The manager of the Davis NY Venture fund offers his thoughts on how best to sift for bargains post-sell-off, his team’s fondness for financial stocks, and why Berkshire hasn’t made any acquisitions yet.
Our guest this week is Chris Davis. Chris is a portfolio manager at Davis Advisors, where he runs a number of strategies, including the Davis New York Venture, Selected American, and Clipper Funds. Chris joined Davis in 1989 and has more than 28 years' experience in investment management and securities research. Among other accolades, Chris was the recipient of the Morningstar Domestic-Stock Fund Manager of the Year award in 2005. He received his M.A. from the University of St. Andrews in Scotland.
Background
“Davis NY Venture Fund: Special PM Update” by Chris Davis and Danton Goei; March 2020
Davis NY Venture Fund portfolio data
Working From Home
“Management by Wandering Around”; Wikipedia
Behavioral Biases
Buffett Partnership Letters—Letter to Partners dated Jan. 18, 1965 (pg. 69)
Richard Feynman bio; Wikipedia
Stocks Referenced
Otis Elevators
Raytheon
Jeff Ptak: Hi, and welcome to The Long View. I'm Jeff Ptak, global director of manager research for Morningstar Research Services.
Christine Benz: And I'm Christine Benz, director of personal finance for Morningstar, Inc.
Ptak: Our guest this week is Chris Davis. Chris is a portfolio manager at Davis Advisors, where he runs a number of strategies, including the Davis New York Venture, Selected American, and Clipper Funds. Chris joined Davis in 1989 and has more than 28 years' experience in investment management and securities research. Among other accolades, Chris was the recipient of the Morningstar Domestic Equity Fund Manager of the Year award in 2005. He received his M.A. from the University of St. Andrews in Scotland.
Chris, welcome to The Long View.
Chris Davis: Thanks so much, Jeff. It's good to be here.
Ptak: So, it seems like a logical place to start is to talk about what your work arrangement is. We've all had to get creative and adapt to our new circumstances. Can you tell our listeners a little bit about how you're working? For instance, where you're working and how it is you collaborate with your team?
Davis: Well, sure, Jeff. I mean, it's almost a perversion to talk about anything good coming out of 9/11. But of course, having our research team based in New York City on that day, one of the byproducts was just an absolutely bulletproof business-continuity plan that we put in place then that we test regularly. So, in a sense, we were able to not miss a beat in terms of just having all of our systems both as a research and a portfolio team, but also in terms of our operations, our call centers, all just absolutely running based on a disaster recovery plan that had been put in place but tested every year from 18 or 19 years ago.
And then, in terms of our research team, we're a small super cohesive team. There are 10 of us. Many of us have been together for two--in one case, 25, 30 years. And yet, we're all based in New York City. But because we do so much sort of bottom-up research, so much leg work, so many company visits, and because we're global in terms of our research orientation, we've also built a system where we are used to, at any given time, half or sometimes two thirds of the research team being on the road. So, asynchronous communication, dedicated conference call lines that we use all the time, people calling into meetings, people Skyping in and so on. It's all been sort of part of how we've worked.
So, in that sense, it's a little bit of business as usual. I think, for me, it's a little bit of a greater strain because I love going to the office. I love the people I work with. I love the environment. Dave Packard from Hewlett Packard had a wonderful saying when he was asked about his management style. He said, “Well, I do a lot of management by walking around.” And that has always been kind of my approach. So, as we speak, I'm communicating from a home office in upstate New York where I feel like the character from Green Acres because I normally ride my bike to work and stay in the city. So, it's a little bit out of my element. But in terms of the way the company and the team functions, it's very much sort of business as usual.
Benz: So, you're a bottom-up stock-picker, but watch the market every day and so surely have a perspective on whether after the recent violent sell-off it's cheap or not. So, do bargains abound currently in your view?
Davis: Well, I think you would want to look at this market through three lenses, right? So, we've had this sudden dramatic shock. And of course, the word that gets pounded in over and over, it's unprecedented, unprecedented. Well, of course, because we don't live in a circular time loop, everything is unprecedented. But of course, there are aspects. What we would say is, anybody who is investing in businesses for the long term should assume that they will be investing through times of recession, through times of dislocation, through times of unexpected shocks. Nassim Taleb talked about Black Swans. But of course, long-term investors have always known unexpected things happen all the time, and you better be prepared for them.
So, with that mindset, we'd say, look, you look at your portfolio in this environment through three lenses. Lens number one: Are the companies where they just because of the nature of their business model, they really face an existential threat. So, the sorts of businesses where you would think about that would be businesses that have high fixed costs, plummeting revenue, and debt. That combination, whether it's the environment that we're in now, whether it's the financial crisis, whether it's a normal recession, you know, if revenue plummets and you have high fixed costs and you have not a lot of balance-sheet flexibility, those businesses sort of have an existential question.
