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Chris Davis Fall 2013 Update - Comments on Bank of New York, Amex, Google

October 03, 2013 | About:
Holly LaFon

Holly LaFon

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The chart below summarizes results through June 30, 2013 for Davis New York Venture Fund. As managers of and investors in Davis New York Venture Fund, my partner Ken Charles Feinberg, our colleagues and I have two objectives: to earn a satisfactory absolute investment return and to generate relative results in excess of the S&P 500® Index. As can be seen in the chart, our performance report card might be said to resemble a barbell. Over the very long term and the very short term, results on both an absolute and relative basis are satisfactory. In the middle, however, both are below our standards and expectations. In particular, we call attention to our five year results where an anemic absolute return of 4.5% per year trailed the Index by roughly 2.5% per year.1 While we view this return as unquestionably disappointing, it is some consolation that during a five year stretch that included the collapse of residential real estate, the financial crisis and the Great Recession, the cumulative return of Davis New York Venture Fund has still been roughly 25%. Bearing in mind how many companies, funds and firms were wiped out in those years, we are glad to have made money for our clients. As a final note, it is striking that while investor sentiment continues to be overwhelmingly negative, returns for our Fund and the market have compounded at a rate in the mid-teens for the last four years. Clearly, there is much truth in the old saying that the market climbs a wall of worry. Make no mistake, however, we have ground to make up.

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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.

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 funds we manage.2 We have ridden through the difficult periods and are fully committed to building on the improved results of more recent periods.

In preparing these reports for shareholders, our goal is to provide the information we would want if our positions were reversed. In times when results were disappointing, our first priority was to provide an accounting, explanation and context for the Fund’s performance. Consequently, we spent a great deal of time looking backward. For example, in 2012, we highlighted the fact that while periods of underperformance are maddening, “we have gone through such periods before and…consider them an inevitable though unpleasant part of generating satisfactory long-term results.” We also provided detailed data showing because “…each past period of underperformance (had) been followed by a period of recovery…we (were) convinced that the greatest risk during periods of underperformance is to give up on a proven long-term investment discipline.”3 In other reports, we quoted legendary investor Bob Kirby who observed, “The basic question facing us is whether it’s possible for a superior investment manager to…(suffer through periods of underperformance). The assumption widely held is ‘no.’ Yet if you look at the records, it is not only possible, it is inevitable.” More recently, we quantified Bob’s observation by examining the records of the best performing managers of the last decade, noting that 96% of them underperformed for at least a rolling three year stretch and 83% underperformed for at least a rolling five year stretch during their decade of outperformance.4

With improving results, it now may be more useful and informative to turn to the future with an emphasis on providing the facts and data that give us confidence returns should continue to be satisfactory. At the most fundamental level, we believe the Fund’s results will be driven by the performance of the underlying businesses we own. In a 1994 lecture, Charlie Munger, vice chairman of Berkshire Hathaway, described this dynamic by saying, “Over the long term, it is hard for a stock to earn a much better return than the business which underlies it earns. If the business earns 6% on capital over 40 years and you hold it for that 40 years, you’re not going to make much different than a 6% return.… Conversely, if a business earns 18% on capital over 20 or 30 years…you’ll end up with one hell of a result.”

As a result, in this report, we thought it might be helpful to dive deeply into the investment rationale for some of the specific businesses we own. Rather than provide a cursory look at 10 or 15 holdings, we have chosen to provide a more detailed review of our three largest investments: Bank of New York Mellon, American Express and Google.5 Because these three holdings make up about 19% of the Fund’s assets, their future alone will not determine the future of the Fund as a whole. However, by sharing our analysis of these companies, we hope to provide shareholders with a better understanding of our research approach and investment process.

Legendary manager Peter Lynch used to argue investors should be able to describe all of the key elements in their rationale for owning a business in two minutes or less. While such an exercise risks being superficial, a concise investment summary can be a helpful discipline. At Davis Advisors, our research and evaluation process involves many steps and considerations. But, in the spirit of Peter Lynch, it can be roughly boiled down to three words: business, people and price. Our goal is to own good businesses (which we define based on such characteristics as return on equity, competitive advantages and growth prospects) run by capable, shareholder-oriented people (whom we identify based on such factors as past record, alignment of incentives, candor, and long-term focus) and selling at reasonable prices (which we calculate based on such factors as adjusted enterprise value, owner earnings and incremental returns on equity). Permeating this entire process is a thorough consideration of the risks facing all aspects of the business. In the pages that follow, we will do our best to provide a “two minute drill” that covers each of these factors for our three largest holdings. These descriptions include opinions as well as facts and although we have been long-term holders of each, our opinion as well as the facts described below can change. Our goal is not to provide a sales pitch or an encyclopedia of data and documentation but to give our shareholders a broader understanding of our investment process and a better sense of some of the individual businesses that make up Davis New York Venture Fund. We would also caution that the price of each of these businesses has risen quite sharply in recent periods and we have not added to our positions at current prices. Finally, we would point out that we may trim these positions from time to time in order to fund redemptions.

