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Holly LaFon
Holly LaFon
Articles (10140)  | Author's Website |

Davis Financial Fund: Interview With Chris Davis, Portfolio Manager

Chris Davis shares his most recent thoughts on why he invests in financial stocks

September 09, 2019 | About:
Chris Davis (Trades, Portfolio) has successfully managed financial stock portfolios for 30 years. He shares his most recent thoughts on why to invest in financial stocks, why he believes active management can add significant value in this vast inefficient sector and why investing in financial stocks offers a unique opportunity today.

“Given today’s low prices, we believe select financials will generate strong returns over the next decade because they combine what we feel are durable business models, the strongest balance sheets in half a century, resilient earnings, good returns on equity, the potential for rising dividends, falling share counts, and low valuations.”

Executive Summary

  • Davis Financial Fund has outperformed the S&P 500 Index and S&P 500 Financials Index since inception in 1991.¹
  • On a cumulative basis, Davis Financial Fund has returned significantly more than the Financial Select Sector SPDR ETF (XLF) since XLF’s inception in 1998.¹
  • Currently, financial stocks are underappreciated and out of favor with investors, offering what we believe to be an attractive long-term investment opportunity.
  • Selectivity and active management are the keys to outperformance in the vast, inefficient financial sector, in our opinion. Investing in stronger companies and avoiding weaker ones can make a significant difference in investor returns.
  • Davis Financial Fund holdings include: Markel, Chubb, Berkshire Hathaway, JPMorgan Chase, BNY Mellon, American Express and Capital One Financial.²

Davis has successfully invested in financial stocks for almost five decades. Why should investors consider this sector now?

In 1947, my grandfather, Shelby Cullom Davis, began investing in financial stocks. Known as the “Dean of Insurance Stocks,” he compounded a $100,000 investment­ into $800 million over his career, largely by investing in financials.³

The characteristics my grandfather looked for in financial companies included competitive advantages, experienced management and disciplined capital allocation. We use these same criteria to select all our investments as an equity research boutique.⁴ What is interesting and more specific to financials is we can find companies within the sector that have above-average long-term growth prospects but trade at below-average price/earnings (P/E) multiples. This is the reason my grandfather called financials “growth stocks in disguise.”

More recently, investors have tended to consider finan­ cial companies inextricably linked to the 2008 financial crisis, resulting in a lingering aversion to this out-of-favor group. However, our research shows certain high quality financial companies remained profitable during the worst financial crisis since the Great Depression, are currently trading at close to a 30% discount to the market and, most important,­ we believe they are less risky today as they have doubled their capital ratios.

In addition, a significant percentage of the assets on these companies’ balance sheets have been added since the financial crisis. Moreover, because of limited competition and extremely tight credit standards, these businesses have record earnings. Now, some financial­ companies are in a position to distribute an increasing percentage of their earnings. Lastly, should interest rates rise as a function of strong economic growth, select financials may be net beneficiaries as net interest margins expand. Put together, these developments are creating a cyclical opportunity in financial stocks in our view.

In addition to the current cyclical opportunity, we believe a strong case can be made that the right financial com­ pany is by its nature a long-term cash-compounding machine. Such a business generates strong current earnings that can be reinvested as well as providing the potential for excellent long-term growth because the industry is so vast and fragmented, and the products and services offered by financial institutions are as long lasting as they are ubiquitous. Almost everyone is a customer­ of at least one, two or three financial companies. In brief, financial companies offer products that generally do not become obsolete.

Why are financial stocks one of the few areas that can perform well even if we are in a low growth environment as many believe?

We see three possible scenarios for financial stocks going forward in which investors benefit from some combination of: earnings growth, P/E expansion, share repurchases and dividends.

In these scenarios, over the next five years we assume a reasonable initial P/E multiple of 12x and that the financial company has to retain 20% of its earnings to increase its capital ratio or strengthen its balance sheet. And, furthermore that the remaining earnings are distributed half as dividends and half as share repurchases.⁶

Scenario 1: No earnings growth and no P/E expansion Under this scenario we see a 7% average annual total shareholder return. Despite no change in earnings growth and no P/E expansion, a satisfactory return is achieved from share repurchases and dividends.

Scenario 2: Modest earnings growth no P/E expansion Under this scenario we see a 10% average annual total shareholder return. This return is driven by modest earnings growth of 3% per year, share repurchases and dividends, while the P/E stays flat.

Scenario 3: Modest earnings growth and modest P/E expansion

Under this scenario we see a 13% average annual total shareholder return. This returns is driven by modest earnings growth of 3% per year, modest P/E expansion from 12x to 14x, in addition to share repurchase and dividends.

