Q: Please provide an update on Davis Advisors as an organization.A: Davis Advisors, founded in 1969, is an independent, employee-owned investment manager serving clients worldwide. We have approximately $50 billion of assets under management,1 more than 200 employees and are extremely well capitalized. Our sole focus is on investment strategies in which we have a proven record of adding value over the long term. Market and economic conditions may vary over time, but we steadfastly adhere to a clear and repeatable investment process of buying durable businesses at value prices and holding them for the long term. In addition to our core mission of generating competitive results for our shareholders, we are recognized as a leader in the principles of stewardship and closely align our interests with those of our shareholders. The Davis family, Davis Advisors, employees, and directors have more than $2 billion of their own money invested side by side with fellow shareholders in the various mutual funds our firm manages.2
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 As of September 30, 2012.2 As of June 30, 2012.
Q: How should shareholders evaluate Davis New York Venture Fund’s performance?A: The Fund’s results are published on a daily basis. However, internally we evaluate our results over what we believe are statistically significant periods of five to 10 years. Accordingly, the majority of our research team’s compensation is tied to how our five-year results compare with the Fund’s benchmark, the S&P 500® Index. To better understand the effectiveness of our investment approach, we encourage investors to study our results over rolling periods and measure the frequency with which the Fund has outperformed or underperformed its benchmark (i.e., our “batting average”) rather than reviewing results over a single period. Because no manager can outperform over all periods, an important objective of our firm is to increase the probability of outperformance the longer shareholders stay with the Fund and historically we have been successful in that regard as the green bars in the chart below illustrate. Over its entire history, the Fund has outperformed its benchmark in almost 75% of five-year periods and close to 100% of 10-year periods, meaning the longer shareholders stayed with us the more likely they earned above-average returns. This track record stands out as highly exceptional in the investment management business. The longer investors stayed with comparable funds, the less likely they were to outperform as the tan bars in the same chart show.
3 There is no guarantee that Davis New York Venture Fund will continue to outperform the S&P 500® Index and its peers over the long term. See endnotes for a description of rolling performance and definitions of the S&P 500® Index and the Lipper Average Large Cap Fund. Past performance is not a guarantee of future results.
Q: Over the most recent five-year period the Fund has underperformed the S&P 500® Index. Can you provide some insights into why?A: While our long-term record is very solid, both in relative and absolute terms, our results over the most recent five-year period have admittedly fallen short of the standards we set for ourselves. We operate in a batting average business, which means that despite many successes, some periods will fail to produce the outcome we desire. In almost all cases, underperformance results from a combination of multiple factors. Over the most recent five-year period, we made some mistakes of commission and some mistakes of omission in addition to navigating through a low-return market environment with an extremely narrow group of market leaders.
Topping the list of mistakes related to investments we made is American International Group (AIG), which was effectively nationalized in 2009 at the nadir of what has been termed the second great recession of the last 100 years.4 Having researched and owned AIG for decades, we viewed the business as a collection of leading franchises that in aggregate represented more than $100 billion of tangible book value and earned more than $20 billion in pretax earnings at their peak. Our mistake was mispricing the risk of a relatively small portion of AIG’s business known as AIG Financial Products, which had assumed hidden leverage tied to residential real estate values—primarily through credit default swaps—that ultimately overwhelmed the strength of AIG’s other business lines. The key lesson we learned from this mistake was that in complex financial institutions the CEO must have the ability to serve as the de facto chief risk officer and AIG’s former management was simply not up to the task. We have since refocused our efforts on companies with less complex business models and, while we have always set a high bar for management, we have become even more discriminating in our due diligence process.
Our biggest mistake of omission, and a more recent factor in our underperformance, was our decision not to own Apple, which has been what John Maynard Keynes might have referred to as a “stunner” given its superlative performance. Largely by virtue of this exceptional performance, Apple has grown to be an ever larger position in the Fund’s benchmark and continues to defy skeptics. That said, we had—and still have—reservations that are based on historical precedent. Specifically, it is difficult for us to accept the proposition of allocating a significant portion of shareholders’ capital to a business whose products can in a sense be considered fashion accessories and therefore subject to the whims of changing consumer preferences, not to mention fierce and intensifying competition. Taking a long view, the history of the technology sector is rife with once revered iconic brands that eventually fell from grace or even disappeared. The dramatic fall of past market leaders such as Sony, Motorola and Ericsson offers important lessons to investors who believe a good thing can last forever. We continue to re-evaluate our decision regarding this mistake of omission but for now remain uncomfortable owning Apple given its relatively small amount of recurring revenues and the ever loftier expectations for a business whose long-term growth prospects will likely diminish as the company grows in size. That is not to say we will never own Apple. However, circumstances would have to change in such a way that we felt we were being fully compensated for the potential risks involved.
