports a lower-cost capital structure and targets a long-term debt-to-total financial capital ratio of less than 30%. Since 1989, the company has been paying a quarterly dividend of 26%.
Ecolab Inc. (ECL, Financial): Ecolab has a significant international presence. The company operates across 72 countries, especially in Europe, Asia Pacific, Latin America and Canada. Ecolab also operates in Africa and the Middle East. Actually, the international activities account for 48% of Ecolab's net sales. The footprint it has established in those countries has boosted growth. This growth will certainly continue as they are emerging markets.
I think Chris Davis invested in Ecolab because it is committed to shareholders. It is focused on delivering higher returns, thus improving its balance sheet, cash flows and earnings. Actually, by the end of 2010, quarterly dividend moved from $0.155 to $0.175, a 13 percent growth. And that is not all. The company also modified its repurchase program by adding new 10 million shares. The company announced its plans to buy back $1 billion worth of shares. This program is expected to close in 2012.
Apart from the dividend payout ratio, in terms of expansion, Ecolab has decided to restructure its European business to boost efficiency and profitability. The company is focused on realigning the supply chain and applying certain cost cuts, which may involve the elimination of almost 1000 jobs. Once completed, this restructure plan is expected to enable the company to save $120 million.
Ecolab has also engaged in several acquisitions. In September 2010 it acquired Dober Chemical to boost its North American commercial laundry operation and in December it acquired Cleantec, an Australian hygiene company to expand its Asia Pacific present. Furthermore, at the beginning of 2011, it acquired O.R. Solutions, a privately held warming and cooling system maker. Most importantly, it agreed to acquire Nalco Holding Company, a water treatment company, in a cash and stock deal worth $8 billion. The merger is expected to follow major trends in food demand and safety, water scarcity, energy demand, among other issues. The merger is expected to report $1.5billion in sales and increase earnings in 2012 and the following years. The combined entity will have a strong cash flow and balance sheet.
Apart from acquisitions, Ecolab is also engaged in investments to enhance some of its segments, including product innovation, sales organization, healthcare, water and energy and global pest elimination to reduce costs. Moreover, the company is committed to bring new technology to reduce food-safety risks.
In terms of future expectations, management is really optimistic given the increasing demand in hotel lodging and favorable food and beverage trends.
Chris Davis and his team's investment philosophy is based on picking up long-term, well-managed businesses at value prices and hold them for a long time to allow compounding. Davis Advisors applies the Davis Investment Discipline which supports the principle that stocks are long-term economic interests. Based on this premise, the firm considers that two questions should be answered: What kind of business is wanted and how much is it worth?
To answer the first question, the Davis Advisors team figures out the characteristics a company must have to see if it can create value over long periods of time. These characteristics include proven management, financially strong business models and sustainable competitive advantages. The idea, according to the firm, is to identify the categories where these characteristics fall.
Let's start with proven management. According to Davis Advisors, this means that a company must have built first-class management teams. These teams are made up of individuals who see themselves as owner-operators and take into account operation and strategic implications upon decision-making. They allocate capital on a daily basis and do their best to improve shareholders' value. These individuals should act as partners.
The company should also apply strong business models. A strong business model is a durable model that can be sustained in good and bad times. Davis Advisors focuses on companies that generate important cash flows from products and services that do not easily become obsolete, earn high returns on capital and are well positioned.
Finally, Davis Advisors screens the company's sustainable competitive advantages. The purpose of these advantages is to preserve superior economics. Types of advantages include a recognized brand, a dominant or growing share in the market, a profit model, a cost structure, intellectual property, among others.
All this information enables Chris Davis and his team to answer the first question. Now what about price? Once all the above information has been screened, it is necessary to wait for an opportunity in which the company's stock price is at a discount. Purchasing undervalued stock provides margins of safety that can improve return while reducing risk. Davis Advisors' method includes:
- Calculating Owner Earnings rather than taking GAAP earnings at face value.
- Determining a company’s true Enterprise Value.
- Calculating the Owner Earnings Yield.
- Comparing the owner earnings yield to the risk-free rate.
