Please provide your perspective on financials in the current environment:
The S&P Financials Index declined −24% in the first half of 2020, and the KBW Bank Index fell even further at −33%, underperforming the broad market indices. The industry has suffered from a one-two punch of anticipated credit losses resulting from the COVID-19-induced recession and declining interest rate expectations that pose a headwind to its primary source of revenue, interest income.
While this recession will weigh on banks’ earnings for a time, we feel that the market’s reaction has overdiscounted the magnitude of the impact. In times of fear, it is a challenge for investors to keep their emotions in check. Whether it was the bear market of the 1970s and early 2000s or the financial crisis, buying after significant price declines rewarded long-term investors who could do so.
The average annual total returns for Davis Financial Fund’s Class A shares for periods ending June 30, 2020, including a maximum 4.75% sales charge, are: 1 year, −22.69%; 5 years, 0.71%; and 10 years, 7.43%. 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 0.94%. 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 Fund recently experienced significant negative short-term performance due to market volatility associated with the COVID-19 pandemic.
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 6/30/20 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.
Discuss why you are optimistic about financials:
We wrote to you in December that investors remained leery of financial stocks—banks in particular—with memories of the financial crisis still vivid. The lockdowns around the world and associated economic decline have exacerbated investors’ fears. But banks are in a very different position than before the financial crisis.
First, banks are starting from a much stronger capital position. Their levels of common equity are roughly double what they were in 2007. The Federal Reserve’s just-released annual stress test for 2020 revealed that U.S. banks collectively were holding greater than 15% more capital going into this crisis than required to meet the “stress capital buffer”—i.e., the threshold that in theory permits them to distribute capital to shareholders as they see fit.1 However, out of an abundance of caution, for the third quarter, the Fed has asked U.S. banks to refrain from buybacks, and it superimposed a cap on dividends relative to trailing earnings that will impact a few banks despite their excess capital positions. Most U.S. banks are poised to continue paying dividends at the current level. Concerning our European holdings, regulators have demanded or encouraged banks to suspend or delay their dividends without distinguishing between those that can afford to maintain them and those that cannot. All else being equal, we would, of course, prefer their dividends to be continued (and buybacks too where appropriate), but we’re consoled by the fact that this retained capital does not disappear, and all of our European holdings are continuing to generate capital at adequate rates.
Second, bank loans have been underwritten to much higher credit standards than in the buildup to the financial crisis. In contrast to other recessions, this one is not the bust that inevitably follows an economic and financial boom. Our U.S. banks increased their reserves by 0.5% of loans in the first quarter of 2020 and seem poised to repeat a similar increase in the second quarter.2 These are indisputably large credit loss provisions (though in aggregate, our holdings still made money in the first quarter). There was, however, a critical accounting change made at the start of this year to adopt “life-of-loan” loss reserving. The rule means just what it says—you must reserve for all the losses you ever expect to take on a loan. As a consequence, banks will absorb most of the pain of a recession all at once as the economic outlook deteriorates. While it is always possible that the already grim outlook could deteriorate further (and therefore require additional loss reserves), at some point it will stabilize, and that point almost surely will come long before the economy actually starts improving. Bank managements will know considerably more about the state of the economy at the end of the second quarter than they did after the first, so we think it’s reasonably likely that this will mark the low point for loan loss reserves.
The deterioration in the interest rate environment will result in pressure on banks’ revenue, and it will continue for several quarters as maturing fixed-rate assets roll over at lower reinvestment yields. On the funding side, most banks can only decrease their deposit costs by 50 bps or so before hitting the 0% floor, which won’t fully offset the 1.5 point decline in the Fed funds rate or the approximately 1 point decline in the 10-year Treasury yield. In practice, loan yields do not decline one-for-one with their underlying benchmark yields due to LIBOR floors, hedging strategies and credit spreads that seem to widen when rates are so low. Still, an eventual approximate 15% decline in interest income relative to the Q1 2020 run-rate wouldn’t be unreasonable.
So why are we optimistic about financials today? Because the market has already priced in these adverse trends in credit and interest rates, and in our view, it is actually overdiscounting them. The intrinsic value of companies reflect their cumulative earnings over many years into the future, not just the next couple. We don’t forecast the economy or interest rates, but we are confident that in time, our economy will recover, and interest rates will revert to levels sufficiently above zero, thereby restoring banks’ earnings power. Even if that takes several years to come to fruition, the returns to investors at today’s prices should be quite attractive.
1Source: Dodd-Frank Act Stress Test 2020 and DSA analysis. 2Source: Company filings and DSA analysis.