Going forward, we expect an outcome between Scenario 2 and Scenario 3 to be the most likely. This would represent a very satisfactory return for shareholders.

Why have selectivity and active management generated outperformance for Davis Financial Fund?

Davis Financial Fund has delivered significantly more than the return of Financial Select Sector SPDR ETF (XLF) since the inception of XLF in 1998, on a cumulative basis.

Investing in stronger companies and avoiding weaker ones can make a significant difference over time. Because the returns of financial stocks are widely dispersed,­ selectivity is key. In fact, since 2005, the average difference between the best and worst performing financial stock in the S&P 500 Financials Index has been about 132%.⁷ What accounts for these wide differences in outcomes?

A critical factor to recognize when researching financial companies is they are first and foremost human capital businesses. As a result, management judgment, underwriting­ practices, and management and employee incentives play a central role in determining which finan­ cial companies­ should perform well through an entire business cycle versus those that might be structured to perform well in a specific environment but not necessar­ ily to endure over time. As bottom-up active managers, we have flexibility to invest more capital in those businesses we believe are best positioned to build long-term wealth while avoiding those with less attractive prospects.

Contrast our carefully considered approach with many passively managed strategies that indiscriminately allo­ cate the most capital to stocks with the largest market capitalizations­. This approach can subject investors to the risk of concentration in the most vulnerable areas of the sector. For instance, many investors may not know XLF has tremendous industry concentration as four of its top five holdings are banks and account for almost 30% of its assets.⁸

We build our Portfolio one company at a time. The Portfolio includes best-of-breed commercial banks, investment banks, insurance companies, wealth management firms, asset managers, credit card companies, diversified financial conglomerates, and rating agencies.

What are some of the perceived risks with financial stocks today?

One of the perceived risks with financials has to do with leverage within the banking sector. Leverage ratios are at historic lows, reflecting both a conservative posture by financial institutions themselves as well as stricter regulations on leverage that were instituted following the crisis. It is worth noting that all major U.S. banks now undergo annual stress tests which more or less control the degree of leverage they are willing or able to take on, implying that they should continue to operate with far lower overall risk and greater durability than in the pre-crisis period. In short, balance sheets for major financial institutions today look very strong.

A second question that relates to financials today is the prospect of higher credit costs than what we witnessed in recent years when the credit environment was particularly­ benign. Credit costs are an income statement expense and are the rule, not the exception, over any economic cycle. What was unusual in recent years was the near absence of credit losses, but that meant among other things that lending remained rather muted.

Now, with a stronger economy and relatively full employment, demand for loans has risen and credit costs are normalizing which is to be expected. We believe the credit environment remains both very manageable and quite favorable.

With all the positives, why is the opportunity in financial stocks underappreciated and not recognized by the market?

The biggest hurdles to investing in financials in this envi­ ronment are psychological and emotional as investors still remember the aftermath of the 2008 financial crisis. While the overall market has more than doubled since then, financial stocks have not appreciated as much—even though select financial companies are delivering record earnings and have the strongest balance sheets in decades.

As always, investor fear is correlated with prices. When stock prices go down, people feel more fear and are less interested in buying, and when prices go up they feel reassured. This tends to result in an undesirable outcome.

We take the opposite approach. We search for compa­nies with stock prices that have lagged the companies’ true business value. We like to look in unloved or overlooked areas of the market where prices do not reflect true value. In today’s environment, the financial sector offers the opportunity we seek.

  1. Class A shares without a sales charge. Inception date of the Fund is 5/1/91. Past performance is not a guarantee of future results. Inception of XLF is 12/16/98. See the endnotes for a description of the material differences between the Fund and XLF. 2. Individual 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. 3. While Shelby Cullom Davis’ success forms the basis of the Davis Investment Discipline, this was an extraordinary achievement and other investors may not enjoy the same success. Davis Selected Advisers, L.P. was founded in 1969. 4. While we search for those companies possessing these characteristics, there is no guarantee that the criteria will be met or that a given security will be profitable. 5. As of 6/30/19. Source: Credit Suisse. 6. This hypothetical example is for illustrative purposes only and does not represent the performance of any particular investment. Actual results will vary. The return of a stock is based on a number of factors in addition to those discussed. Equity markets are volatile and there is no guarantee that these assumptions will prove to be correct. 7. As of 12/31/18. Source: Davis Advisors and Wilshire Atlas. 8. As of 6/30/19. Holdings are subject to change. 9. The information provided in this material should not be considered a recommendation to buy, sell or hold any particular security.

This report is authorized for use by existing shareholders­. A current Davis Financial Fund prospectus must accom­ pany 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 observa­ tions regarding investment strategies, individual securities, and economic and market conditions; however, there is no guarantee that these state­ ments, 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.