Our largest position is Bank of New York Mellon (BK). Starting with the business, despite having the word “bank” in its name, Bank of New York Mellon is not a bank in the traditional sense but instead primarily provides a range of processing, custody and investment management services to corporations, governments and financial institutions. While absolutely essential, these services are not easily understood by the layman. To use an analogy, if the financial markets are like a thriving city, then Bank of New York Mellon would be the local electric utility, a necessary but unglamorous element of the city’s infrastructure. The two largest segments (comprising approximately 55% of total company earnings) are asset custody (where it holds $26 trillion in assets on behalf of customers) and issuer services (where it acts as trustee for approximately $11 trillion of debt securities and more than 1,300 depository receipt programs). To put these numbers in perspective, the market capitalization of the entire S&P 500® Index is about $15 trillion and the total government debt outstanding (federal, state and local) in the United States is about $20 trillion. Each of these businesses is an oligopoly in which Bank of New York has a leading position with durable competitive advantages derived from economies of scale, the costs of switching and customer loyalty.

In addition to the base fee income earned in its investment services business, the bank generates ancillary revenue from foreign exchange trading, securities lending and the interest rate spread on approximately $220 billion of low cost deposits on which the bank currently pays an average interest rate of less than 0.1%. The “moat” around the investment services businesses is evidenced by the high returns on tangible equity that Bank of New York earns—currently in the mid-20’s and historically in the mid-30’s.

Bank of New York also has a more traditional investment management business that represents approximately 30% of total company’s earnings. This business is made up of a diverse collection of equity, fixed income, alternative asset, and money market management services with an aggregate of $1.4 trillion of assets under management. The investment management business also offers an inherently high return on capital, though the moats surrounding it tend to be lower than for the investment services business. Bank of New York’s diversity of asset classes offers some protection from the ebbs and flows of investor sentiment.

In general, each of the bank’s major businesses should grow in conjunction with the continued increase in the amount and value of debt and equity outstanding globally, with only modest incremental capital needed to support that growth.

In terms of people, CEO Gerald Hassell has held that position since 2011, and prior to that had been president since 1998. Since assuming the role of CEO, he has focused the company on improving operational efficiencies and on the disciplined allocation of capital. Having built up its regulatory capital levels over the last few years to comply with Basel 3 rules (voluntary global regulatory standards developed in response to the global financial crisis of the late 2000’s), Bank of New York is today allocating approximately 70% of earnings to share repurchases and dividends (after already returning some $3 billion to shareholders in the last two years), with the balance retained to support largely organic growth at high incremental rates of return. Given the utility nature of this business, the bank does not need a visionary leader but rather a disciplined one, a description that seems to fit Mr. Hassell. Past leaders have pursued expensive acquisitions and poorly thought-out strategic expansions. Current management seems to understand this well and has wisely set their attention on execution and cost discipline.

As for price, Bank of New York Mellon is valued today at about 13 times this year’s earnings or nearly a 7.5% earning yield. As mentioned above, the majority of these earnings are distributable to shareholders as the company is extremely well capitalized (or will be by the end of this year, depending on some clarification of regulatory standards) and can grow with relatively small amounts of retained capital. Further, we consider these earnings somewhat understated because today’s low interest rates have forced the bank to waive money market fees and have depressed interest margins. We estimate an increase of 100 basis points in interest rates could increase earnings by about 15% and reduce the valuation multiple to only 11 times earnings.

