Chris Davis’ Davis Funds 2013 Portfolio Managers Update
The chart below summarizes results through December 31, 2013 for Davis New York Venture Fund. As the Fund’s managers, my colleagues and I at Davis Advisors have two objectives: to earn a satisfactory absolute investment return and to generate relative results in excess of the S&P 500 (INDEXSP:.INX). In our view, the data in the chart below presents a mixed picture. Over virtually all periods, the Fund’s absolute returns have been satisfactory. In particular, a one year return of 35% and five year compounded annual return of 16% should be considered extraordinary.1 On a relative basis, we fell short of our goal in a number of these periods. Although both goals are important, if forced to choose between strong absolute returns in which we trailed the market or negative absolute returns in which we beat the market, we would far prefer the former. When people choose to invest rather than spend their hard earned money, their objective is generally to be able to afford something more in the future. For our shareholders, this might mean a child’s or grandchild’s education, a more comfortable retirement, a new house, or simply the peace of mind that comes from being prepared for life’s unexpected expenses. Thus, as stewards of shareholders’ savings, we always remember the wisdom of the old saying, “you can’t eat relative returns.” However, we aim to achieve both goals and unquestionably have ground to make up on a relative basis. The year 2013 was a good start but we have a ways to go.
The performance presented represents past performance and is not a guarantee of future results. Total return assumes reinvestment of dividends and capital gain distributions. Investment return and principal value will vary so that, when redeemed, an investor’s shares may be worth more or less than their original cost. The total annual operating expense ratio for Class A shares as of the most recent prospectus was 0.88%. The total annual operating expense ratio may vary in future years. Returns and expenses for other classes of shares will vary. Current performance may be higher or lower than the performance quoted.
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As always, our goal in preparing these reports is to provide the information we would want if our positions were reversed and we were investors in rather than the manager of Davis New York Venture Fund. At Davis Advisors, this mindset is not just theoretical but is grounded in the fact that we, our colleagues and our families have more than $2 billion of our own money invested alongside shareholders in the funds we manage.2 As a result, making decisions and communicating based on what best serves Fund shareholders is second nature to us.
With this perspective in mind, we would like to discuss two important topics in this report. First, we want to provide some perspective on our decision to ask my longtime colleague Danton Goei to join me as comanager of Davis New York Venture Fund. Second, we want to provide an update on the Portfolio as well as offer some insight into our conviction that the Portfolio is well positioned in today’s uncertain world both to generate long-term growth and to weather the inevitable storms and shocks that can occur any time.
This report includes candid statements and observations regarding investment strategies, individual securities, and economic and market conditions; however, there is no guarantee that these statements, opinions or forecasts will prove to be correct. Equity markets are volatile and an investor may lose money. Past performance is not a guarantee of future results. 1Class A shares without a sales charge.Past performance is not a guarantee of future results. 2As of December 31, 2013.
Our Investment Team
Starting with our investment team, in mid December last year we announced that after working together since 1998, Danton Goei would be joining me as comanager of Davis New York Venture Fund effective January 1, 2014. At the same time, we asked Ken Feinberg to step down. We thank Ken for his service and wish him the best.
As fellow investors, we made this decision because we believe it will lead to better investment results in the years ahead. In coming to this conclusion, we considered a number of factors, the most important of which is Danton’s proven investment ability. His research has been the foundation of many of our successful investments over the last 15 years in a range of different industries, including many of our current holdings.
As a member of our analyst team, Danton’s stock recommendations for our larger diversified funds, including Davis New York Venture and Selected American Shares, have meaningfully added to Fund returns.3 In fact, we have had such high regard for Danton’s contribution that we have singled him out more than any other individual in our shareholder commentaries over the years. His performance as one of our most influential contributors was another important consideration in our decision.
Beyond his talent as an investor, Danton also embodies the stewardship culture, research approach, investment philosophy, and valuation discipline of our firm. Given our focus on culture when evaluating potential investments, shareholders should not be surprised that culture played a role in this decision. On a personal level, Danton’s work ethic, modesty and humor make him a collegial as well as a capable partner that I look forward to working with in the years and decades ahead. In sum, as stewards of our clients’ savings, our responsibility is to field the best team we can. Danton’s results and character have earned him this place in our starting lineup.
