April 8, 2005 — For Andrew Davis and Jason Voss, blending convertible bonds with common stocks and bonds is a recipe for appetizing returns.
The co-managers of the Davis Appreciation & Income Fund/A (RPFCX) seek to participate in market upswings while avoiding some of the downside. To do so, they purchase securities in mixtures that will capture 80% of the market’s rise, while reducing the risk of any decline by half.
This strategy, which they call the “80/50 rule,” has earned the fund a 4-Star ranking from Standard & Poor’s. For the one-year period ended February 28, the fund gained 8.8%, versus 3.6% for its peers, and 7.0% for the S&P 500-stock index. For the three- and five-year periods, it rose 11.9% and 4.4%, respectively, versus 8.6% and 1.7% for its peers, and 4.6% and -1.0% for the S&P 500.
While Standard & Poor’s categorizes the portfolio as a domestic taxable fixed-income fund based on its holdings, Davis Appreciation & Income has an equity orientation. “We think of this fund as being an equity-like product, and that’s how we manage it,” said Voss. Accordingly, the fund managers have selected the S&P 500 as their performance benchmark.
Reflecting the fund’s conservative bent, the portfolio has a low standard deviation relative to its peers. Tellingly, it lost -1.0%, -7.6%, and -1.2% during the technology bust years of 2000-02, while the S&P 500 fell -9.1%, -11.9%, and -22.9%, respectively. According to Standard & Poor’s holdings data, the portfolio had 54.19% in U.S. convertibles as of Sept. 30, 2004.
The fund follows the investment philosophy of other Davis family funds, described on the firm’s website as the Davis Research Methodology. However, the 80/50 rule distinguishes this fund from its brethren. By prospectus, it may hold common stocks of small, mid-, and large-cap companies; investment-grade and high-yield bonds; preferred stock; and convertibles.
“We’re looking for businesses that are extraordinarily well run by talented folks,” Voss said. “Those businesses have what we like to call ‘moats’ around them, meaning that their business model is sustainable over long periods of time, and will do well during various economic cycles.”
After identifying such businesses trading at reasonable prices, the co-managers consider the instruments available — be they convertible bonds, preferred stock, or a stock-and-bond combination. Davis explained that the latter mixture “mimics” convertible bonds, with stock providing an 80% potential upside and bonds offering the expected 50% protection.
Of the other factors that the co-managers consider, the most important is “owner earnings yield.” This ratio, a form of adjusted earnings defined as excess cash earnings over enterprise value, lets them compare the attractiveness of investments with the risk-free rate. “We do not focus on earnings per share or free cash flow,” Davis said. “We try to imagine as if we owned the entire business” — that is, how much cash would be left over after investing enough to keep the business competitive. Other considerations are degree of insider ownership, reinvestment of capital, transparent and consistent financial reporting, and level of off-balance-sheet liabilities.