Library / Outstanding Investors

Date of review: August 2021
Book author: John Rothchild
Вook published: 2001

The Davis Dynasty: Fifty Years of Successful Investing on Wall Street by John Rothchild (first published 2001)

Surprisingly, the Davis family is not widely known among a wider investment community. It was a real discovery for me to learn that the founder - Shelby Davis started investing at the age of 38 and turned $50,000 into $900,000,000 by 1994 when he died at the age of 88 years old. His cumulative annual return averaged about 23% - probably the best result over such a long time frame.

How past experience impacts your investment approach

Moreover, he achieved these results by mostly focusing on just one sector - insurance, although geographically he did not just stick to US stocks, investing in Japanese and some other international stocks. If this is not enough, Davis managed to raise a son who launched his own investment management business (Davis Funds) which are now run by his own sons (grandsons of Shelby Davis). The son has also leaned towards financial sector investing in both insurance as well as banks, money managers and other financial companies.

An incredible life story indeed. I am not going to review all the details here. Below I am sharing my notes on investing style and technique of the Davis family. One last reason to read this book is that both Davis father and son invested through 1970s (a period of high inflation and low economic crisis) which I think could be useful in today's environment.

I will refer to the founder (father) as Davis and to his son - as Shelby - to avoid confusion.

An interesting thought on how past experience impacts your investment approach. The book talks about two concepts - one promoted by Edgar Lawrence Smith and the other one - by Gerald Loeb. Smith published a best-selling book - 'Common Stocks As Long-Term Investments' in 1924. This book was even mentioned by Buffett in his 2020 annual letter. Smith argued that companies could grow earnings through reinvesting them into the business and this should allow them to increase dividends over time. Compared to bonds, stocks were more attractive as the former paid fixed dividends which would not rise if business performance continued to improve.

Taken to the extreme, Smith's idea made stocks an absolute favourite investment vehicle which became regarded as safe and reliable.

Loeb, on the other hand, ditched his stocks before 1929 crash. This timely exit from the market convinced him that stocks should be traded tactically, not held for the long-term. Loeb wrote a book in 1935 - 'The Battle for Investment Survival' in which he compared investing to a warfare. To win the war, you had to keep fresh assets (cash). His strategy involved selling on 10% drops and buying on the rise - always ready to move out at the first sign of a turn. In fact, I read Loeb's book in 2009 - it sounded very natural after 2008 crash (I might have bought it on recommendation by some media), but regrettably its conclusions were useless for the bull market that ensued.

Davis was generally an optimistic person which helped him to remain upbeat and have courage to buy during crises (or at least not sell during corrections). A similar quality coupled with strong belief in American capitalism also sets Warren Buffett apart:

"Davis was congenitally optimistic, an indispensable trait for any shareholder. As brokerage houses would later say during prosperous times, "Past performance is no guarantee of future success," but at the end of the worst decade in modern history, Davis realized that past performance was no guarantee of future failure. He was a student of history and a believer in cycles. He never lost faith in Edgar Lawrence Smith's credo that stocks pay off in the long run. He looked beyond the breadlines, the gloomy headlines, the ravages of deflation, and the national disgust with Wall Street brokers and bankers. He focused on America's lucrative knack for innovation".

An important point on market cycles and importance of not extrapolating recent performance (wrote by the author though, not Davis):

"Is it a cruel joke that the most popular asset of each era will impoverish its owners? Every 20 years or so in the twentieth century, the most rewarding investment of the day reached the top of its rise and started a long decline, and the least rewarding investment hit bottom and began a long ascent. These turning points enriched a small group of nonconformists who caught the turn, but the majority continued to put their money on yesterday's proven winner. The majority's loyalty cost them plenty".

I summarise the most important points from the book below

Sources of ideas - ask management about key competitors:

One of Davis's favourite questions was: "If you had one silver bullet to shoot a competitor, which competitor would you shoot?"

Follow strong management:

"since history taught him great civilizations are built by great leaders, he looked for great leadership in executive suites".

An important lesson on investing during high inflation:

"The stockholding masses had shrugged off the rising inflation of the 1960s on the theory that inflation was ruinous to bonds, but healthy for equities. For years, the steady inflationary uptick hadn't stopped the bull market, strengthening the popular conviction that inflation was no threat to portfolios. The assumption that companies could raise prices in lockstep with inflation, and thus preserve their profit margin, proved fallacious in the 1970s, and once Mr. Market realized this, equities were repriced accordingly".

