Chris Davis on Trust: The Investor’s Ultimate Superpower

Dave Nadig, President and Director of Research at ETF.com, had a chance to sit down with Chris Davis, Portfolio Manager at Davis ETFs at Future Proof Citywide. The two talked trust, the value of building long-term investment relationships, why curiosity matters as an active manager, and more. The following is a transcript of their conversation. 

"Trust Is a Superpower"

Nadig: Ladies and gentlemen, thank you very much for joining us here at the ETF beach House, our inaugural one. I'm sure we're going to be doing this again given the response we've got already. I want to thank Chris Davis and Davis for joining us, along with the other sponsors, without whom we literally would not be here. F/m and Pictet in particular, coming in with Davis sort of top line sponsors here for what we're doing. 

I have the unbelievable privilege of spending the next couple of hours having conversations with people I actually want to have conversations with. And we're going to kick things off with Chris Davis from Davis Advisors.

And I'm not going to let him talk much about Davis Advisors. I'm going to tell you, $30 billion, long family history legacy, billions of dollars of co-investing from their own family, old school, high conviction, business ownership mentality, which I'm sure you'll hear more about if you go over and hear Chris later on the main stage.

I want to talk to Chris about something different because we've known each other a while. We live in a really trustless world right now. You're in the business of going and talking to companies — with people, with employees — to try to get the truth out of them so that you can decide whether you, and the billions of dollars behind you, want to become owners of those businesses. 

That sounds archaic. That sounds very antiquated, and it doesn't sound like it works in this kind of trustless world we're in. How do you think about trust as a long term business owner?

Davis: Well, you know, trust, trust is a superpower. I mean, it is amazing, you know; I’m on the board of Berkshire and, you know, you make deals on a handshake because of the amount of trust. And it's hugely efficient. But think about your clients and our investment practice, right. So, when we invest we meet with the managements of the companies we invest in because they're allocating the capital of our clients.

And we have to trust them. We have to trust that they're not going to create some sort of heads-I-win-tails-you-lose compensation plan, that they aren't going to just get bigger for the sake of being bigger, that they have a stewardship gene. That's so that's as investors. 

Now, you think as an advisor, what is your proposition to your clients? It's that they can trust you with their life savings, right? And the strange thing to me is this missing middle step that when advisors allocate capital, especially in the ETF space, there's been this view that trust doesn't really matter. Now, partly they think about sponsors. And a lot of that's been because it's been passive.

But as you begin to consider active management, trust matters enormously because you're going to go through periods of underperformance on a path to long term alpha. There’ll be volatility. And trust is what builds conviction and allows you to stay invested, or even up that investment when there are those inevitable sort of short periods, short term periods in the doldrums.

Nadig: But there's a there's a flip side to that, which is that if you approach investing as a mechanical business that doesn't have people in it and doesn't involve relationships, then it's very easy to say, “Well, I'm going to sell this and buy that.” Because they are just numbers and letters on the screen. When you go out and you work with a company for 20 years and you get to know management and you get to have conversations with people making the real decisions, doesn't that actually make it harder to say, “Well, golly, I know we've had a 15 year investment relationship, but your industry’s screwed.”

Davis: Well, it depends on the nature of the sell. I mean, the first thing I'd say is our goal with every investment we make is to be in the top decile of independent knowledge about that company. So how on earth you can do that and not interview management and get to know the number two, number three, number four people? Look down in the layers, visit the companies, understand the business. So I don't understand how people could expect to have an edge without that being part. But now you get to the south side. Now that's a little tricky because there are really two important reasons to sell. It's like you got to know when to walk away, know when to run.

So you know the run is that something dramatic has changed. And in that case it could be a huge M&A deal. It could be, you know, a litigation out of left field or some malfeasance there. Our relationship often will help us understand if this is temporary or permanent, but we have no trouble running away when facts have been misrepresented.

The more common one is that the business has done so well that the stock has gone from fairly valued to overvalued. Right? We see that a lot in the tech space today. There, I find it's an easy conversation with the manager, because what we tend to do is say, “We love you. We are waiting in the wings to come back, but even you have to admit this is a little nuts.” 

And it is amazing when you have that long relationship, you don't burn that bridge by simply saying, I'm going to step aside.

Harnessing Volatility as an Active Manager

Nadig: Are there examples that you can think of, of companies that you've gotten out of and back into exactly that?

Davis: Oh, absolutely. And in fact, it is amazing how often our outperformance over time has not been driven by our initial purchase. It's been by the ability to add and take advantage of volatility. We've been in a funny low vol world for a long time. Everything's sort of up and to the right. We are moving into a time of greater volatility. That really favors active management.

So I mean, if I was to pick a great example, Applied Materials. Applied Materials is a company that I first visited in 1991. We've known every CEO. We admired the company. It's a semiconductor capital equipment company. But you know it—this last summer it was trading at a third of the price it was trading at today.