Finally, we must consider the risks. When presenting the rationale for an investment, it is common to hear all the reasons the investment will be successful. As a central part of our investment process, we want to examine all the reasons an investment could fail. With acknowledgement to the wonderful behavioral economist Daniel Kahneman, we refer to this exercise as a “pre-mortem.” For any company, the most dire risks might be called “existential risks.” These are the risks of some event or series of events entirely wiping out existing stockholder value. In recent years, existential risks have tended to be caused by either leverage or obsolescence (usually resulting from technological innovation). Although Bank of New York Mellon is certainly leveraged in that assets significantly exceed equity, these assets are predominately government securities and deposits rather than loans or securities subject to credit risk. In fact, in the draconian stress test laid out by regulators, which assumes a 5% decline in GDP over two years, an unemployment rate of 12%, a stock market decline of 50%, and residential and commercial real estate declines of 20%, Bank of New York Mellon would actually make more than $5 billion before taxes. As for technological obsolescence, the very fact the bank is well into its third century of existence would seem to indicate a relative low risk of obsolescence, which is true. As with an electric utility, the services provided by the bank are essential and irreplaceable.

Although such existential risk is low at Bank of New York Mellon, there are other important risks that could hurt our investment. The largest of these may well be a matter of national security. Although the bank maintains outstanding computer systems and other safeguards, a significant disruption, most likely in the form of a cyber-attack, of the bank’s computer operations could result in substantial losses given the sheer number of transactions processed every hour. At a less esoteric level, the bank is regulated as one of the world’s most significant financial institutions. As such, missteps with the regulators or inappropriate conduct toward customers (as happened several years ago when the bank was accused of pricing foreign exchange trades in a misleading manner) could result in significant fines, legal liability or higher capital requirements. Although the bank operates in an oligopoly in most of its businesses, another risk is that participants in an oligopoly do not always behave rationally. Certainly, in recent years a tendency toward undisciplined pricing has permeated this industry, though we hope this trend is diminishing. Finally, we must consider the possibility of the bank making a large, dilutive acquisition. Despite overwhelming data indicating that such acquisitions rarely create value, we are continually surprised by how often companies are tempted by the siren song of investment bankers. Fortunately, we consider this risk a remote one under current management.

Our next largest investment is American Express (AXP). In terms of business, American Express has a unique business model that combines one of the strongest brands in financial services with ownership of the underlying payment network. The company’s strong brand, which stands for high-quality service, success and prestige, attracts affluent credit and charge cardholders who spent an average of $15,700 per primary card in 2012, or about four times the level of Visa and MasterCard credit cardholders. American Express reinforces this higher spending with best-in-class customer service and its leading cardholder rewards program, creating a virtuous circle of strong customer satisfaction, higher share of wallet per customer and lower customer turnover.

In reviewing the company’s competitive advantages, we should start with the obvious observation that using charge cards and credit cards is vastly superior to using cash and checks in terms of convenience, safety and record keeping and thus cards should continue to gain market share from cash and checks for years to come. As noted above, American Express is not the only option within the card industry. However, in comparison to Visa and MasterCard, the company has a number of key competitive advantages. Chief among these are the American Express brand and the higher spending patterns of its wealthy consumer, corporate and small business cardholders. Because American Express customers spend more, merchants are willing to pay the company a higher fee. Furthermore, because American Express is primarily a charge card, rather than a credit card, it is far less reliant on consumer lending for revenue and profits than typical card issuers. For example, the company generates almost four times as much revenue through transaction or interchange fees from merchants ($18 billion) as it does from lending to cardholders ($4.6 billion of net interest income before $2 billion in charge-offs). Cardholder rewards are a key enticement for customers, and with $6.3 billion allocated to rewards in 2012 American Express has the largest program in the industry.

In terms of growth, if the company maintains its appeal and usefulness for consumers over time, per-card spending and transaction fees should increase with disposable income as should market share gains from cash and checks. Because the Internet does not accept cash, the high growth of Internet commerce provides an additional tailwind. The total amount spent by American Express cardholders, or “billed business,” has increased from $124 billion in 1993 to $888 billion in 2012, an increase of seven times in 19 years, or almost 12% per year. International billed business has almost doubled since 2006 and now accounts for $313 billion or 35% of the total, up from 30% then.

Finally, because its payment network is wholly owned, American Express largely avoids sharing its transaction fees with others. This closed loop allows the company to generate significantly greater revenue per transaction dollar than the networks of its competitors Visa and MasterCard, whose interchange fees are shared with issuing banks and other payment processors. Full control over the payment network should also lead to better customer insight over time, perhaps enhancing targeted customer offers and driving higher spending per card.

