This article about Shelby Davis Senior was written by deep value investor Evan Bleker. Article image by Alan O'Rourke, edited from the original.
You may not believe this but I once invested in Starbucks.
By any account, the company had been an enormous success. The company had been growing its store base very quickly over the previous decade and both revenue and net profit were up enormously over the period.
The firm’s products were exceptional, as the company’s international success showed. Despite some blowback in Italy and protest over its store in the Forbidden City, Beijing, the company forged a strong presence in Japan and was continuing to open a lot of stores throughout Asia.
Management were top rated, highly capable, and honest. What’s more, they were fiscally conservative, maintaining a strong balance sheet, and owned large blocks of shares personally.
In fact, as 2006 drew to a close, the only objection a possible investor could have was the price. At $18.75 (post split), shares were trading at a PE of 53x. You could hardly call the stock cheap.
As most investors applauded management and eagerly lapped up more shares, by chance disappointed with the recent share buyback well above fair value, I quietly made my exit.
Two years later Starbucks shares traded down to $4.50. What went wrong?
Slowing growth, for one. Given the company’s mass of stores, it was becoming harder and harder for the company to keep growing at the same pace as it had in its younger years. When growth slowed, investors re-evaluated the company’s prospects, and began dumping the shares in early 2007, before The Great Financial Crisis.
Who Was Shelby Davis Senior?
Shelby Davis (Senior) wouldn’t have bought Starbucks. He wouldn’t have even looked at the company.
Shelby Davis was a Growth at a Reasonable Price (GARP) investor who started his career in the 1940s and built one of the largest fortunes of any investor, ever. By the 1980s, he had made the Forbes list of riches people, eventually amassing a fortune of around $1 billion USD.
While he specialized in insurance companies, he would of appreciated Starbucks’ great performance. But, GARP investing means buying growth companies for prices more on par with the general market valuation or less.
Starbucks was far from reasonably priced, so investors who were buying in at the start of 2006 were setting themselves up for very disappointing performance. So long as they held on rather than sold out after the drop, it would have taken them 6 years to regain the money they lost, and had only earned a CAGR of 12% by 2017.
Starbucks is a brilliant company but great companies do not always make for great investments. Here, investors would have earned a 0% return over 6 years if they bought at a ridiculous price.
Shelby Davis (Junior) Learns The Hard Way
One of the big problems that Shelby Davis (Junior) learned when he was first starting out as a professional investor was the despair that results from buying a high priced growth stock -- a lesson his father should have taught him. No company grows rapidly indefinitely, no matter the hype. But, investors are often attracted to growth companies so bid prices up to extreme levels. When fast growers slow, shareholders re-evaluate the value of the firm and are not willing to pay such a high multiple of earnings.
|Rapid Grower A||2014||2015||2016||2017||2018|
Our Rapid Grower A model shows what happens when a highly priced growth stock starts to see its growth slow. Here, growth slows from 30% to 15% in year 2018, causing investors to reassess the firm’s prospects. Since investors had been paying up for tomorrow’s rapid growth, the stock craters. An investor in 2014 comes out with a tiny return, but an investor who bought in 2017 sees a massive loss.
Investors often buy rapid growers for a high price. When growth slows, investors are not willing to pay such a large multiple of earnings, causing the PE to contract and the share price to crash. If you buy at the wrong time, or the company does not continue its rapid growth for as long as you expect, you can suffer large losses. In the case of Rapid Grower A above, investors buying in 2017 would have faced a -48% share price decline.
Contrast this to buying a slower "stalwart" grower for a moderate price.
In our Stalwart A model, the firm grows at a steady 10% rate, just below a market PE ratio. When investors take notice in the final year, investors increase the amount they're willing to pay for the stock. The early investor benefits from both growth and PE expansion for a Shelby Davis Double Play.
A slow growth company often trades at a moderate PE but, when the investing public notices its consistency, their ears perk up, wallets open, and they’re willing to pay a bit more for the stock. In the case of Stalwart A above, investor recognition of stalwart growth caused the share price to surge from 2017 to 2018, as investors were willing to pay more in terms of a larger multiple for the stock.
Even if earnings growth stumbles, since investors had low expectations and weren’t banking on a lot of future growth, the PE does not contract to the same degree and investors do not experience the same sort of downside that rapid growth investors face.
In our Stalwart B model, the company grows steadily at 10% before seeing growth drop down to 5% from 2017 to 2018. Investor revalue the company down from 15 to 13x earnings. An investor still makes a small return, rather than losing money.
