Market Perspectives
Opportunities are available at very attractive prices, but selectivity is key.
In the first half of 2020, the S&P 500 Index returned −3.08%. Stocks have been volatile, which is understandable, given the near-term disruption and uncertainties introduced by COVID-19. It remains to be seen how the pandemic might ultimately impact individual businesses, different industries and whole economies. Our view is that opportunities are available at very attractive prices, but it is essential to be selective and, ideally, to apply the margin-of-safety principle in terms of valuation discipline.
We are neither optimists nor are we pessimists. Rather, it is a time to be realistic, both about the near-term uncertainty and challenges economically that we face, but also taking into account how the future may improve from here in iterative fashion.
In the immediate term, we know headline figures such as unemployment claims, a decline in gross domestic product, and other such metrics will look unfavorable, and they could persist for some time. We believe, therefore, that investors should be prepared for that potentiality both in terms of their mindset and their allocations and positioning in general. As for how long this period could last, the answer will depend in large part on industry and government efforts to address the virus situation with treatments and/or vaccines. But there are also important components of the U.S. response to the virus already underway, and they must figure into one’s assessment about the probability of successfully weathering these recessionary conditions.
Where businesses and consumers have fallen on very challenging times, the U.S. government has by all measures been willing to step in and provide fiscal and monetary support. It is worth noting that many of the tools and measures being utilized today proved their efficacy in the real-world test of the last crisis of 2008–2009. The key difference in the country’s response this time is that both the scope and the magnitude of stimulus dwarf the last crisis measures. In addition, emergency measures were deployed immediately in the present case, whereas they were rolled out with significant delay in the previous crisis. At the same time, the major U.S. banks that provide the basic economy with the lifeblood of liquidity and credit have, in some cases, more than twice the capital that they did entering 2008, with much more stable, deposit-based funding this time. The Federal Reserve has opened the discount window at minimal cost, providing nearly frictionless liquidity to the banks, precluding the possibility of a “run on the banks” scenario. Last but not least, while some companies have levered up, given the low interest rates and borrowing costs that prevailed over the last decade, many have used the favorable economic and financial conditions in recent years to strengthen their balance sheets. Taken together, we believe these multiple levels of “shock absorbers” put the economy in a position to weather a near-term recession without losing its ability to expand thereafter in resilient fashion.
There are a number of guideposts and parameters that can prove useful in navigating crisis periods while one is in them, precepts we have learned over our more than 50 years navigating the stock market through all manners of conditions and crises:
The first lesson is to focus intensely on each and every investment one holds and to be positioned in highly durable, defensible businesses. Surviving through the period of near-term stress is the paramount goal at the outset. Invaluable attributes in environments like the present include balance sheet strength (with net cash preferably) and stable sources of funds and cash flow to support operations and necessary capital expenditures.
Second, it is important to revisit the long-term and perennial relevance of different businesses—and whole industries—looking out some number of years. Some may fit squarely in the paradigm of how consumers and businesses interface (e.g., e-commerce, semiconductors embedded in smart mobile devices worldwide, financial services, etc.). In other cases, businesses may prove more ephemeral and non-essential in leaner economic times where consumers have to make more choices. Casinos, certain areas of travel, brick-and-mortar retail (already under secular pressure from online competition) and luxury goods, for example, could in theory take longer to recover, and some of those businesses may not recover fully for a long time as they engage in “nice-to-have” products and services versus non-discretionary, “must-have” categories.
Finally, diversifying one’s portfolio with a varied set of businesses can be beneficial in our experience to prevent putting all of one’s eggs in a single basket. It is prudent in our view to hold investments with differentiated drivers of success and to diversify risk factors to reduce the likelihood of a permanent and substantial loss of capital as an additional, portfolio-level risk mitigator.
The average annual total returns for Davis Appreciation and Income Fund’s Class A shares for periods ending June 30, 2020, including a maximum 4.75% sales charge, are: 1 year, −9.49%; 5 years, 0.85%; and 10 years, 5.66%. 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. 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. Total returns are not annualized for periods of less than one year.
