'Who Wouldn't Want to Be Like Berkshire?'

Chris Davis brings rigorous investment and divestment processes to value stock selections

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Jul 25, 2017
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“People will sometimes criticize Markel (MKL, Financial) and say they’re just a Berkshire (BRK.A, Financial)(BRK.B, Financial) wannabe. My response: ‘Who wouldn’t want to be like Berkshire?’ ” - Chris Davis (TradesPortfolio), in a Barron’s interview

In asking who would not want to be a Berkshire Hathaway, Chris Davis (Trades, Portfolio) is acknowledging an intellectual debt to Warren Buffett (Trades, Portfolio) (and it is no coincidence his biggest holding is Berkshire Hathaway Class A stock).

He has learned from Buffett and learned his lessons well. His funds approach investing from a value perspective, always looking for great companies at reasonable prices, and holding them long enough to get the extra leverage of compounding.

In fact, Davis and his team have a well articulated strategy or philosophy, called the Davis Investment Discipline. It’s a strategy that was conceived by his father and grandfather and honed by Davis, who has grown the firm into a multibillion-dollar business.

Who is Davis?

Starting in the 1940s, Chris Davis' grandfather, Shelby Davis Sr., successfully invested in banks and insurance companies. His son, Chris Davis' father, started an investment advisory business in 1969, and launched the Davis New York Venture Fund the same year.

Chris joined the firm in 1989 after receiving an M.A. from the University of St. Andrews in Scotland.

What is Davis Advisors?

Davis Advisors describes itself this way on its Web site:Â “an independent, employee-owned investment management firm founded in 1969.”

It also reports it has aligned itself with its shareholders and clients; the firm’s principals and employees have invested more than $2 billion of their own money in their own products.

The firm operates nine mutual funds; Chris Davis is lead manager for three of them (note that there are different classes for each of these funds):

  • Davis New York Venture Fund, Chris Davis lead.
  • Davis International Fund.
  • Davis Global Fund.
  • Davis Opportunity Fund.
  • Davis Financial Fund, Chris Davis lead.
  • Davis Real Estate Fund.
  • Davis Appreciation and Income Fund, Chris Davis lead.
  • Davis Government Bond Fund.
  • Davis Government Money Market Fund.

In addition, the firm offers several other financial products, including three recently added ETFs.

While the funds have different mandates, Chris Davis says all of them share the Davis Investment Philosophy, a strict regimen used to identify and value stocks.

What is the Davis Investment Discipline?

Broadly speaking, the firm describes its strategy as aiming to “purchase durable, well-managed businesses at value prices and hold them for the long term to allow the power of compounding to work.”

Their research process starts with two key questions:

  • What kind of businesses would they want to own?
  • How much should they pay for them?

Looking at the first question, about the kinds of businesses they would like to own, they further break down the question into the three types of characteristics they value most:

  • Management that has proven itself.
  • Durable business models that are financially strong.
  • Moats, or sustainable competitive advantages.

On the issue of management, Chris Davis and team say first-class management teams think like owner-operators, allocate capital in a way that is financially productive and manage risk to maximize shareholder value over full market cycles.

Further, they think of ideal management as partners and highly valued individuals who demonstrate a high degree of intelligence, energy and integrity.

Regarding durable business models, they want businesses that make the most of good times and have developed enough financial strength to get through more challenging times.

That means looking for companies that produce "ample" free cash flow from products and services not inclined to the risk of obsolescence, that earn high and increasing returns on capital, and can exploit long-term secular tailwinds.

Chris Davis says even strong and well-managed companies must keep building and maintaining their competitive advantages, their moats. Attributes of competitive moats include globally recognized brands, dominant or increasing share of a growing market, a demonstrated profit model, lean cost structure, unique distribution advantages and proprietary intellectual property.

On the second question, Chris Davis and company research four factors:

  • Owner earnings.
  • Enterprise value.
  • Owner earnings yield.
  • Reinvestment rates.

Owner earnings represents the cash that is left after a company reinvests enough to keep up its current capacity and competitive advantages but before investing for growth. Alternatively, we might say Chris Davis wants to know that a company has enough cash to be able to invest in new growth.

To come up with a figure for owner earnings, they study income statements and make many adjustments. They’re looking for extraordinary items, differences between maintenance capital spending and depreciation, how much stock options cost, pension cost projections and more. They also try to reconcile a company’s actual earnings versus its potential over full market cycles.