And the trouble with investing in those businesses in a time like this is, the chances are, the government bazooka comes out, aid is distributed, they get through these periods. So, it's a perfectly--what I would call, it's a speculation or it's a reasonable assumption--that many of those businesses will get through because some sort of aid will be given. However, as people learned in the financial crisis, the terms of the aid can be highly variable and even capricious. So, some banks got government aid in the financial crisis and got their shareholders equity diluted 20%. AIG's share count was diluted 80-90%. Of course, Fannie Mae and Freddie Mac were simply nationalized. So, I think until you know really the terms and conditions, I think, going into companies that you've looked at through that first lens is really--it's a gamble. And it will work out great for people that hit that bottom tick and whether it is casinos or cruise ships or airlines-- we all know the types of businesses that have those dynamics here.
But I would say you don't really know what the cost of the funding that they're going to get will be. You don't know how punitive it will be; you don't know what it will mean to dilution; you don't know what the interest-rate terms will be, and so on. So, we generally don't own those sorts of businesses, because we assume we're going to own businesses through a recession and through a downturn. And so, that's not an area we sort of play in a lot. I will make an exception maybe later in the call to talk a little bit about energy.
But then the second lens that you might look through is companies where we're in an environment that is probably a short-term benefit to their businesses. So, you think of some of the online retail businesses, video conferencing, distance learning, streaming entertainment, gaming, things like that. Now, those of course have seen a sharp increase in usage. And in many cases, the share prices of those types of companies have bucked the negative trend. And so, they've risen while the market has fallen. And so, for long-term investors, looking at that category, the challenge is to distinguish between those companies where this effect is likely to reverse when business gets back to usual--think of Campbell's Soup or something--and those for whom the benefit is likely to be sustained. And then, you can sort of quantify that. And those companies may end up being sources of investable funds in this because they've radically outperformed and yet some of the effects may be temporary.
And then, the third lens is where you say, hey, are you finding stuff that's really cheap, is the
market cheap? I don't know about the market. But if you think of the third area that you would look for, these would be companies where the steep short-term decline in economic activity it's unpleasant, but it's a manageable reality. And here, the opportunities in this environment have been by far the greatest and it's just for the simple reason when investors are afraid, they overweight certainty, they overweight the short term, and they get unsettled by uncertainty. So, in other words, they overvalue uncertainty and they undervalue durability.
And so, here I would say high-quality industrial companies where you're going to have a big sharp drop-off in short-term demand, but long term, their positions are sort of unquestionable--businesses that have gone through wars and stagflation and booms and busts--a lot of those businesses at the lows could be purchased 50% to 70% off. Now, the numbers might be more like 30% to 40%. And then, the second category of companies in that area is definitely the financials. And that's where we've swung the hardest in this environment. I mean, the well-capitalized financial leaders, the Wells Capital--that is where really the biggest bargains have appeared. And a lot of those are off 35% to 55%. And they were pretty cheap to begin with. But really, they're off because of emotion, people's memories of the financial crisis rather than looking through.
So, I think it's hard to generalize about the market as a whole. But I think if you look at companies and put them sort of through those three lenses, you get sort of a sense of where there might be companies where you should sell them, even though they're down, or at least recognize that you're gambling. There are companies that might be companies that you could trim to free up cash to buy the third category, which is the companies where the bargains are.
Ptak: So, I want to talk some more about financials because they figure prominently into what you do in the portfolios that you manage. But before we do that, I wanted to maybe widen the aperture again and maybe talk more specifically about the environment we're in and COVID forecast. I realize that you're not macro investors, but investors having a gloomier COVID forecast than perhaps they ought to is one possible scenario among many. So, given that, how do different macro scenarios and their likelihood of taking place figure into the work you do? You mentioned the three different categories of companies, the first two of which you're probably not going to do much work in. But that third category, I would have to think for all the durability of those businesses, you still have to have different sorts of scenarios and forecasts in mind. So, how does that express itself in the work you and your analysts do?
Davis: Jeff, that's a great question. Well, of course, we deal with the world of probability. So, we don't think about point estimates, but we try to think of ranges and then we try to get very high degrees of confidence that what will happen will be within those wide ranges. So, we used to say, you know, sometimes the size of the range isn't important so much as your conviction in the boundaries of that range.
And so, one of the maddening things about how the COVID crisis has spread, one of the maddening things is, it seems everybody is now an amateur epidemiologist. I mean, it is just amazing how all of a sudden everyone feels he or she is an expert. So, what we try to do is try to sort through--you know, we always say the plural of anecdote is not data--we try to separate out anecdote from data, we try to look at data. And what we would say is, look, in this world, because we have a global research platform, we can look across the world. We can look at how it played out in Korea, how it played out in Italy, how it played out in China, how it played out in Singapore. So, we aren't flying completely blind. But before I even get to sort of trying to quantify the range, I'd say first, just think about it psychologically. And this is where--we went through the financial crisis; we went through 9/11. In a funny way, the environment we're in is a little bit of a hybrid of the two, right? You have an economic sort of one-two punch, like in 9/11, you had the weakening tech, telecom, the capital spending collapse, but then you had this psychological terror planted on top of it. And that fear, that was very personal, sort of, took over people's psyche, right? Once you saw those buildings collapse, you almost… It seemed anything was possible. People were terrified about the idea of nuclear terrorism and so on. And it created this sort of massive psychological paralysis because it was so visceral, the fear.