In the case of Stalwart B above, just as in the case of Rapid Grower A, earnings growth was cut in half. But, unlike investors who had bought the rapidly growing firm in 2017, investors who bought Stalwart B only lost -8.8%. And, while investors who bought Rapid Grower A earned a 13.85% return, those who bought Stalwart B came out with a 21.33% return. It pays to buy cheaper stocks, even if it means lower growth.
As a GARP investor, Shelby Davis (Senior) would be more interested in Stalwart A. Rather that paying up today for growth in the future, he aimed to buy firms with smaller PEs.
What Can Shelby Davis Senior Teach Deep Value Investors?
And this is where this discussion of growth fits in to a site dedicated to deep value investing. Some authors have dubbed Shelby Davis’ method “The Davis Double Play.” Take another look at Stalwart A. Here we have a growing firm priced at a PE of 15x. Over time, assuming growth continues, the investor gets the benefit of both the earnings growth and PE expansion -- hence the Shelby Davis Double Play.
The benefits of such an approach should be obvious -- they were to Shelby Davis. Buying a firm with a PE of 5x, that’s growing steadily at a 10% clip, would ultimately lead to a tremendous revaluation, at least back to an average market PE.
|Deep Value A||2014||2015||2016||2017||2018|
In our Deep Value A model, the firm grows steadily at 10% until its final year. Investors take notice 2 years after purchase and bid the price of the stock up to a market PE. Investors make a fortune with this Shelby Davis Double Play, a 426% return on their initial investment.
Take a look at Deep Value A. This discarded firm was either hated or ignored by investors who were busy chasing the Netflixes of the world. While not a fast grower, it kept chugging along with a 10% growth rate. Eventually investors caught on, and began bidding the price of the company’s shares up. In 2018, investors were willing to pay at least the market’s hypothetical PE. This resulted in a 426% return in just 4 years -- a compound average growth rate of 51.4%!
…from a company growing at just 10% per year!
How often do we stumble across these sorts of firms?
Not often, but they do turn up once or twice a year.
Creighton's Was A Fantastic Deep Value Shelby Davis Double Play
Creighton’s may be one of the best examples of this sort of investing. It was growing at a Rapid Grower A clip while trading for a Deep Value A price. Even better, it was a net net -- trading 1/3rd below liquidation value. The company had a rock solid balance sheet and had a CEO who owned a large chunk of the company.
While hit hard during The Great Financial Crisis, what drew me to the company, was management’s focus on optimizing its product offering, the fact that the company turned the corner in terms of regaining profitability, and the tiny PE ratio.
Creighton’s Plc, a British toiletry manufacturer, was one of the best growth stories of the mid-2010s, and was originally bought as a net net stock. The FTSE 250’s PE ratio was between 20 and 25x at the time of the hypothetical sale.
Unfortunately, at the time I was committed to selling my net net stocks right at NCAV, so was only able to earn ~100% on my investment. If I had of let the company grow and held on until investors bid the company back up to a market PE, I would have earned quite a lot more.
But, what would happen if the company’s growth slowed?
To answer that question, let’s revisit one of our earlier models. Stalwart B saw growth slow from 10% to 5% from 2017 to 2018. As a consequence, its share price was knocked back to $18.20, as investors were only willing to pay 13x earnings for the stock rather than the previous 15x. If Creighton’s growth slowed, the stock would have sank, but it was unlikely to sink as much as our Rapid Grower A model.
As a deep value investor, like Shelby Davis Senior, I love buying companies that are also trading below net tangible assets or net current asset value (NCAV). This provides me with an edge because when earnings growth slips, my shares are still undervalued based on another conservative metric, so I have another reason for my stock to rise. It’s like having both a belt and a pair of suspenders keeping your pants up.
In the case of Creighton’s, the stock was trading below book value per share until mid-2017, but began to leave the shelter of asset value later that year. It took another 10 or 11 months for the stock to reach a market PE.
Finding a growth stock that trades below net asset value is a great advantage. By contrast, PE only investors have to rely on earnings for valuation, since nothing else is grounding the value of their shares. When earnings sink, or disappear, so does the firm’s PE valuation and the basis for investment. If earnings never come back, investors could be out of luck.
As deep value investors, we already know the value of buying well below some form of asset value -- book value, NCAV, NTA… It does not take any earnings growth whatsoever for our firms to rise in price. Buyouts, liquidations, or a shift in investor sentiment can all play a role in helping our stocks reach fair value. In fact, if you bought an entire company, you could just start selling off company assets to recoup the value of your investment.
There are few more rewarding investments in the world of stock investing than a rapidly growing company trading below NCAV. Not only do you have a chance of earning an enormous return on your investment as both earnings and the PE ratio expands -- for a “Shelby Davis Double Play” -- your downside is also well protected. I’m sure Shelby Davis would agree.
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