Davis New York Venture Fund
Spring 2012 Review
Since our founding more than 40 years ago in 1969, Davis Advisors’ mission as a firm has been to serve our shareholders and to do so with high integrity. Mindful of the enormous responsibility that comes with serving as a steward of others’ capital, we are firmly committed to:
- Investment excellence
- Sharing wisdom and perspectives about investor behavior
- Open and honest communications
As a sign of our commitment to and alignment with all those who have entrusted their capital to us, the Davis family, Davis Advisors, employees, and directors have more than $2 billion of their own money invested side by side with fellow shareholders in the various mutual funds our firm manages.1
Market Perspectives
In March the current bull market reached its three year anniversary and passed the 1400 mark on the S&P 500® Index for the first time since 2008. From the lows set three years ago the market has more than doubled despite a backdrop of continued uncertainty, pessimism and challenges. Notwithstanding this impressive advance, the earnings, cash flow, liquidity, balance sheet strength, and dividends of many high-quality, durable businesses have improved so dramatically in recent years that they continue to represent excellent value in our view.
The chart below clearly illustrates the price-to-value gap in the market today by comparing various market metrics on January 1, 2000 with the current period. Despite significant progress in the fundamentals of S&P 500® businesses over this period the price of these businesses has declined overall. We believe this dramatic gap between price and value will eventually close and that may set the stage for higher prospective returns.
Over the long term, stock prices are determined by the fundamentals of the underlying individual businesses. As value investors we are encouraged by the financial strength, competitive advantages and management of the businesses we own. While stock prices in the short run may be influenced by changing investor sentiments, we believe the intrinsic value of these businesses in aggregate is much higher than it was just a few years ago. This is reason for optimism about the long-term prospects for the broader market and more specifically for the handpicked businesses we own in our Portfolio.
Portfolio Positioning
Market conditions may vary from period to period, yet the core tenets of the Davis Investment Discipline and approach remain the same. We start with the premise that stocks represent fractional ownership in real businesses. We seek to purchase durable businesses at value prices and hold them for the long term. We believe that owning shares of well-managed businesses with attractive reinvestment rates, purchased at reasonable valuations and held for years to allow the power of compounding to work, is a reliable method for building capital over long investment horizons. Our Portfolio holds three primary categories of investments:
Market leaders with strong balance sheets—In many cases these are global companies with universally known brands, earnings that are well diversified from the standpoint of product line and geography, proven management, and fortress balance sheets. These businesses span a broad range of industries from consumer products to technology to financial services to retailing, among others. They provide a core foundation of stability within the Portfolio and offer in our view the possibility of long-term sustainable returns through capital appreciation and dividends.
Costco Wholesale, a discount warehouse retailer, is a representative market leader in the Portfolio.3 Costco opened its first few warehouses in 1983 and today has grown to be the second largest retailer in the United States and the seventh largest in the world. The company’s success stems from a somewhat rare combination of traits we look for in our investments, including strong leadership, sound financial footing and a durable business model that provides competitive advantages. In the case of Costco, shoppers must pay a modest annual membership fee to gain entrance to Costco stores where they can enjoy rock-bottom prices on quality brands. In addition to other benefits, this membership-based business model creates a reliable, steady income stream and over time has become a key component of Costco’s profitability. Today, 66 million members generate more than $2 billion in annual fees for Costco. In addition, its members are so satisfied with the value they receive that almost 90% renew their membership each year. This remarkable and well-executed business model has enabled Costco to build its franchise value significantly over the years, generating solid returns for long-term shareholders along the way.
Another representative market leader in the Portfolio is Texas Instruments, a leading workhorse technology company that we have followed for decades. Texas Instruments today is one of the world’s largest microprocessor companies with a special focus on the highly fragmented analog and embedded semiconductor markets. These products are essential components in an increasing number of everyday goods, including electronic devices such as e-books, cell phones, digital cameras, television set-top boxes, and more. In our view Texas Instruments is a well-managed, financially strong company with ample liquidity and a good record of returning capital to shareholders through both stock repurchases and dividends.
