The year 2022 has been difficult for many asset classes. Not only were investors confronted with a decline in their stock portfolios, with the S&P 500 Index falling -18.11% but their investments in bonds also suffered double-digit declines driven by the increase in interest rates.¹

Financial stocks performed better than the broader S&P 500 Index this year, nonetheless the S&P Financials Index still declined -10.53%, while the KBW Nasdaq Bank Index declined -21.40%. Many financial services companies—and banks in particular—stood to benefit from the rise in interest rates as the spread they earn on their customers’ deposits and insurance premiums widens.

In general, they certainly are experiencing meaningful improvement to their interest income, which is dropping to the bottom line. However, the why behind this year’s change in the interest rate environment—an unexpected and significant increase in the inflation rate, which demanded a response from the Federal Reserve to slow the economy—shifted bank stock investors’ concerns toward recession and credit cycles.

Davis Financial Fund declined -8.91% in 2022, slightly outperforming the S&P 500 Financials Index. Primary contributors to relative performance were our investments in property and casualty (P&C) insurance, foreign banks and Berkshire Hathaway. Primary detractors were our U.S. bank and consumer-lending holdings.

Since its inception in 1991, Davis Financial Fund has invested in durable, well-managed financial services companies at value prices, which the fund could hold for the long term. Shelby Cullom Davis’s quip that financial services companies can be “growth companies in disguise” remains a bedrock tenet of our approach. Investors tend to place low valuations on financial companies because of their earnings volatility. But many financial companies generate capital through the business cycle at an attractive rate, which they use to pay dividends, buy back stock or otherwise deploy in ways that generate shareholder value. By focusing on economic reality rather than investor sentiment, Davis Financial Fund has compounded shareholder wealth at 10.83% since its inception almost 32 years ago, outpacing both the S&P 500 Index and the S&P 500 Financials Index.

With rising fear that the U.S. (and global) economy may enter a recession in the coming year driven by inflation, central bank tightening and geopolitical risk, we believe the stage is set once again for select financial companies to generate strong relative and absolute returns over the next decade. We base this belief on the companies’ combination of durable business models, robust balance sheets, decent return on equity, disciplined capital allocation and low valuations.

The average annual total returns for Davis Financial Fund’s Class A shares for periods ending December 31, 2022, including a maximum 4.75% sales charge, are: 1 year, -13.24%; 5 years, 3.65%; and 10 years, 9.51%. 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. For month-end performance, click here or call 800-279-0279. Current performance may be lower or higher than the performance quoted. The total annual operating expense ratio for Class A shares as of the most recent prospectus was 0.94%. The total annual operating expense ratio may vary in future years. Returns and expenses for other classes of shares will vary.

In prior letters we’ve frequently observed that banks were under-earning because of the impact of low interest rates on the spreads that banks can earn on their customers’ deposits. We described this situation as being like a coiled spring waiting for a more favorable interest rate environment to be released. We also offered hypothetical illustrations of how sensitive banks’ earnings should be to an increase in interest rates. We no longer need to hypothesize: Because the short-term Fed Funds rate increased by 425 basis points in 2022, the net interest income generated by the largest U.S. bank holdings in the fund² increased 32% year-over-year in the third quarter as shown in Figure 3. While at this writing we’re awaiting fourth-quarter results, it’s widely expected that banks’ interest income will increase further still—though from there, the pace should slow considerably given that the cost of customers’ deposits tends to reprice on a lag. The vast majority of this tailwind to revenue does drop to banks’ bottom-line profitability. As result, this same basket of banks generated an attractive 17% return on tangible common equity in the third quarter.³

Despite the improvement in financial performance among U.S. banks this year, their stock prices have declined. In fairness, we have posited that companies should be valued on their average (or so-called “normalized”) earnings power. So, this change in net interest income driven by the increase in interest rates doesn’t cause a dramatic shift in our assessment of banks’ intrinsic value. But in our view, this group of stocks was attractively priced even at the start of the year, and with the decline in share prices (combined with the capital generated in 2022) it is now priced at 1.5 times tangible book value. We believe this basket of banks should earn a mid-teens return on equity on average and over time. We believe this is a very powerful combination for investors.