So we were able to buy and build that position. And as we said to the CEO recently, “We don't, we didn't want it to triple so fast.” That, we actually don't want that. We'd rather have our return be driven by the long term return of the business.

Nadig: But importantly, I think you bristle a little bit when people say you're a value manager because you don't just wait around for something to be cheap.

Davis: Yeah. Well, this is, you know, if you really think about it, value manager is a redundancy, right? If management isn't about present value, what is it? I guess it could be momentum. But momentum seems crazy. There's no asset on Earth that the future return is higher because you paid a higher price. Right. Price is a determinant of your return.

The same asset bought at a higher price reduces future return. So valuation has to be part of it. I think where we fall in the middle is a little bit that unlike traditional value guys, we really think of the quality of the business, right? Because we're long term investors and businesses that grow are more valuable than businesses that don't grow.

So we look at growth as a component of value, but we are very different than the growth of managers because we're—I won't say cynical, we're not, but we're skeptical. Maintaining high growth rates is really hard. You know, less than 10% of the S&P 500 has been able to maintain earnings growth above 10% for a decade, and fewer than one half of 1% has been able to maintain margins above 50%.

And yet, I looked at all these tech companies and SaaS companies where analysts were modeling both those assumptions ten, 20% growth on the top line and 50% margins. That is not the way capitalism usually works.

The Value of Owning Mistakes

Nadig: All right. I want to shift here a little bit. We've talked earlier about like, there's a different conversation that happens when your first crash was ‘87. That you've been through it a few times. That means you failed plenty of times. You have lost lots of money because that's how markets work.

Yet you've built this multi-generational team that still shows up to work every day when one of your funds has a bad day, right when you get a call wrong. “We bought one of our 25 high conviction positions. It's a stinker.” How do you deal with that with your team? Because that's just demoralizing it. We live in a world where people are very quick to point fingers and fire people.

Davis: No, I mean, we're in a probabilistic world, right? If you're playing blackjack and you have a 19 and you ask for a hit and get a two, you made a mistake. You got lucky, but you were an idiot. Right? And so we have lots of investments where we look and we write them up so that we know was it good process? Because we're going to get bad outcomes.

Warren Buffett once told me he would bet me $1 billion on a coin toss if I gave him 2 to 1 odds. Now, what that meant is he was willing to take a 50% chance of losing 100% of his investment, so he had to size it, right. He said a billion. He said, I wouldn't bet you ten because I need to be able to make that bet a lot. 

So the way we build that into our culture is that Danton, my partner and I, lead our mistake review. So we have a wall in our research department with the framed stock certificates of our biggest mistakes. And each one has a plaque on the bottom, which is what's the transferable lesson learned? Because the market is an adaptive system and organizations that don't admit their mistakes don't learn from them, and they stagnate.

They become these stubborn, one trick, backward looking ponies, and they get killed when the cycle changes. Being able to adapt from what worked in the ‘70s to what worked in the ‘80s, what worked in the ‘80s to what worked in the ‘90s. I mean, that's one of the huge advantages is that it's a requirement is the ability to adapt.

And you say, my first bear market was ‘87, my first was ‘73-4 I was a kid, but my dad was running the business and I know what it felt like. He had a copy of the Wall Street Journal that showed the Dow Jones Industrial Average, and the graph was completely down and to the right, and he had spray painted over it, “Screw the Dow Jones”.

So I have a very vivid memory, and I think people forget that's more like ‘08-’09. Those are real bear markets. ‘87 was a one and done quick.

Nadig: So that's an institutional learning. 

Davis: Absolutely. 

Nadig: How do you transmit that to younger folks? Because you know, I think somewhat famously not everybody in your firm has gray hair. Yeah. And you're keeping a team growing and alive in a world where all we read in the papers is “AI is going to take all these early analyst jobs. If you're doing any kind of knowledge work and you're 25, you're screwed.” How are you thinking about how AI changes sort of the bottom of the food chain, if you will?

Davis: Yeah, well, you need to create a culture of trust. You need to look at where AI is a magnifier of talent. And in our business, it really is because we can get answers to so much. I just did a little study on Kodak just for fun. You know, in 2000, Kodak had there had been 10 million digital cameras sold. That means there was 10 million people that knew film was dead because it was so much better.

You know, drive to the photo shop, drop off your photos, wait two days, find out your kids eyes were closed. I mean, digital was so much—10 million people knew it. And yet Kodak was still in the top third of the S&P 500. 

And so at a time of turmoil, this is where active can really add the judgment matters. Because looking back, every model wouldn't have predicted that you had to have judgment around that call. So that a real focus in our place around AI is this is a tool to amplify judgment. It provides data to how— it is not a tool to pick stocks, and you're going to get killed if you use it for that. Because it'll work for a while, but then everybody will gather on. There's an old saying in Las Vegas, “We send limos for guys with systems.”

