Inheritance and Beyond: The Investment Legend of the Davis Family

First,

Avoid cheap stocks.

This is the lesson Shelby learned in the 1980s,

Some of the cheapest stocks may indeed be worth that money,

Because those companies are mostly mediocre.

The problem is,

A mediocre company will remain mediocre indefinitely.

The company’s CEO will expect good days ahead,

Just like CEOs have always behaved.

The company may reorganize,

But such a revival is an uncertain proposition.

“Even if a revival is possible,” Shelby says,

“it will take longer than people expect.

You have to be a masochist,

To enjoy this kind of investment.”

Second,

Avoid high-priced stocks.

Expensive stocks may be worth it,

Because they might represent great companies.

But Shelby refuses to buy such stocks,

Unless their prices are reasonable relative to their earnings.

“Any company at any price may not be attractive,” Shelby says.

The Davis family has never paid excessive prices for clothes,

Houses, or vacations.

Why should investors pay too much for earnings? Ultimately,

Isn’t it the company’s profits that people buy?

Chris describes the illusion created by these sizzling hot stocks as “a casino and steakhouse under a microscope.”

The common label for these illusory companies is two words: “Wild.”

As for whether it’s an internet cafe with slot machines,

Who cares! Whatever they do,

As soon as the “Wild” sign lights up,

They will be wildly popular.

Followers will buy these stocks at 30 times earnings,

And over the next four years,

“The ‘Wild’ company’s earnings grow rapidly at 30% annually,

And everyone continues to be caught up in the wild frenzy.

By the fifth year,

The momentum of the ‘Wild’ company wanes,

Earnings growth is only 15%.

For most companies,

15% growth is already quite good,

But ‘Wild’ investors expect more.

Now,

They start to hesitate,

Willing to pay only half of the original valuation—15 times earnings.

The result is a stock price halved,

Down 50% “adjustment.”

By this time,

Those book profits have evaporated,

Any early investors in ‘Wild’ stocks,

After a brief period of glory,

Only get a meager 6% annual return,

Compared to the risk taken,

Better than nothing.

Because the return on US Treasury bonds is 6%,

But with much less risk.

Once a fast-growing stock loses its growth,

Investors become victims of cruel mathematics: when a stock drops 50%,

It must rise 100% to recover the previous loss.

Third,

Buy stocks of companies with moderate growth at reasonable prices.

Shelby believes good investments should be companies with growth rates higher than their P/E ratios.

He avoids buying “Wild” stocks,

And looks for “ordinary” stocks,

Like a regional bank stock.

This “ordinary” stock has only 13% growth,

Not eye-catching,

And is priced at 10 times earnings.

If this “ordinary” stock can maintain such performance for five years,

And attract investors willing to pay 15 times earnings,

Then,

Patient investors will earn a 20% annualized return over five years,

While “Wild” hot stocks only yield about 6%.

Sometimes,

The Davis family also finds a “hidden growth stock,”

With an “ordinary” reputation,

But with high profits like Microsoft.

Low price,

Stunning returns,

An irresistible combination,

AIG and many other stocks discovered by the Davises fall into this category.

If AIG starts selling pacemakers or GMO seeds,

Investors would surely assign a higher valuation multiple to the company.

But as a dull insurance company,

It has never sparked irrational enthusiasm or other hype.

Long-term undervaluation of stocks can minimize downside risk.

Fourth,

Wait for reasonable prices to appear.

When Shelby spots a company,

But the stock price is too high and not suitable,

He patiently waits for its price to fall.

Because analysts often change their views three or four times a year,

This creates opportunities to buy stocks like IBM,

Intel, and HP.

Additionally,

Occasional bear markets are the best friends of cautious investors.

As Davis often says: “A bear market can make you a lot of money,

But many people don’t realize it at the time.”

Sometimes,

An industry encounters its own bear market.

For example, in the 1980s,

The real estate bear market spread to banking,

Giving Shelby the chance to buy Citibank and Wells Fargo stocks.