Some similarities to the current environment (summer of 2021), investing after a decade of strong performance with high expectations baked into valuation:

Whatever happens, Shelby expected stocks to stop racing ahead and revert to their customary canter. "If the Dow continued to rise at the same pace it's risen over the past two decades, it would stand at roughly 100,000 two decades from now," he said. "But we're certain that won't happen. Even if the rise slows to 7 or 8 percent a year, the Dow could reach 40,000 to 50,000. So a lot more wealth can still be created long-term. On the other hand, the surge in corporate profits and P/E ratios that created the 1990s bonanza isn't likely to continue. It won't surprise me if the market is stuck in a trading range for the next five to ten years. Good stock pickers will make money, but the averages may not show much movement."

On importance of being fully invested:

"With Shelby on top of his game, Wall Street got the biggest boost in two decades: The Dow went up 48 percent; the S&P, up 58 percent, and Venture, up 68 percent. In one year, Shelby's fund bagged more profit than in the entire decade since the last bear market. Such surges were unpredictable. To avoid missing them, you had to stay in stocks permanently and, you had to reinvest your capital gains and dividends. This was and is a crucial and often overlooked factor in fundholder prosperity".

Investing during crisis:

"Out of crisis comes opportunity," Shelby remembers him saying. "A down market lets you buy more shares in great companies at favourable prices. If you know what you're doing, you'll make most of your money from these periods. You just won't realize it until much later".

On futility of market timing and best protection against bear markets:

"If a modern Cassandra tipped me off to the exact arrival date of the bear, I'd raise cash to invest after the onslaught. But without a Cassandra, there's no way of timing calamity.

If I prepare for the worst and stocks rise another 15 percent, I don't want my fund to rise zero. "Our best bear protection is buying companies with strong balance sheets, low debt, real earnings, and powerful franchises. These companies can survive bad times and eventually become more dominant as weaker competitors are forced to cut back or shut down."

Consistency:

"He attacked his job with his usual gusto, arriving early and leaving late with his briefcase crammed with reports".

Long-term focus:

"Once he'd bought winning companies, his best decisions were never to sell. He sat on his insurance stocks through daily, weekly, monthly gyrations. He sat through mild bear markets and severe bear markets, crashes, and corrections. He sat through scores of analysts' upgrades and downgrades, technical sell signals, and fundamental blips. As long as he believed in the strength of the leadership and the company's continual ability to compound, he held".

"The bottom line on this portfolio is: A few big winners are what count in a lifetime of investing, and these winners need many years to appreciate. All of the Davis Dozen had been parked in his portfolio since the mid-1970s. Any young, inexperienced investor has a built-in advantage over a mature, sophisticated investor: Time".


Late 1990s were very similar to late 2010s when growth funds strongly outperformed value funds some of which had to close down (just couple of years before a complete reverse in performance).

Investment method:

"You're deploying cash today, hoping to get more cash back in the future. That's all investing is. For us, the whole process hinges on two questions: What kind of businesses to buy, and how much to pay for them? To answer question one: A company worth buying makes more money than it spends. Its profit is recycled for maximum shareholder benefit. The second question, the price tag, is often ignored."

"We ask ourselves if we owned the company outright, how much reward [would] we pocket at the end of the year, after reinvesting enough cash to maintain the status quo, and before reinvesting for growth? The result is called `owner earnings.' This isn't a snap to calculate. We adjust for stock options, the depreciation rate, deferred taxes, and other subtle factors. Owner earnings are almost always lower than the earnings reported by the company. We also take a hard look at debt. Two businesses may have identical earnings and sell for the same price, so apparently they're valued the same. However, if one is saddled with a large debt and the other is debt-free, they're not the same at all."

Advantages of insurance companies over traditional manufacturers:

"Insurers offered a product that never went out of style. They profited from investing their customers' money. They didn't require expensive factories or research labs. They didn't pollute. They were recession-resistant. During hard times, consumers delayed expensive purchases (houses, cars, appliances, and so on), but they couldn't afford to let their home, auto, and life insurance policies lapse. When a sour economy forced them to economize, people drove fewer miles, caused fewer accidents, and filed fewer claims-a boon to auto insurers. Because interest rates tend to fall in hard times, insurance companies' bond portfolios become more valuable".

