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Chris Davis' Davis New York Venture Fund 2013 Annual Commentary
Posted by: Holly LaFon (IP Logged)
Date: March 8, 2013 11:07AM
The chart below summarizes results through December 31, 2012 for the Davis New York Venture Fund compared with the S&P 500® Index against which my co-manager Ken Charles Feinberg, our colleagues and I judge ourselves. Relative results over all recent periods have fallen short of our goal of matching or exceeding this Index after fees and expenses. Furthermore, although we outpaced the market for the five years from 2002–2007, results in the most recent five years have dragged down our 10 year performance so that we now trail the market by about 0.5% per year.1
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 0.90%. 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. For most recent month-end performance, click here or call 800-279-0279.
In the pages ahead, our goal is to provide our investors with the information we would want if our places were reversed. In particular, we will focus on two topics. The first is the past. While the very long-term relative results shown in the chart are satisfactory, the disappointing recent results are maddening. We owe our shareholders an accounting and an explanation for these results. In addition, we will put these results in context showing that we have gone through such periods before and explain why we consider them an inevitable though unpleasant part of generating satisfactory long-term results. As each past period of underperformance has been followed by a period of recovery, we will also highlight why we are convinced that the greatest risk during periods of underperformance is to give up on a proven long-term investment discipline. In our view, the tendency to capitulate is the major reason why so few money managers outperform over long periods of time.
The second topic is the future. Here we will make the case for why we believe results should improve in the decade ahead and why investors should stick with us.2 In doing so, we will focus on the specific companies that make up the Portfolio today. We will show that although their share prices have languished, the vast majority of our Portfolio companies are earning significantly more than they were five years ago. In fact, over the last five years, the select group of companies that make up the Davis New York Venture Fund actually grew their profits more than 40% cumulatively or about 7.5% per year.3 Such profit growth in the face of a fairly dismal economic backdrop reinforces our conviction in the rigorous research that underlies our Investment Discipline. Moreover, our research indicates that these companies have maintained or even enhanced their competitive positions while strengthening their balance sheets and investing appropriately for growth. Despite these facts, the companies that make up the Portfolio currently trade at a meaningful discount to the market averages. Specifically, these companies are currently generating an earnings yield of 7.7% based on our calculation of 2012 adjusted profits and 8.3% based on our 2013 estimate.4 This compares to a reported earnings yield in 2012 of 7.1% for the S&P 500® Index as calculated by Standard and Poor’s. The combination of growing profits, lower stock prices, durable businesses, and low current valuations forms the basis of our optimism about future results. In a final observation about the future, we will demonstrate why the growing tendency of the companies we own to repurchase shares has created a silver lining to this period of poor stock returns as the value of such repurchase programs increases when prices are lower.
If the tone of this report seems less reserved than usual, this is because we want to be crystal clear about why we believe that returns should be much more satisfactory in the years ahead. We do so not to be promotional but rather because we feel a responsibility to help ensure that investors who have already come through these difficult times can be with us for the improved returns we believe we will see in the decade ahead.
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. 1 Class A shares without a sales charge. Past performance is not a guarantee of future results. 2 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.3 Past performance is not a guarantee of future results.4 Source: Davis Selected Advisers. Calculations based on the companies’ publicly available financial information.
Performance ReviewAs always, the first order of business is to provide an accounting of our investment results. Before discussing our relative returns, we want to make a general comment about the absolute returns reported in the chart. Specifically, investors need only turn on the financial news or glance at the financial press to be reminded that stocks have been mired in a bear market. “Invest in Stocks? Forget About It!” screams a front-page headline from USA Today.5 The article goes on to state the “long-running story about how stocks are the safest way to build wealth seems tired, dated and less believable.” Given this background of negative sentiment, it is worth noting that the absolute returns shown in the chart, both for stocks in general and the Davis New York Venture Fund in particular, while not anywhere near the heady numbers of the 1990s bull market are far from the disaster investors might expect based on today’s headlines. With the exception of the five year results, which while not catastrophic are certainly anemic and in our case slightly negative, the absolute returns in all other columns are reasonably positive and in a number of cases quite satisfactory. We draw your attention to these absolute returns not because they are outstanding but simply because they contrast so sharply with the negative sentiment surrounding stock investing. In fact, despite largely positive returns, rising dividend yields and relatively low valuations, investors have withdrawn money from stock funds in record numbers, choosing instead to invest in bonds yielding less than 2% and money market funds with no yield whatsoever.6
While a 10 year total return of 6%–7% may not excite many investors, the fact that this result was earned in a decade that included two wars, an unprecedented nationwide collapse of home values, the greatest banking and financial crisis since the 1930s, the euro crisis, political dysfunction, the fiscal cliff, and the Great Recession should give investors some confidence in the resiliency of the stock market. In addition, the fact that the valuation of the U.S. stock market based both on dividend yields and price-earnings multiples is currently significantly lower than it was 10 years ago should be an added comfort. But, human nature being what it is, many investors continue the self-destructive tendency to follow the crowd and respond to the media.
