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.
As of Dec. 31, 2004, the fund’s five largest sectors represented less than 50% of assets. They included real estate (20.4%), financial services (12.3%), electronics (6.0%), energy (5.4%), and environmental, waste, and cleaning services (4.6%). Among its 46 holdings, the five largest were SL Green Realty (SLG) (5.0% of assets), Lehman Brothers Holdings, Conv. Notes, 0.25%, 82/3/11 144A convertible into Devon Energy (4.6%); American Express, Conv. Notes, 1.85%, 12/1/33 144A (4.1%); Waste Connections Inc. Conv. Sub. Notes Floater, 2.66%, 5/1/22; and Vornado Realty Trust (VNO) , 3.2%. The fund holds some real estate common stocks without the offsetting bonds. These stocks are similar to convertible bonds in their risk characteristics and yield orientation, Davis noted.
Asked how he manages risk within the fund, Voss quoted a former business school professor whose advice was: “Watch everything.” Davis added, “The principal way in which we manage risk is by having a very thorough underwriting process whereby we talk to management, look at the business, [and] how it has performed over five years.” In addition, the fund cannot put more than 5% of assets in any single company.
The fund avoids convertibles that don’t fit into the 80/50 rule, which are usually those with big premiums. Voss said they tend to stay away from “ugly” businesses, such as airlines and steel companies, while favoring financial services, some areas of technology, power, and real estate. The co-managers don’t shy away from companies whose shares are trading below intrinsic value, but they don’t purchase distressed debt intending to turn around (or liquidate) a failing company. “We will not buy something simply because it’s dirt cheap,” Davis said. “That kind of investing can get you in a lot of trouble.”
Once the co-managers do buy securities, they rarely sell; and they generally don’t convert them to stock unless called by the issuer. Davis observed that they are more likely to “add and trim” in order to satisfy the 80/50 rule, rather than to buy and sell. The fund’s 33.4% turnover rate, as of February 28, 2005, includes forced conversions. “It’s probably been four years since we’ve sold out of a position entirely,” Voss noted, recalling the fund’s exit from its Six Flags (PKS) holdings in 2001-02.
From its inception in 1992, the fund was called Davis Convertible Securities Fund. But in March 2001, the SEC implemented Rule 35d-1, a regulation concerning investment company names that would have required the fund to keep 80% of its assets in convertibles. “We would be forced to hold convertibles just to meet that mandate, not to the benefit of our shareholders who are trying to achieve or realize our investment strategy,” Voss explained. The fund’s board agreed to change the fund’s name in order to maintain its convertible holdings at 65%, and the co-managers began adding straight debt to their portfolio of common stock and convertible bonds.
The quality of new convertibles was another incentive to change. “The new-issue convertible market was just not providing us with the opportunities to maintain our 80/50 strategy,” Voss said. “They’re great for the CFOs but they’re not so good for the investors of the business,” Davis said. Both men point to hedge funds, with their appetite for convertible securities, as the culprit. “They’re looking for cheap volatility — they’re trying to hedge out,” Davis said. “And that’s not a game that Jason and I like to play. We’re much more long-term investor-oriented.” The co-managers say they haven’t purchased a new-issue convertible in several years. “It’s been long enough that we can’t remember,” Voss said.
“What is a convertible?” Davis asked rhetorically. “In the simplest terms, it’s a bond and an option to own stock or a warrant to own the stock….[W]e argue that if we own IBM bonds, and IBM stock — if we look at that position as one position, that’s pretty much a convertible.”
Contact Bob Keane with questions or comments at: [email protected].