Owner earnings refer to the excess of cash generated by a business after reinvesting. The amount of exceeding cash should enable the company to maintain its capacity and competitive advantages. Owner earnings are calculated through an analysis of income statements and adjustments. Finally, the firm considers if the company is over-earning or under-earnings vis-Ă -vis full market cycles.
Enterprise value considers account equity, debt and off-balance sheet liabilities as well as adjustments. It is the purchase price to be paid for the business. The other factor is owner earnings yield. This is a standardized method through which an investor can notice if a stock is interesting or not according to the risk-free rate and the earnings yield offered by other potential investments. This factor jointly with Owner Earnings enables an investor to value a business. The formula involves dividing Owner Earnings by Enterprise value to calculate the initial return that could be obtained if the business is purchased at today´s prices.
The last factor is Reinvestment Rates. They are growth rate assumptions based on organic growth and assumptions on ROC.
Now, let's look at Chris Davis' top buys:
Walt Disney Co (DIS, Financial): Disney is a company that operates in different areas and posts strong numbers year over year. Actually, last year the company reported a 21 percent increase in net income and 7 percent in revenue. The company's EPS for the last quarter was 59 cents, which is 31% higher than a year ago.
Lately, the company has made investments in emerging markets such as Russia, India and China to open a TV channel in Russia, a Disney Resort in China and pick up stock from the biggest TV Empire in India. The purpose of these investments was to boost growth.
Now, the company is engaged in opening new resorts and parks across the world and continues profiting from its resorts, cruises, movies and TV channels. Most importantly, the company is shareholder-friendly. It issues dividends although it issues them at a low yield (1.52%). However, it is permanently raising their payout ratio. For instance, last year it increased dividends from 40 cents to 60 cents. Besides, the company keeps buying back shares every quarter, which helps boost the prices. The stock currently trades at $39.44 and it's been up by 76% in the last three years.
Disney is a very profitable business and posts strong growth. Chris Davis decided to bet on it because it is a company that has been trading in the market for decades and despite certain headwinds, it has always been able to keep its position.
Wells Fargo & Co (WFC, Financial): Wells Fargo is the largest U.S. financial based on market capitalization. In the fourth quarter it reported a 20% increase in profits, surpassing analysts' estimates. Net income rose to $4.11 billion or $0.73 cents per share exceeding the $3.41 billion or 61 cents reported in the fourth quarter of 2010.
Most importantly, the company is willing to increase dividends to return more capital to shareholders. Its current quarterly dividend stands at 12 cents per share. At the beginning of 2011 it sat at five cents per share.
Wells Fargo clearly outperforms other large banks in the United States. Although it lost 11 percent in 2011, it is one of the banks with highest market value surpassing JP Morgan by $20 billion.
Wells Fargo is facing certain problems, though. Lately, it has faced litigation losses from claims by RMBS investors. Its exposure in this area has been driven by the acquisition of Wachovia three years ago. Wells Fargo has set aside $2.04 billion for credit losses and reported $2.64 billion in net loan writedowns.
Despite the litigation problems Wells Fargo is facing, Chris Davis also saw that the company is a leader in online banking, where customers tend to be more profitable than traditional banking clients, so it can easily improve its situation.
Bank of New York Mellon (BK, Financial): BK is the oldest bank in America and it is the only one that has been rated AAA by Moody's. Its customer base is made up of other financial institutions, governmental agencies and high net worth individuals. BK has a very strong 14.0% Tier 1 capital ratio and a 16.1% total capital ratio.
In 2011, BK reported a profit of $2.645 billion. Although it severely suffered from the 2008-2009 economic crisis, during which it reported a loss of $978 million and the dividend was cut from $0.96 to $0.51, it has regained its position in the market. Now the bank has started to recover, has recovered its strength, has stabilized loan loss provisions and earnings rose. Unfortunately, in October 2011, the DOJ filed a lawsuit against BK alleging price manipulations against clients and claimed $2 billion in illegal profits. The issue is still unresolved. BK has also been affected by the severe drop in Investment Management revenues, driven by the uncertainty regarding the European crisis and the plummeting of the U.S. market. This segment accounts for 75% of BK's NOI. Wells Fargo is extremely sensitive to markets.
