Davis New York Venture Fund Q1 2013 Investor Letter
A: The first quarter of 2013 marked the four year anniversary of the powerful stock market rally that followed the financial crisis of 2008–2009. During this time, most market indexes have fully recovered from their 2009 lows and some are near or above their previous all-time highs. The absolute level of stock prices is not what matters when assessing the risk/reward of equities, however. What ultimately counts is the relationship of price to value with the latter determined by long-term earnings power. On that basis stocks continue to represent good value in our view as business fundamentals have in many instances improved even more than share prices. Equities look all the more favorable when compared with U.S. Treasury securities and other asset classes.1 In short, much of our optimism about the stock market in general—and about our Portfolio in particular—is grounded by the reality today that many opportunities exist to purchase worldclass franchises at reasonable prices that can be held for the long term. This fact should bode well for skilled, fundamentals-based investors with a long-term perspective in our opinion.
Q: Please review the Fund's long-term and more recent performance results.
A: Davis New York Venture Fund has outperformed its benchmark, the S&P 500® Index, by a significant margin since inception in 1969. A hypothetical investment of $10,000 in the Fund on February 17, 1969 would have grown to $1,317,944 by March 31, 2013 versus only $603,467 for the S&P 500® Index.2 This result shows how the power of compounding can turn small performance advantages over many individual years into vastly better results on a cumulative basis. It also illustrates that active portfolio management can add significant value relative to indexing, which is easily overlooked in times when active management underperforms passive management as has been the case for much of the period following the financial crisis of 2008–2009.
Turning from results since inception to more recent periods, the last five years proved challenging and our performance fell below our standards, primarily due to three factors: 1) poor results in energy where we underestimated the supply shock in North American natural gas; 2) our investment in American International Group (NYSE:AIG) during the 2008–2009 crisis; and 3) our decision not to own Apple (NASDAQ:AAPL), which was among the most important drivers of the benchmark's return over the last five years.
The most recent three month and six month periods were more encouraging with technology and financial holdings driving our sound relative results. The Fund not only outperformed its benchmark over those periods, but perhaps more significant our results reflected renewed investor appreciation for the businesses we own rather than changes in the Portfolio, which were minimal. Whether this represents the start of a new phase for the market remains an open question. However, we believe the market will eventually move beyond a "risk on/risk off" trading range to an environment where investors differentiate properly between good and bad businesses based on durability and long-term earnings power, closing the gap between price and value. We believe the Davis Investment Discipline is a perennial approach and one that is especially well suited for a stock picker's market.
Q: Looking ahead, please discuss why you have confidence in your Portfolio.
A: While the U.S. stock market has rebounded strongly from its lows, share price returns for many of the businesses we own have not kept pace with improving business fundamentals. As a result, equity valuations still appear quite attractive in our view especially when compared with the prevailing risk-free rate and relatively less attractive valuations for other asset classes.3
To illustrate the divergence between price and value over the past five years, the chart below shows the top 10 holdings of the Fund as of December 31, 2012 and compares each company's five year earnings per share growth—a rough approximation for changes in business value—with its five year share price performance (ex-dividends).4
The top 10 holdings of Davis New York Venture Fund have grown earnings an average of 89% on a cumulative basis over the past five calendar years yet their shares have returned only 10% not counting dividends, meaning that weak share price performance has masked strong and improving business fundamentals during that period. We expect our Portfolio of businesses will continue to grow earnings and over time that growth should be reflected in the Fund's share price.
We have other reasons to be hopeful as well. As recently as year-end 2012, the Fund traded at a valuation of roughly 12 times earnings, which translates into an 8% earnings yield. That is the initial return that investors would receive if they could purchase the businesses in the Portfolio outright. This return is approximately four times the prevailing risk-free rate on 10 year U.S. Treasuries and is attractive in our opinion both in absolute and relative terms.5
Last but not least, throughout corporate America companies are returning vast amounts of capital to shareholders. Half of the companies in the S&P 500® Index today offer dividend yields at or above the risk-free rate (with room to grow) and many of them are repurchasing shares aggressively as well.
The market can ignore fundamentals for only so long. Eventually, as we move past what has been a "risk on/risk off" trading range, we believe share prices should recover to levels more indicative of true business value. For this reason, we remain very optimistic about the future prospects of equities in general and in our Portfolio, in particular.
Q: According to financial theory, the market should be perfectly efficient and therefore difficult to beat. Yet, Davis New York Venture Fund has successfully outperformed the S&P 500® Index in the majority of long-term time periods.8 What are the keys to outperforming a market index?
A: Davis New York Venture Fund has outperformed its benchmark, the S&P 500® Index, in the vast majority of long-term holding periods. The chart below shows our batting average, or the percentage of time the Fund outperformed the market, over various holding periods since the Fund's inception in 1969.