Now, you get to the financial crisis. And in terms of economic impact, the financial crisis was in order of magnitude greater than 9/11. But it was somehow--the closer you were to the industry, the more terrified you were. But if you were the person on the street, there was no visceral terror, right? I mean, I always think, was it Hank Paulson that, you know, threw up in the garbage can? You know, it was like the idea of really seeing how the system could shut down, but you didn't have this layer. You had a huge economic impact without that layer of terror.
This has been this sort of funny hybrid where there's a significant economic impact, but in a way, it is definable, and it's definable because of time. That's what I'll get to. But the psychological impact, the idea that it's so visceral, that people are fearful of their own lives and the lives of their loved ones, adds sort of an intensity to it that you really have to be aware of.
So, in terms of… What I would say is, I'd say, look, there is a wide range of short-term forecast. So, when will the U.S. open up? When will things start again? What will be unemployment in the third quarter? What will unemployment be in the fourth quarter? What about the first quarter of next year and so on. But the farther out you go, the more all of those estimates begin to converge. And that is sort of the key. What we know with very high degree of conviction is sometime between two or three months and 12 to 18 months, life is going to get back to normal, right? Baseball is going to reopen. Businesses, travel is going to reopen. People are going to get back to work. People are going to go about their businesses. So, in a sense, what we know is that if we can just focus on that area as we get out 12 to 24 months, we know that the virus will have largely run its course, right? The vaccine will be available. As a result of the lessons learned, we're going to be far better prepared for future pandemics.
So, while we don't know the precise timing, we do know that within a relatively short period of time, the period of uncertainty is going to come to an end. And so, there will be a powerful emotional cost, but the economic cost I think is likely to be far less. So, when we invest through this, what we're thinking of is sort of a mindset that says businesses could get better and reopen in a shorter time period than we think is most likely, but we should be prepared for this effect to really linger in that sort of 12- to 18-month range. And so, what we think is, by 24 months you're kind of back to where you started. It could be a bit longer; it could be less. But we think that most probabilities would sort of converge on that.
So, we don't want to own a business where if instead it's 30 months, we're out of business. We can build a margin of safety in on that. And we certainly want to own businesses where if it's sooner, we'll do very well. But we think that's sort of where the probabilities converge and where we don't really have to be expert about whether the virus will resurface next winter or whether the vaccine instead of taking 12 months takes 17 or 18 months for us to be able to invest and build financial models on that. So, we're looking for unemployment to peak. Right around where we are now, we look for the recovery to be not a steep V, but also not a long lingering recession. A lot of people will get back to work quickly. We think that the government intervention has been an enormous short-term positive. Long term, we'll have to figure out how to deal with bigger deficits.
But in terms of the framework that we look at, we think that sort of makes sense. We think people are way overreacting to trying to predict whether we're going to be back to people out walking around in two weeks or six weeks. We think that's not really--if people focus on where we'll be in December, where we'll be in next February, then you invest with that high degree of conviction. You might miss the cheapest thing that gets the biggest snapback if you make some massively correct back-row prediction. But you don't need to take that risk to make a lot of money in this environment.
Benz: So, you stated that many wonderful businesses are on sale as a result of the recent epidemic. Let's talk about some examples, maybe one outside of financials and perhaps one inside of financials.
Davis: Well, I think, by far our biggest buy in this period was buying United Technologies. We already owned a lot of it. We could not understand what the hell that thing was doing going down 30%, 40%, 45%. It has a strong balance sheet, great management, it was on the cusp of splitting into three businesses, which just happened last Friday. But it's the sort of thing, if you think about it, Christine, if you were passing businesses on to your kids, and you said, well, I've got three businesses in this old family portfolio. I've got Pratt & Whitney and Raytheon, let's call that one business--one of the largest jet engine manufacturers in the world. It's a global duopoly, maybe a triopoly if you throw a Rolls-Royce in there, but functionally a duopoly. We've got Raytheon, one of the oldest most dominant defense electronics company--very, very slow to change, hard to dislodge. So, think of that as business one.
Then you have Otis elevators, right? A global business, enormously durable, a huge amount of their business is recurring maintenance contracts, nobody is going to stop paying to have their elevator serviced in their skyscrapers. I mean, it is just an incredibly durable business. Those, by the way, are businesses that have gone through one or two world wars and through stagflation and hostage crisis and financial crisis and euro crisis. I mean, enormous. And then Carrier air conditioning system, again, mostly a global duopoly, triopoly, very reliable, difficult to dislodge.