Enterprise value is the second of the four factors that help Chris Davis and team determine how much they should pay for a firm, and it refers to how much an investor would need to pay to own the business outright. The fundamentals that determine enterprise value include account equity, debt liabilities, off-the-balance sheet liabilities and some technical balance sheet adjustments.

Owner earnings yield is a measure calculated by dividing owner earnings by enterprise value and calculating the initial yield they would earn if they bought the whole business at today’s prices.

This measure provides a standardized method for judging the potential of a business relative to both the current risk-free rate (short-term U.S. Treasury bills) and the earnings yield of other potential investments.

Reinvestment rates refers to a range of growth rate assumptions that arise out of organic growth and assumptions about future returns on capital.

Looking at investing from another perspective, Chris Davis argues that investors fail to achieve their goals because of temperament rather than ability. In A Conversation with Chris Davis on Successful Investing, he says, “Quite simply, people often want to do today what they wish they had done five years ago.” Or they buy when prices are high and sell when prices are low, rather than the reverse.

Digging deeper into the subject, Chris Davis says investors often use interest rate forecasts and stock market predictions as the basis for their decisions, even thought there is overwhelming evidence that neither of these have any prediction value. He cites a survey of economists in The Wall Street Journal from December 1982 to December 2013 and compares their forecasts with actual outcomes and finds the economists were wrong 63% of the time (worse than throwing a proverbial dart at a list of stock names).

Next, Chris Davis warns about chasing hot stocks, sectors or anything else. He points out that investors often gravitate to hot managers or hot strategies, only to be disappointed when periods of underperformance follow hot streaks. Recently, passive, index-oriented strategies have been on a hot streak, but he believes we now may be entering a period in which success will depend on professional portfolio managers using their discipline and judgment.

The third recommendation is to invest systematically, putting equal amounts into an investment at regular intervals, no matter the market environment at the time (dollar-cost averaging). Chris gives as an example the case of a person with $10,000 to invest; if he or she invests $1,250 every three months for two years they will do better than a person who invests all $10,000 at once.

There are three key benefits to a systematic strategy: removing emotion from investment decisions; buying more shares when prices are low and fewer when prices are high; and, capitalizing on market volatility by buying when the market drops.

Chris has a set of rigorous rules that define how the investment and divestment processes should work, and all indications are that his firm is sticking by its mandate to buy durable, well-managed businesses at value prices that can be held for the long term.

Current holdings

As the name Davis Financial Fund suggests, this company is heavily weighted to financials of one kind or another. This table comes from the Fund’s Fact Sheet:

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These are the top 10 holdings in the Davis Financial Fund, as listed at Yahoo! Finance:

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Chris Davis and his team have focused on large and high-quality names in the financial arena. His biggest holding is Berkshire Hathaway Inc. Class A; it’s a stock in which he must have confidence. At the close of trading on July 24 it traded at $257,689.00, likely making it one of the more illiquid stocks available.

Davis Financial Fund’s performance

The following Morningstar chart shows the Davis Financial Fund’s performance, as compared with its peers and its benchmark, the MSCI ACWI Index:

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And this chart, also from Morningstar, shows how all of the firm’s funds have collectively fared:

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Naturally enough, performance has been bumpy, or volatile. In the firm’s 2017 Annual Investor Letter, Chris Davis writes, “While our disciplined investment approach has not always been rewarded by the market over shorter periods, this active management approach has created wealth for our shareholders in the long run.”

These charts again show the wisdom of a long-term perspective. Buy in at any point on the chart and you don’t know if the year that follows, or even two, will leave you with gains or losses. Buy in with a mindset of at least five years, and the odds are high you will profit.

Conclusion

Chris Davis has a succinct strategy: to buy durable companies that are well managed, at a discount to their intrinsic value and hold them long enough to allow compounding to work.

To find those companies, he and his team search for companies that have proven management, financially robust business models and moats of some kind.

Finally, they arrive at reasonable purchase prices by assessing a company's owner earnings, enterprise value, owner earnings yield and reinvestment rates.

Investors who can't or don't want to do all that research might simply buy a Davis fund that suits them. The guru has delivered on his promise to increase the wealth of his fund buyers.

Disclosure: I do not own shares in any of the companies named, and I do not expect to buy any in the next 72 hours.