Turning to people, Ken Chenault (age 62) has been CEO for 12 years, having joined the company in 1981, and we give him high marks. Working closely with his predecessor Harvey Golub, Mr. Chenault helped refocus the company on the core charge/credit card business while spinning off the financial advisors business (Ameriprise) in 2005 and other unrelated businesses before that. Since becoming CEO he has repeatedly lowered the cost structure of the business, including cutting costs in the corporate and retail travel business in late 2012 with a goal of reinvesting at least half the savings in the card business. President Ed Gilligan (age 53), Mr. Chenault’s likely successor, also has had a long and distinguished career at the company, having joined in 1980 and previously run the travel, international and corporate services divisions. In addition to the fact this team has done a good job managing their business, they also deserve praise for avoiding both large acquisitions and, to use another excellent term coined by Peter Lynch, “diworsification.” Finally, we commend this team for maintaining generally sensible compensation practices and exercising unusual restraint in the granting of large amounts of dilutive equity compensation.

Turning now to price, American Express trades at approximately 14 times our 2013 estimate of owner earnings, what an owner of the entire business could distribute or choose to reinvest on a discretionary basis. Put differently, purchased at today’s price, the company generates about a 7% earnings yield. The dividend yield is 1.2%. The company’s return on equity has consistently been above 20%, and the company generates substantial discretionary free cash flow that can be returned to shareholders, often in the form of share repurchases and dividends. The number of shares outstanding has declined 24% since 1993, a decrease of about 1.5% per year. More recently, shares outstanding at year-end 2012 were down 4.2% from year-end 2011, and we expect the trend of higher share repurchases to continue in 2013. At the same time, the dividend has increased from $0.33 per share a year in 1993 to $0.80 per share a year, an increase of 2.4 times or 5% per year. The potential capital returns are enabled by a very strong capital position, with a Tier 1 capital ratio of 11.9%.

Finally, and most important, we should discuss our view of the major risks facing this wonderful business. Chief among these is the possibility of the company losing its consumer relevancy in terms of convenience, brand, service, or the value proposition (rewards). Although such a decline can happen slowly or quickly, we are reassured that management continues to plough money into marketing and cardholder rewards rather than “milk” the business for short-term earnings. A second critical risk lies in the possibility of a dramatic upheaval in the payments industry, likely enabled by Internet technology. In considering this possibility, we note that a number of small and larger companies have attempted to break into the electronic payments industry, but so far PayPal is the only clear success story. Others, such as Square, actually have expanded the reach of the industry by allowing smaller merchants to accept cards. In addressing this risk, the company has also made a number of small acquisitions of new technologies, which might be viewed as a type of R&D expense. A third major risk is that the economics of American Express’s existing business could be slowly eroded as other card issuers pursue the same transaction-based (rather than lending-based) customers. JPMorgan Chase has been a particularly determined competitor in the affluent customer segment, with aggressive marketing and rewards programs. For example in its most recent financial statements, JPMorgan indicates that its total payment volume and customer spending per card are almost as large as American Express’s U.S. retail card business. While this trend must be watched closely, we feel management is doing a good job meeting these competitive challenges. For example, since 1999 American Express has grown its share of U.S. credit card purchases from 20% to 26%, a meaningful increase in market share in 13 years. Next, we must always consider the actions of regulators. Retailers are not forced to accept credit or charge cards, but they often complain to regulators and legislators about the fees they pay. Although this is a more modest risk for American Express than Visa or MasterCard and also less likely today than a few years ago, it could become an issue again at some point. Finally, we must consider the possibility of American Express making a large, dilutive acquisition, a risk we also noted above in our discussion of Bank of New York Mellon. Fortunately, as with Bank of New York Mellon, we consider this risk a remote one under American Express’s current management.

Our third largest position is an extraordinary technology company dedicated to organizing the world’s information and making it both useful and accessible to anyone, anytime, anywhere. In just 15 years, this company’s remarkable collection of engineers have been so successful that the company’s once strange-sounding name, Google (GOOG), has become a verb synonymous with Internet search. As a business, the company currently receives payment for the value of its technology by selling advertisers the right to place ads above or alongside a user’s search results. Such advertisements currently represent 95% of Google’s revenue, making the company the largest and most profitable advertising company in history. Because search has the advantage of allowing advertisers to control and track the return on their advertising expenditures (for example, they only pay if the ad is clicked on), they finally have a response to the lament of department store owner John Wanamaker who famously complained, “Half the money I spend on advertising is wasted; the trouble is I don’t know which half.”

