The time to make money is in a bear market

By Larissa Fernand
Morningstar India
May 13, 2016
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Imagine this scenario.

A hungry teenager asks his grandfather for a dollar so that he can buy a hot dog from a street vendor.

This is how the patriarch responds:

“Do you realise that if you invest that dollar wisely, it will double every five years? By the time you reach my age, in 50 years, your dollar will be worth $1,024. Are you so hungry you need to eat a $1,000 hot dog?”

It’s true. Shelby Davis did say that to his grandson.

Shelby who?

Shelby Cullom Davis, one of the great investors the world has ever known. A peer of Warren Buffett, but not at all a household name. In his time, he was rich as sin (one of Forbes’ 400 wealthiest individuals). He also was frugality personified. He saved old shoes with tape and glue. When his family hounded him for a swimming pool, he agreed if they dug it themselves. He did not like to waste paper and often wrote on the back of envelopes and scraps of paper which were tossed away.

(He might have been frugal but not ungenerous. He gave away millions to charity and at one time demanded that his daughter Diana give up her $3.8 million trust fund to a charity of his choice. Not surprisingly, a battle ensued).

In 1947, when in his late thirties, he took $50,000 from his wife Kathryn (daughter of a wealthy carpet mogul) and invested it in stocks. But not any stock. He was focused on a rather unloved sector – insurers. Not too unusual when you realise that he had a deep knowledge of the workings of insurance companies having worked in that industry. To his credit, he saw much more than met the eye.

Most insurers were selling well below book value. Dividends were large and kept coming. While life insurance policies were selling rapidly, policyholders were not kicking the bucket. Moreover, the insurance float (the money collected from premiums that has not been paid out as claims) is valuable. This large pool of money sits on the balance sheet as a liability. But it can be invested in stocks, bonds, and other securities, and hence generate cash for the insurer.

So Davis ignored all other sectors and staked out the least popular spot. He was bang on.

Between 1947 and 1949 the Dow Jones Industrial Average fell 24%, while Davis’ portfolio of 7 insurance stocks more than quadrupled in value. By the mid-1950s, his net worth had soared. His stake in insurance companies was worth $1.6 million, so Kathryn’s original $50,000 had multiplied 32 fold.

Life insurers grew their earnings at a rapid pace. In 1950, insurance companies sold for 4x earnings; 10 years later, they sold for 15x to 20x earnings and their earnings had quadrupled.

In the book The Davis Dynasty, a fictitious example is provided to drive home this point. Let’s say Davis acquired 1,000 shares of Insurance USA for $4,000 when the company earned $1 a share. He holds on until the company earns $8 a share and a crowd of camp followers pounce on the opportunity. What he’d bought for four times $1, they bought for 18 times $8. His $4,000 was now worth $144,000. In terms of profit, he made 36 times his initial outlay, plus dividends.

Davis called this lucrative transformation the “Davis Double Play,” an initial boost from earnings and another from investors bidding up the multiple.

A 1957 report explained his thought process regarding insurance stocks:

The present opportunity in life insurance stocks stems from three factors: (1) They are desirable long-term growth investments. (2) They are attractively priced at 10-12 times estimated 1956 adjusted earnings. (3) They have undergone a price correction for 18 months which has carried many issues as much as 30% to 40% below their highs. Yet earnings this year will be at an all-time high and the fundamentals on which earnings rest (sales, improved mortality, high interest rates) appear favorable for the foreseeable future. The present opportunity exists largely because of market congestion.

But he was not blind to what he picked. He picked undervalued stocks but ensured they were quality insurers by focusing on fundamentals and a solid balance sheet.

He travelled extensively to meet with the management and quiz them on recent results and plans for the future. He acknowledged that good management is key to a successful business and face-to-face meetings helped him separate the “bluffers from the doers”. If a company made a prediction about its long-term profit growth but was vague on how it planned to achieve it, that immediately raised a red flag.

He once told his grandson that the first lesson of investing is to ask as many questions as you can and listen carefully to the answers. The key is to learn as much as possible about the companies in whose stock you have invested. He evaluated the vision, character and goals of the company’s management. It was always the “long view rather than the short view” that gave him conviction.

One of his favourite questions was: If you had one silver bullet to shoot a competitor, which competitor would you shoot? He would then make it a point to research that stock. After all, “a company that was feared by its rivals must be doing something right”.

Despite all the legwork, he still ensured that he was sufficiently diversified so that unpleasant surprises were outnumbered by the pleasant ones. For instance, the Korean War and its aftermath produced an outburst of reckless driving. Coupled with an inflationary outbreak, it became more expensive to fix cars and settle accident claims. Thanks to carefree underwriting, a reputable auto insurer got caught in a double whammy and landed in bankruptcy court.

But it was not just low valuations of high quality insurers that helped him make money. It was leverage too. In fact, by 1959, he was riding on $8 million in leverage.

Since he had a seat on the New York Stock Exchange, he had access to lower margin rates and could buy more shares on margin because the regulator – the SEC, gave firms more leeway to borrow money than it gave individuals. He utilized the maximum allowable amount of margin (slightly over 50%). The interest payments on his margin were tax deductible (another savings). He did not leverage himself by 5x or 10x. He used a sensible amount of leverage that did not drastically increase his risk, yet significantly increased his returns.

(Buying on margin is the purchase of an asset by paying the margin – the down payment - and borrowing the balance from a bank or broker).

One of Shelby’s winning traits was that he did not dart in and out of his favourite insurers. He hung onto many of his largest investments through his entire investment career. One stock he probably regretted exiting was GEICO. Here’s how

Value Walk described the entire saga.

Davis started buying GEICO when the company reported its first loss in 36 years. A combination of overexpansion, inflation, federal price controls, bad risks and questionable accounting had floored GEICO. An aggressive turnaround plan resulted in 3,000 layoffs, the company withdrawing from markets with overbearing regulatory regimes, hiking rates by as much as 40% in some regions and tightening its insurance criteria.

When these measures failed to shore up GEICO’s balance sheet, the management persuaded 27 competing insurance companies to contribute capital to help avert a bankruptcy. Eventually $75 million in convertible preferred stock was issued. Disappointed with the capital raising, Davis sold out of GEICO. Buffett stepped in and continued buying consistently till Berkshire eventually purchased GEICO.

Although he deviated somewhat from insurance companies over his lifetime, his most successful investments were still in that industry.

He once profoundly said: "Out of crisis comes opportunity. You make most of your money in a bear market. You just don't know it at the time."

He should know. Between 1973 and 1975, his $50 million portfolio shrunk to $20 million. But when the market rebounded, so did his portfolio. Once again, during the stock market crash of 1987, he went on a shopping spree.

From 1947 to his death in 1994, he turned $50,000 into $900 million.

This article was also published in Morningstar on 13, May , 2016