So, you have, in a way, a portfolio of super-high-grade industrial companies with a strong balance sheet. And the uncertainty about what was going to happen in the next year somehow drove that stock down 40% or so, 35%, 40%, 45%. I think at one point it may have even been down in half, but I think it was about 40%. So, down way more than the market with way better businesses with high returns on equity, huge durability. So, that was a big buy for us. And now, last Friday, it did indeed split into three companies. So, now, you have, I think the old Pratt & Whitney is now, I think it'd be called Raytheon. RTX is the symbol. But that will include the aircraft engine and the defense business. Then you have Carrier and then Otis. And so, you've ended up with three pieces of paper. It was a long plan, but all of them very durable and a wonderful little portfolio of companies.
So, I don't know if it was concern over the split up; I don't know if it was concern over the black hole of what could happen to earnings in the short term given all the issues with air travel and what Boeing has been going through. But whatever it was, there's never a question about the durability of that business, or the ultimate long history of profitability and the prospect of profitability. So, I think that was for us sort of an easy, big add. So, maybe that's a good example of industrials. I know there were others. But that was one where it was really in our wheelhouse. We've known the company a long time and we were just amazed to have an IRR on a company like UTX at 14% or 15% for a company of that quality.
Ptak: And then, what about in the financials realm?
Davis: Well, financials, I would say, there were two that both are controversial in different ways that were very, very high-conviction adds for us. And by the way, I still think they're two of the cheapest stocks in the New York Stock Exchange. I think they are incredibly durable businesses. They're both financials, they are both banks, they are both top-10 banks. And I think that… But before I mention the two that I'm going to mention, what I'd say is, if investors over time if they listen to what we say about financials and banks, and they just feel that they want to buy Bank of America or U.S. Bancorp, they should do fine. Those are wonderful companies. They've been knocked down a lot. They're cheap. They're going to have wonderful growing dividends. They have huge capital ratios. They're going to get through this storm. I think banks are going to come through this with a really enhanced reputation for how aggressively they've been able to work with customers instead of pulling in credit like they had to in the financial crisis to reduce leverage. They came into this with 90% to 100% more capital than they had before the financial crisis. They came in with stress tests, that indicating that they could go through the financial crisis again and not suffer real dilution. So, if you just wanted to own something where everybody said, OK, well, that's not very controversial. Those are high-quality banks. They're in their second century--Bank of America, U.S. Bancorp, that's right there.
But the two that I would really highlight as the cheapest are Wells Fargo and Capital One. And Wells Fargo, of course, was the preeminent super regional bank for the last 20 or 25, 30 years. We all know what happened when they got into the enormously bad behavior regarding opening fake accounts. It was not the sort of fraud where the company was making money on it. But they grossly underreacted. It reflected a real problem that had evolved in that culture. The stock went from trading at a premium to the group to a big discount to the group. They've been in the penalty box for, I would say, two, three years now. They've changed out the senior management. They've changed out the majority of the board. They have somebody who we've known for 20 years as the CEO. He had been the CEO of Bank of New York, the CEO of Visa before. We knew him in both those roles, and of course, previously had been a lieutenant, and a trusted lieutenant, of Jamie Dimon's. He has a wonderful reputation with regulators. He will get that place on track.
But what happened was, it came into this crisis cheap, because of all this reputational damage that we would have said will work itself out. Bank of America used to be the bad boy that was, you know, every regulator paying all the fines, all the terrible behavior. Just like people, companies learn, companies adapt, companies improve, companies get better. So, that was the opportunity that we saw sort of buying it before this period. But then, somehow in this period, it went down way more than the average bank. And that seemed crazy to us. They have high capital ratios. They have incredible franchises. They've had a long history of a very strong credit culture. They had the asset caps that had kept their leverage down. They have relatively low dividend-payout ratios. So, they went down more. So, they, in a sense, went from being relatively cheap compared to the group. In other words, what we would call, an above-average franchise trading at a below-average price to being sort of a screaming bargain-basement distressed price. And I don't really know why given that the fundamentals of the business were sort of intact. But I think Wells is the cheapest of the big banks given the quality of the franchise. And as I said, if Wells ends up to just be average, you're still going to make money as the valuation improves from below average to average. But I think over time, the fact that it has above-average franchise in banking will end up eventually to be reflected in the valuation. So, that's Wells.
And then, second Capital One. Well, Capital One is the only major bank in the United States, as far as I know, that is still run by the founder. I mean, we own – if you were to look at our portfolio of banks, probably the vast majority of them are in their second century. Several of them are in their third century. I mean, these are very durable businesses. But Alexander Hamilton is not still running the Bank of New York and Mr. Wells and Mr. Fargo aren't still running Wells Fargo and so on. But Capital One is still being run by Rich Fairbanks, who I think has been one of the greatest entrepreneurs and innovators and executives in financial services. And so, Capital One was created essentially as a technology company. Because they said, well, we're going to basically create a company that using data will market credit card offers to people and will build a business without ever having branches or a brand name. They eventually bought some branches and became the enterprise that they are now. But it is a very technologically data-driven bank. The culture there looks like a culture of data scientists, not a culture of typical bankers.
