Friday, September 17, 2010

An Interview with Portfolio Managers Christopher C. Davis and Kenneth Charles Feinberg

Found via GuruFocus.

Q: What characteristics give businesses the ability to endure and adapt?

A: Assessing a business’s durability and adaptability is the foundation of our investment research process at Davis Advisors. These assessments are complex and not based on rules or certainties but rather ten dencies and probabilities. As in many complex prob lems, it is often useful to begin by first inverting the question, in this case by asking, What characteris tics tend to lead to business failure or impairment? When asked in this inverted fashion, a number of answers seem immediately obvious. Generally, busi nesses fail or become impaired due to some combi nation of debt, low returns on capital, competition, obsolescence, over-concentration (by geography or product), ‘diworsification’ (a wonderful term coined by legendary portfolio manager Peter Lynch to describe foolish acquisitions), and hubris. If such characteris tics are most often associated with failure or impair ment, then we can turn back to the original question and conclude that those businesses without these traits will tend to be more durable and more adapt able. Therefore, in the face of inherent uncertainty, investors should look for businesses with strong balance sheets, satisfactory returns, sustainable competitive advantages, products with low risk of obsolescence, geographic and/or product diversification, a skeptical view of mergers and acquisitions, and a healthy fear of arrogance and complacency.

Q: Are such companies always good investments?

A: If identifying businesses with such attractive characteristics is the foundation of our investment process, buying them at the right price is the capstone. Because the stock market works like a pari-mutuel system, those businesses that are most admired tend to trade at the highest valuations, which in turn can make them poor investments.

Q: How do such companies compare to other alternatives today?

A: Because of the enormous risks in today’s economy, characteristics such as durability and adaptability should be especially highly valued. But despite these risks, shares in many global leaders are trading at or near their lowest absolute and relative valuations in decades, creating a significant opportunity for long-term investors.


Over the past five years, our largest mistake by far was our investment in AIG. This investment detracted approximately 5% from our returns and was almost two and a half times more costly than our next largest mistake, which was Merrill Lynch. We have written extensively about these two mistakes in past reports and because these companies remain the largest detractors from our five year results, we have left these reports on our website and commend them to your attention. (Please see the “Portfolio Manager Commentaries” section of to read these reports.) The lessons learned from these mistakes have been pounded into your investment managers and while we will make mistakes in the future, we do not expect to repeat these. The most important lessons learned are worth reiterating. First, the chief executive officer of any large financial institution must have the skills, experience and discipline to also serve as the chief risk officer. Both AIG and Merrill Lynch were run for a number of years by executives who clearly failed this important test. Second, because of leverage, stupidity in even a relatively small part of a financial firm can bring down the entire enterprise. AIG’s global insurance operations and Merrill Lynch’s outstanding network of financial advisors were both the largest and most profitable parts of their respective firms. However, the steady profits of these huge and well-run opera tions were swamped by the losses at what were essentially small proprietary trading desks. In other words, the idiocy of a tiny minority overwhelmed the competence of the vast majority. Finally, both mistakes reinforced the importance of liquidity. Net worth and earnings power may be valuable, but in times of crisis only cash matters. Both companies faced calls on cash that was simply not available. Worse, their attempts to raise the cash by selling assets during a time of panic simply added fuel to the fire by driving down asset prices further. As Warren Buffett has rightly said, it is dangerous “to count on the kindness of strangers in order to meet tomorrow’s obligations.”

In our last report, we also highlighted the fact that often the largest mistakes we make will never show up in our financial statements. This is not because we are glossing over them but rather because they were mistakes of omission. For example, our costliest mistakes during this financial crisis may well be the investments we failed to make when others were panicking. Wells Fargo, for example, traded roughly as low as $8 per share and American Express as low as $10. Had we added approximately 1.5% of the Fund to each of these positions at those low prices, we would have more than made up the cumulative losses we suffered in AIG and Merrill Lynch.

Finally, in our earlier discussion of energy companies, we highlighted the critical importance of capital discipline. ConocoPhillips, which was one of our largest holdings in the energy sector, failed this important test and was a meaningful detractor from our returns, particularly over the last three years. Management’s lack of discipline becomes evident when contrasted with one of our other large energy holdings, EOG. For example, from 2003 to 2009, it cost ConocoPhillips roughly 60% more than EOG to replace each barrel of oil (or oil equivalent) it sold. As a result, despite spending $111 billion, Conoco Phillips only managed to grow its reserves per share (debt adjusted) 2%. During the same period, EOG grew its reserves per share almost 80%. Over time, the combination of reinvesting huge amounts in low-returning projects as well as an ill-timed acquisition binge during which the company issued its relatively undervalued shares in exchange for over priced acquisitions destroyed an enormous amount of shareholder value. As a result, over the last five years, ConocoPhillips’ share price declined while EOG’s appreciated almost 80%. In fact, ConocoPhillips’ stock price trailed our other four holdings by an average of 12% per year. Despite our misassessment of management, we were bailed out by the rising price of oil during our holding period and were able to sell the shares at a respectable profit. Furthermore, because the shares are strikingly cheap on the basis of reserves, we continue to monitor the company and would be open to repurchasing the shares should the board and management team become more disciplined.