Other market leaders in the Portfolio include Coca-Cola, the world’s largest beverage company; Microsoft, a major global software company; Walt Disney, an entertainment franchise that operates theme parks around the globe and is a majority owner of the ESPN network; and Johnson & Johnson, a premier consumer health care company with worldwide reach.
Out-of-the-spotlight businesses—The next major category of investments in the Portfolio is “out-of-the-spotlight” businesses. These are lesser known companies with attractive economics that in our opinion should eventually command higher valuations. Given the right leadership and attractive reinvestment rates, these low-profile holdings have the potential to add meaningfully to results in our estimation.
Canadian Natural Resources, an independent oil and gas exploration and production company with operations focused mostly in Western Canada, is an example of an out-of-the-spotlight holding in the Portfolio. The company is in the early phase of developing its tar sands reserves in Alberta, which may be one of the largest land-based oil fields outside of Saudi Arabia. The company has a strong track record of generating shareholder value and its managers and directors are aligned with shareholders through significant ownership of the company’s stock.
Other out-of-the-spotlight businesses in the Portfolio include Potash, a Canadian-based fertilizer company; Iron Mountain, a document storage company; and Loews, a diversified conglomerate with interests in insurance, energy and hotels.
Headline risk or contrarian investments4—On a very selective basis we make contrarian investments. These often involve controversial situations where we believe the market has overly discounted a company’s shares given the probable economic risk to the business’s long-term fundamentals. As with all our investments, underpinning these positions is our internal assessment that the overall risk/reward trade-off is favorable.
An example of a headline risk holding in the Portfolio is Hewlett-Packard, the world’s largest information technology company. Despite its well-publicized strategic and management challenges, we believe Hewlett-Packard is a durable franchise with a leading position in both the personal computer and printer businesses. Through its 2008 acquisition of EDS the company is also an increasingly important presence in business enterprise software that corporations use to run their diverse operations. Market sentiment is overly negative in our view as Hewlett- Packard’s recent stock price seems to reflect a near worst case scenario while not giving adequate credit to the company’s earning power. The investments we have made in market leaders, out-of-the-spotlight companies and headline risk businesses combine to create a Portfolio we believe is well diversified with a balance of offensive and defensive characteristics that can produce satisfactory compound returns over full market cycles.5
Performance Review
As the chart below illustrates, the Davis New York Venture Fund outperformed the S&P 500® Index over every 10 year period since its first full year of performance in 1970.6
click here or call 800-279-0279.
This track record was generated through decades that encompassed a variety of economic, political and investment conditions, including inflation, deflation, high interest rates, low interest rates, political crises, wars, and more. We believe these results are a testament to the value an active manager may add overall and to the durability of the Davis Investment Discipline in particular.
Over the past 12 months ending March 31, 2012, the S&P 500® Index returned 8.54%. The Davis New York Venture Fund trailed the broader market over that period.9 Relative to the Index, consumer staples and financial holdings performed well on balance, offset primarily by materials, energy and information technology holdings which may be currently out of favor but in our view have strong merits as long-term investments. In addition, our holding in Sino-Forest, a timber plantation management company, has been marked to zero as we believe there is a likelihood of a permanent loss of capital on this particular investment.
Based on current valuations, the companies in the Portfolio today are trading at an estimated owner earnings yield (i.e., the first year return an investor would earn by purchasing the businesses outright) of roughly 7% to more than 8%, well above the prevailing risk-free rate of 2% to 2.5% for 10 year U.S. Treasuries.10 By historical measures, that is a very wide disparity and signals in our opinion that high-quality businesses presently offer a great deal of value relative to the alternatives.
Given our businesses’ vast sources of earnings power (including in many cases meaningful exposure to fast-growing developing economies), we believe it may be possible for the owner earnings yield to approach 10% or more in the years ahead. The case for equities may be further bolstered by the fact that many of the companies we own are reducing their number of shares outstanding through share repurchases and returning capital to investors through higher dividends. If these trends continue, the total return shareholders could potentially realize starting from today’s low levels may well prove quite satisfactory in the long run, a message that seems all too absent from current market debates.
