Chris Davis' Davis Opportunity Fund Fall 2022 Review

Discussion of markets and holdings

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Sep 15, 2022
Summary
  • In the first seven months of 2022, the S&P 1500 Index declined -12.44%.
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Market Perspectives

In the first seven months of 2022, the S&P 1500 Index declined -12.44%. Inflation and interest rates, the war in Ukraine and the potential for a near-term recession are key factors impacting markets presently. We believe bottom-line fundamentals will drive shareholder returns in the long run. Financial services, technology, industrials, communication services and healthcare companies represent the majority of our current investments.

In the year-to-date period through July 31, 2022, the S&P 1500 Index declined -12.44%. During this period, the Federal Reserve explicitly guided towards and instituted a series of interest rate increases in response to signs of inflation in the U.S. The key concerns in our conversations with clients include inflation and interest rates, the war in Ukraine and the potential for a near-term recession, among other topics.

We do not have a precise expectation or view relative to how long above-historic inflation can continue nor when prices will stabilize. We believe, therefore, that we should be prepared for a range of scenarios. We are focused on balance sheet strength, product longevity, valuation and competitive advantages, each of which can be an indicator of durability under a wide range of conditions. While we are being strict in our discipline to guard against potential risks, we also look to capitalize on market price dislocations intelligently where and when they may occur.

From a high level, two attractive sectors represented in the portfolio and that demonstrate the breadth and contrast between individual business types are healthcare and financials—two of the market’s most well-established, enduring sectors. Both can generate enormous amounts of cash with attractive full-cycle economics. Within healthcare, we have chosen to own primarily healthcare services, generic pharmaceuticals and health insurance companies in leading industry positions.

Similarly, in financials, we are invested in what we believe are some of most durable and profitable companies in the sector, all while the sector is trading at relatively low valuations.

We also own a number of information technology leaders in the semiconductor space, in technology-centric communications services and in consumer discretionary enterprises engaged in e-commerce and cloud computing primarily.

Last but not least, our industrial positions and broadly diversified conglomerates, among a handful of other holdings, round out the portfolio. Overall, we believe our capital is spread in selective fashion across 42 distinct holdings, covering a significant number of different business types and even business lines within companies.1 Our expectation for these businesses is that on balance, they will generate attractive returns on capital—providing growth over a full cycle—and are currently trading at below-market multiples on average.

Shown below are the number of select holdings in the portfolio versus the S&P 1500 Index. The portfolio held 42 positions as of the most recent quarter end. At the same time, the portfolio’s five-year trailing EPS growth rates and forward P/E multiples appear to us more attractive than the alternatives available in the broader market today.1

Portfolio Review

The Fund’s performance lagged the S&P 1500 Index year to date. Healthcare and financials benefited our performance in relative terms, while industrials, consumer staples and our lack of exposure to energy detracted.

In the year-to-date period, Davis Opportunity Fund returned -14.48% versus -12.44% for the S&P 1500 Index.

The Fund’s performance lagged the S&P 1500 Index year to date. Healthcare and financials benefited our performance in relative terms, while industrials, consumer staples and our lack of exposure to energy detracted.

Among recent changes, our percentage of assets in market-leading healthcare companies has increased over the year-to-date period due to active additions to positions and the sector’s relatively better returns than the broader market.

We are maintaining our positions in the semiconductor area, as we feel its long-term potential is underestimated and because valuations have come down considerably.

Voids or underweighted sectors in the portfolio include energy, which surged in the first quarter 2022 but reverted somewhat in the most recent quarter. We believe the range of possible outcomes—given new and increasingly stringent regulations and an eventual end to the supply shock associated with the Ukraine conflict—constitute a poor risk/ reward profile at this time.

The business types that we favor in our selective approach to investing include:

  • Major financial institutions—large, well-capitalized banks such as Wells Fargo (WFC, Financial), select property casualty and reinsurance companies such as Markel Corporation (MKL, Financial) and the financial elements of Berkshire Hathaway (BRK.B, Financial) and businesses with significant profit generation from payments and spending such as Capital One (COF, Financial)
  • Leaders in healthcare services and pharmaceuticals—companies with significant market share that possess competitive advantages such as Quest Diagnostics (DGX, Financial), a leading independent lab services company, and Viatris (VTRS, Financial), a major global pharmaceuticals company with a strong position in generics
  • Workhorse technology companies—businesses that specialize in vast, global end markets such as semiconductor-related technologies, including Intel (INTC, Financial) and Applied Materials (AMAT, Financial), as well as an investment in middleware software represented by VMware (VMW, Financial)
  • Dominant e-commerce, cloud computing, social media and video game companies—including Amazon.com (AMZN, Financial), Meta (META, Financial) (aka Facebook) and Prosus (WBO:PRX, Financial)

Fund Outlook

We are positive about the Fund’s long-term investments, which represent a selective list of extremely durable companies and industries, all while acknowledging near-term headwinds.

Looking ahead, we would encourage clients to look through the current headlines at what may occur on the other side of our present challenges and to derive conviction from the sheer power and profit potential of the businesses found within Davis Opportunity Fund. While the near term presents headwinds ranging from the political and geopolitical to economic implications from COVID and the war in Ukraine, our view for the long-term attractiveness of equities over other asset classes has not diminished. In fact, valuations have come down to a level where we perceive there to be, purely based on valuation, lower risk in certain areas of the market than just a year ago.

Our businesses reside in extremely durable industries, and at the company level, they provide what we believe are attractive risk/reward proportions, given their balance sheet strength, growth potential over the long term and current valuations. It is a time, in our view, to be selective and to consciously adhere to a discipline of asking continually: What kinds of businesses do we want to own? And how much should we pay for them? This back-to-basics approach has been a central part of our investment discipline since our founding in 1969.

In terms of what can be gleaned from recent price volatility, we would argue that in periods of heightened uncertainty and even dislocation, it is important to bear in mind that historically the nature of such headwinds is that they ebb and flow. Near-term conditions are mixed, but our portfolio of businesses have overall stood the test of time, and in our view, offer attractive long-term economics for shareholders, based on their ongoing relevance and profit generation.

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 6/30/22.
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. All fund performance discussed within this piece refers to Class A shares without a sales charge and are as of 7/31/22 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. The Attractive Growth and Undervalued reference in this piece relates to underlying characteristics of the portfolio holdings. There is no guarantee that the Fund performance will be positive as equity markets are volatile and an investor may lose money.
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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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