When the Clinton administration introduced flawed healthcare reform,

Top pharmaceutical companies (like Merck,

Pfizer,

Lilly) all fell sharply by 40%–50%.

Shelby and Chris held shares in these three companies.

Any company can face its own bear market,

When bad news (like oil spills,

Class actions,

Product recalls) occurs,

It often triggers a stock price decline.

This is usually a good buying opportunity,

As long as these negatives are temporary,

And do not affect the company’s long-term prospects.

“When you buy a resilient company’s stock that has been hit,” Shelby says,

“You only take on some risk at the time of purchase,

Because investors’ expectations are relatively low.”

Throughout the 1980s,

Shelby could pick many growth stocks with P/E ratios of only 10–12 times.

But,

By the boisterous 1990s,

Such good-value stocks became scarce.

Chris and Ken have never experienced this,

Now they are forced to wait for the market to decline.

Fifth,

Go with the trend.

Shelby is very cautious about choosing tech stocks,

But he does not completely avoid them,

Unlike two famous investors with tech phobia—Warren Buffett and Peter Lynch.

As long as he can find companies with reasonable prices,

Real profits,

And sound management,

He enthusiastically includes them in his portfolio.

Otherwise,

He prefers to miss out on the most dynamic parts of the economy.

He invested early in Intel,

And profited handsomely.

He also held IBM shares since the mid-80s.

He bought Applied Materials stock,

In a modern version of the “pick and shovel” game.

During the gold rush of the 19th century,

Those selling picks and shovels made big money,

But the prospectors using those tools went bankrupt.

The same story repeats,

Applied Materials sells equipment to semiconductor “prospectors.”

Sixth,

Theme investing.

For “bottom-up” investors,

They prefer to invest in companies with good attributes.

As long as there is a bright future,

From oil rigs to fast-food chains,

Across industries,

They may invest.

For “top-down” investors,

They first analyze macroeconomic trends,

Then identify which industries might perform well in the current environment,

Finally select specific companies within those industries.

Shelby’s style combines both “top-down” and “bottom-up,”

Integrating them into a cohesive approach.

Whenever he allocates capital,

He looks for a “theme.”

Often,

The theme is obvious.

In the 1970s,

Rampant inflation was a clear theme.

Shelby included companies involved in oil,

Natural gas,

Aluminum, and other commodities,

In his New York risk fund’s portfolio,

Because these companies could profit from rising prices.

By the 1980s,

Signs indicated that,

In the fight against inflation,

The Fed had gained the upper hand.

At that point,

Shelby identified a new theme: falling prices,

And declining interest rates.

So,

He reduced investments in hard assets,

And bought financial assets: banks,

Brokerages, and insurance.

Financial companies could benefit from the declining interest rate environment.

Shelby invested 40% of his funds in financial stocks,

Seizing the opportunity of industry expansion.

These “hidden growth stocks” did not grow as fast as Microsoft or Home Depot,

But they offered attractive returns.

By the 1990s,

Shelby and Chris focused on another theme: aging baby boomers.

As America’s wealthiest generation ages,

Pharmaceuticals,

Healthcare,

Nursing homes become beneficiaries.

After a big rally in pharma stocks,

Shelby patiently waits for market dips to buy again.

Seventh,

Let your winners run.

A typical growth fund sells 90% of its assets annually,

And then,

Replaces them with potentially more promising investments.

But Shelby’s New York risk fund has an annual turnover rate of only 15%.

Davis prefers to buy and hold stocks,

To avoid paying high capital gains taxes.

This “buy and hold” strategy reduces transaction costs,

And minimizes mistakes caused by frequent trading.

The results of frequent trading are mixed,

Wins and losses,

Uncertain outcomes,

But transaction costs are definite.

When Shelby was young,

Davis told him more than once,

“Timing the market” is futile.

Shelby passes this advice to the next generation: Chris and Andrew.

“Once we buy stocks at a discount,” Shelby says,

“We can hold them long-term,

And ultimately,

We want to sell at a ‘reasonable price.’