Objective and Risks. Davis Financial Fund’s invest­ ment objective is long-term growth of capital. There can be no assurance that the Fund will achieve its objective. Under normal circumstances the Fund invests at least 80% of its net assets, plus any borrowing for investment purposes, in securities issued by companies principally engaged in the financial services sector. Some important risks of an investment­ in the Fund are: common stock risk: an adverse event may have a negative impact on a company and could result in a decline in the price of its common­ stock; credit risk: The issuer of a fixed income security (potentially even the U.S. Government) may be unable to make timely pay­ ments of interest and principal; depositary receipts risk: depositary receipts may trade at a discount (or premium) to the underlying security and may be less liquid than the underlying securities listed on an exchange; emerging market risk: securities of issuers in emerging and developing markets may present risks not found in more mature markets; fees and expenses risk: the Fund may not earn enough through income and capital appreciation to offset the operating expenses of the Fund; financial services risk: investing a significant portion of assets in the financial services sector may cause the Fund to be more sensitive to systemic risk, regulatory actions, changes in interest rates, non-diversified loan portfolios, credit, and competition; focused portfolio risk: investing in a limited number of companies causes changes in the value of a single security to have a more significant effect on the value of the Fund’s total portfolio; foreign country risk: foreign companies may be subject to greater risk as foreign economies may not be as strong or diversified. As of 6/30/19, the Fund had approximately­ 17.6% of assets invested in foreign companies; foreign currency risk: the change in value of a foreign currency against the U.S. dollar will result in a change in the U.S. dollar value of securities denominated in that foreign currency; headline risk: the Fund may invest in a company when the company becomes the center of contro­ versy. The company’s stock may never recover or may become worthless; interest rate sensitivity risk: interest rates may have a powerful influence on the earnings of financial institutions; large-capitalization companies risk: companies with $10 billion or more in market capitalization generally experience slower rates of growth in earnings per share than do mid-and small-capitalization companies; manager risk: poor security selection may cause the Fund to underperform relevant benchmarks;­ mid- and small-capitalization companies risk: companies with less than $10 billion in market capitalization typically have more limited product lines, markets and financial resources than larger companies, and may trade less frequently and in more limited volume; and stock market risk: stock markets have periods of rising prices and periods of falling prices, including sharp declines. See the prospectus for a complete description of the principal risks.

The Morningstar Rating™ for funds, or “star rating”, is calculated for managed products (including mutual funds, variable annuity and variable life sub­ accounts, exchange-traded funds, closed-end funds, and separate accounts) with at least a three-year history. Exchange-traded funds and open-ended mutual funds are considered a single population for comparative purposes. It is calculated based on a Morningstar risk-adjusted return measure that accounts for variation in a managed product’s monthly excess performance, placing more emphasis on downward variations and rewarding consistent performance. The top 10% of products in each product category receive 5 stars, the next 22.5% receive 4 stars, the next 35% receive 3 stars, the next 22.5% receive 2 stars, and the bottom 10% receive 1 star. The Overall Morningstar Rating™ for a managed product is derived from a weighted average of the performance figures associated with its three-, five-, and 10-year (if applicable) Morningstar Rating™ metrics. The weights are: 100% three-year rating for 36–59 months of total returns, 60% five-year rating/40% three -year rating for 60–119 months of total returns, and 50% 10-year rating/30% five-year rating/20% three-year rating for 120 or more months of total returns. While the 10-year overall star rating formula seems to give the most weight to the 10-year period, the most recent three-year period actually has the greatest impact because it is included in all three rating periods.

Davis Advisors is committed to communicating­ with our investment partners as candidly as possible­ because we believe our investors benefit from under­ standing 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,” “antici­ pate,” 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.

The information provided in this material should not be considered a recommendation to buy, sell or hold any particular security. As of 6/30/19, the top ten holdings for Davis Financial Fund were: U.S. Bancorp, 7.64%; Berkshire Hathaway Inc., 7.56%; Capital One Financial Corp., 7.53%; JPMorgan Chase & Co.,

6.33%; American Express Co., 6.21%; Markel Corp.,

5.61%; Wells Fargo & Co., 5.46%; Chubb Ltd.,

5.00%; Bank of New York Mellon Corp., 4.93%; Loews Corp., 4.46%.

Davis Funds has adopted a Portfolio Holdings Disclosure policy that governs the release of non-public portfolio holding information. This policy is described in the statement of additional information. Holding percentages are subject to change. Visit davisfunds.com or call 800-279-0279 for the most current public portfolio holdings information.

About the author:

Holly LaFon
I'm a financial journalist with a Master of Science in journalism from Medill at Northwestern University.

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