3 This is not a solicitation for Selected American Shares.
Turning to the Portfolio, strong market returns over the last five years have divided investors into two camps. The first camp includes those who worry because stock prices have gone up so much the market must be due for a fall. These investors point out the S&P 500® Index now trades a bit above the highs of 2000 and 2007, both of which preceded a steep market decline. The second camp includes those who have been heartened by the price increases and are anxious to jump on the bandwagon for fear of missing out. These investors are quick to point out because the world seems far less risky than it did during the dark days of the financial crisis now is a better time to invest.
Although one of these camps will ultimately prove to be correct both their forecasts rest on the faulty assumption that short-term changes in stock prices are predictable when the overwhelming evidence suggests that they are not. For example, in the chart below, the tan line represents investment strategists’ average forecast for stock market returns in the following 12 months. The green line shows what actually happened. As far as we can tell, these lines are uncorrelated.
Beyond the folly of short-term market predictions, investors in both camps are making a second mistake by focusing on price rather than value. Because stocks represent ownership interests in real underlying businesses, discussing the price of a stock without reference to the value of the underlying business makes no sense. Bearing in mind the old saying “price is what you pay, value is what you get,” a closer look makes clear both the pessimists and the optimists are overlooking some important facts.
The pessimists who point out the market fell sharply in the years following the high prices reached in 2000 and 2007 are forgetting stocks purchased today are a much better value than those purchased in 2000 or in 2007 for the simple reason the underlying businesses are more profitable and less leveraged. To understand why this is important, imagine two hypothetical businesses for sale in your hometown. The first has a price of $1.5 million and generates annual earnings of $50,000 per year. The second has a price of $1.8 million and generates annual earnings of $100,000 per year. Although the price of the second business is only slightly higher, its much higher earnings clearly make it a better value. Looking back to the market high in 2000, the math is almost identical for the companies that make up the S&P 500® Index. At that time, the market as measured by the S&P 500® Index was priced at about 1,500 while the earnings of companies underlying the Index were only $51 per share. Today the market sells at a price around 1,800 but the underlying companies generate earnings around $108 per share making them a far better value. Similarly, since the highs of 2007 just before the financial crisis, the earnings of companies underlying the Index have climbed from $83 per share then to $108 per share today, while at the same time companies have significantly reduced leverage. In short, by simply comparing today’s share prices to past market highs, the pessimists overlook the significant increase in the value of the underlying businesses.4
On the other hand, the optimists who point out that because the world seems less risky than it did during the dark days of the financial crisis now must be a safer time to invest are forgetting that, all other things being equal, higher prices may increase risk and reduce future returns. Investors buying stocks today are paying 30% more than if they bought one year ago while underlying earnings have only grown about 12%. This diminished gap between price and value leaves investors today with the prospect of lower future returns and a reduced margin of safety. Instead of feeling reassured by today’s higher prices, the optimists should acknowledge a rapid increase in prices is not good news for long-term investors.
4 Source: Bloomberg.com, http://www.irrationalexuberance.com and Davis Advisors. Earnings per share are based on the reported income of the S&P 500® Index member companies. The S&P 500® Index high for the year 2000 was 1,527 on 3/24/00. Earnings per share for March 2000 were $50.94 and for March 2007 were $83.15. The market was 1,848 on 12/31/13. Earnings for today are represented by the 2013 full-year earnings estimate.
That said, where do we stand? In managing Davis New York Venture Fund, we are neither optimistic nor pessimistic but realistic. Though our realistic approach may seem too restrained to the optimists and too confident to the pessimists, it recognizes the inherent uncertainty investors always face not just in trying to predict stock prices but in trying to predict all sorts of short-term variables from economic growth rates to interest rates to geopolitical developments.
By accepting that uncertainty is a constant, we can focus on the more realistic question of how best to invest in an uncertain world. Framed this way, the answer seems clearer. Investors should build a portfolio able to withstand downturns while also generating long-term growth. This is exactly our objective in managing Davis New York Venture Fund.