Turning from absolute returns to relative returns, the chart presents a less sanguine picture, with our relative results trailing in all recent periods. In discussing relative returns, we will focus on the trailing five year period as the lagging result in this period more than offset our leading result in the prior five years.
Without question, lagging the Index by 2.6% per year over this period is a disappointing result that unequivocally falls short of our goals. However, it is not unprecedented or even particularly unusual within the context of our long-term record. In fact, we would suggest that a willingness to be out of sync with the market for stretches of time is a requirement for outperforming over a long period of time. Lee Scott, a former CEO of Wal-Mart, once said, “You can’t do what everyone else does and expect a different result.”
Since our inception we have achieved a compound annual growth rate of 11.5% per year versus about 9.5% for the market.7 While that may not sound like a large difference, it means that an investor who entrusted us with $10,000 at inception would now have $1.2 million versus approximately $550,000 if the same $10,000 had been invested in the S&P 500® Index. Over this long time period, we outperformed the Index in roughly 75% of all five year periods. However, by the same math, we underperformed in roughly 25% of all five year periods. In our Semi- Annual Review 2012, we provided detailed information about these periods showing that while results over the last five years have been maddening, they are not an outlier either in magnitude or duration. In fact, the Davis New York Venture Fund has trailed by more than 2% per year in no fewer than five previous five year cycles. In all cases, going back to our founding in 1969, every five year period of lagging results was followed by a five year stretch in which we more than made up the lost ground.8 For investors interested in reviewing the data supporting these historical patterns, please see our Semi-Annual Review 2012.
In the remainder of this report, our goal is to focus on the future rather than the past. Specifically, we want to present the facts and data that give us confidence that the companies we own are undervalued and that as a result investment returns should be much better in the years ahead. While investment fads come and go, the fundamental truth is stocks represent ownership interests in real businesses. If we are correct in our analysis of the businesses, then their stock prices will eventually reflect our positive outlook. This is the basic reason we intend to stick with the long-term, research-based Investment Discipline that has served us well for more than 40 years. We believe being out of sync with the market, while never comfortable, is a necessary requirement of successful, long-term investment management. Because of human nature, however, the most common investor response to a period of underperformance is to give up on a proven investment discipline at exactly the wrong time. The inevitable but unfortunate consequence of this capitulation is to make temporary underperformance permanent. In order to avoid this tendency, we find it helpful to focus on the performance of the underlying businesses rather than their stocks. This is the topic to which we now turn.
5USA Today, May 8, 2012.6 Common stocks and bonds represent different asset classes subject to different risks and rewards. Unlike bonds, the Fund does not offer a fixed rate of return if held to maturity, and the Fund has risks not associated with holding a bond. Bonds are considered to have less risk than equities. Future economic events may favor one asset class over another.7 Class A shares without a sales charge. Past performance is not a guarantee of future results. Inception date is February 17, 1969.8 Class A shares without a sales charge. There is no guarantee that periods of underperformance will be followed by outperformance. Past performance is not a guarantee of future results. See endnotes for a description of 5 year Under/Outperformance.
Portfolio OutlookBefore discussing the prospects of the companies that make up the Portfolio, it is useful to be more precise about terminology. For example, in the chart shown at the beginning of this report, performance is essentially measured by changes in the stock prices plus dividends of the companies we own less fees and expenses. For example, over the last five years, the chart indicates that the performance of the Portfolio was a decline of around 1% per year. However, changes in price are not the same as changes in value. This difference is well understood in everyday usage as captured by the old saying, “Price is what you pay, value is what you get.” More specifically, the value of an asset is determined by the cash it produces. The price of an asset is determined by what an individual buyer will pay at a specific time. Taking this one step further, a business that earns more money seems clearly more valuable by definition. For example, the owner of a private business would almost certainly measure performance based on how much money the business earns each year after all expenses. Over time, if the business consistently generates more cash each year than the year before and this trend is expected to continue then it would seem obvious the business is performing well and its value rising.
When we apply the same thought process to our Portfolio companies, a striking divergence between price and value emerges. Indeed, although the stock prices (without dividends) of the companies that currently make up the Davis New York Venture Fund returned −2.1% per year over the last five years, the earnings per share of these same companies increased 43% or more than 7% per year during that same period.9 While earnings are not a perfect proxy for value and while we certainly take into account a range of other metrics, this is as sharp a divergence as we have seen in our careers.
