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Stock Market Lessons From Legendary Small Cap Investors

InvestorEducation / Learning to Invest Mar 22, 2010 - 07:58 PM GMT

By: Joseph_Dancy

InvestorEducation

Best Financial Markets Analysis ArticleIt has been said that Shelby Davis was one of the best investors the public has never heard of—unlike the well known Warren Buffett and Charlie Munger of Berkshire Hathaway fame.


Davis grew an investment of $50,000 in 1947 to roughly $900 million on his death in 1994. Like Buffett he favored stocks in the insurance industry. Davis had little money management experience before starting his portfolio and active management activities (actually, stocks were considered a very risky asset class in the 1940’s, not suitable for most individuals or institutions).

A book on his life and investment philosophy entitled “The Davis Dynasty” was published a few years ago. Davis acknowledged he was lucky to start his investment activity when the market was at the start of a long bull run, making it easier to perform well.

Investment Strategy.  Like Buffett and Munger, Davis focused on very small companies due to the mis-valuations and inefficiencies present in that sector of the market. He also concentrated his portfolio on a very small subset of firms he considered excellent businesses (around 30 companies). For the most part these firms had little analyst or institutional coverage. Davis was one of the few that followed many of the companies in his portfolio.

Not a trader, Davis held the stocks for the longer term and benefited as the firms grew in size and profitability. He also invested in a sector he knew well (the insurance sector) - a sector that generally was not in favor. He conducted extensive due diligence on the firms he bought, and was also very thrifty keeping his investment related expenses at a minimum. Davis also lived well below his means and was know for his frugal nature. These strategies also served Warren Buffett and Charlie Munger well.

Volatility & Investment Returns.  An interesting fact about the Davis portfolio is that in the bear market of 1973 to 1975 his $50 million portfolio shrunk to $20 million—a loss of roughly 60%. But after 1975 the $20 million in his portfolio grew very quickly—the stocks of small firms performed very well coming out of the economic decline, as has generally been the case historically. Stock prices of larger firms recovered after 1975, but not to  the extent of the small, illiquid firms.

Davis bought very aggressively as firms became grossly undervalued in 1975 and the economy began to recover from the steep recession. He noted that “a down market lets you buy more share 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.” Over the next 19 years the $20 million portfolio grew to $900 million.

Charles Munger, Co-Chairman of Berkshire Hathaway, also was running an actively managed portfolio in the 1973-1975 time frame. In a book on his investing activities entitled “Damn Right” it indicated he also ran a concentrated portfolio of small, illiquid firms, investing for the longer term in companies not covered by analysts or followed by institutions.

Like Davis, Munger’s portfolio was down in the 1973-75 recession—by roughly 60% from the portfolio highs seen in 1972. Like the Davis portfolio the Munger portfolio recovered after the recession quite well as the small company, inefficient and illiquid sector of the market, outperformed as the economy began to grow – and his portfolio gained 73% in 1975.

By the time of the 1973-75 recession Buffett had liquidated his investment partnership. His investors had the option of rolling their money into the stock of Berkshire Hathaway—but even the stock of Berkshire Hathaway fell by 50% during the downturn (keep in mind the company was a microcap at the time).

Lessons of the 1973-1974 Recession. Note several things about the Davis, Buffett, and Munger’s experience during the 1973-1975 downturn. First, no matter how good the business prospects of companies in the portfolios, or the quality of management at Berkshire Hathaway, stock prices were depressed with the general market. Like the recent bear market, statistically all the portfolios and stock prices of public companies correlated closely with the general market trend—which was down.

All of their portfolios (or in Buffett’s case the stock price of Berkshire Hathaway) were very volatile. All focused on investing in small companies that were illiquid but growing. All the managers ran a concentrated portfolio, with a few stocks they knew well (Buffett of course by this time concentrated all the assets into one company, Berkshire Hathaway, which could buy assets or stocks of other firms).

The portfolios, and Berkshire stock price, declined in value by a substantial amount in the 1973-75 bear market—over 50%, correlating closely with the market. These great stock pickers and portfolio managers and their investors did not avoid the massive bear market. As the economy recovered after 1975 the performance of all the managers was very good—a reflection of their focus on firms in the inefficient small and micro-cap sector of the market.

Economic data indicates the current recession is as severe, if not more so, than the 1973-75 period. Alan Greenspan in recent comments has noted in many respects the current economic downturn is worse than the Great Depression. In our opinion the micro-cap sector is as ignored today as it was back in 1973, and the inefficiencies are just as large.

While the losses have been significant in this downturn, in our opinion opportunities exist for investors that are as attractive as those in 1975. If history repeats small firms, like the ones that Davis, Munger and Buffett focused on, should substantially outperform as the economy begins to recover.

The tools available to find small, attractive firms, are much more powerful than those available to Davis, Munger and Buffett. Buffett and Davis spent hours searching for attractive companies in the S&P stock guides. The factors they found attractive—growth, valuation, size, market niche—can be screened for using computers and electronic databases today.

The pool of small public companies available to invest in is also much larger today than thirty-five years ago, and SEC reporting requirements are in many ways more rigorous resulting in more information available on which to base investment decisions. 

Looking Forward. Many investors have not been pleased with the recent performance of their portfolios or the market in general. But if an investor employs the same strategies that served Mr. Davis, Buffett, and Munger so well they may perform nicely going forward, even though the current economy and market conditions may not be as attractive as in previous periods.

Even during the sharp 1973-1975 recession all of these successful investors: (1) focused on very small companies, (2) ran concentrated portfolios, (3) looked for companies with niche markets, (4) focused on the longer term, (5) were not afraid to buy illiquid stocks, (6) looked for firms with growth potential and (7) the ability to generate attractive margins, (8) bought at reasonable valuations, (9) managed a limited amount of assets so they could take advantage of the small company niche, (10) tolerated above-average portfolio volatility, and (11) bought firms that they understood (12) only after conducting extensive due diligence.

Each of these investors outperformed the major market indexes over time.

By Joseph Dancy,
Adjunct Professor: Oil & Gas Law, SMU School of Law
Advisor, LSGI Market Letter

http://www.lsgifund.com

Email: jdancy@REMOVEsmu.edu

Copyright © 2010 Joseph Dancy - All Rights Reserved

Joseph R. Dancy, is manager of the LSGI Technology Venture Fund LP, a private mutual fund for SEC accredited investors formed to focus on the most inefficient part of the equity market. The goal of the LSGI Fund is to utilize applied financial theory to substantially outperform all the major market indexes over time.

He is a Trustee on the Michigan Tech Foundation, and is on the Finance Committee which oversees the management of that institutions endowment funds. He is also employed as an Adjunct Professor of Law by Southern Methodist University School of Law in Dallas, Texas, teaching Oil & Gas Law, Oil & Gas Environmental Law, and Environmental Law, and coaches ice hockey in the Junior Dallas Stars organization.

He has a B.S. in Metallurgical Engineering from Michigan Technological University, a MBA from the University of Michigan, and a J.D. from Oklahoma City University School of Law. Oklahoma City University named him and his wife as Distinguished Alumni.

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