• The Davis Dynasty is a story about Shelby Collum Davis and his family. The author mixes Davis’s story of how, over a 47-year investing career, he made a fortune with the market history he experienced along the way.

• The notes are based on an abridged version of The Davis Dynasty (a few chapters were cut from the original) which was given out to fund shareholders back in the day.

• Shelby Cullom Davis

  • Was born in 1909.

  • His success in investing came later in life. He started in his late 30s.

  • He bought a seat in the NYSE in 1941 for $33,000. Davis thought it was a great deal. 12 years early (1929), seats sold for $629,000! A year after his purchase, seats sold for half what he paid, but eventually rallied over the next few years. It grew to $830,000 in 1994.

  • Davis was extremely frugal.

  • Davis used leveraged in his portfolio. He noticed how mortgages (leverage) boosted net worth via real estate ownership over time. He believed leverage applied stocks had more profit potential than a mortgage.

  • Davis took a contrarian stance and embraced stocks fully. In 1947, the Dow traded at 9.6x earnings, with a 5% average dividend yield while bonds offered historic low rates.

  • Davis’s timing was nearly perfect. He started a few years before the post-war boom.

  • He focused on analyzing insurance companies because that’s what he knew best. He began his career working for the state’s insurance department.

  • Insurance stocks were severely depressed because earnings were nonexistent due to low bonds yields. Most sold below book value but paid a high dividend. Davis saw it as an opportunity with limited downside.

  • Insurance companies were compounding machines. Low cost to run, no factories to upgrade or high Capex costs each year. Just an increasing marginal cost that comes with a growing customer base.

  • He quit the state’s insurance department in 1948, bought an interest in a brokerage firm (Frank Brokaw & Co.), renamed it Shelby Cullom Davis & Co., and promoted insurance stocks to anyone who would listen.

  • He began to heed his own advice around 1948 and started buying insurance stocks himself. His firm’s underwriting and brokerage operations became secondary.

  • Davis had 2 advantages over the average investors because of his firm and NYSE seat. He could buy more shares on margin. His firm could borrow more money than an individual investor. And his firm paid a lower interest rate on margin loans.

  • Davis regularly visited insurance companies to meet with management. His favorite question: “If you had one silver bullet to shoot a competitor, which competitor would you shoot?” Then he’d research that competitor.

  • He looked for greater leadership in management.

  • He looked for low-cost operators in the industry and avoided the underachievers.

  • His early portfolio was mostly in small-cap insurers that traded OTC.

  • He saw his portfolio fall by $125 million in the 1987 crash but saw it as a buying opportunity. He went on a buying spree. The next year he made Forbes 400 list with a “lowball” estimated net worth of $370 million.

  • Davis Double Play: low-priced stocks with the potential for above-average earnings growth. Investors buy at a low multiple, get exceptional earnings growth, and then see multiples expand.

  • “Davis’s financial life had three phases: learn, earn, and return. The learn phase lasted into his early forties, and the earn phase stretched from his forties into his late seventies. At that point, he tackled the return phase.” Return phase = philanthropy. Davis died in 1994 leaving $900 million to personal causes.

  • In 1992, 100 insurance companies made up 75% of his portfolio, with the rest spread across 1,500 companies (including a few hundred losers). Davis had a habit of buying 1,000 shares anytime a company appealed to him. And he just rarely sold. “The printout left no doubt what had put Davis on the Forbes list. It wasn’t a phone book list of stocks; it was a few names in the phone book. These were oldies from the 1960s that he had faithfully held… Davis remained loyal. Names he owned in 1950 still occupied his portfolio in 1990.”

  • Davis Dozen: 12 stocks accounted for a quarter of his total worth — $261 million — 11 were insurers plus Fannie Mae. All were bought before the mid-1970s. “He won this prize on the original cash outlay of $150,000. The prize required a 50-year waiting period to accumulate… Once he’d bought winning companies his best decisions were never to sell. As long as he believed in the strength of the leadership and the company’s continual ability to compound, he held.”

• Shelby Davis

  • Was born in 1938.

  • He learned under his father, from “stock talk” at the dinner table, and by helping his dad make copies of a biweekly insurance letter starting around the age of 9.

  • Early lessons from his father included the benefits of being a stockholder over a bondholder and compounding.

  • He learned the mistake of buying high-priced growth stocks and being sold by management after recommending Reynolds Aluminum a “buy” in 1960 when it was selling at 40x earnings.

  • He looked for companies with potential for earnings growth and/or multiple expansion (low multiples was not a requirement).

  • He looked for industries with changing characteristics.

  • Early positions in the fund were in tech. The fund was up 25% the first year. Saw $55 million in inflows by the first quarter of 1970. Then the market crashed. Their holding fell in price after bad earnings reports. A position in Memorex dropped from $168 to $20 (were they sold after buying more on the way down!) It was a bottom 10% fund based on performance in 1970. It was a tough lesson learned that led to looking for undervalued opportunities too.