Other contributors and detractors affected the Fund’s relative results as well but to a lesser extent. For instance, certain financial and consumer-related holdings have been net contributors while energy holdings as well as a Canadian-listed timber company have been detractors from results. However, the two decisions discussed above— AIG and Apple—account for the vast majority of our underperformance relative to our benchmark over the past five years.
Notwithstanding recent history, the Davis Investment Discipline has proven very resilient historically. Over our organization’s entire history spanning more than four decades and encompassing many different market cycles Davis New York Venture Fund has not suffered a five-year period of underperformance that was not followed by a subsequent period of outperformance.
What happens over the next five years is unknowable. However, we look to the future with a degree of optimism, not because we are Polyannas, but because we recognize many of the world-class businesses we own trade at prices offering compelling value today even given a wide range of scenarios. Owning such businesses—whose revenues, earnings, free cash flow, dividends, and balance sheet strength continue to progress—at the right price has in our experience been a key factor in determining long-term investment success and we believe all other things being equal it should be a key factor in future periods. We are putting our money where our mouth is and have increased our investment in the funds we manage.
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 0.89%. 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.
4 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.5 Class A shares without a sales charge. There is no guarantee that periods of underperformance will be followed by outperformance. See Outperforming the Market in the endnotes for a description. Past performance is not a guarantee of future results.
Q: Indexing and other passive investment strategies have grown in popularity. What is Davis Advisors’ view on this trend and why should investors still consider active management for their portfolios?A: The market tends to move in cycles and periods during which active managers as a group underperform naturally lead investors to consider indexing or so-called passive strategies as an alternative. We offer one primary reason for not tilting 100% toward indexing: While not often considered in this way, indexing strategies are not truly passive in our view. Indexes are designed by individuals who set parameters for selecting, weighting and rebalancing holdings. In other words, indexing strategies are actually low turnover, actively managed strategies that involve their fair share of risks. Most notably, index funds by definition tend to hold winners and cut losers. They tend to allocate more capital to what has worked historically and to take capital away from what has not done as well. This is tantamount to a form of momentum investing that works until it does not, and that is precisely how the bull market of the 1990s came to a painful end in the 2000–2002 bear market when some of the largest companies with the richest valuations came back down to earth.
In our experience, managing portfolios actively and to some extent in a contrarian fashion can help investors mitigate some of the embedded risks that are by design largely unmanaged within market indexes and uncover mispriced opportunities through well-informed stock selection.6 These small advantages can produce substantially different results. As a case in point, Davis New York Venture Fund has returned 11.54% on an annualized basis since its inception in 1969 versus 9.61% for the S&P 500® Index, outperforming the Index by 1.93% on an annualized basis during that time. Small differences compound over time however and $10,000 invested in the Fund at its inception would be worth $1,170,277 today versus $547,651 if the same investment had been made in the S&P 500® Index.7
6 While we research companies subject to such contingencies, we cannot be correct every time, and a company’s stock may never recover.7 Class A shares without a sales charge. If a sales charge were included performance would be lower. Past performance is not a guarantee of future results.8 Returns for other classes of shares will vary. All returns include the reinvestment of dividends and capital gain distributions. See the endnotes for a description of the S&P 500® Index. Past performance is not a guarantee of future results.
Q: What is your outlook for the market and where are you finding new opportunities?A: The stock market is a market of individual stocks that represent fractional ownership interests in real businesses. The key to investment success is first and foremost to identify individual, highly durable businesses and then have the discipline to buy them when prices are attractive and the risk/reward trade-off is compelling.