The weight on bank stock valuations seems to be credit concerns. Credit trends have been exceptionally good through and coming out of the COVID-19 pandemic. There is no dispute that credit will eventually “normalize” from this low run-rate of charge-offs. But, in our view, we are very far away from an economic scenario in which bank capital is impaired.

Let’s consider our largest holding in Davis Financial Fund, Capital One. The company’s two main consumer-facing lending businesses are credit cards and autos. Credit quality trends in both lines have followed a similar path, as seen in Figure 4. Delinquencies and charge-offs declined in 2020-2021 relative to pre-COVID-19 levels, but more recently they’ve started to experience an uptick in delinquencies (which naturally would precede any increase in charge-offs). So, the trajectory does suggest that the credit environment is deteriorating from what it was, but the absolute level of the trend remains favorable relative to the longer-term past. As Capital One’s CEO Rich Fairbank recently noted, “It would be very abnormal if we were not seeing normalization."

We try to avoid making forecasts about macroeconomic variables, though given the Federal Reserve’s desire to rein in inflation through tighter monetary policy, a recession within the next year or so remains the most plausible scenario. Regardless of exactly how the next six-to-eighteen months play out we’ve always assumed that our companies would need to live through a recession at some point during our holding period.

The important question is, how well prepared are the companies to get through it? Their first line of defense is the allowance for loan losses that has already been booked. Accounting rules require a company to make a “life of loan” estimate of total credit losses, so their existing allowance already reflects a consensus economic outlook that calls for a slowing economy and a gradual rise in the unemployment rate. The actual path taken by the economy can of course veer adversely from the current outlook, but the point is that banks’ reserves already incorporate a down payment on reversion to the mean of economic trends.

The second line of defense is the considerable amount of pre-provision earnings generated by the business, which at Capital One is currently running at slightly more than $15 billion annualized. That’s sufficient to cover charge-offs equivalent to, say, 8% on their credit card loan portfolio, 4% on their auto loans, and 2% on their commercial loans—levels that are nearly on par with Capital One’s experience in the Great Financial Crisis of 2008-2009, when the unemployment rate reached 10%. By definition, a “typical” recession would be far less painful. The final line of defense against any future recession is the bank’s capital. And all U.S. banks, including Capital One, are holding materially more capital against their credit, markets and operating risks than they were leading up to the financial crisis.

That the economy may enter a recession in the coming year or two is hardly news to us. Recessions are an unpleasant but inevitable feature of the economic landscape for long-term investors. The question then is, as always, what is priced into valuations? At today’s stock prices, we believe these risks are being overly discounted by investors whose memory of the financial crisis remains vivid. A recession could very well put pressure on banks’ earnings in the coming year, but they should bounce back in subsequent periods. It’s interesting to note that Capital One has never once in its history experienced a four-year period in which it did not earn at least a 13% return on tangible common equity. It’s a great illustration of Warren Buffett’s quip, “I would much rather earn a lumpy fifteen percent over time than a smooth twelve percent.”

Davis Financial Fund leaned into investments in property and casualty insurance⁴ in 2020–2021. As we wrote to you last year, the industry had been pushing through substantial price increases across most commercial lines, driven by elevated catastrophe-related losses, “social inflation” in the size of litigation settlements and awards, and the (then) low level of interest rates. We felt that the market wasn’t recognizing the improvement in the profitability of commercial P&C insurers. In 2022 that sentiment has begun to shift, as P&C insurance stocks performed well on a relative basis, with the median return for P&C companies within the S&P 500 Financials Index of +18%. This was the fund’s primary source of relative outperformance in the year, given our 19% position in the sector at the outset.⁵

As the relative risk/reward trade-off has shifted back toward our bank holdings, the fund has reallocated some capital away from P&C insurance, though it still remains a meaningful position at 17%. A closer look at one of those holdings, Markel Corporation, illustrates why. Referred to by some as a “mini-Berkshire Hathaway,” Markel allocates its capital between writing P&C insurance, investing in publicly traded stocks, purchasing controlling interest in private companies and repurchasing its own stock. Such flexibility conveys an advantage over those who limit themselves to one or two of those options. It also complicates the analysis of the company by investors, and despite its $18 billion market capitalization, Markel is covered by relatively few brokerage analysts. Insurance companies in general earn two streams of profits: the profit (loss) from underwriting clients’ risks, and the investment income generated from assets financed with the float provided by their customers (and their own capital). Markel has a demonstrated record as a highly competent underwriter, illustrated by management’s targeted underwriting margin of 10% in the medium-term, an outcome that would translate into an attractive mid-teens return on equity if it were conventionally structured.

