Chris Davis' Davis New York Venture Fund Semi-Annual 2021 Review

In the five-year period culminating in June of last year (2020), the stock market generated a compound annual return of roughly 11%. Importantly, this return masked a huge dispersion between two different investment approaches, most commonly described as growth and value. For example, over the same five-year period that the S&P 500 Index returned 11%, the growth component of the Index compounded at almost 15% per year, while the value component lagged growth by almost 900 basis points per year, returning only 6% per year.

As we wrote in our last report, “For active managers like us, (such) dispersions create opportunity for enhanced future returns (as)…this widening gap allows us to trim positions in high fliers, while adding to durable growth businesses trading at bargain prices. By avoiding the speculative bubble of extreme valuations at one end of the market and instead owning resilient and proven growth businesses that can be purchased at bargain prices at the other end of the market, the portfolio is positioned with less risk and more relative upside than we have seen since the late 1990s.”

Looking back, our analysis proved prescient, and we are pleased that the carefully selected companies that make up our portfolio appreciated by 53% in the last 12 months, compared to 41% for the averages.¹ What’s more, as can be seen in the chart below, despite the very strong performance of our portfolio, the overall dispersion between growth and value remains historically wide.

As a result, although the short-term direction of the market is unknowable, we would paraphrase Winston Churchill in characterizing our strong performance over the last 12 months as the end of the beginning, rather than the beginning of the end, of the opportunities and risks created by wide dispersion.

Our ability to take advantage of this dispersion derives from our willingness to be highly selective. Selectivity means that we invest in fewer than one out of every 10 companies included in the S&P 500 Index. Just as with the best universities or best companies, the ability to select from a large pool of applicants creates the opportunity to choose only the most exceptional candidates and reject those that are average or worse. Our research efforts comb through hundreds of potential investments, seeking those whose business and financial characteristics can turn long-term investments into compounding machines.

In particular, we look for durable, growing businesses that can be purchased at attractive valuations and reject businesses that generate low returns, are stagnant, overvalued, overleveraged or competitively disadvantaged. While funds that passively mirror the S&P 500 Index are forced to invest in all companies, including those that we view as significantly overvalued or competitively challenged, our selective approach allows us to reject such companies. In this environment of wide dispersions, the ability to selectively reject certain companies and sectors from our portfolio may prove just as valuable as the ability to selectively invest in others.

While the growth/value categorization discussed above is helpful in illustrating both mania and opportunity, the best way to build wealth is by finding those select few businesses that combine the best characteristics of both categories. After all, categories do not build wealth. Nor do average businesses. Instead, generational wealth is built by investing in those select few businesses that combine durable and resilient growth with attractive valuations.

As can be seen in the table below, by being extremely selective, we have built a portfolio that has the best of both growth and value. While the earnings of our portfolio companies have grown about 0.5% per year faster than average, they can currently be purchased at a 42% discount to the average. We consider this a value investor’s dream, as companies that grow profitably over time are more valuable than companies that don’t.

To find such an attractive combination, our research goes beyond simplistic categories to identify growth businesses with attractive valuations, as well as value businesses with attractive growth.

Within the traditional growth category, growing euphoria has led to bubble prices for many companies, most especially those with new and unproven business models. In contrast, our research focuses on a select handful of proven growth stalwarts whose shares still trade at reasonable valuations. For example, because of concerns about future litigation and regulation, several dominant internet businesses, including Amazon (AMZN, Financial), Google (GOOG, Financial) and Facebook (FB, Financial), trade at steep discounts to many unproven and unprofitable growth darlings that, in our view, trade at euphoric prices. While we expect a continued barrage of negative headlines around these names, as well as increased regulation in the years ahead, we do not expect a significant decline in their long-term profitability.

We have also found opportunities to buy proven growth companies at attractive prices by looking overseas, particularly at companies such as Alibaba (BABA, Financial), New Oriental Education (EDU, Financial) and Naspers (JSE:NPN, Financial) that serve, educate and entertain the fast-growing and enormous Chinese middle class. We believe headlines and near-term stock price volatility in some of these companies has created opportunities.

Finally, we have found bargain-priced growth companies in less glamorous parts of the technology ecosystem. Like the manufacturers of picks and shovels during the Gold Rush, outstanding companies such as Intel (INTC, Financial), Texas Instruments (TXN, Financial) and Applied Materials (AMAT, Financial) generate wonderful profits manufacturing the underlying hardware that enables such exciting but speculative new fields as self-driving cars, cloud computing, artificial intelligence, machine learning, software as a service and the internet of things.