Please provide an update on the Fund’s long-term performance and more recent results:
Since its inception in 1991, Davis Financial Fund has invested in durable, well-managed financial services companies at value prices that can be held for the long term. In 1991, financial stocks were deeply unpopular. The scandals of the savings and loan crisis and the steep decline in commercial real estate that occurred in the late 1980s and early 1990s were fresh in investors’ memories. However, where others saw unfavorable news, we recognized opportunity, for the simple reason that even as investors were avoiding financial stocks, many underlying financial businesses were both durable and improving. By focusing on economic reality rather than investor sentiment, Davis Financial Fund has compounded shareholder wealth at 10.1% over the 29 years since then, outpacing both the S&P 500 Index and the S&P 500 Financials Index.
Through the first six months of 2020, Davis Financial Fund declined −28%, exceeding the decline in the S&P Financials Index by approximately 4 points. The primary source of that relative performance stems from our underweight positions in “non-balance sheet” financials such as exchanges, ratings agencies, insurance brokers, and asset managers (one in particular), whose stocks have actually performed quite well this year. While we admire many of these companies, in our view, they had become quite expensive, and in some cases, have become more expensive, trading at multiples of 20x, 25x and even 30x earnings. We’re not prepared to call our portfolio positioning a mistake just yet, but it certainly has hurt returns so far. As Ben Graham said, “In the short run, the stock market is a voting machine. In the long run, it is a weighing machine.”
Please discuss how Davis Financial Fund is positioned today:
Our approach in assembling our portfolio has remained consistent over time: we look for companies with durable competitive advantages coupled with competent and honest management, priced at a discount to their intrinsic value. We invest under the presumption that we will own our companies through business cycles. We do not attempt to build a portfolio around a particular speculative forecast of where interest rates or the economy will go, but strive to construct a portfolio that will perform well over the long term across a range of outcomes. The resulting portfolio is diversified across leading franchises earning above-average returns on capital in banking, payments, custody, wealth management and property and casualty insurance.
Our portfolio, by some measures, is rather concentrated in our favorite investment ideas. The S&P Financials Index is quite concentrated as well, with two names sized above 10% and five names comprising about 40% of the fund (four of which are money-center banks), but of course, those position sizes are determined by solely market cap. On occasion, those large companies might coincidentally be the “right” stocks to concentrate in; they certainly weren’t in 2008.
Discuss some of the businesses Davis Financial Fund owns and any notable changes during this period:
Capital One (COF, Financial) is among our largest holdings and one we leaned into during the first half of 2020, as loan loss concerns weighed on its share price. At the end of the first quarter, Capital One had already reserved for losses on its credit card book equal to 11% of loans outstanding, after adding approximately 2.3 points to its reserves in the quarter.3 While we expect the company will add additional reserves in the second quarter, we also observe that management has earned a reputation for recognizing bad news early. Admittedly the economy is experiencing unemployment rates unlike anything since the Depression, but with the bulk of the federal government’s stimulus bill geared toward the replacement of wages (e.g., enhanced unemployment benefits, stimulus checks, the Paycheck Protection Program loans), consumers largely have the means to honor their financial obligations (at least through the first few months of this recession, and Congress may do more in the coming weeks). Capital One should soon be able to put reserve-building behind, is capable of earning returns on capital in the mid-to-low-teens over time and is valued at only 0.8x tangible book value.
Bank of NY Mellon (BK, Financial) acts as a custodian to asset managers and owners, is the trustee for bond issuances and depository receipts and operates a clearing business for brokers, dealers and RIAs. It incurs little credit risk for a “bank” of its size—a trait well-illustrated in Bank of NY Mellon’s supervisory stress test where the Federal Reserve officials modeled that it would earn more than $4 billion in pre-tax profits in the “severely adverse” scenario. The majority of its revenues are fee-based, but it also earns approximately one-fifth of its revenue from interest income on the approximately $250 billion of client deposits that these businesses attract. The decline in interest rates erodes that revenue stream and does so relatively quickly, given the short duration of its assets. It’s valued today at 10x current year earnings, which already reflects most of the impact from lower interest rates. The earnings upside from an eventual rise in interest rates could be 20–30%.
3Source: Company SEC filings. Figures are inclusive of losses shared with retailer partners.
Looking ahead, what is your outlook for Davis Financial Fund?
Investors’ fears of the credit losses that could be incurred during the COVID-driven recession, combined with the decline in interest rates, are weighing on the stock prices of financial companies, notably banks. We believe that banks are far better positioned to withstand a recession than they had been before 2008, and their valuations are so low that we think they should generate strong returns from here.
We are excited by the investment prospects for the companies in Davis Financial Fund. Nothing provides a stronger indication of that than the fact that the Davis family and colleagues have more than $50 million invested in the Fund alongside our clients.4 We are grateful for the trust you have placed in us.
4As of 6/30/20.
This report is authorized for use by existing shareholders. A current Davis Financial 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 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.
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.
