Q&A with Chris Davis & Ken Charles Feinberg 2006

Sub-advisors to the Masters’ Select Equity and Focused Opportunities Funds

The opinions and conclusions expressed herein are those of Litman/Gregory Fund Advisors, LLC and Chris Davis & Ken Feinberg at the time the material is written and may not be reflective of current conditions.

Christopher C. Davis and Kenneth Charles Feinberg are the co-portfolio managers for the segment of the Fund’s assets managed by Davis Selected Advisers, L.P. (“Davis Advisers”). Davis joined Davis Advisers in 1989, and began his tenure as a portfolio-manager of the Davis New York Venture Fund in 1995. Before joining Davis Advisers, Davis was an associate at Tanaka Capital Management. Feinberg joined the firm in 1994 and was named co-manager of the Davis New York Venture Fund in 1998. Their investment approached has been strongly influenced by working closely with veteran investor Shelby Davis.

What first attracted you to the investment business?

Chris Davis: My family has been investing in the stock market for three generations so I grew up around the investment business. Dinner discussions with my father were often about the power of compounding – for instance, whether it would be better to have $1,000 or a penny that doubled every day for a month — and Friday evening’s family activity was watching "Wall Street Week" together. Later, in our college years, my father paid my siblings and me for each research report we wrote on companies. So I guess we were exposed to the discipline of researching businesses early on. However, what drove me to pursue investment management as a career is the same fact that led my grandfather, who was an extraordinarily successful investor, to call money management “the best game in town,” namely, you get to study success stories day in and day out. Spending time studying the decisions of bright, entrepreneurial people running highly successful business models is something I am very passionate about.

Ken Feinberg: Investing was a longstanding personal interest for me before I made it my profession. Like Chris, I love studying successful people and businesses, and I believe you have to love what you do in order to be really good at it so this was the right calling for me. We have the opportunity to meet some of the smartest people in their industries, whether that be the Sandlers at Golden West Financial, Peter Lewis and Glenn Renwick at Progressive and especially Charlie Munger and Warren Buffett at Berkshire Hathaway, and that is very exciting.

How did your investment philosophy develop?

Chris Davis: My investment philosophy was strongly influenced by my grandfather and my father. My grandfather taught me to think about stocks like businesses, meaning people, capital and ideas. He spent a lot of time sizing up managements, a process he described as separating the “doers” from the “bluffers.” I think the notion that management can make an enormous difference for shareholders in the long run remains central to our approach today.

My father then taught me the importance of quantifying the data and thinking independently of the consensus view. His courage to invest based on the strength of his own convictions and firsthand research – rather than following the herd mentality or mimicking the index – really shaped the way we approach the research process at our firm. We try to do rigorous work, look at the facts independently of Wall Street and the media, and then “quantify, quantify, quantify” in my father’s words to know what constitutes good value in the market.

Outside of my family, I think all long-term investors have been blessed by being able to study Warren Buffett and Charlie Munger. They combine enormous intellectual capacity with humility and absolute clarity of thought, and they are so open about educating others in their annual reports and during the Berkshire annual meetings which we have attended for years.

Ken Feinberg: Warren Buffett and Charlie Munger have been great teachers. One of the things that Buffett has emphasized over the years is the importance of finding businesses with sustainable competitive advantages and I agree with him 100% on that point. He has also talked about knowing your circles of competence, meaning the types of businesses you can understand well enough to develop an edge. As a general rule, I believe you are always better off focusing on businesses you really know well.

Chris’s father, Shelby, also taught me a lot. I was fortunate enough to work closely with Shelby for three or four years and that left a strong imprint. Among other things, he taught me to think critically about management and the difference that great management can make in the long run. Shelby used to say that you never really knew how far a great CEO could take a business. He also stressed the importance of thinking about how a business might perform in the future, especially under new and improved management, rather than just focusing on the past which seems to be the prevailing tendency on Wall Street.

These individuals have been important influences for me in other ways than shaping my investment philosophy. They are also great role models, conducting themselves with the highest integrity and acting as true stewards of capital. After all, this business is not just about making money. It is really about being a good steward of other people’s capital, helping them save for retirement, putting kids through college, etc. At our firm, we take that responsibility very seriously.

Can you briefly discuss the key elements of your stock picking discipline?

Chris Davis: We look at stocks as businesses. Therefore, investing should boil down to two questions: What kind of businesses do we want to own? Then, how much should we pay for them? The first question really describes our research process of identifying companies with high returns on capital, sustainable competitive advantages and capable, honest management. We pore over SEC filings, annual reports, proxy statements and pretty much any information we can get our hands on. Then, we arrange meetings with senior management and, if possible, other layers of management as well. We do a lot of work on the competitive landscape. In fact, for every company that ultimately makes it into the portfolio, it is safe to say there are usually at least three or four others that we have researched thoroughly and deliberately chosen not to own.