In its core Internet search business, Google is the unquestioned global leader, with a 67% share of all Internet searches in the United States (compared to Bing’s 16% and Yahoo’s 12%), a stunning 93% share in Western Europe and a 74% share globally. While an estimated 80% of all searches still come from desktop PCs and tablets, Google is also the leader in mobile searches, which already account for 20% of searches and are growing rapidly. Google’s costs are largely fixed and consist of people and data centers. Each additional time a user clicks on an ad, the incremental revenue represents almost 100% profit. Google’s current operating margins in the low 30% range understate the company’s true profitability as they include enormous investments in innovative products such as Android, Google+, Google Wallet, and Google TV, which help widen its competitive moat, as well as “blue sky” products such as Google Glass and the Google car.

The company benefits from a number of key growth drivers including growth in the number of people and devices accessing the Internet both here and abroad, the continuing growth in the number of searches performed per user, the increasing number and value of display advertisements, and the global spread of smartphones through which billions of new users can gain access to the Internet. The company has significant competitive advantages, the most important of which is scale. Google’s industry-leading scale means that it has more advertisers bidding for key words than its competitors, which allows it to earn a disproportionate amount of search revenue (for example, Google has a 67% share of searches but an 82% share of search revenue). Scale also generates more search data, which leads to better search results, and more ads, which lead to better targeting and more useful ads. In addition, scale results in a larger R&D budget, which leads to an improved product and the ability to attract top engineering talent, which then attracts other talented engineers.

Google’s people and corporate culture are further important sources of competitive strength. As its co-founder and CEO, Larry Page, has only just turned 40 and is passionately engaged in the business, the company’s intensely innovative, driven and entrepreneurial culture is unlikely to change for the worse and, more important, the company is likely to remain the employer of choice for the country’s top technology minds. From a shareholder point-of-view, however, the culture is not perfect. The opportunistic repricing of stock options during the financial crisis was extremely unfortunate and, in our view, unnecessary. In addition, the company’s pay policies are structured so that a Google employee will rank in the 95th percentile or higher compared to employees performing a comparable function at other companies. However, this policy will be truly problematic only if the company’s employees fail to perform at the 95th percentile level (a dynamic that New York Yankee fans have come to understand all too well!). Finally, the company has a dual-class share structure, which means that public shareholders (like us) have no say about the direction of the company. Taken together, such policies may indicate a culture that favors employees over shareholders. However, having spent time over the years with management, our tentative response to this troubling aspect of an otherwise wonderful company is that management’s cynical view of investors is shaped by their formative exposure to the Wall-Street-hyped nonsense of the millennial Internet bubble and the short-term analysts and traders that have tended to leap in and out of Google’s stock based on quarterly results. Ultimately, we think the idealism, passion and principles of the founders are genuine. We would note, for example, the total compensation of Larry Page and co-founder Sergey Brin since going public has been $1 each per year.

At a share price of $880, Google has a $259 billion enterprise value, and trades at approximately 21 times estimated fiscal year 2013 owner earnings and 17 times estimated fiscal year 2014 earnings. Given the company’s growth prospects and competitive advantages, we consider this a fair price for a great company. The balance sheet is strong, with a net cash position of $49 billion, or 16% of the company’s market capitalization. The company has consistently generated high returns on invested capital, ranging from 38% to 48% over the last five years.

A main risk with the investment is that incremental searches, mainly in emerging markets and on smartphones, are less profitable than historic searches and might be insufficient to offset slowing core desktop PC search in the United States and Europe. Although we have seen revenue per search falling in the last few years, we believe that over time the value of both emerging market and mobile searches will rise. For emerging markets, we expect that increasing Internet penetration (globally now 39% compared with 81% in the United States) and a rising middle class will increase Google’s revenue per search from today’s low levels. In smartphones, we believe advertisers will start building mobile specific advertising campaigns using location-based advertising and features such as “click to call” and “click for directions.” A second risk would come from users choosing to bypass Google because a more useful search mechanism developed based on data that Google cannot access. At this point, the only plausible contender would be Facebook’s attempt to develop ways of searching for information from your “friends,” which might be more relevant than information from the Web in general. While this seems possible at the margin, it remains more theoretical at the moment. A final important risk may be a lack of discipline in capital allocation or a gradual trend toward “diworsification.” While there is some debate about the apparently high price paid for Motorola’s handset business, for example, the success of a number of Google’s other acquisitions, including Android and YouTube, lead us to give them the benefit of the doubt.

