Q: What kinds of risk do you monitor and what do you do to mitigate it?

A: This portfolio is designed around the concept of weighting the capital stack appropriately within ownership of each company and having the right balance of available securities. Equities, preferred stock, straight debt, convertible debt - these categories allow us to spread or mitigate risks.

Moreover, we adjust our expected return hurdles to match the perceived risk of the companies we are evaluating. We also try to “right-size” our gross exposures to issuers to reflect the risk that we see in the position and how that might relate to other portfolio holdings. We try to maintain a broadly diversified portfolio.

Reiterating what we’ve said earlier, underwriting the current value of a business and correctly assessing its growth potential remain the key to our process. The most important question we ask ourselves at the end of the day is what we are willing to pay to acquire a position in a company. There have been a number of instances where we have not been able to buy as much stock as we wanted because the stock rallied out of our price range. We rarely chase prices up. We are never so arrogant as to expect that we’ll be able to “bottom tick” a stock purchase; we fully expect that at some point during our holding period the stock will probably trade below where we first bought it and can add more to the position then.

Q: Could you illustrate your thinking with a historical example of a situation where you decided to reduce the overall size of a position in the portfolio?

A: Coca Cola is probably a good example. We bought that stock a year ago when it was around $48 dollars and we could model a conservative volume growth profile with a decent discount rate. We were in the 11.5% range for an expected return in our modeling process and had price targets somewhere above the $60 range.

Subsequently, Coke’s organic growth performance improved and market woes caused investors to value Coke’s relative predictability more dearly. So, when we revisited our valuation after adjusting volume growth rates and expectations going forward, we found essentially an implicit discount rate below 10%. We didn’t think that rate was justifiable in the face of other opportunities that we were seeing in the market. So we chose to reduce the overall size of that position. We sold some of the common stock as well as some of the bonds with which it was paired. This sale enabled us to rightsize our gross exposure and preserve our target risk profile. Importantly, this sale enabled us to reallocate capital to other better opportunities.

Q: What else do you think is important for our readers to understand about your investment style?

A: We are proud to be able to say that the largest group of investors in the Davis Appreciation and Income Fund is our family, our board of directors and the employees of our firm. Simply put, we eat our own cooking. We aren’t just managers, we are owners. We like the motivation that this produces. We reap the benefits of good performance and feel the pain of weak markets, just like every other shareholder.