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Davis: Value or Growth? We Want Both

Dan Culloton

Dan Culloton: Hi, I'm Dan Culloton, associate director of manager research at Morningstar. I'm here at the Morningstar Investment Conference with Chris Davis, manager of the Davis New York Venture Fund and Selected American Fund.

Chris, thanks for being here with us.

Chris Davis: Dan, it's good to be here. Thank you.

Culloton: Chris, according to Morningstar metrics over the last few years, the Selected American and Davis New York Venture funds have spent a lot of time in the growth area of the Morningstar Style Box. Does this mean that you and your team have changed your style?

Davis: It's such a great question, and you know, I feel unequivocally that Morningstar is a force of good in the world, but this is one place where to me, it can be misleading because I think often to investors, they think that growth and value are something different. And of course, a company that grows profitably is more valuable than one that doesn't grow. My father used to say, he never bought a company that he thought was going to be earning less money five years from now than when he bought it. So, growth is a component of value, and in that sense, I'd say well, we are growth investors because we think about growth as a component of value.

On the other hand, we are value investors for two critical reasons. One is that we think that growth is hard. We think one of the mistakes people make is projecting rosy estimates way into the future. And growth is hard because the economy shifts, the competitive environment shifts, technology shifts, or whatever it is. And the second reason is because the valuation discipline is central to what we do.

We always say we need to adapt to changing times and hold to unchanging principles, and how we assess growth as a component of value is one of those unchanging principles. So I think the philosophy, the discipline, and the methodology are all the same, but sometimes where the opportunities are shift.

And I guess, I was getting at the second part of the answer that always our goal is to buy companies that are cheaper than they look. So we adjust the earnings. We adjust the accounting. So companies that have big noncash charges like amortization of intangibles, we'll add that back into earnings. What that means is sometimes a company that looks optically expensive, which might put it in the growth category as a high P/E, when you adjust those earnings to reality, it's is actually a big value stock. So that's the second component.

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Culloton: Let's take a specific example, an example that shows up in a portfolio of a noted growth manager who you will be speaking with on a panel later today, Will Danoff, is Activision. Where is the value in that growth stock?

Davis: What's spectacular about Activision is, one, it has one of the most value-driven managements I have ever seen. Of course, Bobby Kotick has shaped it. In fact, I ran into him in Omaha, Nebraska, this year at the Berkshire Hathaway meeting with he attends every year. He is a value creator, a value disciplined sort of CEO. Then you look at their business, and what you realize is every decision they make, they make based on the returns they are going to get for the money that they're spending.

Now there are two different parts of their business, and I think that's what sometimes confuses people. One part is how we think of the old video game hits-driven business. You have the cartridge game that the kids want to play. But the other side are these massive franchises like World of Warcraft and Call of Duty, things like this that people line up to play around the world; in Korea, in China, in Japan, all through Asia, not just in the United States and they pay a subscription for that.

Well, as value investors, we love subscription businesses because we can measure the value. We look at renewal rates, we look at customer retention, we look at pricing, and we look at margins. So it's a much easier business to analyze than a hits-driven business of the old days.

 

Culloton: The fund still has a big financial stake as it has historically, but how is that financial stake changed since, say, 2008, the financial crisis and now?

Davis: Well, that's a good question. Financials often get lumped into this sort of single category, and it's funny, because I used to say to people, if we had a three-stock portfolio and it had three financials in it, and we had a separate portfolio and it had a capital goods company, one financial, and one retailer, you would say automatically, oh, that second portfolio is more diversified. But if the second portfolio had Home Depot, Toll Brothers homebuilders and Countrywide finance, you would realize it's not diversified at all. They are all tied to housing, and very closely.

If we look back at that first portfolio of financial stocks and if one of them is Progressive automobile insurance, one of them is American Express, and one of them is Bank Julius Baer in Switzerland, you'd say, well, there are three very different businesses and they are going to be affected by different macroeconomic events.

One will be based, of course, on consumer spending; one will be about auto accidents, frequency and severity with some weather components and the competitive environment with GEICO and so on. And the third will be about private banking regulations, asset management returns, and so on in Europe. So, it would be a very diversified portfolio.

But in terms of how things changed from 2007 and the financial crisis, I would say the one key part of our discipline has always been about investing in the businesses that have a culture, and Wells Fargo has a culture, American Express has a culture, even J.P. Morgan has a culture, Berkshire Hathaway has a culture, Progressive. They are specialists in what they do and there's a coherence about what they do.

And I think one of the mistakes we made was when the culture changed at AIG. Well, of course, culture changes with management. And I think that as we look back and then look ahead, the recognition of that central importance of culture is really been baked in, seared in by that experience of the crisis.

We avoided a lot of the blow-ups those years; not owning Baer or Lehman or Fannie or Freddie or WaMu or Countrywide. But the mistake we made in AIG was one about culture, and that's right in our wheelhouse as analysts, and so that I would say is something that's been reinforced.

Culloton: One final question. You said earlier in the year that you thought that equities in general was one of the more attractive asset classes even after last year's runup and the runup of the last few years. Do you still feel that's the truth?

Davis: Dan, absolutely. I mean, that's the thing that drives me crazy. I look at high-grade commercial real estate. And what are the cap rates on these things? 3.5%, 4%, 3.2%. You know, those are pretax cash flow yields from owning a portfolio of high-grade commercial real estate, and yet I can own a company like American Express with a 7.5% or 8% aftertax free cash flow yield. So the whole market, even if it's, you pick the number, 15 to 17 times earnings, let's say. So I invert that. Think of the earnings yield as the invert of that.

So, you are starting at a 6% or 7% earnings yield, and then think of the resiliency of the businesses. Because I think one of the things--my grandfather got in the business in 1948, and everybody clinged to bonds, right, because they remembered the Depression, they remembered the crash. And even though the market had come back, right, it was back to sort of a little higher than it was in '29, people said, never again. I am not going back. I am going to cling to the safety of bonds. They then lost money for 30 years. Year after year after year they lost money in bonds because they didn't recognize that starting with those low yields created risk.

So, here are bonds at a 33 times pretax earnings multiple. Here is real estate at a 25 times pretax multiple and here are equities at a 15 to 17 times aftertax multiple. And they have that ability to adapt to be global, to innovate, to reinvent that resiliency, which is what I think ought to draw investors to equities.

Culloton: Thank you very much, Chris.

Davis: Thank you, Dan.