But the concern is, oh, well, they do a lot of consumer lending, and particularly lending not to the most affluent customers. And what's happened is, every other bank, especially every other credit card operation, they've all galloped to what I would call the American Express model: high rewards, high spenders, wealthy people--market to them, because they're safer than people that are lower income. Well, of course, there's… We used to say in the insurance business, there's no bad risk, just bad price. The real question is, what are you getting paid for. And, of course, Capital One was left alone in the side of the credit card business that markets to Main Street, and I think they've done a terrific job.
So, again, the fear of the financial crisis, the fear of subprime drove that stock where the average bank was down 30% to 40%, it was down 50%, 55%. And we just thought that was terrific. So, Capital One and Wells have been our biggest buys, but generally, within the broader theme of the idea that banks have gone into this crisis incredibly well prepared.
And if you want a great image, Christine, to think about, when my grandfather was investing a lot in financials in the ‘50s, and he said, you know, the thing about banks in the 1950s is that by the time you got to the ‘50s, the banks that were still in business had gone through the crash of '29, the Depression, and World War Two. They had been regulated by all of the new banking legislation. And what had happened is, by the ‘50s, banks were considered boring; reliable and boring. They traded at 15 times earnings. They paid a 4% dividend. They were sort of the meat and potatoes of a trust portfolio. They were safe and dull. And I think that is the future of how investors will come to view banks. And the idea that you're buying these banks at 5, 6, 7 times earnings now to me is sort of the opportunity, and I think they're going to replace the dividend darlings where we see a lot of risk. And I think they're the cheapest part of the market right now.
Ptak: So, when you see a stock that you have high conviction in move down to the extent that you've described in the case of United Tech, Wells, and Capital One, I mean, I suppose one reaction is, you salivate, you rub your hands together, then you start buying some more. I mean, another reaction could be that you reflect on it and try to take apart your thesis and assert the bear case just to maybe try to test your own assertions and some of the assumptions that you built in. So, I would imagine that you went through some of those progressions on each of those names. Maybe you can pick out one and just talk about how it is you were able to maybe dispel concerns that you might have had about the bear case that one had made about one of those names, like, how did you get past that?
Davis: Well, it's such a good question, Jeff, because, obviously, there's an economic discipline about being a securities analyst, about being an investor. That is where you focus on the numbers and the data and so on. But there is a huge part of being a successful investor that is behavioral. And I actually think Morningstar does an amazing job at sort of helping people understand the behavioral biases, the blind spots that both professional and retail investors can develop. And there's almost no field where I think the behavioral costs are so high.
So, when we build our research team, we try to start with this question of what are the biggest behavioral biases. And I think Buffett wrote a letter--well, it would have been in the ‘60s--to his partners in the Buffett partnership before Berkshire and he highlighted why he thought most institutional money managers underperformed over time and he highlighted five reasons. And if you were to look at those five reasons, listen to how many of them were behavioral. Now, I'm doing this from memory on my back porch. But number one was the desire to conform your portfolio and policies to what other large well-regarded firms are doing, so sort of that herd mentality. Two was group decisions, right, you know, that idea of tending towards consensus. Three was the asymmetry of risk and reward. You'd better to fail conventionally than succeed unconventionally. Four was over-diversification. And five was inertia. And so, when you listen to those reasons, a lot of those are behavioral.
And so, when we go through our investment process, we focus enormously on what are the ways we can reduce these sorts of behavioral risks that come in. So, one of the things that we do for every company that we own, we have a written report that's called a premortem instead of a postmortem. And that is a report that is written that starts with the premise: We bought this company in--let's say, the year today, 2020--we bought this company in March of 2020 at such and such a price. Over the next five years, it ended up being a terrible investment. This is what happened. And so, we have to, in a sense, affirmatively state the bear case. Now, we also do things like we frame the stock certificates of our biggest mistakes. We hang them on the wall. Each one of those has a plaque on the bottom, that's the transferable lesson learned. Because we want to acknowledge, study, learn from the mistakes. The successes tend to take care of themselves.
So, in just the environment that we're in now, you're right, you know, we could say, we're so excited about the banks, we have a thesis. Now the prices are down, they must be cheap, because our thesis must be right. So, it is really important. Facts and circumstances change every day. Every day we have new data. How do we incorporate that in, how do we not blind ourselves to the disconfirming evidence? As Richard Feynman said, the first rule is not to fool yourself and you have to remember, you're the easiest person to fool.
So, I think, in this environment, there are two big threats to the banks. One threat is that credit gets really bad. And the other threat is bid. Well, we're in a lower longer interest-rate environment. We're in a Japanese-style world of zero interest rates. What does that mean for banks that typically earn a lot of money making a spread? And so, how is that impacted? And so, we try to quantify both of those. And with the credit side, we have a huge advantage, which is, after the financial crisis, the Fed created a stress test that they make the banks go through. And that stress test has numbers that are really pretty apocalyptic. That doesn't mean they couldn't be worse. Of course, they could be worse. Let me make sure I have exactly the right numbers here.
