Davis Appreciation and Income Fund
Christopher Davis, Peter J. Sackmann, CFA
and Creston A. King III, CFA
Fall Review 2021
Christopher Davis, Peter J. Sackmann, CFA
and Creston A. King III, CFA
Fall Review 2021
For the first seven months of 2021, the broader equity markets delivered solid positive performance, with the S&P 500 Index returning 17.99%. Fixed income markets were more challenged understandably, with the Bloomberg Barclays U.S. Aggregate Bond Index returning -0.50% over the same period, much in response to the recent rise in intermediate and longer-dated interest rates.
The financial resiliency and health of most major economies have been tested, but one by one, they are beginning to show the green shoots of recovery. Meanwhile, unlike the financial crisis of 2008–2009, the recent recessionary conditions did not stem from, nor cause, excessive leverage or other balance sheet problems for the U.S. economy. With relatively healthy credit conditions (which are rare after most recessions) and the important support of both fiscal and monetary stimulus, we are seeing evidence that the U.S. economy is healing and even growing again.
Aiding the resumption of economic activity and expansion is the fact that the major banking institutions in the U.S. are, by and large, holding excess capital with which, as COVID subsides, they can increase return of capital through higher dividends and share buybacks; they can also redeploy large amounts of money into loans at significantly higher net interest margins than what they endured in the recent years of compressed spreads. The main point is that we have a relatively strong foundation underpinning this economy from a balance sheet and financing perspective, coupled with signs of stirring economic activity, significant spend at both the consumer and business levels and a healing employment picture.
In certain spots, speculative valuations have bubbled up. That does not describe the whole market. The stock market is just a market of individual stocks, and when we sift through the landscape of hundreds of companies, we believe there are well-priced investment opportunities. On the subject of hype and manias in the markets, our more than 50-year history as a firm has taught us not to be lured into such risky situations.
We are not optimists nor are we pessimists. We try to be realists, and our sense of reality is grounded in history. Every decade has its iconic examples of excessively priced, speculation-driven momentum stocks. Relatively few of those stocks, from their peak levels, delivered competitive returns against the broader market over subsequent periods that in many cases lasted a half decade or more.
In short, the existence of some overvalued situations in the market is commonplace, but does not mean there is a dearth of things to buy. On the contrary, we own today some of the finest businesses in the world, and through true active management and stock-picking, we are concentrating on a portfolio of stocks that we believe are well-priced. Every business we hold presently has the potential in our estimation to generate, over a business cycle, attractive returns on capital, which is an important input when our investment discipline relies to a large degree on compounding shareholder wealth through the businesses we own. It is not always necessary nor advisable, in our opinion, to jettison good businesses in the short term in search of all-new businesses. If the businesses we have identified can compound their internal free cash flow at high rates, then theoretically we could do well by simply holding these financial locomotives, with some changes at the margin as truly warranted.
In the year-to-date period through July 31, Davis Appreciation and Income Fund returned 21.49%, outperforming the balanced 60/40 Index’s 10.35% return as well as the Endowment Index’s return of 11.96%.1
We manage the portfolio in a way that seeks to achieve a competitive total return relative to the risk-free rate and inflation, while maintaining a degree of diversification by always holding a mix of stocks and bonds.
The drivers of performance this year include many businesses that had negative stock price trends just a year or so ago, as the effects of COVID were being felt much more. The Fund’s largest sector allocation—a byproduct of individually chosen stocks that each have their own merits in our analysis—is financial services, which saw performance hurt in 2020, but has been a tailwind this year. Rather than jump to a conclusion that this is synonymous with concentration risk, we note that some of our largest positions include:
These four businesses are all lumped into the same sector even though each one is tied to very different drivers and risk factors. In most scenarios, the credit profile of a Norwegian bank would likely not be directly or immediately correlated with life insurance claims—a function of mortality rates—in many countries, referring to DNB Bank and AIA Group by way of example, respectively. Hence when we look at the portfolio in detail, we would note the eclectic and diverse business models making up the whole, and that is done intentionally to build in a degree of durability.