With our focus on balance sheet strength, proven management and durable business models, we look for companies with the resilience to weather the inevitable shocks and disruptions that can come at any time. Such strength allowed banks like Wells Fargo and Bank of New York Mellon to weather the worst financial crisis since the Depression.5 It enabled retailers like Costco Wholesale Corporation (NASDAQ:COST) and Bed Bath & Beyond Inc. (NASDAQ:BBBY) to grow despite the Great Recession and consolidation in the retail sector. And it has allowed health care companies like UnitedHealth Group Inc. (NYSE:UNH) and CVS Caremark Corporation (NYSE:CVS) to navigate the uncertainty and changing regulation associated with government reform.
At the same time, with our focus on secular growth, competitive advantages, global leadership, and innovation, we also seek out companies that can generate the growth needed to build wealth over the long term. Companies like Google Inc (NASDAQ:GOOG) and Texas Instruments Incorporated (NASDAQ:TXN) use innovation to unleash technology’s potential across a range of applications. American Express Company (NYSE:AXP) and Visa Inc (NYSE:V) are leaders in transforming the global payments industry away from cash and checks. The fact the Internet does not accept cash makes the explosive growth of Internet commerce an additional tailwind. Finally, companies like LabCorp and Agilent Technologies Inc. (NYSE:A) benefit from the growing demand and cost savings that can come from more sophisticated diagnostic testing.
As investors in an uncertain world, one final characteristic that we seek is adaptability. Very few business models can be carved in stone and a number of our important holdings are companies with a proven record of adaptability. For example, roughly 50 years ago Berkshire Hathaway Inc. (NYSE:BRK.A) (NYSE:BRK.B) was nothing more than a New England-based textile mill. Today the company is one of the most valuable conglomerates in the world with leading positions in businesses ranging from insurance to railroads. As another example, 50 years ago Loews was a chain of movie theaters that today has been transformed into a diversified holding company including operations in insurance, hotels and energy. These examples are worth highlighting because they remind us that in a changing world standing still is not an option. Long-term success requires constant learning and a willingness to change.
This brings us full circle. We began this report by sharing with you our thoughts about a change in our investment team with the addition of Danton as my new comanager in overseeing Davis New York Venture Fund. We went on to discuss why we believe the Portfolio is well positioned in an uncertain world both to weather the inevitable storms and to build wealth over the long term. And we ended by highlighting the importance of adaptability and a willingness to change. Although we cannot know what the immediate future holds, we have never had more confidence in the strength, resiliency, capability, growth prospects, and adaptability of our Portfolio companies, our investment team or our firm.
On behalf of all of our colleagues, we thank you for the trust you have placed in us and look forward to reporting to you in the years ahead.
5 Individual securities are discussed in this piece. While we believe we have a reasonable basis for our appraisals and we have confidence in our opinions, actual results may differ materially from those we anticipate. The return of a security to the Fund will vary based on weighting and timing of purchase. This is not a recommendation to buy, sell or hold any specific security. Past performance is not a guarantee of future results.
This report is authorized for use by existing shareholders. A current Davis New York Venture Fund prospectus must accompany or precede this material if it is distributed to prospective shareholders. You should carefully consider the Fund’s investment objective, risks, charges, and expenses before investing. Read the prospectus carefully before you invest or send money.
This report includes candid statements and observations regarding investment strategies, individual securities, and economic and market conditions; however, there is no guarantee that these statements, opinions or forecasts will prove to be correct. These comments may also include the expression of opinions that are speculative in nature and should not be relied on as statements of fact.