  • He ran the New York Venture fund until 1997. He beat the S&P 16 out of 20 years and by 4.7% annualized over that period.

• Chris Davis

  • Owner Earnings: the amount of reward pocketed each year after a company reinvests cash to maintain the status quo, but before reinvesting for growth and adjusted for stock options, depreciation, amortization, and deferred taxes. Owner earnings are almost always lower than reported earnings.
  • How much to pay for a company — compare the owner earnings yield to Treasury rates. Divide owner earnings by stock price to get yield. A $20 stock with $2 of owner earnings, yields 10% ($2/$20). A $70 stock with $2 of owner earnings, yields 2.9% ($2/$70). The smart investment goes to the higher of: owner earnings yield or Treasury rate.

• Market History

  • Foreign investors poured gobs of money into early U.S. railroad projects in the mid-1800s, leaving them with big losses.
  • Keynes called the low-interest rates of the 1940s the “balm and sweet simplicity of no percent.”
  • Enthusiasm for bonds hit a peak in the 1940s (the disdain for stocks was high). Rates on long-term Treasuries bottomed at 2% in 1946. It would kick off a 34-year bond bear market.
  • A 1946 Federal Reserve Board survey showed 90% said they would not own stocks. The masses held a “collective grudge against the market.”
  • The late 1960s kicked off a growth fund craze. Momentum-driven stocks soared. Electronics were hot stocks. The Nifty-Fifty were viewed as never sell stocks. Investors became performance chasers, moving in and out of the top mutual funds. Buffett closed his partnership in 1969 and bought municipal bonds.
  • The Nifty Fifty lessons:
    • Only 3 Nifty Fifty stocks went on to grow earnings at 15% or more through 2000 — Philip Morris, McDonald’s, and Merck.
  • A study by Twentieth Century Fund found that blindly owning the entire market from 1960 to 1968 was more rewarding than paying a fund manager to pick stocks.
  • 1969 ended the bull market. It continued falling into 1970. Both inflation and recession existed — stagflation. Dow down 36%. Hot stocks and electronics got killed, down 77% on average.
  • Following the bear market of 1973-’74, stocks still looked cheap in ’76. Buffett said he felt like an oversexed teenager at a dance hall.
  • 1979 — stocks were priced for terrible news, selling at single-digit P/E’s and less than book value.
  • The 1980s — the Fed fights inflation. Prime rates rose to 20.5% and 30-yr Treasuries hit 15% (bond deal of the century which few people bought). The average investor couldn’t see past high inflation to notice a great deal of 15% Treasuries. Investors are always too focused on short-term worries to recognize long-term opportunities.
  • Gold and silver prices soared in 1980. The high demand and fear buying dropped off after gold bugs predicted higher prices.
  • 1981 — recession and the Dow fell 24%. The last bear market before a 20-year bull run. Inflation subsided, Fed cut rates, commodity prices fell.
  • The late 1980s — Reagan added $1 trillion in new debt. Low rates drove consumer/corporate borrowing and overpaying on assets. Mike Milken led the junk bond frenzy, the famous Predator’s Ball, leveraged buyouts and hostile takeovers.
  • The 1980s brought trading back in vogue. Newsletters popped up to profit off the fad.

1987 crash — Dow lost 23% on Black Monday. A 36% drop from the high that year. Doom and gloom pundits called for further losses. They were wrong. Despite the crash, the 1987 market ended slightly positive for the year.

• 1991 — recession. Banks had trouble due to the high debt of the ’80s. Citicorp was too big to fail in the late ’80s. Japan in the ’90s was like the US in the ’30s.

• The similarity between the late ’60s and ’90s: ’69 was computer peripherals, mainframes, and electronics companies. The ’90s were Dotcoms, chip makers, networking, and connectivity. All were high P/E stocks which everyone was buying.

• The 1920s, the 1960s, and 1990s were each high P/E market crash events. About 30 years between each one, roughly one generation removed, and enough time to forget each prior blowout and bust.

• Ben Graham issued a market excess warning in the ’60s. Buffett did it in the ’90s. The Fed called market exuberance each time too – William McChesney Martin in ’65 and Alan Greenspan on Dec. 5, 1996. Both markets continued higher for 4 more years.

• The 1990s again drove high debt use, this time by consumers. People borrowed to pay bills, borrowed against homes to buy stuff, which doesn’t make debt work for you.

• The 1990s — like each boom before it, only short-term performance mattered to investors, media, and pundits. Mutual funds were graded based on their performance over 6 months or less.

• Creative accounting pops up in boom times. It happened in ’69 and late ’90s (saw it in ’08 too), where some “companies were fluffing the books to meet Street expectations and create an illusion of predictable success.”

• Buffett called the 1999 top. Most people were buying the market at 50x earnings after fees (Fortune 500 companies were selling at $10 trillion, on $300 billion of earnings, minus the 1% fees or $100 billion, gives a payoff of $200 billion). Buffett said the market had to sell off slowly or quickly or stay flat until earnings caught up. It couldn’t rise further without violating the laws of financial gravity. $3 trillion valuation on $200 billion is reasonable, not $10 trillion.