Portfolio Positioning
We seek businesses that are cash-generative with attractive returns on capital and strong competitive moats.
With the ultimate long-term goal of growing purchasing power, it is necessary by definition to seek total returns well above inflation. To achieve our long-term investment goals, we have positioned the portfolio so that it maintains— and will normally maintain—a large allocation to equities with approximately a quarter of the Fund in cash and bonds. Within the equities portion, we are invested in both the proverbial tortoises and hares of the market—individual businesses that are cash-generative, have attractive returns on capital and strong competitive moats, and are trading at value prices.
On the one hand, we own positions in staid, fairly mundane cash-generative industries such as financial services and certain types of healthcare and industrials, many of which have a long history of returning capital to shareholders through dividends and share repurchases, while also reinvesting at attractive, if not exceptional, returns on equity. They tend to be slower growth in nature, but extremely proven, durable, established and cash-generative, and they can deliver value to shareholders through a combination of dividends, accretive share repurchases and capital appreciation driven by reinvestment rates.
At the other end of the spectrum are exceptional companies that possess superior growth characteristics, in our estimation. For example, we hold a number of technology-related businesses serving a wide range of industries, from e-commerce and cloud computing to software services and semiconductors, among others. Beyond choosing the right businesses, it is imperative with these types of businesses to adhere to a valuation discipline and to establish why one should feel confident those companies are likely to sustain their leading edge in the face of formidable competitive forces. Overall, we are trying essentially to capture total returns in a variety of ways involving considerations around both defense and offense in our selections.
The equities portfolio is diversified consciously across 24 differentiable businesses, each with its own attractive features, according to our analysis. What unifies the entire Fund thematically is the concept of durability. First, we seek to own businesses that are built to last, and second, we look to them as vehicles for compounding shareholders’ capital over the long term—and in that order, starting first with defense and then proceeding on to offense. We “look down,” assessing downside risk, in other words, before “looking up” at the total return potential long-range for each investment.
Regarding recent changes in the Fund, the market volatility of late has allowed us to make a number of adjustments to the portfolio at the margin. Certain sectors, especially high-grade financials, have declined more than the overall market, and they present investors with, in select instances, single-digit valuations and possess financial strength well beyond the 2008–2009 crisis. This means, importantly, that we have a constructive view of our financial positions over the next three to five years and beyond—even if the current year proves somewhat challenging. The major banks in the U.S. have more than twice as much capital coming into this year as they did entering the 2008–2009 crisis. From a cash flow perspective, they continue to take in cash as their business models center around the activity of “making money on money,” which is really a digital product at this point, not a foot-traffic-dependent, physical product that must be sold in a store, for example. We are avoiding consciously businesses and industries that, in a new normal environment looking ahead, fail to meet the definition of “evergreen”—i.e., perennial and enduring—favoring instead contrarian areas whose financial soundness is underappreciated, in our view.
It is really time to avoid extreme optimism or pessimism. It is a time to be realists, as noted earlier. One reality is that the near-term news headlines, headline economic statistics and possibly share price performance may prove trying psychologically for investors. We are prepared for that potentiality and are focused instead on ensuring that the businesses we own do not fluctuate in their true long-term earnings power—and therefore intrinsic values—anywhere near the extent to which their share prices might vacillate. We believe that a realistic view also should leave open the possibility that from this point of extreme depression and stress, conditions can and should improve markedly for at least the right businesses in the right sectors in the coming years and possibly quarters. Starting at low multiples of normalized earnings, we feel we have an appropriate and favorable balance of risk and reward in terms of business characteristics in our portfolios, as well as a consciously built-in margin of safety, valuation-wise. Lastly, we own a wide array of different businesses for the purpose of diversification.
Portfolio Review
In 2020, the Fund returned −12.26%, with e-commerce, communication services and technology contributing while financials and energy lagged.
