Behind Davis Advisors’ “Wall of Mistakes”

How do you define an attractive stock?

Our primary yardstick for valuation is what we call “owner earnings,” or the amount of cash an owner could take out of the business while still appropriately investing for the future. It is essentially a normalized free-cash-flow metric. We then look at the owner earnings yield that a business generates, for example, a 12.5x owner earnings multiple is an 8% yield. Whether that 8% owner earnings yield is attractive or not will depend on the future growth rate of those earnings, how those earnings are reinvested or distributed and the yield offered by other investment opportunities.

An 8% owner earnings yield, for example, would be attractive if earnings were growing 7-8% and the cash was available for dividends and share repurchases. Such an investment would likely generate a 15-16% annual return which compares very favorably to other equity and certainly fixed income opportunities.

Davis has launched what it calls the first truly active ETFs, in the U.S. large cap, international, financial and global asset classes. What was the rationale for pivoting to the ETF space?

Our goal is to provide our clients with market-beating investments over the long term. Whether the appropriate structure is in a mutual fund, a separately managed account or an ETF depends on the client’s preference. Our clients have been well-served by mutual funds to date but intraday trading, portfolio transparency and in some cases tax efficiency also make ETFs an attractive vehicle. We want to offer our services in whatever format works best for the client.

How do the ETFs differ from the mutual fund portfolios?

Our ETFs are analogs of our mutual funds and so have the same investment approach and many of the same holdings. The main difference in the portfolios is that illiquid names such as private placements are not included in the ETFs.

You focus on the international and global asset classes. What kinds of opportunities are you seeing there?

We are bullish on the U.S. long-term and continue to find a number of attractive domestic equities, which is why U.S. companies are approximately 40% of our global portfolio. U.S. financials, for example, are very attractive with very strong balance sheets and good market positions. They are trading at 10-13x owner earnings. Our largest positions include Wells Fargo (WFC), Capital One (COF) and JP Morgan (JPM).

European companies have generally gone global, by necessity, earlier than U.S. companies and so we own a number of exciting European multinationals. Our European holdings include Safran (SAF FP), a French aerospace company, which along with their JV partner General Electric are leaders in the jet engine space, and LafargeHolcim (LHN FP) which is a Swiss-French global cement company with a strong emerging markets (EM) presence.

When it comes to emerging markets we have increasingly found attractive investments in specific developing countries. The key in emerging markets is selectivity, because while BRIC makes for a catchy acronym we know that Brazil, Russia, India and China have very different levels of economic development, political stability and investment opportunities. We are only invested in four emerging markets compared the 26 EM countries in the index. Selectivity matters.

In China, for example, for the past five-plus years we have been focusing on the consumer space rather than the entire market. We own e-commerce leaders such as Ali Baba (BABA) and JD.com (JD), as well as travel leader Ctrip (CTRP) and the leader in for profit education in New Oriental Education (EDU). All these companies are leaders in their field, have strong business models, and are benefiting from rising consumer spending.

In a global portfolio such as yours, you have a lot of flexibility. What are you avoiding?

Knowing what to avoid is just as important as what you own. The low interest rate environment has led to a number of market distortions including investors over-valuing dividends. Don’t get us wrong; we love companies that have the financial wherewithal to return cash to shareholders in the form of dividends. But we don’t want to pay 20x earnings for slow growth businesses just because they are paying a 3% dividend. Often what investors perceive to be the safest investments are risky because of high valuations. We include many consumer products and beverage companies in that group.

We are also very selective about the emerging markets in which we want to be heavily invested. India, for example, is a country that is attractive from a long-term perspective with good demographics and a pro-reform government, but with a market multiple of 20x much of the good news has already been priced in and there is little margin of safety. So while we are following India closely, we currently only have a single investment there

I understand that you have a “wall of mistakes” at Davis. Why?

Mistakes are an inevitable part of investing. The key is to get a “return on your mistakes.” Learn from what you did wrong and avoid repeating the same mistake. So as you enter our office there is a wall posted with the stock certificates of our most significant mistakes. In the frame of the stock certificate we write the key transferable lesson. It then becomes part of company lore and is shared across the team.

Just as important as the wall itself is the culture of learning and humility that makes sharing your mistakes publicly on a daily basis acceptable. We encourage mistake reviews and commend analysts (and portfolio managers!) for analyzing and sharing what went wrong and what we can do in the future to avoid the same mistake.

What was your most educational investing mistake?

We owned Valeant Pharmaceuticals (VRX), which was a mistake for a number of reasons. Two big reasons were its highly acquisitive model and the company’s use of leverage. While the initial premise of increasing efficiency and cutting costs in the healthcare sector made sense, the company was too aggressive in making increasingly large acquisitions with debt. A driven culture with results at any cost led to a number of bad behaviors and an M&A machine focused on meeting Wall Street’s rising expectations.

While we came away with an appreciation of some things we did right, such as significantly reducing the position size after the stock doubled, as well as, keeping the position under 3% of the portfolio, it was a painful experience we aim not to repeat. Today we are even more skeptical of highly acquisitive companies both because they often use financial leverage and they provide ample room for accounting shenanigans as the financial statements are in constant flux. While we bear the scars, we also believe that we will achieve a “return on the mistake” and be better investors because of the experience.

Read more articles by Robert Huebscher