GDP decline--real GDP decline of 8%, stocks down 50%, commercial real estate down 35%, residential down 25%, and unemployment peaking at 10% over a three-year period. So, when we think about credit, we can say, well, we do have a stress test that the credit portfolios of all of these major banks have been put through, and we can look at that data. We can look at how they perform. So, in the case of Wells Fargo, even after that scenario, Wells Fargo would still earn money. I mean, it's sort of amazing. It wouldn't even lose money over that cumulative period. So, that is very, very powerful. If you're able to buy Wells Fargo below book value, and you have a scenario that says: even if we went through something worse than the financial crisis, book value would not go down--that can give you a lot of reassurance about the credit side. Capital One, I think is trading at 20%, 25% below book value. And even under that scenario, I think book value would only decline 5% to 10%, something like that. So, you're buying it below book value, even if we went through that scenario. So, credit, you can look company by company, that's the first test that you would want to look through and say, am I being blind? Could credit get much worse than we think? And that's how we get comfortable there.
And then, interest rates. Well, that's another one that's quantifiable, right? So, we wrote a paper where we said, hey, we've generally assumed in the next decade or two interest rates and inflation will be higher than they've been in this very unusual period of near-zero rates. But we might be wrong. And so, if we're wrong, let's quantify it. And so, when we do that for our portfolio, there are banks that have more interest-rate sensitivity, like think of Bank of New York. It has less credit exposure, but it's a more interest-rate sensitive model. So, that lower, longer environment might knock 30% off of earnings power over time, not in a single quarter, right? It takes time for assets to reprice and for it to work through. But for banks like Wells and so on, the impact is less, and it's generally between 10% and 20%. So, we book that in, and we say, we don't think this is the most probable scenario. But if we end up in that scenario--in other words, if we're wrong--how wrong will we be? And if the answer is, well, instead of buying them at 6 or 7 times earnings, we really are paying 8 or 9, that ends up feeling like we've built in a pretty good margin of safety.
So, what do you say about the behavioral biases, how do you test, how do you push yourself through, what if we're wildly wrong? That is a big part of our culture. And I think it's hugely important.
Benz: So, Chris, you referenced energy at the top of the conversation, and it seems like that's been a tough area for the funds. Apache had troubles. Ultra Petroleum was another misfire. So, I guess the question is, why don't you put energy in the too-hard pile and just say this industry isn't for us?
Davis: Christine, why didn't we talk a year ago? Well, I think the reason is, there's an interesting saying--it came from really my biggest mentor and a person I admire most outside of my own father and grandfather, which is Charlie Munger. And the comment he made is: you can get into a lot more trouble with a good premise than a bad premise. And sometimes, if you make a lot of money in an industry, you can confuse brains with a bull market. So, we had an approach to analyzing energy in the early 2000s that I think was very different than the typical energy analyst. And we really focused on reserves per share, right? A lot of companies, you know, if people focus on P/E or barrels in the ground I mean, people have strange metrics when they look at energy. But we really thought about how many barrels of oil are we getting per share. And then, we focused on incremental returns on capital. The company produces a lot of oil, but then they sell that, and they've got to reinvest the proceeds that they get from selling it to replace the oil they just sold, or they will go out of business on average in seven years.
And so, we had this mindset. We found a small handful of companies in the early 2000s. Among them EOG and Devon Energy and we just made a killing. I mean, they were just… I mean, I think in EOG alone, we may have made for our clients over $1 billion. They were so successful at growing reserves per share; they had enormous capital discipline, return on capital discipline. So, I think, in a way, our early success in energy in that period made us sort of a little bit more confident than we should have been in this most recent period. And what I mean by that is we really focused on the idea, which is, I think, very plausible--that if we can have some high degree of conviction about what an incremental barrel of oil costs to produce, over time, the price of oil will approach that number. And if that number, let's say, is between $50 and $70, we should value our companies with oil in that range and then see what we're paying, recognizing that it can go out of that range for periods of time. But over time, in any commodity business, the price of that commodity will tend over time towards the cost of producing that last incremental barrel and that last incremental ounce and so on.
So, so far, so good--a good framework. And I think what has happened in energy is when we stress-tested those scenarios, our focus came completely in shale companies that had very low incremental cost could produce. They were low-cost producers. And we would stress-test those things. And we would say, well, economic law would dictate that oil will on average trend somewhere between $50 and $70, but we'll stress-test it, and we'll take it down to $30. And of course, we don't need to stress-test the upside, that's all gravy. But we'll say, we think it will be between $50 and $70. But if it goes down to $30, we'll be OK. And of course, what happened in this scenario is, we had this lollapalooza in energy where of course you had the Saudi-Russia conflict coupled with plummeting demand, and those two things happening at the same time took oil down to $15. Well, of course, that was outside of where we were stress-testing. And so, companies where the balance sheets--most energy companies have some leverage. And of course, what happened though, when I talked in the beginning about high fixed costs and plummeting revenue? Well, if you have high fixed costs and plummeting revenue, you're going to lose a lot of money. If you're going to lose a lot of money, you either are depleting your cash account, or you're having to borrow. And so, of course, what happened was, it was so extreme that companies where we felt a high degree of conviction that their balance sheets were fine, have ended up in a situation where how they will finance themselves through this period can be more questionable.