We hope that this more in-depth discussion of our largest holdings provides a deeper insight into both our investment discipline and our optimism about the Fund’s future prospects. While we could go on for many more pages about every aspect of these companies, the bottom line is that the combination of good businesses run by value-creating managers selling at reasonable prices should lead to satisfactory investment returns over time. Although we must constantly learn from mistakes and adapt to a changing world, we are convinced that the proven investment approach that has served us well over the last four decades should serve us well in the decades 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 As of June 30, 2013.3 Class A shares without a sales charge. Periods referenced are rolling 5 year periods. There is no guarantee that periods of underperformance will be followed by outperformance. See endnotes for a description of 5 year under/outperformance. Past performance is not a guarantee of future results. 4 Source: Davis Advisors. 151 managers from eVestment Alliance’s large cap universe whose 10 year gross of fee average annualized performance ranked in the top quartile from January 1, 2003–December 31, 2012. Percentages represent the portion of those managers whose performance fell to the bottom half of their peer group for at least one three year or five year period, respectively. Past performance is not a guarantee of future results. 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.

Firm Update

Despite record high markets, equity investment firms in general continue to face outflows as memories of the long bear market still haunt investors. For firms like ours that specialize in fundamental research and active portfolio management and that have gone through a period of lackluster relative results, this trend of outflows is exacerbated by the relative popularity of passive index funds and exchange-traded funds (ETFs). Because these trends could continue for some time, it may be helpful to provide some perspective on how our firm is positioned and prepared.

One advantage of having a long history in the investment business is the recognition that stock markets, investment styles and client sentiments all go through significant cycles. As a result, we have long recognized one of the great dangers in good times is to forget that hard times will surely follow. All too often, we have seen investment firms over-expand when assets are pouring in only to find themselves closing offices and trying to cut costs when the cycle reverses. Such distractions can pull managers away from their investment focus and thus detract from client returns. As a result, we are and always have been privately owned, frugal, singularly focused, and well capitalized. Consequently, clients can rest assured that we have never made changes in our investment team or research resources because of changes in the amount of assets we have under management. This commitment is underscored by the very large investment that we, our colleagues and our families have side by side with our shareholders in the funds we manage. Remaining focused on investment returns is job number one, two and three at our firm, regardless of where we are in the investment management cycle. In 1886, Collis Potter Huntington founded Newport News Shipbuilding with the mission statement, “We shall build good ships here. At a profit if we can. At a loss if we must. But always good ships.” To paraphrase Mr. Huntington, at Davis Advisors, we will generate the best investment returns we can. With a large client base if possible. Or a small client base if necessary. But always the best investment returns we can.

Conclusion

Over the last several years, we have used these reports to provide an accounting and explanation of past results. We pointed to past periods of underperformance in our own history, we studied the records of other successful investment managers and we presented data indicating the value of the companies that make up Davis New York Venture Fund had grown despite years of lagging stock prices. In light of improved recent results, we thought it might be more useful in this report to present the investment rationale and specific characteristics of our largest investments in order to help investors understand why we believe that Davis New York Venture Fund is well positioned for the future and that results should be satisfactory on both an absolute and a relative basis. Missouri is famously nicknamed The Show-Me State. In our view, Davis New York Venture Fund is now a “show-me fund.” If we are correct in our analyses, then the numbers we report in the future should speak for themselves.

As always, we would like to end by thanking our colleagues. Ken and I believe unequivocally we have the best research team we have ever had. We have come through a gauntlet together and look to the future with resolve and optimism. Although we are a team first, we still must single out our longtime colleague Danton Goei. In the 15 years we have worked together, his insights have meaningfully contributed to our returns and his character has meaningfully contributed to our firm.

We are deeply grateful to the shareholders who came through this difficult period with us. We are mindful of the trust you have placed in our firm and we are committed to building on these improved returns in the years ahead. Thank you.

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 June 30, 2013, the Fund had approximately 12.3% 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 June 30, 2013, the top ten holdings of Davis New York Venture Fund were: Bank of New York Mellon Corp., 6.53%; American Express Co., 6.43%; Google Inc., Class A, 5.96%; Wells Fargo & Co., 5.93%; Berkshire Hathaway Inc., Class A, 5.53%; CVS Caremark Corp., 5.26%; Bed Bath & Beyond Inc., 3.95%; Costco Wholesale Corp., 2.92%; Canadian Natural Resources Ltd., 2.52%; UnitedHealth Group Inc., 2.39%.

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 October 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.

#4772 6/13 Davis Distributors, LLC, 2949 East Elvira Road, Suite 101, Tucson, AZ 85756, 800-279-0279, davisfunds.com


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