We invest in what we understand, continuing to pore over the universe of businesses within our many circles of competence that meet our management, capital allocation, business model, and valuation criteria. Some areas that we believe offer the greatest opportunity in terms of prospective returns include:
- Global market leaders such as Coca- Cola (KO), Nestlé (NSRGY) and Heineken (HINKF) that are beneficiaries of a growing global middle class and consumer culture. The global wealth effect, particularly in developing economies, is a real and very powerful force that should serve as a tailwind for these types of global brands over the long term.
- Well-managed financial services companies with true franchise value due to the success of their particular products or brand that have the ability and management prowess to build market share over time in a highly fragmented marketplace. American Express (NYSE:AXP), Wells Fargo (NYSE:WFC) and Berkshire Hathaway (NYSE:BRK.A)(NYSE:BRK.B) are representative examples in this category. The depth of the recent financial crisis is well known. What is less understood is that certain market leaders used the downturn to dramatically strengthen their capital base and significantly grow their market share at the expense of weaker competitors. These winners ultimately increased their earnings power and intrinsic value while many of the losers disappeared or were consolidated at fire sale prices.
- Certain health care-related businesses that stand to benefit from aging populations around the world and are also able to play a well-defined role in managing health care cost inflation. We own a number of businesses that are well positioned to capitalize on the shift from brand-name medications to generic drugs, for instance. Two investments in this category are CVS Caremark (NYSE:CVS) and Express Scripts (NASDAQ:ESRX). Both of these businesses actually make more money selling generic drugs than they do selling brand-name medications and the market share of generic drugs is likely to grow for years, if not decades, to come.
- Energy and natural resource-related businesses such as Occidental Petroleum (NYSE:OXY), Potash (NYSE:POT) and Monsanto (NYSE:MON) that have exhibited above-average capital allocation discipline and that sell commodities where supply/demand dynamics appear favorable over the long term.
- Workhorse technology companies such as Microsoft (NASDAQ:MSFT) and Google (NASDAQ:GOOG) that are market leaders with durable competitive moats and that also offer an attractive risk/reward proposition at current valuations in our opinion.
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 September 30, 2012, the Fund had approximately 15.2% 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 September 30, 2012, Davis New York Venture Fund had invested the following percentages of its assets in the companies listed: American Express, 5.57%; Berkshire Hathaway, 4.05%; Coca-Cola, 1.50%; CVS Caremark, 6.29%; Express Scripts, 3.34%; Google, 5.03%; Heineken, 0.71%; Microsoft, 1.08%; Monsanto, 2.88%; Nestlé, 0.19%; Occidental Petroleum, 3.03%; Potash, 0.86%; Wells Fargo, 5.88%.
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, 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.
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.
The Lipper Average Large-Cap peer group is a combined category including the Lipper Large-Cap Growth, Core and Value peer groups. Lipper Large-Cap peer groups are funds that, by portfolio practice, invest at least 75% of their equity assets in companies with market capitalizations (on a three-year weighted basis) above Lipper’s USDE large-cap floor. Funds are categorized as Growth, Core or Value based on their portfolio characteristics; price to earnings ratio; price to book ratio; and three year sales per share growth value. Growth funds typically have above-average characteristics, Core funds typically have average characteristics and Value funds typically have below-average characteristics, compared to the S&P 500® Index.
Rolling Returns. Davis New York Venture Fund’s average annual total returns for Class A shares were compared against the returns of the S&P 500® Index as of the end of each quarter for all time periods shown from February 17, 1969, through September 30, 2012. The Fund’s returns assume an investment in Class A shares on the first day of each quarter with all dividends and capital gain distributions reinvested for the time period. The returns are not adjusted for any sales charge that may be imposed. If a sales charge were imposed, the reported figures would be lower. The same comparison was done for the Average Large Cap Fund. The figures shown 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.
Outperforming the Market. Davis New York Venture Fund’s average annual total returns for Class A shares were compared against the returns of the S&P 500® Index for each 5 year period ending December 31 from 1974 to 2011. The Fund’s returns assume an investment in Class A shares on the first day of each period with all dividends and capital gain distributions reinvested for the time period. The returns are not adjusted for any sales charge that may be imposed. If a sales charge were imposed, the reported figures would be lower. The figures shown 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.
After January 31, 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.
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