Investing in Hell with Chris Davis

Investors should be careful what they wish for, said Selected American Shares (SLASX) manager Chris Davis at the opening keynote address of the 2009 Morningstar Investment Conference. He speaks from experience.

Throughout his career Davis said he often envied his grandfather and father, legendary investors Shelby Cullom Davis and Shelby M.C. Davis, for having lived and worked through severe bear markets that allowed them to buy great companies at bargain prices and set themselves up for years of strong returns. As Shelby Cullom Davis told his grandson, "You make most of your money in a bear market, you just don't realize it at the time."

"Now I finally got my chance and it feels like Hell," Chris Davis said during Wednesday's address.

It's no wonder. The funds Davis runs, notably Selected American, Davis New York Venture (NYVTX) and Clipper (CFIMX), have suffered steep losses since the bear market that began in October 2007, even after you factor in the stock market and these funds' rebounds since March of this year.

Though he's subject to the same emotions that we all have experienced in the recent turmoil, Davis said he and his firm have not been mastered by their feelings. Investors shouldn't give in to their passions either, he said.

While admitting some terrible mistakes (he called owning AIG a Waterloo moment for the firm) Davis said he, his comanager Ken Feinberg and fellow analysts at Davis Selected Advisors have tried to set their funds up to make money coming out of this bear market by sticking to what has delivered strong results for the firm in the past: rigorous bottom-up research of individual stocks. He put the stocks they've been buying in the last several months into five buckets:

Globally dominant, self-financing companies like Johnson & Johnson (JNJ) that don't need to pause for capital injections. He called them camels because they can travel long distances without stopping for a drink. "These are the sorts of things you can buy and put away," Davis said.

Well-managed companies with the capital and mind-set to exploit the market dislocation and "counterpunch" by making opportunistic acquisitions or investments. Davis put conglomerates Berkshire Hathaway (BRK.A) and Loews (L) in this group.

Select financials. Davis admitted buying stocks near the epicenter of the crash is controversial, even after financial stocks' strong rally in recent weeks. Yet the opportunities to grab market share and lend money at attractive spreads for the companies that survive the crisis are huge. "Look, this is a non-obsolete-able business," Davis said. "I'd be willing to bet anyone $1,000 that we will never see spreads as high as they are now in the banking business."

Energy, commodity and agriculture related companies because the growth of the middle class in emerging markets is inexorable and will continue to increase demand for resources.

Special Situations, such as the debt of Home Depot (HD) and Sealed Air (SEE), cash-rich companies with which the firm was already familiar, when they offered double-digit yields.

Davis said it's natural for investors after nearly two years of mostly downward volatility to ask why they should risk making these moves or even to invest in anything but Treasury bonds. He argued, however, that the greatest risk now might be sitting on the sidelines or in Treasuries.

Even if we have entered a second Great Depression, it makes sense to stick to a disciplined investment program. It took the Dow Jones Industrial Average 25 years to climb back to its 1929 peak during the Depression. Nevertheless those who diligently invested $10,000 per year in the index during that time turned their $260,000 total investment into $1.7 million over that time period--an annualized compound return of 12.5%--thanks to the growth and reinvestment of dividends, Davis said.

So while investors and advisors probably wish they could predict the future and avoid bear markets, most of the time they are better off sticking with their plan.

"We want to know, we wish we could know, but we can't know," Davis said.

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