Even if it reaches that point,

As long as it continues to grow,

We’re willing to hold.

We like to buy at ‘value’ prices,

But hope they keep growing.”

“I can hold a stock through two or three recessions or market cycles.

That way,

I can see how the company responds under different economic conditions.”

Eighth,

Invest in excellent management.

Davis invests in great management teams,

Like Hank Greenberg at AIG,

And Shelby follows the same logic,

Investing in Andy Grove at Intel,

And Eli Broad at Sun America.

If a great leader leaves one company for another,

Shelby will allocate funds to the new company,

A sign of re-investing in management talent.

When Jack Grefenstein moved from Wells Fargo to First Bank,

Shelby bought First Bank stock.

When Harvey Golub joined American Express,

He bought American Express stock.

“Any company’s success depends on excellent management,

This is a well-known Wall Street truth.

But,” Chris says,

“Most analysts overlook this,

They love to discuss the latest data,

But without evaluating leadership,

We never make investments.”

Ninth,

Ignore the rearview mirror.

“Advances in computer technology have caused investors to focus excessively on past endless data,” Shelby says,

“People have never been more committed to finding the future from the past.”

The most valuable summary in Wall Street history is,

History never repeats itself exactly.

In the 25 years after the 1929 crash,

People avoided stock investing,

Because they harbored an illusory belief: the market was about to collapse.

After World War II,

People also avoided investing,

Because they believed that after the war, a depression would follow.

In the late 1970s,

People also avoided investing,

Because they thought a crash like 1973–1974 would happen again.

As Shelby wrote in 1979: “Most investors spend too much time,

Prevention of disasters of a similar magnitude that we think are unlikely to happen.”

In 1988–1989,

People avoided stocks,

To prevent a repeat of the 1987 crash.

But,

All these preventive behaviors are regrettable,

Because whenever people think about preventing a stock market crash,

It’s actually the best time to invest heavily.

From Wall Street’s investment history,

Many fallacies can be learned.

For example:

“Stocks only go up when company profits rise,”

But in reality,

Stocks often perform well even when profits are weak.

“During high inflation,

The stock market suffers,”

But in the early 1950s,

This damage did not occur.

“Stock investing is the best hedge against inflation,”

But the early 1970s proved otherwise.

Tenth,

Stick to it.

“Over 1 year,

3 years, or even 5 years,

stocks are risky,

But over 10 or 15 years, the picture is different,” Chris says.

“My father entered the stock market at the peak of a bull market,

But after 20 years,

His initial poor choices became irrelevant.

In letters to shareholders,

We repeatedly emphasize: we are running a marathon.”

Davis Investment Checklist

On May 22, 1997,

Shelby wrote a memo explaining the reasons for each stock holding in his New York risk fund.

Even if these holdings do not meet all criteria,

They should at least meet most characteristics.

Top management and a good track record of integrity.

Innovative research,

Using technology to maximize advantages.

Operations abroad as excellent as domestic.

Overseas markets provide a second space for mature American companies to grow rapidly.

Some Wall Street analysts in the early 1980s claimed Coca-Cola had entered maturity,

But its successful expansion into international markets proved their prediction wrong.

The same story applies to AIG,

McDonald’s, and Philip Morris.

Products or services sold will never become obsolete.

Companies that provide strong capital returns to shareholders,

And management that cares about investors’ interests.

Maintaining the lowest costs,

Giving the company a low-cost advantage.

In a growing market,

Companies that dominate or continually expand their market share.

Skilled at acquiring competitors,

And increasing their profit margins.

Financially strong companies.

……

After tough times,

The Davis family discovered the joy of the “72 Rule,”

They realized that if you can make your investments grow 10% annually,

You will earn substantial returns.

And if you can achieve 15% or higher,

Such an extremely attractive return makes current setbacks seem like a trivial illusion.

Patience,

Long-term thinking, and the wisdom of three generations,

These are the secrets to the Davis dynasty’s investment success.