Last year around this time, the share prices for many of our holdings declined dramatically in the face of the COVID outbreak. We sharpened our collective pencils, and after some significant investment of time studying the direct and indirect implications of COVID, we took a few notable actions.
The first was to compare the relative opportunities, since prices had changed significantly in virtually every group in the market, with some being buoyed by investors favoring so-called “COVID trades”— i.e., internet-related businesses and food delivery, by and large.
We pared some of our larger technology-related holdings (including, for this purpose, the e-commerce and broader online space), some of which had held up better than other parts of the portfolio.
We exited energy entirely. Despite the rebound that has occurred in oil and gas since our sale, our view was that the longer-term outlook for the fossil fuel industry could become far more difficult both operationally and, even more, financially over the coming decade and perhaps beyond. Between regulation, taxation, and changing social and political attitudes towards drilling, it is yet to be seen whether the recent run in this sector has a sustainable path looking out years, and we have decided for now to avoid the area for fundamental reasons, rather than any outlook on the commodity price.
In terms of what we purchased, we added to a number of our financial positions that, based on both our internal stress tests and the Federal Reserve’s years of stress tests for banks, seemed to us like a very attractive risk/reward opportunity set. Our view was that the amount of capital required to foot the bill, even in the case of a deep economic crisis scenario, was in place precisely as a counter-cyclical buffer. Between very high capital ratios going into COVID with a substantial sum of earnings still coming in the door—aided in no small part by stimulus checks—we felt comfortable adding to select financial businesses, and that decision, as noted earlier, has been beneficial to this year’s results thus far.
Lastly, in terms of fixed income, we are holding a little more than 25% of the Fund in fixed income— including mortgages, asset-backed securities and corporates, among other sectors—and cash. In certain environments, fixed income offers interesting yields and over certain cycles the potential for appreciation of the principal. We are not in one of those times. Just as we are wary of reaching too far out on the spectrum when it comes to valuations on the equities side, we are equally mindful of not chasing a few extra basis points of yield if it entails more than commensurate risk— and that is, at a high level, the setup for many fixed income areas currently. Still, if one is careful, there are acceptable risks that one can take today in fixed income for some income generation. In any event, we will always devote a portion of the Fund to what we deem sensible fixed income, as well as cash equivalents.
The average annual total returns for Davis Appreciation and Income Fund’s Class A shares for periods ending June 30, 2021, including a maximum 4.75% sales charge, are: 1 year, 37.20%; 5 years, 10.60%; and 10 years, 6.97%. The performance presented represents past performance and is not a guarantee of future results. Total return assumes reinvestment of dividends and capital gain distributions. Investment return and principal value will vary so that, when redeemed, an investor’s shares may be worth more or less than their original cost. The total annual operating expense ratio for Class A shares as of the most recent prospectus was 1.02%. (The Adviser is contractually committed to waive fees and/or reimburse the Fund’s expenses to the extent necessary to cap total annual fund operating expenses of Class A shares at 1.00%. The expense cap expires May 1, 2022.) The total annual operating expense ratio may vary in future years. Returns and expenses for other classes of shares will vary. Current performance may be lower or higher than the performance quoted. For most recent month-end performance, click here or call 800-279-0279.
Given the strong performance enjoyed by many investors this year in stocks, a legitimate question is to ask whether there are still appealing opportunities. We would encourage investors to look very much individually at companies throughout different areas of the economy and markets. A detailed scan should reveal that many fine businesses still represent good value, particularly considering that conditions for most sectors are improving. Owning durable compounding machines with the potential for free cash flow growth over many years is a core part of our discipline. We feel it is a sensible and perennial way to invest as stewards of both our and others’ savings—pre-COVID, through COVID and after.
At Davis Advisors, we seek to purchase durable businesses at value prices and hold them for the long term. The more than $2 billion Davis Advisors, the Davis family and Foundation, our employees, and Fund directors have invested in similarly managed accounts and strategies remains a true sign of our commitment to and conviction in this enduring philosophy.2
We are grateful for your confidence and trust, and 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.