Looking ahead, these same companies seem well positioned to continue growing at a respectable rate. Based on metrics like balance sheet strength, market share, cost structure, brand awareness, and economies of scale many of our core holdings such as Wells Fargo (WFC), Costco (COST), CVS Caremark (CVS), Bed Bath & Beyond (BBY), American Express (AXP), Bank of New York Mellon (BK), Monsanto (MON), Google (GOOG), and Berkshire Hathaway (BRK.A)(BRK.B) are actually in a stronger competitive position now than five years ago.10At the same time, the broader economy, while certainly not robust, has absorbed the shocks of the residential real estate decline and financial crisis and seems to be in a somewhat healthier position, with unemployment trending down and home prices stabilizing and, in most markets, beginning to rise modestly. Finally, the valuations of the companies we own remain compelling when compared to their own histories, equity averages and, most dramatically, fixed income securities of any kind.
Putting a finer point on valuation, we would note that our Portfolio companies currently trade at about 13 times our calculation of trailing earnings or a 7.7% earnings yield versus about 14 times or 7.1% for the S&P 500® Index. Even more striking, if current trends continue, our Portfolio companies could approach an 8.3% earnings yield in 2013.11
In short, the reason we are so positive about prospects for improved results in the years ahead is simply because we see such a wide gap between price and value. The Portfolio is anchored by companies that have grown their value and improved their competitive positions while their share prices have lagged to the point that they now trade at below-average valuations.
While waiting for the gap between price and value to close has been frustrating, we see a silver lining to this period that bears mentioning. This silver lining is based on understanding how our Portfolio companies are increasingly using the earnings they generate.
In general, when a company generates a profit, management is responsible for deciding what to do with the money, typically choosing among six alternatives. First, management can spend these earnings to expand the company’s capacity, deciding, for example, to build new factories. While such capital spending can be an attractive use of cash when the economy is robust and customer demand is surging, it can be a waste in sluggish times like these. Second, management can use the cash to acquire other companies. Although this is a very popular choice as it raises the prestige and often the income of the CEO while generating fees for investment bankers, the data overwhelmingly indicates that most large acquisitions destroy value. How can it be otherwise when the sellers know so much more about what they are selling than the buyers can know about what they are buying? In commenting on the risk of acquisitions, David Packard, who along with his partner Bill Hewlett created what was for decades one of the greatest companies in America, rightly observed, “More companies die from indigestion than starvation.” Third, management can just let the cash accumulate on the company’s balance sheet. To do so when the cash earns virtually 0% without a clearly articulated rationale for how the cash might be deployed in the future reflects a startlingly common disregard of shareholders and basic economics. Fourth, the company can pay down outstanding debt. However, the fact that most leading companies are currently underleveraged at the very time that borrowing costs are at historic lows makes debt reduction an irrational alternative at most companies. Fifth, management can choose to return the cash to shareholders by paying dividends. While this alternative clearly benefits shareholders and can create a sound culture of fiscal discipline, paying dividends is not an efficient use of cash because dividends are taxed twice: first at the corporate level and again when shareholders receive the dividends. Moreover, given the state of our government’s finances, it seems prudent to assume that the trend toward higher tax rates on dividends and income will continue in the years ahead.
The final alternative is what creates a silver lining to the widening gap between price and value mentioned above. Management can use the cash to repurchase shares. Whether or not this is a good choice depends on one simple question: Are the shares undervalued? If they are, then the opportunity for management to repurchase shares for less than they are worth is a powerful risk-free and tax-efficient way to increase shareholder value. In fact, the more the share price declines the greater the value created by share repurchases.
In Berkshire Hathaway’s 2011 annual report, Warren Buffett explains this counterintuitive dynamic by noting when Berkshire buys “stock in a company that is repurchasing shares, we hope for two events: First, we have the normal hope that earnings of the business will increase at a good clip for a long time to come; and second, we also hope that the stock underperforms in the market for a long time as well. . . . The logic is simple: If you (own) . . . a company that is repurchasing shares, you are hurt when stocks rise. You benefit when stocks swoon.”
This logic becomes crystal clear if you imagine that you own a business with only one other partner. If you plan to gradually buy out your partner’s interest in the business, then it seems obvious that you would want the business to do well and your partner to sell you shares at a lower price rather than higher price. What is true when there is only one other shareholder is equally true when there are thousands of other shareholders. Buying at lower prices increases future returns.
