by Frederik Vanhaverbeke
In the latest of a series of articles for Master Investor Magazine, Frederik Vanhaverbeke, author of Excess Returns: A comparative study of the methods of the world’s greatest investors, looks at how some of the world’s greatest investors are so successful.
You make most of your money in a bear market, you just don’t realize it at the time.
—-Shelby Davis
In the raft of top investors that are featured in my book Excess returns: a comparative study of the methods of the world’s greatest investors, Shelby Davis is somewhat of an outlier. To most people he definitely fits the picture of the market beater you never heard about. Undeservedly, though. Through disciplined investing Shelby Davis turned the $100,000 he started out with in the late 1940s into a fortune of $427 million by 1988. At that moment he entered the Forbes’ list of 400 richest Americans. By his death six year later, his fortune had grown to about $900 million.
In my previous articles (e.g., the one on Peter Lynch) I highlighted the importance of one’s “circle of competence.” Many top investors argue that one should invest in industries about which one has more expertise than the average investor, because then one competes with an edge in the market. Although the circle of competence of most top investors covers various industries, Shelby Davis is an example of a top investor who stuck mainly with one industry: insurance.
He had built considerable expertise in this industry and was fond of it. He reasoned that, unlike other industries (e.g., technology), insurance would always be needed. He also liked the fact that insurers don’t work with assets that can become obsolete (such as expensive factories or machinery). Finally, because financials are seldom trendy they often trade at cheap prices.
Shelby Davis
Despite it’s appeal Davis realised that insurance is a sluggish industry.
Indeed, Warren Buffett has repeatedly pointed out that competition in insurance is so intense that its return on equity is poor compared to that of the average industry. Knowing this, Shelby Davis was very selective in his choice of insurers. He invariably ignored the opinions of analysts, and always did his own due diligence on potential investments. He looked primarily for those insurers that distinguished themselves through low-cost operations. Therefore, he hated excessive corporate spending and was always on the lookout for signs of waste and frills (e.g., expensive furniture) when he visited companies. GEICO is an example of an insurer that Davis purchased in the 1970s (at about the same time that Warren Buffett and Benjamin Graham also took a stake in the business) because he was impressed with its rigorous cost focus.
Davis paid at least as much attention to the company’s management as to its financial statements. He realised that strong leadership is of the utmost importance with insurers. In managers he sought those that were smart, focused on detail about how they would achieve their financial goals, and had vision in the form of an aggressive and resourceful strategy. He preferred workaholics, and therefore always checked out the parking lot (to see whether all senior managers were present) when he arrived at a corporate headquarters. Because he was impressed with Warren Buffett as the CEO of Berkshire Hathaway, he added Berkshire to his portfolio. This became a permanent position that obviously contributed enormously to his returns.
In my previous article on John Templeton we saw that he made a lot of money in the Japanese stock market way before most other Americans even had Japan on their radar. Shelby Davis is another example of a contrarian investor who discovered Japan two decades before it became hot. In 1962, Davis visited a number of Japanese insurance companies and decided to buy them. Three of these insurance companies were still in his portfolio 30 years later and had made him rich beyond imagination.
Although Davis was primarily a contrarian value investor who tried to purchase stocks at a sizable discount to his estimate of fair value, he was slightly different from other top investors in some respects.
We already mentioned his unusually sharp focus on one particular industry (i.e., insurance). Another practice that is rather uncommon among top investors was his use of margin loans to increase returns. Furthermore, Shelby Davis once dabbled in day trading. But what he earned with this activity was dwarfed by the gains he made in his buy-and-hold insurance portfolio. This illustrates excellently that in investing the old saying applies: let the cobbler stick to his last! Davis was not the first market operator who was successful in one type of market approach but who failed in another. Jesse Livermore – the father of momentum trading – once tried investing, for example, but lost tons of money with it.
Shelby Davis embodies many of the traits and characteristics that we encounter in numerous other top investors. He was very successful by focusing on his circle of competence. He demonstrated that a superior and independent evaluation of the qualitative aspects of business and management in the sluggish insurance industry can lead to market-crushing returns. He was contrarian and looked for bargains in places that other people overlooked (e.g., Japan). And last but not least, he exhibited a high amount of patience. At the end of his investment career, it turned out that what had made him rich was holding on to a limited number of star performing stocks (Wyeth, Rauschenberg, Warhol, AIG, Berkshire Hathaway and three Japanese insurance stocks) over several decades.