Now, the companies that you mentioned, Apache, what was in Encana is now Ovinta, you know, we think that they will come through this. We think they have really great assets and that they're very cheap. But they are in that category of the first types of companies that I mentioned, where they are going to have to in likelihood draw down lines of credit, they're going to be closer to the brink than we would want to be. And the stock prices have sort of behaved accordingly.
But I think we had a good, what I would call, owner-earnings framework for energy. But it just seems that what keeps happening in the macro environment has been so outside of what we thought was plausible--even with a high degree of conviction--that we've sort of botched it all up. Now, as I say, I sort of liked them from here, but I'd put the much more in the speculative camp than I would what we see in the banks. And we went into this period with a very low weighting in energy, but it has net our energy investments have been dilutive to our returns for some period. And so, it's something we have to take a hard look at what are the lessons that we can learn from that and how do we do it better.
The trouble is, Christine, just to finish that quickly, the one trouble is, is that even the best energy companies over a long period of time are not such great businesses, because they just--the maintenance capital spending is so high and the maintenance capital spending tends to go up if the price of the commodity goes up. So, just when you're getting paid for the commodity, your replacement costs go up too. So, I would say that I can imagine a time when we would own zero energy. There have been times in our past when we've owned zero energy. We don't have any love. We just have felt that when we're able to buy companies that have really low-cost positions, we get sort of tempted in. And I think over time our discipline net has made money, but it hasn't in a long time and it's really hurt us in this recent period. So, even though it's a small weighting for us, it's going to factor importantly on our mistake wall.
Ptak: Wanted to shift if we can and talk a little bit about portfolio construction. I think that something an investor in the New York Venture Fund would notice is that over the past decade, the portfolio has gotten a bit more concentrated in terms of number of names. And also, you've bunched up a bit more than I think you have in the past in financials. I think that's always been a conviction area for you. But it's become even more pronounced, I would say, in recent years and correct me if I'm wrong on any of that. And so, maybe if you were to explain to the layperson why the portfolio has evolved in those ways, how would you describe that?
Davis: Well, we don't start with sort of a macro view and try to do some sector rotation or something like that. The weightings in the portfolio tend to be a byproduct of where we find the highest expected IRRs, right, and those IRRs are risk-adjusted. And every company we look at we look at through the lens of that internal rate of return over our holding period, assuming all of our return comes from the returns of the underlying business, right, as if we bought the whole thing. And it's easy to understand that if what we were buying was apartment buildings, because somebody would say, OK, well, you've paid $10 million for an apartment building and it's generating $1 million of income. And if somebody came along and said, “I'll give you $5 million for it.” You wouldn't say, “Oh, my God, I've just lost half my wealth.” Right? You'd say, “Well, I'm not selling it for $5 million.” You would say, “My return that I'm earning on that is 10%. Even if I can't sell it for $10 million today, my earning is 10%.” And obviously, if that $1 million of income on that apartment building grows to $2 million over time, you'd say, “Well, now I'm earning 20% on what I paid for it.” And we view our businesses exactly like that. All of our analysis is based on the cash the business produces relative to the price we paid.
It's interesting, I just did something, Jeff, that I don't quite have it in a format yet where I can really share it, but we're working on it, which is, we looked at I think the top 20 companies in our portfolio. Now, some of those we've owned for three years, two years, some we've owned for five, some we've owned for seven, 10, 15, 20, and some more than 20 years. And then we said, OK, let's put all of those businesses on this graph based on the day we bought them, what was the earnings yield? What was, in a sense, going back to that apartment analogy, we paid $10 million, it was earning $500,000; it would be a starting earnings yield of 5%. And then, let's track that company over our holding period. And what you see is, when you put all those on one graph is you see a lot of noise, but it's sloping up and to the right. And the longer out you go, on average, the higher the earnings yield is, so that when you're out in year 10, that earnings yield might be 12%, 13%, 14%, 15%. When you're out in year 15, 20, we have yields on a number of them that are 30%. So, in essence, it's as if you paid $10 million for that building and now it's producing $3 million a year of income.
So, when we build the portfolio, that is what we're thinking. So, what that means is that there are companies you could buy like, let's say, Wells Fargo, where you would say, well, it looks like we're getting a 12% earnings yield out of the gate. But we don't expect it to grow very fast. And that produces, if it didn't grow at all, of course, our IRR would be 12%. Now, we might instead say, well, we're going to buy a business like Google. And Google, when we buy it, the earnings yield might only have been 5% or 4%. So, think of that as a 25 P/E, right? So, we're only making 4%. But the great thing is, they are able to grow that earnings yield without having to invest a lot of capital, so that now Google might be up to an 8% earnings yield for us or 9% and still growing fast. Amazon, of course, when we bought it had very little in reported earnings, although it actually was generating quite a bit of free cash flow, which we think is actually more important. But now, of course, relative to our cost is probably earning 20% or 25% a year.