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.
Objective and Risks. Davis Appreciation and Income Fund’s investment objective is total return through a combination of growth and income. There can be no assurance that the Fund will achieve its objective. The Fund is subject to both equity and debt risk. 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; 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; 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; 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; preferred stock risk: preferred stock is a form of equity security and is generally ranked behind an issuer’s debt securities in claims for dividends and assets of an issuer in a liquidation or bankruptcy. An adverse event may have a negative impact on a company and could result in a decline in the price of its preferred stock; bonds and other debt securities risk: Bonds and other debt securities generally are subject to credit risk and interest rate risk; interest rate risk: interest rate increases can cause the price of a debt security to decrease; variable current income risk: the income which the Fund pays to investors is not stable; credit risk: the issuer of a fixed income security (potentially even the U.S. Government) may be unable to make timely payments of interest and principal; convertible securities risk: convertible securities are often lower-quality debt securities; changes in debt rating risk: if a rating agency gives a fixed income security a low rating, the value of the security will decline; extension and prepayment risk: the pace at which borrowers prepay affects the yield and the cash flow to holders of securities and the market value of those securities; foreign country risk: foreign companies may be subject to greater risk as foreign economies may not be as strong or diversified. As of 6/30/21, the Fund had approximately 9.1% of net assets invested in foreign companies; 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; fees and expenses risk: the Fund may not earn enough through income and capital appreciation to offset the operating expenses of the Fund; 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 high-yield, high-risk debt securities risk: issuers of these debt securities are unlikely to have a cushion from which to make their payments when their earnings are poor or when the economy in general is in decline. These issuers are likely to have a substantial amount of other debt, which will be senior to the high-yield, high-risk debt securities. An issuer must be current on its senior obligations before it can pay bondholders; See the prospectus for a complete description of the principal risks.
The information provided in this material should not be considered a recommendation to buy, sell or hold any particular security. As of 6/30/21, the top ten holdings, not including cash and equivalents, of Davis Appreciation and Income Fund were: Capital One Financial, 6.88%; Berkshire Hathaway, 6.24%; Applied Materials, 5.96%; Alphabet, 5.91%; Wells Fargo, 5.10%; Amazon.com, 4.46%; Texas Instruments, 4.07%; Intel, 3.72%; DNB Bank, 2.97%; Microsoft, 2.80%. The cash and equivalents were 11.13%.
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.
We gather our index data from a combination of reputable sources, including, but not limited to, Lipper, Wilshire, and index websites.
The Fund can invest in a variety of derivative investments to pursue its investment objective or for hedging purposes. The Adviser and the Fund have claimed exclusions from the definition of the term “commodity pool operator” under the Commodities Exchange Act and, therefore, are not subject to registration or regulation as a pool operator under the Commodities Exchange Act.
The Combined Index reflects an unmanaged portfolio (rebalanced monthly) of 60% of the S&P 500 Index and 40% of the Bloomberg Barclays U.S. Aggregate Bond Index. 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. The Endowment Index is an objective benchmark for investors who manage a portfolio incorporating three dimensions: global equities, global fixed income, and alternative investments. This index, comprised of investable components, is used for portfolio comparison, investment analysis, and research and benchmarking purposes. The Index is used by fiduciaries such as trustees, portfolio managers, consultants and advisors to endowments, foundations, trusts, DB/DC plans, pension plans and individual investors. The Bloomberg Barclays U.S. Aggregate Bond Index is a broad-based flagship benchmark that measures the investment grade, US dollar-denominated, fixed-rate taxable bond market. The index includes Treasuries, government-related and corporate securities, MBS (agency fixed-rate pass-throughs), ABS and CMBS (agency and nonagency). Investments cannot be made directly in an index.
After 10/31/21, 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.
Item #4439 7/21, Davis Distributors, LLC 2949 East Elvira Road, Suite 101, Tucson, AZ 85756, 800-279-0279, davisfunds.com