The fact that the stock prices of so many of our companies have lagged their earnings growth means that the returns generated by share repurchases should be increasing, creating an important silver lining to the weak market performance of recent years. In addition, because this topic is so poorly understood and rarely discussed by market commentators, it is a source of differentiation for our Portfolio that should help relative returns in the years ahead. Amazingly, 18 of our top 20 holdings repurchased shares last year and at many of our companies the amount being repurchased is accelerating. For example, in 2012 two of our largest holdings Bank of New York Mellon and CVS Caremark repurchased 4% and more than 7% respectively of their shares outstanding while Bed Bath & Beyond, another top 10 holding, repurchased more than 6%. Significant share repurchase programs (as well as dividends) can help investors be more dispassionate about stock price volatility. Put differently, with disciplined capital allocation many of our Portfolio companies should be able to build shareholder value in the face of an anemic economy while actually benefiting from their lagging stock prices and the market volatility that worries so many investors.
9Source: Wilshire Atlas. Earnings and stock prices are for a static portfolio of all companies held in the Fund as of 12/31/12. Weighting of companies is based on 12/31/12 holdings. Sixty-six companies were in the study, which is a majority of the Fund’s holdings in both time periods. Past performance is not a guarantee of future results.10 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.11 Past performance is not a guarantee of future results.
ConclusionThomas Jefferson famously said, “I like the dreams of the future better than the history of the past.” In preparing this report, we have given weight to both the past and the future by providing an accounting of our trailing results and the facts and data underlying our positive outlook. Like Jefferson, we have come to conclude that we too like the future outlook better than the past history.
Although we are disappointed by the Fund’s trailing results, our study of history indicates that such periods are a difficult but necessary component of achieving satisfactory long-term returns. The fact that this period is not an outlier in magnitude or duration and that in the past such periods of lagging results have always been followed by periods of improved results strengthens our determination to stick with our proven investment discipline.
Importantly, this determination is not based on stubborn optimism or Jeffersonian dreams but on a simple understanding of the difference between price and value. Specifically, while the prices of the companies that make up the Davis New York Venture Fund have languished over the last five years, their value has increased significantly. Evidence of this increasing value includes the fact that these companies are now earning 43% more than they were five years ago. Moreover, our research indicates that far from being 10-year-old racehorses whose past record of achievement has little to do with future prospects, our Portfolio companies have generally maintained or improved their competitive position, financial strength and growth outlook.
Matt Ridley, the science writer, concluded the introduction to his excellent book The Rational Optimist by saying, “I am a rational optimist . . . because I have arrived at optimism not through temperament or instinct, but by looking at the evidence.” Similarly, we arrive at our optimism about the prospects for the Davis New York Venture Fund by looking at the evidence. In presenting this evidence, it is our hope that those investors who have come through this difficult period will remain invested for the better times we see ahead.
We thank you for your continued trust.
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; 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; 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; trading markets and depositary receipts risk: depositary receipts involve higher expenses and may trade at a discount (or premium) to the underlying security; 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; and fees and expenses risk: the Fund may not earn enough through income and capital appreciation to offset the operating expenses of the Fund. As of December 31, 2012, the Fund had approximately 16.1% of assets invested in foreign companies. 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, 2012, the top ten holdings of Davis New York Venture Fund were: Bank of New York Mellon, 6.64%; Wells Fargo, 5.74%; CVS Caremark, 5.57%; American Express, 5.54%; Google Inc., Class A, 5.08%; Berkshire Hathaway Inc., Class A, 4.41%; Bed Bath & Beyond, 3.46%; Costco Wholesale, 2.99%; Monsanto, 2.96%; Canadian Natural Resources, 2.92%.
Davis Funds has adopted a Portfolio Holdings Disclosure policy that governs the release of nonpublic 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, broker-dealers 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.
5 Year Under/Outperformance. Davis New York Venture Fund’s average annual total returns were compared against the returns of the S&P 500® Index for each 5 year period ending December 31 from 1974 to 2012. The Fund’s returns assume an investment on the first day of each period with all dividends and capital gain distributions reinvested for the time period. The Fund’s returns do not include a sales charge. If a sales charge were included returns would be lower. The figures reflect past results; past performance is not a guarantee of future results. There can be no guarantee that the Fund will continue to deliver consistent investment performance. The performance presented includes periods of bear markets when performance was negative. Equity markets are volatile and an investor may lose money. Returns for other share classes will vary.
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, 2013, 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.
12/12 Davis Distributors, LLC, 2949 East Elvira Road, Suite 101, Tucson, AZ 85756, 800-279-0279, davisfunds.com
Guru Discussed: Chris Davis: Current Portfolio, Stock Picks
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