Experience has taught us that building long-term wealth requires patience to wait for the gap between price and value to close. This perspective has helped us generate attractive long-term results for shareholders, as the chart below demonstrates. During its 40 year history the Davis New York Venture Fund outperformed the S&P 500® Index 64% of the time over one year periods, 67% over three year periods, 75% over five year periods, and 100% over 10 year periods and longer. Based on this historical data, the longer an investor held the Fund, the more likely that investor’s return would exceed the return of the Index.
from 2/17/69–12/31/11. Returns would be lower if a sales charge were included. See endnotes for a description of our rolling 10 year performance and a definition of the S&P 500® Index. Past performance is not a guarantee of future results. 8 Returns calculated from 2/17/69 through 12/31/78.9 Past performance is not a guarantee of future results. 10 Common stocks and bonds represent different asset classes subject to different risks and rewards. Unlike bonds, the Fund does not offer a fixed rate of return if held to maturity, and the Fund has risks not associated with holding a bond. Bonds are considered to have less risk than equities. Future economic events may favor one asset class over the others. 11 Returns are from 2/17/69–3/31/12. Returns would be lower if a sales charge were included. See endnotes for a description of our rolling performance and a definition of the S&P 500® Index. Past performance is not a guarantee of future results.
Where We Are Finding Opportunities
Our confidence in our investment approach rests to a large degree on what we view as favorable prospects for the businesses we own. The Portfolio is essentially a group of business models we have researched and consider attractive vehicles that may compound capital over the long term based on their management quality, business durability and competitive advantages, coupled with relatively attractive valuations. In our view the keys to outperforming the market over the next decade are to:
- think long term and not get caught up in short-term cycles;
- continue to exercise a highly selective and disciplined approach with respect to business quality, valuation and risk; and
- remain focused on in-depth, bottom-up research.
Today we are finding compelling values in many areas of the market that in our view represent attractive avenues for compounding clients’ capital over the next decade. Most of these opportunities fit within the following long-term themes:
Globally dominant world leaders— These industry leaders are characterized by strong pricing power, diversified earnings, healthy balance sheets, strong competitive moats, and durable business models. Because these businesses produce excess cash, they are not generally dependent on external funding.
Beneficiaries of crisis—The business model, capital position and management discipline of certain companies allow them to take advantage of dislocations in their industry, the economy or the capital markets. Given strong free cash flow and a conservative balance sheet, these companies may be able to use distressed prices to make investments, arrange acquisitions or buy back their shares at accretive prices. Other companies may significantly decrease their cost structure allowing for potentially increased returns as revenues return to more normal levels.
Select financial companies—Although the future is always uncertain, we believe the financial services industry has much growth ahead of it and its products carry little risk of obsolescence. As a general rule, people will always need basic banking services, insurance products, investment management advice, and other such services. Nonetheless, it is necessary to differentiate between strong and weak players in order to invest successfully in this area of the market.
Energy, commodities and agricultural businesses—Well-managed companies in these areas are positioned to benefit from the inexorable long-term growth of a global middle class, which may result in increasing demand and potentially higher prices for most natural resources. We seek businesses with a history of smart capital allocation that have mostly avoided the pitfalls of rapid expansion and costly acquisitions during periods of relatively high commodity prices.
Investing in companies that can grow the intrinsic value of their business through economic cycles may create the opportunity for long-term growth that is not solely dependent on the pricing of the underlying commodity while also allowing the potential for higher returns should rapid commodity price inflation occur in the future.
Select special situations—We may periodically invest in highly opportunistic companies in diverse industries with unique or not well understood characteristics that may make them compelling long-term investments in our view.
The investment opportunities discussed above combined with the breadth of our other investments create a Portfolio that is broadly diversified with a conscious blend of both offensive and defensive components in our view.12 The common thread running through the Portfolio is each holding has been selected according to the Davis Investment Discipline with an emphasis on management quality, business model strength, durable competitive advantages, and appropriate valuations. The sum total of our investments creates a Portfolio we believe affords our clients the potential to generate satisfactory compound returns over the course of many years.
All of us at Davis Advisors thank you for investing with us. We take our responsibilities to our clients seriously and appreciate your confidence. We look forward to continuing our investment journey together.