Davis taught his son (Shelby) how new life insurance sales built future prosperity while resulting in continuously reporting short-term losses, because commissions and marketing costs were deducted from earnings up front. An insurance policy that brought income to the company for the next 30 to 40 years went on the books as a debit.

Banking is similar to insurance because it is always in demand, yet is considered boring and faces low risk of disruption (compared to phones, computers, media etc).

On importance of leaving your ego and emotions aside and focusing on business fundamentals .

Case of Davis selling out of GEICO after being frustrated by Buffett.

On writing:

"Why do we bother with this?" he asked Davis, "when nobody reads it?" "It's not for the readers," Davis said. "It's for us. We write it for ourselves. Putting ideas on paper forces you to think things through."

The 10 tenets of the Davis family:

1. Avoid cheap stocks.

Cheap stocks deserve to be cheap because they're attached to dud companies. Chances are, a dud company will stay that way. Its CEO will predict better times ahead, as CEOs always do.

2. Avoid expensive stocks.

"No business is attractive at any price," says Shelby. The Davises never overpaid for clothes, houses, or vacations. Why should investors overpay for earnings, which after all, are what they're buying whenever they invest in a company?

3. Buy moderately priced stocks in companies that grow moderately fast.

Shelby's idea of a superior investment was a company that had a growth rate faster than the multiple.

4. Wait until the price is right.

Price correction may come from negative news on the sector or a specific company. "When you buy a battered stock in a solid company," Shelby said, "you take some risk out of the purchase. Investors have low expectations".

5. Don't fight progress.

Shelby chose his tech stocks carefully, but he didn't avoid them entirely.

6. Invest in a theme.

In the 1970s, the obvious theme was rampant inflation. Shelby filled Venture's portfolio with oil, natural gas, aluminium, and other commodity-based companies that stood to profit from higher prices. In the 1980s, there were signs the Fed was winning its war against inflation. Shelby found a new theme: lower prices and lower interest rates. He cut back on the hard assets and bought financial assets: banks, brokerage houses, and insurance companies. A financial group benefits from falling interest rates. Shelby sank 40 percent of his fund's assets into financials, just in time for their great leap forward.

7. Let your winners ride.

"We buy at a bargain price we can live with for a long time," Shelby said. "Eventually, we hope to see the stock sell at `fair value,' and once it reaches that point, we tend to keep it as long as earnings continue to rise. We like to buy at a value price but we want to end up with growth companies". His turnover was about 15%.

7. Let your winners ride.

"We buy at a bargain price we can live with for a long time," Shelby said. "Eventually, we hope to see the stock sell at `fair value,' and once it reaches that point, we tend to keep it as long as earnings continue to rise. We like to buy at a value price but we want to end up with growth companies". His turnover was about 15%.

8. Bet on superior management.

9. Ignore the rear-view mirror:

For 25 years after the 1929 Crash, hordes of investors avoided stocks on the false premise that a 1929 rerun was imminent. After World War II, they avoided stocks because they'd learned wars are always followed by recessions. In the second half of the 1970s, they avoided stocks and prepared for a repeat of the 1973 to 1974 bear market. As Shelby wrote in 1979, "The majority of investors today are spending an inordinate amount of time defencing against what we believe is an improbable if not almost impossible decline of similar magnitude." From 1988 to 1989, they avoided stocks and prepared for a repeat of the 1987 Crash.

10. Stay the course.

"Stocks may be risky for one, three, or even five years, but not 10 or 15 years," said Chris. "My father got in at a market top and, 20 years later, his bad start was irrelevant. In our messages to shareholders, we keep repeating ourselves: We're running in a marathon."

Shelby's Checklist:

  • First-class management with a proven record of keeping its word.

  • Does innovative research and uses technology to maximum advantage.

  • Operates abroad as well as at home. Overseas markets have given mature U.S. companies a second chance at fast growth. Some Wall Street analysts dubbed Coca-Cola a has-been in the early 1980s, but Coke went abroad and proved them wrong. The story was the same for AIG, McDonald's, and Philip Morris.

  • Sells products or services that don't become obsolete.

  • Insiders own a large chunk of shares and have a personal stake in the company's success.

  • Company deliver strong returns on investors' capital, and managers are committed to rewarding investors.

  • Expenses are kept to a minimum, which makes the company a low-cost producer.

  • Company enjoys a dominant or a growing share in a growing market.

  • Company is adept at acquiring competitors and making them more profitable.

  • Company has a strong balance sheet.

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