Investment Results
The Davis Appreciation and Income Fund seeks to generate total returns through a combination of capital appreciation and income with a degree of downside protection.1 We regard the Fund as an all-in-one solution for growing shareholders’ purchasing power over the long term.
For the year ended December 31, 2019, the Davis Appreciation and Income Fund returned 20.33%. By comparison, the Bloomberg Barclays U.S. Aggregate Bond Index returned 8.72%, the 60% S&P 500/40% Bloomberg Barclays U.S. Aggregate Bond Index returned 22.16%, and the Endowment Index returned 20.19%.2 The performance of the Fund, as well as the indexes during the period reflect in part the strong performance of U.S. equities. The S&P 500 Index returned 31.49%, making it one of the 10 best years in the last half century. In addition, bonds have in many instances benefited from declining interest rates.
Fund Overview
The Davis Appreciation and Income Fund is benchmark-agnostic and designed as an all-in-one solution for our clients, seeking to generate satisfactory absolute returns above inflation over the long term. Our mandate, in other words, is first and foremost to preserve and grow shareholders’ purchasing power over time. We seek to achieve three main goals: (1) growth of capital through equities, (2) rising income, and (3) a degree of downside protection.3
Over the last several years, and against a very favorable economic backdrop, the Fund has returned close to 9% per annum versus an inflation rate of approximately 2% and a risk-free rate under 2% currently. Hence our real return and our return over prevailing interest rates have been relatively solid thus far, with purchasing power having grown over the last several years overall.
The income yield of the Fund is relatively low, with fixed income yields compressed due to the low interest rate environment. To the extent the Fund’s income yield has been rising steadily, it is being driven by rising dividends primarily, particularly in financial services. Given the current environment, it is our preference to build a growing stream of income starting from low payout ratios (in financials especially) than overpay for the privilege of owning higher dividend (but expensive) names today with stretched payout ratios.
Meanwhile, in terms of downside protection, a mix of stocks and high-grade fixed income should provide a natural degree of diversification. That stated, the most important measure of downside risk is not marked-to-market share price volatility, but the potential for large and permanent impairments to capital at the position level. For this reason, the Fund holds exceptionally durable businesses with fortress balance sheets in the main. To the limited extent we hold some businesses with leverage, position sizes for those businesses are set accordingly, and those holdings tend to be few and far between. We cannot control or predict market volatility or share price fluctuations, but we can construct a diversified portfolio of businesses that are built to last and that can weather a number of economic or market conditions.
The average annual total returns for Davis Appreciation and Income Fund’s Class A shares for periods ending December 31, 2019, including a maximum 4.75% sales charge, are: 1 year, 14.62%; 5 years, 3.75%; and 10 years, 6.99%. 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 1.01%. 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.
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. All fund performance discussions within this piece refer to Class A shares without a sales charge and are as of 12/31/19 unless otherwise noted. This is not a recommendation to buy, sell or hold any specific security. Past performance is not a guarantee of future results. Total returns are not annualized for periods of less than one year. 1 While we seek to structure a portfolio that will increase in value when the S&P 500 Index increases and that will provide downside protection when the S&P 500 Index declines in value there can be no assurance that the portfolio will perform in line with our expectations. 2 The 60% S&P 500/40% Barclays Aggregate Index is a composite blend of 60% of the S&P 500 Index and 40% of the Bloomberg Barclays U.S. Aggregate Bond Index and represents a broad measure of the U.S. stock and bond markets, including market sectors in which the fund may invest. 3 While we seek to structure a portfolio that will increase in value when the S&P 500 Index increases and that will provide downside protection when the S&P 500 Index declines in value there can be no assurance that the portfolio will perform in line with our expectations. Past performance is not a guarantee of future results.
Portfolio Review
The Fund is consciously positioned in 27 high-conviction equity holdings as well as a portfolio of high grade fixed income securities.
In 2019, the Davis Appreciation and Income Fund returned 20.33%. It has compounded at close to 9% for the last three years, which is close to the very long-term average return for U.S. equities and well above the 2% current domestic inflation rate.