In the first six months of 2020, Davis Appreciation and Income Fund returned −12.26%. By comparison, the S&P 500 Index returned −3.08%; a traditional blended index consisting 60% of the S&P 500 Index and 40% the Barclays Aggregate Bond Index returned 1.88%; and the Endowment Index returned −7.96%.1 To address the relative performance of the Fund this year, we recognize that our near-term results have been disappointing. On balance, the performance of financial and energy stocks, in particular, have caused us to lag this year. Our belief is that the future could and should be very different from the last six months, which flow of course not only through the most recent six months, but suppress our longer-term trailing figures as well for the time being. We expect many businesses to recover, if not fully at first, then gradually, and feel that long-term fundamentals are in many instances overly discounted today, especially in the lagging financials sector. With some exceptions, particularly in energy, we believe many of the positions that have hurt performance most this year could well stage a recovery on a fundamental, earnings-defined basis and feel they are trading at unjustifiably low valuations.
Financial shares have been a notable laggard this year relative to the broad market. We expect that to prove temporary in the case of the businesses we have chosen in that sector. In fact, the steep declines in the share prices for financial services companies, especially in late first quarter and early second quarter, resulted in nearly depression-level multiples, despite the reality that today they are truly built to last, in our view. The Federal Reserve has conducted stress tests on the major banks in the U.S. year after year, using a range of very strict assumptions. This Fed stress test is a useful indicator of how durable and resilient our bank holdings should be. In addition, we model out a range of adverse scenarios internally. In both cases, our analysis and findings have led us to become net buyers of financials in the first half of the year, both in the U.S. and in certain foreign markets. We believe our current investments in this sector represent good value in both absolute and relative terms.
As the largest sector exposure in the portfolio, it is worth elaborating on our financials as they are more individually nuanced than their recently correlated share prices would suggest. For instance, at one end of the spectrum is Berkshire Hathaway (BRK.A, Financial)(BRK.B, Financial), which commands a strong market position in insurance and reinsurance, utilities, railroads and a host of other industries, in addition to holding more than $130 billion in cash and Treasuries on its balance sheet and more than $180 billion of marketable securities in its portfolio of liquid investments.2 It is a juggernaut with a fortress balance sheet, in other words. Looking beyond the temporary near-term earnings headwind, we have extremely high conviction in the durability of its businesses and the potential for both the operating earnings and investment returns to increase our value over the long term.
Among more traditional, pureplay financials, the portfolio holds several leading, dominant banking institutions such as JPMorgan Chase (JPM, Financial), Bank of America (BAC, Financial) and Wells Fargo (WFC, Financial); Chubb (CB, Financial), which we regard as a best-in-class property casualty insurer and reinsurer globally; consumer finance leaders American Express (AXP, Financial) and Capital One Financial (COF, Financial); and foreign banks such as DBS Holdings (SGX:DO5) (Singapore), Danske Bank (OCSE:DANSKE) (Denmark) and DNB Asa (OSL:DNB) (Norway). We believe in all of these cases that the balance sheets, funding stability, liquidity, risk management, capital ratios and management experience combine to form a relatively favorable case, starting at these low valuations. It is a contrarian thesis for the time being, but one that we believe has the potential to be among the future drivers of results over the long term.
Energy, as a sector, is challenged due to collapsing oil prices in recent years. Our energy investments, which we recently exited, focused on low-cost shale producers with above-average production growth and above-average economics relative to the broader industry. We believe the economic slowdown across the globe could prove to be extremely challenging to the supply and demand picture for energy commodity prices, with oil trading at uneconomical levels, even for low-cost producers. Therefore, as the facts changed on a secular basis, we revised our views and decided to exit at a loss. The loss realized on those positions, which had been a relatively small percentage of assets, had the ancillary benefit of effectively neutralizing any future cap gains, but the fact is that our results in this area were disappointing. We feel confident that allocating to more attractive areas today is a better use of capital and are willing to admit and learn from our mistakes in energy.