So, we build the portfolio that way. And what we've found over time, in terms of concentration, is what we found is that although we've been in a world where the averages have done great in terms of stock performance, when you look through it, the underlying businesses, we're seeing fewer and fewer businesses that have the combination of characteristics that we love: really strong balance sheets, a period of deleveraging, earnings, decent returns on incremental capital, capital allocation discipline, and so on. And what we've seen is a lot of sectors of the market have performed great, but we look at the business and we say, holy crap, this looks terrible. The dividend darlings is the best example I can think of. These consumer companies that are trading at 18 to 22 times earnings, on average they've increased their net debt 40% or 50% in the last five or six years; their revenue is barely growing, maybe 2% or 3%; and net of acquisitions is not really growing at all. But they've traded at these high multiples because they pay a 3.5% dividend. They've never cut the dividend. Well, I think a lot of them are going to cut the dividends. We saw it at Anheuser-Busch or Kraft or whatever, and now they've had more leverage, but we think that the writing is on the wall.
So, we've chosen not to own big sections of the market, because when we look through it, the companies, we just say, we know the stocks have performed great, but it sure looks like the businesses have gotten a lot riskier. So, the number of companies that we feel have this combination of a great business but a low valuation, good management, we just feel there are fewer and fewer. So, we've had sort of a gradual concentration, and the more the market has gone up, the more we've become more and more selective. And when you put that together, the amazing thing is, in New York Venture Fund today, we have, let's say, 48 holdings, the S&P, let's say, 500. So, basically, that means we've rejected nine out of 10 companies we looked at. And yet, if you looked at the five-year growth of our companies in EPS, it's been like 20% or 21% versus 17% for the S&P. So, they've grown faster, and yet, they trade at a 25% discounted P/E.
So, we think that ability to be selective and define those few companies where you have this durable growth and are undervalued, that's sort of the sweet spot. That's a value investor's dream, because usually, you have to buy the cigar butts. But we've felt like that – the companies that we talked about, the United Technologies, some of the financials, some of these sort of blue chips of tomorrow, even the Googles and Facebooks, they got tarnished with all the concerns around the hearings and the monopolies and so on, and they got knocked way down. We haven't bought them every day. But we've had opportunities to buy those at really attractive valuations over the last seven years or eight years, and we have.
And now, I would say, going back to the very early question I think Christine asked, or maybe you did, Jeff, about this environment, I would say, we've been in an environment now where probably those companies have been relatively performed so much better than the financials and the industrials that we've actually been trimming some of them in this environment. So, that's how the portfolio has gotten relatively more concentrated, but also in terms of number of names, but also relatively more eclectic in terms of where we're finding the opportunities. To have a huge holding in Wells Fargo and a huge holding in Google is a pretty unusual portfolio, but it's not based on a sort of macro thematic bet; it's based on where we see the best earnings yield unfolding over time.
Ptak: Berkshire is a top holding in a number of your portfolios. So, I'm curious to get your perspective as a longtime Buffett and Munger watcher, whether you're surprised that they have not acquired something amid the recent turmoil?
Davis: Well, of course, we're always excited for them to put cash to work. And Berkshire is one of the few companies where whatever your estimate of intrinsic value of Berkshire is, it should go up when there's turmoil in the markets. So, we would expect when you have tumultuous capital markets, that Berkshire would be increasing the returns that they get on their liquidity. And so, we haven't seen anything big happen yet. That doesn't mean that they haven't gotten close to the goal line on some things or that some things aren't in the works. I have no idea. But yeah, I would have said that, if this environment--I think the market going down and snapping back is not perfect for them. They would probably rather the cheaper the better and the more chaos, the better. So, we'll have to see.
But Berkshire, the company has held up well. It's unquestionably more valuable when there's blood in the streets. I haven't seen them do anything of size. I haven't heard of them doing anything of size. But I would bet a large sum of money that they have been aggressively working in this period to try to do something. And so, we'll have to see when it's all over where they do. When they bought Burlington Northern, the market dropped 30% after they bought it, if I remember right. I'm sort of doing that from memory. It didn't look like it was the smartest thing ever. But, of course, it ended up to be a wonderful purchase. So, we've got a lot of conviction that those are the right hands to have a lot of $120 billion of cash in those hands in this environment. And I would guess that they have been actively pursuing all sorts of things, but they haven't been able to get anything over the goal line yet.
Ptak: Well, Chris, this has been great. We really, really appreciate your time and insights today. Thank you so much for sharing your perspectives with our listeners. We've enjoyed having you on The Long View.
Davis: Oh, well, thank you, Jeff. Thank you, Christine. I'm really glad to be here and have a chance to speak with you.
Benz: Thanks so much, Chris.
Davis: All right. Thanks, guys.
Ptak: Thanks again.
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Benz: You can follow us on Twitter @Christine_Benz.
Ptak: And at @Syouth1, which is, S-Y-O-U-T-H and the number 1.
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