Success Under Stress

When the markets get tough, the tough go shopping. That's what Selected American Shares co-managers Chris Davis and Ken Feinberg are doing.

At Morningstar, we've long been fans of Selected American. Davis and Feinberg are in their forties, so they've seen a couple of brutal markets. But they have wisdom beyond those years.

Chris is the third generation of the Davis family to manage money, and he learned quite a few lessons from his father and grandfather. Davis and Feinberg are also big fans of Warren Buffett and Charlie Munger of Berkshire Hathaway. They try to put their lessons to use in times like these.

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Quality counts. I talked with Davis soon after the books were closed on a dismal first quarter, in which the swoon by Bear Stearns highlighted another awful stretch for financial stocks. Yet despite Selected's hefty financials stake (nearly a third of assets), the fund is currently ahead of Standard & Poor's 500-stock index for 2008 because Davis and Feinberg are in some of the healthiest financials. What's more, they own a pretty diverse group, from Progressive to Wells Fargo to Berkshire Hathaway.

In a downturn such as this one, the two fund managers like to double-check that their investments are on track and tap the knowledge of those who have seen more bear markets. They visited important companies that were already big holdings in the fund, such as Wells Fargo, Hewlett-Packard, Cisco Systems, JPMorgan and Merrill Lynch. They also visited some of the best investors around, beginning with Chris's dad, Shelby Davis, a legendary Wall Street figure who preceded Chris at Selected American.

They then turned their attention to upgrading the quality of Selected American's portfolio by putting more money behind its strongest holdings and trimming holdings they have less confidence in. This is something they have done in past selloffs, notably in 2002. That year, Davis snapped up some blue chips he hadn't been able to buy cheaply enough for years -- stocks such as AIG, Microsoft and Berkshire Hathaway.

This time out, Davis and Feinberg are adding to positions in steady growers with heavy overseas revenues -- for instance, Johnson & Johnson. Among financials, they are adding more of AIG (symbol AIG) and Bank of New York Mellon (BK).

Holding shares of Progressive (PGR) even as the stock declined illustrates Davis and Feinberg's approach with disappointing stocks. Rather than run for the hills, they take the time to do a thorough review. If the stock is still trading for much less than their estimate of its worth, they'll stick around or even buy more. In mid April they gave GE a closer look after it reported weak earnings.

Another move within financials illustrates Davis's view of the potential for profits in controversial stocks. Davis believes that a wide gulf has developed between investment banks and some insurers -- which have to "mark to market" their holdings (essentially, the firms' holdings must reflect their fair market value at any given point in time) -- compared with some commercial and regional banks, which don't have to mark loans to market. Thus, most of the bad news may have already been written off by insurers and investment banks. So Davis is buying some controversial investment banks, such as Merrill Lynch (MER), and selling some commercial banks.

Think twice. I suggest that you adopt a similar mind-set. Treat downturns as buying opportunities and take the time to evaluate your holdings thoroughly so that you aren't acting out of fear. Fund investors can employ a version of this strategy by selling higher-cost, poorly managed funds and adding lower-cost, proven standouts, such as Selected American Shares (SLASX) or one of the other 160 Morningstar Fund Analyst Picks or Kiplinger 25 funds.

Columnist Russel Kinnel is director of mutual fund research for Morningstar and editor of its monthly FundInvestor newsletter.