In terms of positioning, we believe the combination of well-researched, durable businesses within our equities allocation (approximately 75% of the Fund) with prudently selected, high-grade fixed income makes the Fund an all-weather, all-in-one strategy intended to serve relatively conservative investors seeking to grow purchasing power over the long term with a moderate risk tolerance.
Equities
At a high level, and in a market that contains both undervalued and overvalued stocks, we have consciously positioned the equities in the Fund to strike an intelligent balance of select, very durable, growing businesses that are trading at value prices—a key to our long-term success over our 50-year history as an investment manager.
Our selectivity when choosing investments is evident in the fact that we hold 27 individual equity investments versus more than 500 securities in the S&P 500 Index. Our portfolio companies have generated five-year earnings per share growth of 17.4% versus the Index’s 17.1% growth rate over the same timeframe. Meanwhile, our portfolio trades at a very reasonable forward multiple of 15.7 times earnings versus a much higher multiple of 20.0 times for the S&P 500 Index. Overall, we believe our positioning is strong on a prospective basis and should benefit from an advantageous starting point into the coming decade.
At a more granular level, we have constructed a rather eclectic equity portfolio that includes:
- High-grade financials (both U.S. and non-U.S.) such as U.S. Bancorp (USB, Financial), Wells Fargo (WFC, Financial), DNB ASA (OSL:DNB, Financial) of Norway, and DBS Holdings of Singapore which, while mundane, offer some of the best value of any sector in our view;4
- Intensely innovative, fast-growing market leaders such as Amazon.com (AMZN, Financial), Alphabet (GOOG, Financial), and Microsoft (MSFT, Financial), as well as workhorse technology companies such as Applied Materials (AMAT, Financial), Intel (INTC, Financial), and Texas Instruments (TXN, Financial). Whether these businesses are engaged in e-commerce, cloud computing, or other large and rapidly expanding end markets tied to semi-conductors, our technology holdings are all in leadership positions that we believe will play to their advantage competitively in vast new, profitable fields.
- Select industrial companies like United Technologies (UTX, Financial) and Johnson Controls International (JCI) with strong recurring revenue characteristics, defensible competitive positions, and relatively attractive margins.
- A select healthcare business, Quest Diagnostics (DGX), which is a leader in independent lab and diagnostics services. The company’s business model relies on it delivering on the value proposition of lowering lab-related expenses and effectively serving as part of a cost solution to rising healthcare costs in the U.S.
- A very small allocation to energy companies Apache (APA) and Encana, which have been detractors to performance in recent periods but are, in our view, trading at depressed multiples today.
Fixed Income
Our fixed income allocation represents approximately 22% of the portfolio. Our investments in this asset class have a weighted average credit rating of A+ with a duration of 1–2 years. We are largely invested in senior debt positions in corporates in addition to holding agencies and mortgages. We have both fixed and floating rate instruments. While our income yield is actually higher in certain equities than in the fixed income sleeve, we are on the lookout for opportunities that fit our risk tolerance and offer adequate compensation for the risks involved within the bond markets. What is clear is that accessing income is perhaps the most challenging feature to deliver to investors without taking undue credit, valuation, or other risks. For the time being, we are erring on the side of prudence in protecting principal and are comfortable maintaining credit quality over yield at this juncture.
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.
Conclusion
Overall, we feel confident in the durability of the Fund because of the fundamental strength of the businesses we own as well as the natural diversification created by a multi-asset class portfolio. Our main objective is to offer our shareholders an all-in-one solution that can achieve growth in purchasing power, rising income over time, and a degree of downside protection.
At Davis Advisors, we seek to purchase durable businesses at value prices that can be held for the long term. The more than $2 billion Davis Advisors, the Davis family and Foundation, our employees, and Fund directors have invested in similarly managed accounts and strategies remains a true sign of our commitment to and conviction in this enduring philosophy.5 We look forward to continuing our investment journey together.
5 As of 12/31/19.
This report is authorized for use by existing shareholders. A current Davis Appreciation and Income 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.