The Fund outperformed the Index in 66% of three year periods, 73% of five year periods, 97% of 10 year periods, and 100% of 15, 20, 25, 30, and 35 year periods. Interestingly, in contrast to the industry, our batting average actually improved the longer investors held the Fund, which we believe reflects the long-term merits of our approach.
The keys to outperforming a market index in our experience are discussed below. The basic message is simple: Investors cannot construct portfolios that are very similar to a particular index yet expect better results. Experienced stock pickers recognize they must invest and construct their portfolios differently in order to achieve better-than-average returns and that is precisely what we seek to accomplish by focusing on five key components of long-term investment success:
1. A clear, consistent and repeatable investment discipline—A strong investment track record usually begins with a strong investment discipline. While market conditions vary from period to period, having a clear, repeatable investment approach that is rational and consistent is important. Since its inception in 1969, Davis New York Venture Fund has been managed according to the same investment discipline of buying durable businesses at value prices and holding them for the long term. In our view, the performance and batting average data presented earlier are a testament to the effectiveness of the Davis Investment Discipline over time and in a wide variety of different environments.
2. In-depth, original research—Through rigorous research and analysis we believe it is possible to identify above-average businesses as defined by proven management, high and/or improving returns on invested capital, balance sheet strength, and sustainable competitive advantages. Owning better quality businesses is an important starting point for outperforming market averages over the long term in our experience, all other things being equal.
3. Distinguishable portfolio construction— We believe a portfolio should reflect the fund manager's views and level of conviction in each holding. Davis New York Venture Fund's positions are weighted according to our level of conviction, on the one hand, and our view of risk, on the other hand. Market indexes are typically weighted according to the size of the company (from largest to smallest), which we believe is a less than optimal ranking system. Our approach, which draws from our own research, not surprisingly results in a distinctly different list of holdings than our benchmark index. Our Portfolio also looks quite distinct at the industry and sector levels. We believe this degree of differentiation from market indexes is critical to generating better results.
4. A long-term, low turnover approach— One of the key advantages passive investing can claim over active investing is low frictional costs (i.e., the direct and indirect costs of executing financial transactions). We practice a low turnover approach primarily because we wish to participate in the long-term compounding of growing businesses, but we recognize our low turnover approach has the important ancillary benefit of keeping our transaction costs to a minimum. This dramatically reduces the index's relative advantage in this regard.
5. A learning and adaptive culture—We adhere steadfastly to a set of constant principles that have proven effective over time. We view stocks as ownership interests in real businesses. We believe that owning shares of durable, wellmanaged companies purchased at attractive valuations is a reliable, timetested method for compounding capital. That said, we recognize we can always improve the application of our discipline. Having the humility to admit and learn from mistakes and to constantly strive for improvement is an important characteristic of successful investment managers. Managers must also have the insight to recognize when the world changes and then adapt as the times require. We have outperformed the S&P 500® Index in 97% of all 10 year periods since 1969, yet the market never looked or acted the same way from one decade to the next.9 In other words, we had to adapt along the way. We believe it is a strength if an investment manager's understanding of businesses and competitive dynamics evolves with the times, all the while staying true to a set of constant, guiding principles.
In short, there is no silver bullet for success in the investment business, but the discussion above highlights some of the characteristics we feel are particularly important.
We thank you for your continued support and look forward to continuing our long investment journey together. •
3. The risk-free rate corresponds to the yield on 10 year U.S. Treasury bonds. 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. 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. The yield on 10 year Treasury bonds according to the U.S. Treasury is 1.87% as of March 31, 2013. 6. Earnings per share refers to Davis Advisors' estimates of excess cash earnings, or owner earnings. In the case of Berkshire Hathaway, the figure refers to book value per share. Source: Davis Advisors, Bloomberg. 7. Equal-weighted average.
8. Class A shares without a sales charge. 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 Outperforming the Market and a definition of the S&P 500® Index. Past performance is not a guarantee of future results.
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, visit davisfunds.com or call 800-279-0279.
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. Common stocks and bonds represent different asset classes subject to different risks and rewards. Unlike bonds, the Portfolio does not offer a fixed rate of return if held to maturity, and the Portfolio 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. 2. Class A shares without a sales charge. If a sales charge were included performance would be lower. 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.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 March 31, 2013, the Fund had approximately 14.6% 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. Forwardlooking 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 forwardlooking 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 March 31, 2013, the top ten holdings of Davis New York Venture Fund were: Bank of New York Mellon, 6.6%; American Express, 5.9%; Wells Fargo, 5.4%; Google–Class A, 5.3%; CVS Caremark, 5.2%; Berkshire Hathaway–Class A, 5.1%; Bed Bath & Beyond, 3.7%; Progressive, 3.0%; Costco Wholesale, 2.8%; Canadian Natural Resources, 2.8%.
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. Visit davisfunds.com 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.
Over the last five years, the high and low turnover rate for Davis New York Venture Fund was 16% and 8%, respectively.
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.
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 as of the end of each quarter for all time periods shown from February 17, 1969, through March, 31, 2013. 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 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 July 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.