But Markel is not conventional: It carries far more equity capital than its insurance operations need on a standalone basis, and that excess is allocated to stocks and owned private companies. Markel is projected to earn $1.25 billion of net income in 2023⁶, but this metric only captures the dividends received on its $8 billion stock portfolio. The underlying companies in that portfolio—which include Berkshire Hathaway, Deere & Co., Home Depot and Alphabet, among others—earn perhaps $350 million more than they pay out in dividends.⁷ Moreover, these companies are reinvesting much of that into their own businesses at attractive rates of return, which over time will materialize into stock price appreciation. Adjusting Markel’s reported earnings for these retained earnings would decrease its 2023 valuation multiple from 14 times to 11 times. Furthermore, the contribution to this adjusted measure of earnings from these stocks and from the approximate $2 billion invested in private companies is roughly 45% of the total. These are non-financial businesses that generally command higher valuation multiples than typical financial companies.⁸

Figure 5 shows the growth in Markel's book value. Markel’s rolling five-year compound growth rate in book value per share has ranged from a low of 7% to a high of 20% over the preceding 20 years, and has averaged 12% during that entire period.⁹ This is a reasonable (though arguably understated) proxy for the growth in intrinsic value, and reflects the quality of Markel’s underwriting business combined with their discipline in investing capital into equities and private companies. Market and intrinsic values will of course diverge at times but ultimately the former follows the latter. The path may not always look like a smooth one, but Markel has demonstrated its ability to compound intrinsic value at a steady pace over time.

We first purchased a small position in residential mortgage lender, Rocket Companies, on its initial public offering in the summer of 2020. The country was in the middle of a massive refinancing boom, and as the leading mortgage originator, Rocket was earning approximately $3 billion per quarter (pre-tax). While the then-high level of profitability certainly influenced the math of valuation, by no means was it the whole story, as it was anticipated that origination volumes would be cyclical. Rocket, which continues to be controlled by its founder Dan Gilbert, had built a digitally driven platform in an otherwise labor-intensive industry, which we believe is an enduring source of competitive advantage.

As long-term interest rates began to rise in late 2021, the wave of refinancing volumes began to slow, and in 2022 they fell off a cliff. Rocket will earn little if any money in 2022, and profits in 2023 likely will again be meager. But the company’s stock price declined by more than half over this period. To us this seems like a case where everyone knows that the sector is facing challenges, but not everyone acknowledges what is priced into the stock. Davis Financial Fund nearly doubled its position in Rocket Companies in 2022 at much lower prices. Yes, the flow of mortgage originations has dried up for now, but the stock of mortgages outstanding has increased by 18% to $12 trillion in the past three years.¹⁰ And the value of homes increased by an even greater rate, meaning that loan-to-value ratios have actually fallen. People do eventually move homes, or they will look to tap into their home equity for myriad purposes, and Rocket will be there to help them finance those transactions.

Again, we prefer a lumpy fifteen to a smooth twelve.

We remain consistent in our approach to allocating capital in our portfolio: We look for companies with durable competitive advantages coupled with competent and honest management that are priced at a discount to their intrinsic value. We invest presuming that we will own our companies through business cycles. We do not attempt to build a portfolio around a particular speculative forecast—where interest rates or the economy will go, for example—but strive to construct a portfolio that will perform well over the long term across a range of economic outcomes. As such, our portfolio is diversified across leading franchises earning above-average returns on capital in banking, payments, custody, wealth management and P&C insurance.

Currently, investors’ fears of a future recession are weighing on stock prices of financial companies, notably banks. While a recession is quite plausible in the next year or two, we believe banks are well positioned to withstand it. Although short-term market fluctuations are unpredictable, our companies’ valuations are so low that we think they should generate strong returns over the next decade.

We remain excited by the investment prospects for the companies in Davis Financial Fund. Nothing provides a stronger indication of that than the fact that the Davis family and colleagues have more than $70 million invested in the fund alongside our clients. We are grateful for the trust you have placed in us.¹¹