Remember, the market is a parimutuel betting system. In other words, buying the one that's going to win is not the best strategy if it's priced for that, right? So it's really this idea of judgment. When is the past going to be discontinuous? That is the value of active management. And that's what we sort of focus people on. Use these tools to amplify judgment, not to replace it.

The Right Mindset Matters Most

Nadig: What do you do with young folks that enter your firm? Like what is the training program?

Davis: Oh my God. I have to say, I am a little bit horrified by what we put them through. We we used to try lateral hires. That doesn't work. We really want to grow our own. So the number one characteristic we're looking for is just ravenous curiosity, right? It's so much. I study science a lot in science institutions and research institutions.

And, you know, I used to run Bell Labs once said, “So much of science advances because someone's curious enough to get a result and say, ‘huh, that's strange.’ And they start pulling that thread.” So that's but I will give you a real case in point. One awful thing we do, and I'm going to say don't tell this to them, but, is about the—once everybody's going through all the barrage of interviews, we bring them in in the morning. We put them in a closed office with no access to the internet, and we give them three abridged 10-k's for the same company that cover about an eight year period.

And we're pretty sure it's a company they've never looked at. I won't say what industry it's in, but it's a boring industry. And what we do is we say, “We're going to leave you in here for four hours. When we come, when we come back, we want to sit around a table and just talk about it. Talk about what you've learned, talk about what you think about it. We know you've never looked at it.” 

And I opened that door four hours later, and I immediately know this person aced every interview. They used all the active verbs. You know, they were engaged, but you opened that door and they're beaten dogs. They just. But you open it and somebody's like, “I have no idea what's happening, but I can't, I don't understand why depreciation changed here. Or look at this footnote about the pension plan. I don't know anything about pension counting, but that's weird. Or what happened here that all of a sudden equity got changed so much in one year.”

Now we know what happened because we all did it as a team. Each individual on our team did this same test, wrote up our answer key. And so we're not looking for the right answers. We're looking for the right mindset.

Nadig: But I love that you're not asking for an artifact, right? I mean, so much of our conversation about knowledge work, which investing is, has become this discussion of where is the human being in the creation of the artifact, and the artifact here is actual knowledge.

Davis: Yeah, absolutely. And and so, you know, we've got a team with an average tenure of 25 years of industry experience, 20 years working together. And yet we have people on the team that have been there for five years, and we have interns just starting now. And so it's a long, slow process. But the important thing is we're trying to build a place to last because people are trusting us with savings.

That's why I don't understand firms that are owned by private equity. Like they've got a different strategy. I don't understand investing with managers that don't own invest in their own funds. We would never own a company where the CEO didn't own shares in their stock. We don't understand why when people look at active, they focus on the firm, not the managers. Who are the managers who are making those decisions?

What's their incentive? What's their tenure? If they're good, do they go out? And so all those sorts of things we want to offer the clients the same thing that we look for in the companies we invest in: trust, alignment, conviction, long term orientation.

Cooperation, Trust, and Optimism

Nadig: All right, I love it. We only have three minutes. I really wanted to make sure I got this last question, because I actually just want the answer. Look, we're about to do a panel in ten minutes on institutional decay, where we're talking about all the things going wrong in the world and all the things we can't trust anymore.

Outside of your firm, your family, your process, your immediate circle, when you look at the other things, we have to look at—companies, the SEC, governments, media, all of the other actors in our world—who do you actually trust right now?

Davis: Well, it's what I'd say is I trust human beings, right? As a group, they can be very mistrust, you know, untrustworthy. But the great superpower that has allowed us to separate from the Neanderthals, that allowed us to survive was cooperation. And cooperation was built by trust, right? If you are you.

And that's why we have these psychological tendencies that are so strong, like reciprocity, right? Somebody does something for you. You feel, “Oh, God, I gotta do that. They had me for dinner. I gotta have them for dinner. They borrowed my lawnmower.” You know, reciprocity. So I think we are an amazing species based on the superpower of trust and cooperation.

We're great at not dying and improving the quality of our species. People live longer, people starve less. One of the great advantages of growing up in the ‘70s was that we still had nuclear bomb shelters, and we had a bear market. We had stagflation. We had the Iran hostage crisis. It was a terrifying time.

And it's just amazing to think that that feels like ancient history. We're great at muddling through, but what I would say is the more you look at the news, the more you look at the macro. Look down at your neighborhood and look how people really behave. And that optimism, I think, is necessary for investing.

So I'll end it there.

Nadig: Well, thanks so much, Chris.

Davis: Thank you so much.

Nadig: What a pleasure to be here.

To learn more about Davis ETFs, go here.