In terms of quarter results, Bank of New York Mellon is trading at less than $20 per share. It is clearly undervalued. It severely dropped after reaching a peak of $50. This situation can be attributed to the litigation problems it is facing, the banks' general situation which has worsen and the global financial uncertainties. Chris Davis invested in Bank of New York Mellon because, although the stock is 31% below book value and 62% off its high price, it is considered a speculative buy.
In terms of future expectations, BK should be able to reach $3 per share and P/E should improve too. At 16-18.0X and $3.25 per share BK would trade at $52.80-58.50. The dividend rate, which currently sits at $0.52 per share with a stock trading at $19 and providing a yield of 2.7%, should go up with the increase in earnings.
Charles Schwab Corp (SCHW, Financial): Charles Schwab Corporation is a financial services company that offers retail brokerage and banking services through its investor services segment and independent advisor, retirement plan, and other corporate services through its institutional services segment. Its primary subsidiaries are securities broker-dealer Charles Schwab & Co., Charles Schwab bank, and investment advisor Charles Schwab Investment Management.
Financially speaking, the company is performing well. Its fundamentals remain in steady improvement as well as revenues, which have gained strength. Earnings are benefiting from management's efforts to increase clients’ database. However, cash holdings decreased to pre-crisis levels and profitability metrics have been affected by fee cuts. Nevertheless, analysts consider that in the long term this situation will be important from a competitive viewpoint.
Now, the company is focused on rising interest rates to let earnings grow. As most of the company's income is driven by interest revenue and asset management, the company is not price dependent.
By the end of 2011, Charles Schwab acquired optionsXpress Holdings Inc. to enhance the company´s options and futures. The company expects to generate revenues of $60 million and costs of about $20 million in the first full year of combined operation.
Chris Davis was attracted to the company because it has a comfortable capital position. Most importantly, as regards dividends, the company keeps its payout ratio of 20 to 30%. Management supports a lower-cost capital structure and targets a long-term debt-to-total financial capital ratio of less than 30%. Since 1989, the company has been paying a quarterly dividend of 26%.
Ecolab Inc. (ECL, Financial): Ecolab has a significant international presence. The company operates across 72 countries, especially in Europe, Asia Pacific, Latin America and Canada. Ecolab also operates in Africa and the Middle East. Actually, the international activities account for 48% of Ecolab's net sales. The footprint it has established in those countries has boosted growth. This growth will certainly continue as they are emerging markets.
I think Chris Davis invested in Ecolab because it is committed to shareholders. It is focused on delivering higher returns, thus improving its balance sheet, cash flows and earnings. Actually, by the end of 2010, quarterly dividend moved from $0.155 to $0.175, a 13 percent growth. And that is not all. The company also modified its repurchase program by adding new 10 million shares. The company announced its plans to buy back $1 billion worth of shares. This program is expected to close in 2012.
Apart from the dividend payout ratio, in terms of expansion, Ecolab has decided to restructure its European business to boost efficiency and profitability. The company is focused on realigning the supply chain and applying certain cost cuts, which may involve the elimination of almost 1000 jobs. Once completed, this restructure plan is expected to enable the company to save $120 million.
Ecolab has also engaged in several acquisitions. In September 2010 it acquired Dober Chemical to boost its North American commercial laundry operation and in December it acquired Cleantec, an Australian hygiene company to expand its Asia Pacific present. Furthermore, at the beginning of 2011, it acquired O.R. Solutions, a privately held warming and cooling system maker. Most importantly, it agreed to acquire Nalco Holding Company, a water treatment company, in a cash and stock deal worth $8 billion. The merger is expected to follow major trends in food demand and safety, water scarcity, energy demand, among other issues. The merger is expected to report $1.5billion in sales and increase earnings in 2012 and the following years. The combined entity will have a strong cash flow and balance sheet.
Apart from acquisitions, Ecolab is also engaged in investments to enhance some of its segments, including product innovation, sales organization, healthcare, water and energy and global pest elimination to reduce costs. Moreover, the company is committed to bring new technology to reduce food-safety risks.
In terms of future expectations, management is really optimistic given the increasing demand in hotel lodging and favorable food and beverage trends.