Supporting results in a positive way were companies generally engaged in different areas of technology that, as a sector, have proven remarkably resilient. We own a number of leading semiconductor and semiconductor-related businesses such as Applied Materials (AMAT, Financial), Texas Instruments (TXN, Financial) and Intel (INTC, Financial), whose future prospects are expanding in potential rather than shrinking, as areas such as cloud computing, artificial intelligence, autonomous driving vehicles, 5G, video gaming and e-commerce continue to proliferate. We also hold market leaders such as Microsoft (MSFT), Alphabet (GOOG), Amazon.com (AMZN) and Facebook (FB) in the portfolio.
Within the healthcare sector, we hold Quest Diagnostics (DGX), a leading independent lab and diagnostics services provider that offers lab testing at a fraction of the cost of hospitals—an important long-term competitive advantage and moat. We believe Quest Diagnostics is well-positioned as demand for healthcare services continues to increase with not only the pandemic, but also longer term as the population ages, since it is clear that costs must be contained. Quest Diagnostics essentially has exposure to the healthcare industry’s growing demand, but is a rare business insofar as it makes more money by driving down costs for the system—an uncommon combination that figures prominently in our long-term assessment of the business model, its competitive position and longevity overall.
In the industrial space, we own Raytheon Technologies (RTX) and Carrier Global (CARR), among other large, strong businesses. Raytheon Technologies has leading industry positions in aerospace and in certain high-technology areas of defense. Carrier Global is the leading Heating, Ventilation and Air Conditioning (HVAC) provider in the U.S. These are historically extremely durable, high-recurring revenue businesses that enjoy wide competitive moats and serve vast end markets, yet they are trading today at very attractive valuations, in our opinion.
Overall, our conviction is that the businesses in the Fund should, in our estimation, demonstrate their considerable earnings power over the coming quarters and years, and they are trading at very attractive valuations on fortress balance sheets by and large. Even taking into account the likelihood that near-term economic realities may prove challenging for businesses of all types, what will matter ultimately is whether investors hold businesses that are sufficiently resilient and relevant to confront the near-term realities and whether these investments have the ability to resume an expansion of earnings power in the years ahead. We are willing to be contrarians by owning such companies in volatile markets, provided the short-term challenges do not markedly alter what we see as attractive long-term economics for those companies.
The fixed income segment of the Fund is approximately 25% of the portfolio and is composed of corporates, mortgages, agencies and Treasuries, among other sectors, and we stress as a general rule credit quality and soundness of principal over income yield. While interest rates remain suppressed and with the expectation they may remain so for an extended period of time, we maintain this allocation for diversification purposes and to serve as a superior income generator relative to cash.
1The 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. 2Individual 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
Times of crisis, especially those that are truly unprecedented, are universally difficult and unsettling. Whether the crisis is war, natural disasters, terrorist attacks or in this case, a global pandemic, there is always an adjustment period afterwards that can change the fortunes of people and certainly of businesses and industries on a secular basis. With many unknowns in the near term, what an investor should seek to understand with a high degree of confidence in our view is how and why their businesses should be able to sustain recessionary conditions for a time and then resume a pattern of growing earnings thereafter—and then whether that long-term earnings accumulation is appropriately priced in.
In terms of whether this is an advantageous time to invest or not, we remain fully invested and maintain a constructive multi-year view for our businesses, especially starting from a point of modest expectations. That stated, it is advisable in our opinion to invest today with a very selective eye and on a bottom-up, company-by-company basis. This also means applying an independent fresh lens to the broader market and being willing to avoid certain industries or sectors whose futures have changed due to the coronavirus and/or other secular forces such as competition or commoditization.
Thank you for your confidence, and we wish all of our shareholders and their families well in this time.
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.
The information provided in this material should not be considered a recommendation to buy, sell or hold any particular security. As of 6/30/20, the top ten holdings, not including cash and equivalents, of Davis Appreciation and Income Fund were: Amazon.com, 5.69%; Applied Materials, 5.62%; Berkshire Hathaway, 5.36%; Capital One Financial, 4.57%; Alphabet, 4.45%; Intel, 4.13%; Texas Instruments, 3.59%; Wells Fargo, 3.06%; Quest Diagnostics, 3.04%; U.S. Bancorp, 3.04%. The cash and equivalents were 2.85%.
