Chris Davis' Davis Opportunity Fund Annual Review 2022

Discussion of markets and performance

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Feb 03, 2022
Summary
  • For the year ended December 31, 2021, Davis Opportunity Fund delivered a return of 24.96%.
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Market Perspectives
The Fund has prospered because of its reliance on the resiliency and strength of bottom-line fundamentals, represented by holdings in financial services, technology, communication services, industrials and healthcare companies.

For the year ended December 31, 2021, Davis Opportunity Fund delivered a return of 24.96%, reflecting real progress in the underlying business fundamentals across most of our holdings.

The Fund is positioned to capitalize on business opportunities that span a wide array of industries. Financial services, technology, communication services, industrials and healthcare companies make up the vast majority of our holdings and the largest aggregate percentage weights.

Within financial services, we have emphasized resiliency and strength of bottom-line fundamentals in our holdings. These businesses, comprised primarily of well-capitalized banks (in the U.S. and in select foreign jurisdictions), have durable economics, according to our research and analysis, in terms of current demonstrated earnings power, margin structures and forward-looking prospects.

The absolute level of revenues and profits generated by such companies is in fact so large that most of the major financial holdings in the portfolio produce enough annual operating income individually that a number of them could, in theory, purchase several entire businesses among hundreds of choices within the S&P 1500 Index, using just a year’s cash earnings without dipping into capital. This is theoretical, as financial companies would not be in the business of buying healthcare or technology companies, for example, but we point out these facts to illustrate the sheer scale of the economics produced by single financial companies in a given year, which is often a multiple of the cash earnings yielded by companies in a host of other industries.

Given this cash-generation power, we are naturally drawn to what we believe are strong and profitable financial institutions when the price is right. Presently, we believe the valuations of our financial holdings are not only reasonable, but extremely compelling, and our portfolio composition reflects this view. Representative financial holdings in the Fund include Wells Fargo (

WFC, Financial) and Capital One Financial (COF, Financial).

Within technology and communication services, we own a number of online businesses and semiconductor related companies, including Alphabet (

GOOG, Financial), Amazon (AMZN, Financial), Intel (INTC, Financial), Applied Materials (AMAT, Financial) and Texas Instruments (TXN, Financial). Within the realm of high technology, we believe that leadership positions reflect enduring and widening competitive advantages over smaller competitors, with few exceptions. This is because online businesses, as well as semiconductor companies, benefit from economies of scale. An online search and advertising engine will, in general, be more profitable per unit of cost as it grows larger in terms of users and advertising dollars. It is a hub-and-spoke model, in other words, where it is generally not necessary to grow expenses at the same rate that revenues grow beyond a certain threshold. Therefore, returns on capital tend to be higher, the larger and more dominant the online search company is.

Healthcare is included in the portfolio both for company-specific reasons, as well as big picture trends. At the company level, we hold select companies in pharmaceuticals, healthcare services and health insurance at attractive valuations. This is at a time when the average age of the U.S. population is fast approaching 40, older than Asia-Pacific and a little younger than the aged populations of Europe and Japan. The number of seniors in the U.S.—i.e., 65 years or older—now surpasses 54 million, or about 15% of the population. Seniors, on average, take a much greater number of medications and account for a large and disproportionate share of healthcare spending, and we expect that trend to continue due to both raw demographics and a proliferation in the number of available treatments and services available now, the latter being driven by innovation and investment in the healthcare industry. Representative holdings in the Fund include Cigna (

CI, Financial), United Health Group (UNH, Financial), Viatris (VTRS, Financial) and Quest Diagnostics (DGX, Financial).

The portfolio is rounded out by a number of other industries with the common thread being the attractiveness of individual businesses.

Outlook
In the near-term, investors are confronted with twin challenges: COVID and inflation. But we believe they can be overcome by the resiliency of the U.S. economy.

The future cannot be predicted with precision, but we are operating on a few working assumptions:

First, we believe that COVID in its various iterations will be dealt with gradually by methods and treatments already available or in research and development. Never in modern history has so much intense focus by the private and public sectors around the world been exerted to solve a common problem. The closest analog in terms of spending and investment, as well as coordinated effort, would arguably be a major war. That does not ensure the eradication of the pandemic, but it means that from this starting point, where we are in the thick of the ordeal, the future may well be brighter as the health issue is attenuated. That would likely augur well for a host of industries, many of which have representation in the Fund today.

Second, with respect to inflationary pressures, we believe they are unavoidable for a time but that the inflation trend could moderate, with the easing of supply and logistical bottlenecks that are a by-product of the pandemic. Furthermore, we believe that inflation not only affects the liabilities and expense side of the corporate accounting ledger, but also the income and revenue side, provided companies have the competitive position and clout to raise prices. In nominal terms, if revenues and profits can expand at a rate commensurate with upward cost pressures, there is no reason to assume that operating margins will necessarily be compressed and impaired on any permanent basis. We will monitor this situation carefully, but believe that the probabilities favor further economic productivity in the face of rising costs, especially if supply chain problems begin to ease and economic activity is allowed to resume in full.

Lastly, we note the strong and healthy credit picture and balance sheets of both corporate America and U.S. households overall, which means that any improvement in economic terms need not go to repairing capital positions, as it was necessary in the aftermath of the 2008–2009 financial crisis. Earnings growth, therefore, may well be largely additive on an incremental basis, should revenues rise in conjunction with a partial or full resolution of the pandemic over time. Once again, many of our businesses are dramatically undervalued relative to that setup.

Conclusion
The Fund is focused on delivering tangible value to investors, safeguarded by diversification.

Context and having well-founded perspectives on the big picture are important, insofar as they can point to multiyear tidal trends benefiting groups of companies. We respect this rule of thumb and pay close attention to big picture forces.

In the final count, however, investing in specific businesses is where we believe we can add the most value for our shareholders. Sometimes the levers that managements can pull within their respective businesses are not apparent to the market, as they involve multiyear efforts that may not bear obvious fruit in the short term. That means investing in growth and reducing both expense structure and share count (at advantageous valuations) can create value, however delayed the response and appreciation of the general population of investors may be at times.

Taking a multiyear and multidecade view, we are confident that our portfolio is built to last at the individual business level. Furthermore, we would contend that the Fund is appropriately diversified to capture a range of possible outcomes in the future, as well as to mitigate the risk of putting all of one’s eggs in one basket. And finally, our observations suggest that the overall environment—particularly related to the impact of COVID—may well be poised to improve from here, looking out into the intermediate-term future.

At Davis Advisors, we seek to purchase durable businesses at value prices and to hold them for the long term. The Davis family, its foundation, our company, and our employees and directors have more than $2 billion invested alongside clients in similarly managed portfolios—a testament to our commitment to, and alignment with, shareholders.1

We are grateful for your confidence and trust, and we look forward to continuing our investment journey together.

1As of 12/31/21.
This report is authorized for use by existing shareholders. A current Davis Opportunity 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.

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Disclosures

I/we have no positions in any stocks mentioned, and have no plans to buy any new positions in the stocks mentioned within the next 72 hours. Click for the complete disclosure
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