Ken Feinberg: That brings us to the second question which is “How much should we pay for a business?” We think having a clear method for valuing businesses — and one that is independent of the market’s pricing — is important for making portfolio decisions that add value over the index. So many factors can figure into a stock’s price in the short run, some of which have nothing to do with the long-term fundamentals of the underlying business and a lot to do with investor psychology instead. Ben Graham used to say that the market is like a voting machine in the short run but a weighing machine — measuring earnings and free cash flow — in the long run.

Our valuation approach is based on a concept called owner earnings, which is essentially the amount of free cash that a sole proprietor could take out of a business at the end of a year after spending what was needed to maintain current levels of output and competitive positioning. Arriving at that figure typically involves extensive adjustments to the reported financials of any business we look at. We adjust our earnings estimates for hidden costs such as employee stock options, the mismatch between depreciation and true maintenance capital spending, and fictitious earnings that derive from unrealistic pension assumptions.

We divide owner earnings by enterprise value which, in its simplest form, consists of a company’s equity market cap plus net debt, to arrive at the owner earnings yield. That is essentially the “going-in” yield that we would earn if we bought the business outright and assumed (or satisfied) all of that business’s outstanding debt obligations. We like to buy stocks when the owner earnings yield provides a reasonable margin of safety over the prevailing risk-free rate (e.g., the 10-year Treasury yield). Then, we try to make some educated guesses about future return on capital and the growth possibilities for the company. That gives us a range of fair value that is useful in guiding our buy and sell decisions. Naturally, we try to buy when companies are trading at the low end or below the range of fair value and to sell when companies trade meaningfully above the range.

What factors have been most important to your success?

Chris Davis: I think that as an organization, a lot of our success is a direct result of the culture we have worked to create over the years. We have a culture of admitting and learning from mistakes. The market is a dynamic, evolving place and we believe it takes constant learning and improving to stay ahead. We also pride ourselves on maintaining a research focus and nothing focuses the mind like having your own money on the line. My family, our employees and directors have more than $2 billion invested in the mutual funds we manage, so we are aligned with clients. Just as important, that is a powerful motivator for us always to be thorough in our work, to watch our investments closely and to think critically about what risks we are willing to take.

Ken Feinberg: I would just add something that Chris’s father, Shelby, really helped me to appreciate, which is that successful investing is a lot of work and takes relentless perseverance. There are no short cuts to truly understanding a business. Shelby used to say that if you read 10 annual reports, maybe you come away with one unique insight. Reading 20 annual reports might give you two unique insights. And so on and so forth. The point is, you have to be willing to do the work and pursue the facts to their conclusion and that takes more than skill – it takes passion. To wake up each day with a sense of excitement that a mountain of annual reports and proxy statements await you at the office or to look forward to meetings or calls with company managements requires that you love this sort of activity. Finally, I think having a very competitive nature where you are intent on doing well for your investors and beating the market consistently is critical. You have to want to win.

How do you and your team work together and how do the research efforts of the team contribute to the portfolio you run for Masters’ Select?

Chris Davis: At the end of the day, Ken and I are responsible for all portfolio decisions. Together we decide when to buy, how to weight individual positions, and when to sell. However, in terms of the research that goes into each name, Ken and I are analysts first and foremost and work closely with the other members of our team in a very collaborative fashion. We have intentionally structured our group of twelve researchers to include both “vertical” expertise, referring to individuals who possess a deep knowledge of particular industries, and “horizontal” expertise, meaning individuals who bring a functional skill set to the process that can be applied across the portfolio. For example, while our consumer and retail analyst studies the front-end, “merchandising” aspects of Home Depot, another analyst on the team who has developed an expertise in distribution models might study the company’s supply chain and logistics. Ken and I work with the analyst team getting to know companies and their managements so that when an opportunity arises, we have followed the company ourselves for a while and have the conviction to invest.

As you and your team research companies, what are the most important sources of information?

Ken Feinberg: We find lots of information in publicly available documents such as 10-Ks and 10-Qs, annual reports and proxy statements, especially in the footnotes. Then, meetings with management are invaluable because they can give you a sense of the capital allocation discipline, integrity, drive and strategic thinking of the people you are entrusting to run your business. Management meetings, especially with the CFO, are also useful because you can ask questions to determine whether the company’s financial statements are generally conservative or aggressively stated. We also try to “walk around a business” by speaking with knowledgeable third parties such as customers, suppliers, vendors, etc. Finding out that a business’ customers derive real value from its products or services is often a sign, for instance, of a “virtuous circle” business, meaning one that improves the lives of its users which leads to greater and greater use and greater and greater success. Financial statements may provide clues about this sort of thing, but it is no substitute in my opinion for meeting firsthand with management and “kicking the tires” so to speak.

How does running a very concentrated portfolio that is part of a diversified fund differ from running a more broadly diversified portfolio? How do you choose the 8 to 15 stocks you hold for Masters’ Select from your more diversified portfolios?

Chris Davis: Left to our own devices, we tend to favor concentration and enjoy running focused portfolios which draw from among our highest conviction investment ideas. Generally speaking, we think our highest conviction names should outperform our other holdings over time. What is admirable about the way Masters’ Select was conceived is that it preserves the focus that comes with a “best ideas” approach but offers it in a diversified format by aggregating multiple manager “sleeves.”

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