Instead, Davis suggests that long-term investors should root for more volatility and shouldn’t try to predict when these corrections will occur.
“I think we forget that volatility and corrections are the norm. They are an unpleasant but regular part of the landscape. On an average, you could expect a 5% correction every 51 trading days. You could expect a 20% correction every 630 trading days. So, the most important thing is not to try to predict when these corrections will occur, but rather to recognise that of course they will occur,” he says in an interview to a financial website.
According to Davis, when pullbacks and corrections do occur, media overreacts which leads to panic among investors.
He says investors should welcome these corrections because when volatility occurs, active management is expected to shine more, and add extra value to their portfolio.
Davis is the portfolio manager at Davis Advisors and he only invests in his most high-conviction ideas. There are only a very few businesses that meet his stringent investment criteria.
“Although we’ve been in a world where the averages have done great in terms of stock performance, when you look through at the underlying businesses, we’re seeing fewer and fewer businesses that have the combination of characteristics that we love,” he says.
Davis looks for characteristics like strong balance sheets, a period of de-leveraging, earnings growth, solid returns on capital, and wise capital allocation discipline before making an investment decision.
Davis invests in durable, well-managed businesses that can be purchased at value prices and held for the long term. The holding period of a stock in his fund is four to seven years.
Davis focuses primarily on financial services companies and looks to buy companies when they are out of favor.
How to manage risk
Davis says when investors think about risks, the first thing to recognise is that for most investors, risk really boils down to the loss of purchasing power over time, or a lower quality of life.
“It isn’t necessarily about volatility, which has a disastrous effect on investor behavior. When prices go down, the wiring in people is not to invest more, it’s often to invest less. When prices go up, people get more excited. That is an old story and one of the most important risks out there,” he says.
According to Davis, the best world for investors is one in which they feel that markets are risky.
“People say that stock went from $45 to $30, it must be very risky and this is where you should invert it. There’s a simple truth: Lower prices may help increase future returns and decrease risk,” he says.
Davis says long-term investors should be rooting for more volatility and look for that 20% correction that is far overdue and is a normal part of the landscape.
Davis says in order to amass spectacular returns, investors need to find wide-moat businesses with room for margin expansion and earnings growth when average companies may be facing falling margins because of higher labor costs, higher raw material costs and higher interest costs
How investors can navigate market volatility
Davis says while common sense dictates that buying stocks when prices are low is better than buying when prices are high, investors often do the opposite.
“Falling prices make investors fearful and soaring prices make them greedy,” he says.
According to Davis healthy investor behavior means being disciplined, patient and unemotional which requires having the temperament and discipline to invest especially when prices are low.
He says, in contrast, unhealthy investor behavior typically leads to selling during periods of great pessimism and buying at the top of bubbles.
“Such emotional decisions can wipe out years of gains achieved through compounding,” he adds.
Davis reveals three specific lessons that investors can keep in mind while investing:
1. Ignore short-term market and economic forecasts
Davis says investors often rely on interest rate forecasts and stock market predictions despite overwhelming evidence that these have little or no value in predicting stock price moves.
“To build long-term wealth, investors must disregard such forecasts,” he says.
2. Do not try to time the market
Davis says investors should not chase the latest hot-performing investment category or asset class and should avoid timing the market.
“Again and again we see investors flock to managers and strategies that have recently done the best, only to be disappointed when those same managers go through the periods of underperformance that so often follow such hot streaks,” he says.
3. Invest systematically
Davis says investors who want the growth potential of equities but may be too concerned about a market correction should consider investing in a systematic investment plan.
He says systematic investing involves investing money in equal amounts at regular intervals, regardless of the market environment
According to Davis a systematic investment strategy has three key benefits:
• It removes the emotion that can adversely affect the timing of investment decisions.
• It means investors automatically purchase more shares during periods of uncertainty when prices are low and fewer shares during periods of euphoria when prices are high.
• It capitalizes on market volatility because more shares are automatically purchased at lower prices when the market drops.
Biggest contributors to long-term outperformance
Davis says the three biggest drivers of long-term outperformance are perspective, discipline and alignment with investors.
According to Davis in terms of perspective, investors should never forget stocks represent ownership interests in real underlying businesses.
“As a result, we focus steadfastly on the durability and long-term growth of the businesses we own rather than their fluctuating stock prices. If we are right about the business fundamentals, then time and the power of compounding will work to our advantage in building wealth over the long term,” he says.
Davis says regarding discipline, investors should recognize the growth of the underlying business can be amplified if the business is bought at a bargain price.
“As a result, a strong valuation discipline is a central tenet of our investment philosophy. This discipline also serves to reduce risk by providing a “margin of safety” in our purchase price as a buffer against inherent uncertainties and gives us the staying power to weather occasional but inevitable economic storms,” he says.
Davis says in terms of alignment, investors in addition to thinking about the upside potential of any investment, should also think about the downside.
“As fellow investors, we are also motivated to maintain a relentless focus on research and results while avoiding the conflicts that can arise when portfolio managers invest their own money differently than their clients’ money,” he says.
Key mistakes investors should avoid
Davis says the most common reason investors fail to achieve satisfactory results over the long term has more to do with temperament than ability.
“Quite simply, people often want to do today what they wish they had done five years ago. Time and again investors choose to buy after prices have gone up and to sell after prices have gone down. Investors often want to purchase funds and asset classes that have strong performance in recent periods and sell funds and asset classes that have lagged. Such behavior reflects emotion rather than rationality,” he says.
Davis says investors should not be optimistic or pessimistic but realistic, taking into account the key important and knowable factors, both positive and negative, that can affect their returns over time.
Best vehicles for compounding wealth
According to Davis, durable businesses run by able and honest managers with strong competitive moats, reasonably attainable growth prospects and high returns on capital are the best vehicles for compounding wealth, provided they are purchased in a disciplined fashion and held for the long term.
“Moving in and out of stocks, funds, investment styles, or asset classes based on what has already gone up or down generally results in unsatisfactory long-term returns,” he says.
(Disclaimer: This article is based on various interviews, columns and speeches of Chris Davis)