In the same way our research focuses on durable growth companies that are not overvalued, we also seek out value companies capable of long-term growth. In doing so, we seek to avoid risks inherent in companies that we would classify as value traps or speculative value. While the shares of such companies may trade at cheap prices, their businesses are often fragile, impaired, prone to disruption or highly sensitive to the timing of an economic recovery. Decades of experience have taught us the dangers of owning weak businesses unable to withstand unexpected shocks, even if they sell at cheap prices. Although such speculative gambles may hit from time to time, poor businesses do not build generational wealth. Instead, our attention within the value part of the market remains steadfastly focused on companies that combine strength and resiliency with long-term growth, profitability and competitive advantages. In today’s uncertain economy, select financials represent the best combination of proven durability and low valuations.

As the pandemic unfolded, panicked sellers abandoned the banking sector, making it one of the worst-performing areas of the market, despite the fact that banks entered this downturn with record high levels of capital and extremely conservative loan portfolios. As a result, we purchased or added to select well-capitalized financial leaders, such as Wells Fargo (WFC, Financial), Capital One (COF, Financial) and U.S. Bancorp (USB, Financial), all of whom were able to build enormous reserves for loan losses while still remaining profitable. With the pandemic now moving into the rearview mirror, some of the charges taken to build reserves are being reversed, further adding to profitability.

The combination of growing profitability and lagging prices was not just a 2020 phenomenon. In fact, over the last decade, during which the earnings of financials grew from 15% to more than 20% of the S&P 500 Index, their prices have fallen from roughly 18% to a record low 12% of the Index. This disconnect between price and value creates the significant opportunity that we have positioned for today.

Although bank stocks have enjoyed a sharp recovery from last year’s panic-induced lows, investors need not worry that they missed an opportunity. As can be seen in the chart below, financials remain the cheapest sector in the market. What’s more, the current valuation of the financial sector is low, not just relative to the market, but even relative to its own historic discount.

Given the strength that the sector demonstrated in remaining profitable through such a challenging year, we believe that investors’ attitudes towards the sector are poised for change, leading to an increase in their relative valuation and a sharp closing of this enormous discount.

Beyond financials, our selectivity and willingness to look beyond simplistic definitions and categories has led to a portfolio that includes growth companies at value prices and value companies with long-term growth. As a result, the portfolio is both growing and undervalued. This rare combination positions us to build on our long-term record of wealth creation and outperformance in the years and decades ahead.

While the pandemic of 2020 extracted an awful toll on so many families, it also highlighted the inventiveness, creativity and ingenuity of our society. From e-commerce to biotechnology, 2020 was a year of explosive innovation, adaptability and resiliency and a powerful reminder of two seemingly contradictory investment truths.

First, unexpected bad things can and will happen. Over our fund’s history, we have navigated countless awful and unexpected crises including the energy crisis, the hostage crisis, the inflation crisis, 9/11, the financial crisis, the COVID crisis and the ongoing climate crisis. As fiduciaries, we must incorporate both expected and unexpected challenges and crises into every aspect of our investment process.

Second, we must also recognize the incredible power of innovation and invention. In the early stages of the pandemic, the most optimistic forecasts called for a vaccine in three-to-five years. And yet, scientists developed one in a matter of months. Similarly, over the longer term, human ingenuity has led to stunning progress in addressing a vast range of horrific global challenges. The graphs below offer a compelling if incomplete quantitative picture of this progress.

Betting against progress has been a losing proposition.

Thus, while we always ensure that our portfolio companies have the durability and strength to withstand unexpected shocks and crises, we also select those that also have the ability to innovate, adapt and build wealth in an ever-changing and unpredictable world.

With more than $2 billion of our own money invested alongside clients, our interests are aligned, and our conviction is more than just words.⁵ This alignment is an uncommon advantage, given that 88% of all funds are overseen by managers who have less than $1 million invested alongside their clients.

Although our investment discipline may not be rewarded by the market over shorter periods, our proven active management approach has built wealth for our shareholders over many decades.

We value the trust you have placed in us and look forward to continuing our investment journey together

^{1Based on the Fund’s return vs. the S&P 500 Index for 6/30/20–6/30/21.}

²Source: Credit Suisse as of 4/22/21.