Objective and Risks. Davis New York Venture Fund’s investment objective is long-term growth of capital. There can be no assurance that the Fund will achieve its objective. The Fund invests primarily in equity securities issued by large companies with market capitalizations of at least $10 billion. Some important risks of an investment in the Fund are: stock market risk: stock markets have periods of rising prices and periods of falling prices, including sharp declines; manager risk: poor security selection may cause the Fund to underperform relevant benchmarks; common stock risk: an adverse event may have a negative impact on a company and could result in a decline in the price of its common stock; large-capitalization companies risk: companies with $10 billion or more in market capitalization generally experience slower rates of growth in earnings per share than do mid- and small-capitalization companies; mid- and small-capitalization companies risk: companies with less than $10 billion in market capitalization typically have more limited product lines, markets and financial resources than larger companies, and may trade less frequently and in more limited volume; headline risk: the Fund may invest in a company when the company becomes the center of controversy. The company’s stock may never recover or may become worthless; financial services risk: investing a significant portion of assets in the financial services sector may cause the Fund to be more sensitive to problems affecting financial companies; foreign country risk: foreign companies may be subject to greater risk as foreign economies may not be as strong or diversified. As of December 31, 2013, the Fund had approximately 13.3% of assets invested in foreign companies; emerging market risk: securities of issuers in emerging and developing markets may present risks not found in more mature markets; foreign currency risk: the change in value of a foreign currency against the U.S. dollar will result in a change in the U.S. dollar value of securities denominated in that foreign currency; depositary receipts risk: depositary receipts may trade at a discount (or premium) to the underlying security and may be less liquid than the underlying securities listed on an exchange; and fees and expenses risk: the Fund may not earn enough through income and capital appreciation to offset the operating expenses of the Fund. See the prospectus for a complete description of the principal risks.
Davis Advisors is committed to communicating with our investment partners as candidly as possible because we believe our investors benefit from understanding our investment philosophy and approach. Our views and opinions include “forward-looking statements” which may or may not be accurate over the long term. Forward-looking statements can be identified by words like “believe,” “expect,” “anticipate,” or similar expressions. You should not place undue reliance on forward-looking statements, which are current as of the date of this report. We disclaim any obligation to update or alter any forward-looking statements, whether as a result of new information, future events, or otherwise. While we believe we have a reasonable basis for our appraisals and we have confidence in our opinions, actual results may differ materially from those we anticipate.
The information provided in this material should not be considered a recommendation to buy, sell or hold any particular security. As of December 31, 2013, the top ten holdings of Davis New York Venture Fund were: Bank of New York Mellon, 7.4%; Google–Class A, 7.0%; American Express, 7.0%; Wells Fargo, 6.0%; CVS Caremark, 5.1%; Berkshire Hathaway– Class A, 4.5%; Bed Bath & Beyond, 4.0%; Costco Wholesale, 2.9%; Canadian Natural Resources, 2.7%; UnitedHealth Group, 2.6%.
Davis Funds has adopted a Portfolio Holdings Disclosure policy that governs the release of non-public portfolio holding information. This policy is described in the prospectus. Holding percentages are subject to change. Click here or call 800-279-0279 for the most current public portfolio holdings information.
Broker-dealers and other financial intermediaries may charge Davis Advisors substantial fees for selling its funds and providing continuing support to clients and shareholders. For example, brokerdealers and other financial intermediaries may charge: sales commissions; distribution and service fees; and record-keeping fees. In addition, payments or reimbursements may be requested for: marketing support concerning Davis Advisors’ products; placement on a list of offered products; access to sales meetings, sales representatives and management representatives; and participation in conferences or seminars, sales or training programs for invited registered representatives and other employees, client and investor events, and other dealer-sponsored events. Financial advisors should not consider Davis Advisors’ payment(s) to a financial intermediary as a basis for recommending Davis Advisors.
We gather our index data from a combination of reputable sources, including, but not limited to, Thomson Financial, Lipper and index websites.
The S&P 500® Index is an unmanaged index of 500 selected common stocks, most of which are listed on the New York Stock Exchange. The Index is adjusted for dividends, weighted towards stocks with large market capitalizations and represents approximately two-thirds of the total market value of all domestic common stocks. Investments cannot be made directly in an index.
After April 30, 2014, this material must be accompanied by a supplement containing performance data for the most recent quarter end.
Shares of the Davis Funds are not deposits or obligations of any bank, are not guaranteed by any bank, are not insured by the FDIC or any other agency, and involve investment risks, including possible loss of the principal amount invested.
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