• 10 Davis Tenets:

  • Avoid cheap stocks: it’s cheap for a reason, likely because it’s a poor company. Even if it turns around, it takes longer than most expect.
  • Avoid expensive stocks: great companies may be expensively priced but should be bought at sensible prices. “No business is attractive at any price.” — Shelby Davis
  • Buy moderately priced stocks with moderate growth: find companies with growth rates faster than the multiples — leads to earnings growth and multiple growth.
  • Wait until the price is right: bear markets are buying opportunities and can happen market-wide, industry-wide, or to individual stocks. “Bear markets make people a lot of money, they just don’t know it at the time.” — Shelby Cullom Davis
  • Don’t fight progress: carefully choosing tech companies, with real earnings and franchises, lets you profit off dramatic changes in the economy.
  • Invest in a theme: were the “top-down” theme influences were to look for “bottom-up” value.
  • Let your winners ride: “I was comfortable owning a stock through two or three recessions, or market cycles. That way, I learned how the company handled bad times, as well as good times.” — Shelby Davis
  • Bet on superior management: never buy anything without assessing leadership. It may pay to follow great leaders that move to new companies.
  • Ignore the rear-view mirror: “The most valuable lesson to learn from history on Wall Street is that history doesn’t exactly repeat itself.”
  • Stay the course: investing is a marathon.

• New York Venture Fund Stock Checklist:

  • First-class management with a track record of honesty.
  • Innovative research used to the company’s maximum advantage.
  • Operates home and abroad.
  • Sells products/services unlikely to become obsolete.
  • High insider ownership.
  • High returns on investor capital and management that rewards investors.
  • Low-cost producer.
  • Holds dominant/growing market share.
  • History of being good at M&A — makes acquisitions more profitable.
  • Strong balance sheet.

Quotes

“It’s unrealistic to expect companies to grow at 15 percent for extended periods. Most great companies can’t do it. People who pay high prices for stocks, based on high growth assumptions, are asking for trouble up the line.” — Chris Davis

“Owning some of the finest companies in the world was a lousy deal if you overpaid and a worse deal if you bought the most expensive Nifties.”

“Fast growth in the latest emerging phenom doesn’t necessarily mean fat profits for foreign enthusiasts.”

“You’d be crazy to own a business that yields 3.3% instead of a 6% bond, unless the business can increase its earnings yield in the future. In other words, it must be able to grow. The challenge is to project the growth out eight or ten years. For any projection to be close to the mark, the business must be relatively predictable. You can’t pin a ten-year forecast on the typical tech company. Even if you buy tech at a relatively cheap price, it can take years before the return on the stock matches the return on a bond.” — Chris Davis

“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.” — Chris Davis

“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 benefits. The second question, the price tag, is often ignored.” — Chris Davis

“Owning shares in a successful company is far more rewarding than owning its bonds.”

“If you know the rate of return on your investment, the Rule of 72 tells you how long it will take to double your money. The greater the return, the faster the compounding.”

“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.”

“Any young, inexperienced investor has a built-in advantage over a mature sophisticated investor: Time.”

“For maximum compounding, stocks can be held indefinitely, while bonds outperform intermittently.” — Peter Lynch

“Great investing requires an independent spirit, and the courage to acquire assets the crowd disdains.” — Peter Lynch

“Some of my most rewarding investments came from slow-growth industries where expectations were low and profits lackluster. By looking for the most inspiring competitors in uninspiring lines of work, I often found great growth enterprises priced for mediocrity.” — Peter Lynch

“We’ve all heard that people who are ignorant of history are doomed to repeat it. On Wall Street, history repeats itself routinely, as corrections and bear markets turn into bull markets sooner or later. Investors who are ignorant of this pattern aren’t necessarily doomed, but they are likely to lose money trying to escape stocks at inopportune moments.” — Peter Lynch

“My father hated taxes, so margin became his favorite weapon against the IRS. The interest he paid on his loans was tax-deductible, and his deductions wiped out the taxes he’d otherwise have owed on the dividends he got. Also, by raising the stakes on his investing, margin kept him focused.” — Shelby Davis

“Out of crisis comes opportunity. A down market lets you buy more shares in great companies at favorable 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.” — Shelby Cullom Davis

“Where is the incentive if children and grandchildren start out with a trust fund which guarantees they never had to work?… I believe in providing a “safety net” in case of emergency but, predominantly, I believe in the incentive to excel…and contribute to the common good.” — Shelby Collum Davis

“Philosophy and theology give you the perfect background for investing. To succeed at investing, you need a philosophy. Then you’ve got to pray like hell.” — Shelby Collum Davis

On writing his insurance newsletter: “It’s not for the readers. It’s for us. We write it for ourselves. Putting ideas on paper forces you to think things through.” — Shelby Collum Davis

On insurance earnings: “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.”

References

• The Davis Dynasty summary by novelinvestor