3 Lessons From A Stock That Was Held By 3 Legendary Investors - 01 Jul 2020
The three legendary investors I’m talking about here are Warren Buffett, Benjamin Graham, and Shelby Davis.
Buffett is perhaps the most well-known investor in the world today, so he does not need an introduction. Meanwhile, his late mentor, Benjamin Graham, is revered as the father of the discipline of value investing. The last investor, Davis, is less known. In a recent article for the personal investing blog that Jeremy and I run, The Greatest Investor You’ve Never Heard Of, I introduced him this way:
“I first learnt about Shelby Cullom Davis sometime in 2012 or 2013. Since then, I’ve realised that he’s seldom mentioned when people talk about the greatest investors. This is a pity, because I think he deserves a spot on the podium alongside the often-mentioned giants such as Warren Buffett, Benjamin Graham, Charlie Munger, and Peter Lynch.
Davis’s story is well-chronicled by John Rothchild in the book, The Davis Dynasty. Davis started his investing career in the US with US$50,000 in 1947. When he passed away in 1994, this sum had ballooned to US$900 million. In a span of 47 years, Davis managed to grow his wealth at a stunning rate of 23% annually by investing in stocks.”
The stock mentioned in the title of this article is GEICO, an auto insurance company that was fully acquired by Buffett’s investment conglomerate, Berkshire Hathaway, in 1995. In 1976, Buffett, Graham, and Davis all owned GEICO’s shares.
The GEICO link
Back in 1975, GEICO was in serious trouble due to then-CEO Ralph Peck’s decision to relax the company’s criteria for offering insurance policies. GEICO’s share price reached a high of US$61 in 1972, but by 1976, the share price had collapsed to US$2. The auto insurer lost US$126 million in 1975 and by 1976, the company had ousted Peck and was teetering on the edge of bankruptcy. Davis and Graham both had invested capital in GEICO way before the problems started and had suffered significant paper losses at the peak of GEICO’s troubles.
After Jack Byrne became the new CEO of GEICO in 1976, he approached Buffett to come up with a rescue plan. Peck promised Buffett that GEICO would reinstate stringent rules for offering insurance policies. Buffett recognised the temporal nature of GEICO’s troubles – if Byrne stayed true to his promise. Soon, Buffett started to invest millions in GEICO shares.
The rescue plan involved an offering of GEICO shares which would significantly dilute existing GEICO shareholders. Davis was offended by the offer and did not see how GEICO could ever return to profitability. He promptly sold his shares. It was a decision that Davis regretted till his passing in 1994. This was because Byrne stayed true to his promise and GEICO’s share price eventually rose from US$2 to US$300 before being fully acquired by Berkshire Hathaway.
The GEICO lessons
Davis’s GEICO story fascinated me, and it taught me three important lessons that I want to share.
First, even the best investors can make huge mistakes. Davis’s fortune was built largely through his long-term investments in shares of insurance companies. But he still made a mistake when assessing GEICO’s future, despite having intimate knowledge on the insurance industry. There are many investors who look at the sales made by high profile fund managers and think that they should copy the moves. But the fund managers – even the best ones – can get things wrong. We should come to our own conclusions about the investment merits of any company instead of blindly following authority.
Second, it pays to be an independent thinker. Davis stood by his view on GEICO’s future, even though Graham and Buffett thought otherwise. Davis turned out to be wrong on GEICO. But throughout his career, he prized independent critical thinking and stuck by his own guns.
Third, it is okay to make mistakes in individual ideas in a portfolio. Davis missed GEICO’s massive rebound. In fact, he lost a huge chunk of his investment in GEICO when he sold his shares. But he still earned a tremendous annual return of 23% for 47 years in his portfolio, which provided him and his family with a dynastic fortune. This goes to show that a portfolio can withstand huge mistakes and still be wildly successful if there’s a sound investment process in place. In The Greatest Investor You’ve Never Heard Of, I wrote:
“The secret of Davis’s success is that he started investing with a sound process. He was an admirer of Benjamin Graham, Buffett’s revered investing mentor. Just like Graham, Davis subscribed to the discipline of “value investing”, where investors look at stocks as part-ownership of businesses, and sought to invest in stocks that are selling for less than their true economic worth. Davis’s preference was to invest in growing and profitable companies that carried low price-to-earnings (P/E) ratios. He called his approach the ‘Davis Double Play’ – by investing in growing companies with low P/E ratios, he could benefit from both the growth in the company’s business as well as the expansion of the company’s P/E ratio in the future.
Davis also recognised the importance of having the right behaviour. He ignored market volatility and never gave in to excessive fear or euphoria. He took the long-term approach and stayed invested in his companies for years – even decades, as you’ll see later – through bull and bear markets. Davis’s experience shows that it is a person’s behaviour and investing process that matters in investing, not their age.”
Breaking the rules
There’s actually a bonus lesson I want to share regarding GEICO. This time, it does not involve Davis, but instead, Graham. In Graham’s seminal investing text, The Intelligent Investor, he wrote (emphases are mine):
“We know very well two partners [Graham was referring to himself and his business partner, Jerome Newman] who spent a good part of their lives handling their own and other people’s funds on Wall Street. Some hard experience taught them it was better to be safe and careful rather than to try to make all the money in the world. They established a rather unique approach to security operations, which combined good profit possibilities with sound values. They avoided anything that appeared overpriced and were rather too quick to dispose of issues that had advanced to levels they deemed no longer attractive. Their portfolio was always well diversified, with more than a hundred different issues represented. In this way they did quite well through many years of ups and downs in the general market; they averaged about 20% per annum on the several millions of capital they had accepted for management, and their clients were well pleased with the results.
In the year [1948] in which the first edition of this book appeared an opportunity was offered to the partners’ fund to purchase a half-interest in a growing enterprise [referring to GEICO]. For some reason the industry did not have Wall Street appeal at the time and the deal had been turned down by quite a few important houses. But the pair was impressed by the company’s possibilities; what was decisive for them was that the price was moderate in relation to current earnings and asset value. The partners went ahead with the acquisition, amounting in dollars to about one-fifth of their fund. They became closely identified with the new business interest, which prospered.
In fact it did so well that the price of its shares advanced to two hundred times or more the price paid for the half-interest.The advance far outstripped the actual growth in profits, and almost from the start the quotation appeared much too high in terms of the partners’ own investment standards. But since they regarded the company as a sort of “family business,” they continued to maintain a substantial ownership of the shares despite the spectacular price rise. A large number of participants in their funds did the same, and they became millionaires through their holding in this one enterprise, plus later-organized affiliates. Ironically enough, the aggregate of profits accruing from this single investment decision far exceeded the sum of all the others realized through 20 years of wide-ranging operations in the partners’ specialized fields, involving much investigation, endless pondering, and countless individual decisions.”
Graham’s investment in GEICO broke all his usual investing rules. When there was usually diversification, he sank 20% of his fund’s capital into GEICO shares. When he usually wanted to buy shares with really cheap valuations, GEICO was bought at a price “much too high in terms of the partners’ own investment standards.” When he usually sold his shares after they appreciated somewhat in price, he held onto GEICO’s shares for an unusually long time and made an unusually huge gain. So the fourth lesson in this article, the bonus, is that we need to know our investing rules well – but we also need to know when to break them.
