Chris Davis: Compounding Interest by Value Investors Insight
Recognizing a company’s competitive advantage is much easier than making a call on how long it lasts. Making such calls is Chris Davis’ stock-in-trade.
Few investment firms have a more storied history than Davis Advisors. Founded by Shelby M.C. Davis in 1969 to offer to outside clients the approach honed by his father, Shelby Cullom Davis, the firm now manages $35 billion, more than $2 billion of which is Davis-family money. Its flagship New York Venture Fund has earned over its 46-year history a net annualized 11.8%, vs. 10.0% for the S&P 500.
Such outperformance has been elusive of late, but current CEO Christopher Davis sees no need for alarm. “We’ve had periods like this before,” he says. “We don’t believe the basic laws of value investing have been repealed.” With co-portfolio manager Danton Goei, he’s finding opportunity today in such areas as energy, cement, banking and healthcare services.
You’ve said your research process starts with asking, “What kind of businesses do we want to own?” What’s the general answer to that question?
Chris Davis: We’re looking for businesses with high or improving returns on capital that are run by first-class management teams and that have the financial strength to weather difficult environments. Equally important is the sustainability of those returns, supported by things like strong brands, intellectual property, low costs, distribution advantages, growing end markets and limited risk of technological obsolescence. We’ll often find opportunity because the market doesn’t look out far enough to correctly value durable competitive advantages. Sometimes we’ll just perceive a business as being great that the market doesn’t – my grandfather called them “growth stocks in disguise.”
Two examples we’ve owned for a long time – related in the news of late because the nature of their relationship changed – would be Costco and American Express. Both have produced excellent returns on equity over long periods. Both have quantifiable competitive advantages: Amex cards generate more than three times the amount of spend per card of the competition, while Costco has roughly twice the sales per square foot of other major warehouse chains. The business models are obviously different – for Amex it’s about brand, security and service, for Costco it’s about scale, low costs and low prices – but similarly durable.
The appeal of these types of businesses is their ability to compound value. If you’re going to own a company for a long time, the earnings it generates today will be a small component of the eventual return. Much more important will be how those earnings can be reinvested over time to build value. When companies with positive compounding characteristics become available at really attractive prices, we’ll hope to take advantage.
You mention the importance of first-class management. What is your – or any investor’s – value-add in judging that?
Chris Davis: There is a risk of the halo effect, where if the business has done well, everybody assumes management must be good. We try to differentiate ourselves in judging management around this idea of understanding reinvestment. You often see companies invest at increasingly lower rates of return simply to get bigger. CEOs of bigger companies, by and large, make more money, so they’ll reinvest in growth even if the incremental returns are low.
That’s exactly what we don’t want to see. We want there to be a clear understanding of incremental returns on capital and that returns matter more than size. That gets to the heart of a company’s culture, along with things like how management communicates, how they pay themselves and the accounting choices they make. What constitutes great management isn’t as universally held as you might think, and to figure it out takes quite a bit more insight than just analyzing trailing financial results.
How would you handicap the management of portfolio holding Google?
Chris Davis: The fact that Google has a spectacular business was obviously the result of a stunning insight by the founders, and the fact they’ve been able to capitalize on it as they have is a demonstration of good management. But what will define Google as a successful investment over the next 10 to 20 years will be how they reinvest the profits made from this extraordinarily good business they have today. We have to have insight into their ability to invest to create value over time.
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