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.
Objective and Risks. Davis New York Venture Fund’s investment objective is long-term growth of capital. There can be no assurance that the Fund will achieve its objective. The Fund invests primarily in equity securities issued by large companies with market capitalizations of at least $10 billion. Some important risks of an investment in the Fund are: stock market risk: stock markets have periods of rising prices and periods of falling prices, including sharp declines; manager risk: poor security selection may cause the Fund to underperform relevant benchmarks; 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; financial services risk: investing a significant portion of assets in the financial services sector may cause the Fund to be more sensitive to problems affecting financial companies; headline risk: the Fund may invest in a company when the company becomes the center of controversy. The company’s stock may never recover or may become worthless; fees and expenses risk: the Fund may not earn enough through income and capital appreciation to offset the operating expenses of the Fund; foreign country risk: foreign companies may be subject to greater risk as foreign economies may not be as strong or diversified; emerging market risk: securities of issuers in emerging and developing markets may present risks not found in more mature markets; 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; trading markets and depositary receipts risk: depositary receipts involve higher expenses and may trade at a discount (or premium) to the underlying security. As of March 31, 2012, the Fund had approximately 16.3% of assets invested in foreign companies. See the prospectus for a complete description of the principal risks.
Davis Advisors is committed to communicating with our investment partners as candidly as possible because we believe our investors benefit from understanding 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,” “anticipate,” 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 March 31, 2012, Davis New York Venture Fund had invested the following percentages of its assets in the companies listed: Canadian Natural Resources, 2.64%; Coca-Cola, 1.83%; Costco Wholesale, 3.82%; Hewlett-Packard, 0.46%; Iron Mountain, 1.41%; Johnson & Johnson, 0.97%; Loews, 2.69%; Microsoft, 1.45%; Potash, 0.81%; Sino- Forest 5% 8/1/13 Conv. Notes, 0.06%; Texas Instruments, 1.62%; Walt Disney, 1.74%.
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 prospectus. Holding percentages are subject to change. Click here or call 800-279-0279 for the most current public portfolio holdings information.
Broker-dealers and other financial intermediaries may charge Davis Advisors substantial fees for selling its funds and providing continuing support to clients and shareholders. For example, broker-dealers and other financial intermediaries may charge: sales commissions; distribution and service fees; and record-keeping fees. In addition, payments or reimbursements may be requested for: marketing support concerning Davis Advisors’ products; placement on a list of offered products; access to sales meetings, sales representatives and management representatives; and participation in conferences or seminars, sales or training programs for invited registered representatives and other employees, client and investor events, and other dealer-sponsored events. Financial advisors should not consider Davis Advisors’ payment(s) to a financial intermediary as a basis for recommending Davis Advisors.
We gather our index data from a combination of reputable sources, including, but not limited to, Thomson Financial, Lipper and index websites.
The S&P 500® Index is an unmanaged index of 500 selected common stocks, most of which are listed on the New York Stock Exchange. The Index is adjusted for dividends, weighted towards stocks with large market capitalizations and represents approximately two-thirds of the total market value of all domestic common stocks. Investments cannot be made directly in an index.
Rolling Returns. Davis New York Venture Fund’s average annual total returns for Class A shares were compared against the returns of the S&P 500® Index as of the end of each quarter for all time periods shown from February 17, 1969 through March 31, 2012. The Fund’s returns assume an investment in Class A shares on the first day of each quarter with all dividends and capital gain distributions reinvested for the time period. The returns are not adjusted for any sales charge that may be imposed. If a sales charge were imposed, the reported figures would be lower. The figures shown reflect past results; past performance is not a guarantee of future results. There can be no guarantee that the Fund will continue to deliver consistent investment performance. The performance presented includes periods of bear markets when performance was negative. Equity markets are volatile and an investor may lose money. Returns for other share classes will vary.
After July 31, 2012, this material must be accompanied by a supplement containing performance data for the most recent quarter end.
Shares of the Davis Funds are not deposits or obligations of any bank, are not guaranteed by any bank, are not insured by the FDIC or any other agency, and involve investment risks, including possible loss of the principal amount invested.
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