Davis International Fund
Update from Portfolio Manager
Semi-Annual Review 2022
Update from Portfolio Manager
Semi-Annual Review 2022
The Fund’s biggest contributors for the first
six months of the year were mainly Chinese
holdings, including Alibaba, Meituan, Ping An
Insurance, Hollysys Automation and JD.com,
as they rebounded from trough levels.
For the first six months of 2022, Davis International Fund returned -17.28%, ahead of the MSCI ACWI (All Country World Index) ex US decline of -18.42% by 1.14%. While unpleasant, this down-market year comes after a decade of strong cumulative market returns. At Davis, after more than five decades of investing, we understand that crises and corrections are painful, but inevitable. Since 1928, a bear market (where the market declines by at least 20%) has occurred approximately once every three years. A market correction of at least 10% occurs on average once a year.
Yet despite numerous crises, including the Great Depression, World War II, the Korean War, the 1970s oil shock, the dot-com bust, the global financial crisis, the COVID-19 pandemic and the Ukraine War, the market has continued its upward march. If you had invested in the S&P 500 Index at the beginning of 1929 through June 2022 (over 93 years), your return would have been a satisfactory 9.16% a year, and adjusted for inflation, would have been 6.07%.1 A long-term focus and holding period has been and will continue to be the path to building wealth.
Although inevitable, market downturns are never pleasant. Falling returns and the accompanying negative headlines are worrisome, but as legendary investor Shelby Cullom Davis said, “You make most of your money in a bear market, you just don’t realize it at the time.” The global financial crisis of 2008– 2009 was a severe and destabilizing downturn, but starting in 2010, the MSCI ACWI ex US returned 69.96% over a decade.2 Historically, equity market returns have been strong in periods following a bear market. For example, in the year following a 20% market decline, on average, the S&P 500 Index return was a robust 23.9%.3 The market can continue falling as it did in 2009 after being in bear market territory in 2008, but an average return of 23.9% in the following year speaks to how lower valuations may seed higher future returns.
The Fund’s biggest contributors for the first six months of the year were Alibaba, AIA Group, Meituan, Ping An, Hollysys and JD.com. These e-commerce, insurance and industrial automation companies have rebounded from trough levels, as regulatory and economic concerns have abated. While Alibaba, JD.com and Meituan were impacted by COVID-related lockdowns in April and May, they rebounded in June and July as business normalized. AIA Group and Ping An outperformed, where, despite COVID-related disruptions, insurance sales remain resilient. Both insurance companies profile as good long-term compounders trading at attractive valuations. Finally, Hollysys, a leader in Chinese industrial automation, has continued to grow its business and backlog while maintaining a very strong balance sheet despite COVID-related disruptions. We will discuss the China outlook in further detail later in this update.
Detractors to performance included technology and industrial leaders Tokyo Electron, Samsung and Schneider Electric. All three companies have experienced very solid results, but investors have sold off these industry leaders as fears of an economic recession have risen. As a leader in the semiconductor equipment industry, Tokyo Electron has benefited from the very strong demand for semiconductors, with sales up 43% and EPS up 80% over the past fiscal year. The stock, however, was down 43% in the first six months of 2022 due to recession fears, but the long-term outlook driven by multiple trends, including cloud computing, artificial intelligence, Internet of Things and 5G, continues to look bright. Similarly, Samsung reported sales up 21% and EPS up 13% in the second quarter of 2022, but the stock is down 33% year to date and is trading at only 6x our estimate of 2023 owner earnings. Schneider Electric, the French electrical products manufacturer, reported sales up 17% and EPS up 11% in the first six months of the year despite the impact of COVID-related lockdowns in China and the Ukraine war’s impact in Europe. All three companies, based on our analysis, are solid companies with bright long-term outlooks trading at attractive valuations, and we expect their share prices to rebound over time.
One detractor that we moved on from, however, is the Chinese online grocer Missfresh. As a pioneer in online-only grocery, Missfresh accurately forecast the consumer desire to have groceries delivered to their doorstep. While the global pandemic sharply increased the demand for its services, it also attracted a large set of competitors and investment funds ready to fund their expansion. Fierce competition and rising costs led to a decline in profitability and a more uncertain business outlook. Given the broader stock market decline, as well as the fall in the valuations of some of our larger holdings, we decided to sell out and redeploy the funds.
One area of the portfolio that has generated many investor questions over the past two years, and is also one with what we believe has a great deal of opportunity, is China. Chinese companies held in the portfolio after being strong contributors for many years have been detractors to portfolio performance since the beginning of 2020. Looking over the past decade, in the first seven-and-a-half years leading up to 2020, the Chinese holdings of Davis International Fund returned a cumulative 213.9% compared to 72.2% for the MSCI ACWI ex US as a whole and contributed significantly to the Fund’s outperformance over this time period.4
Over the past two-and-a-half years, however, our Chinese holdings have underperformed. In fact, owning Chinese companies has become a very emotional issue with many investors, who decry them as “uninvestable.” Some investors fear that unpredictable Chinese government involvement in market regulation makes Chinese companies unanalyzable and thus uninvestable. While understanding any policy changes is important, we believe that three decades of nearly 10% compound annual growth in the economy—led by a dynamic private sector that has created many of the world’s leading consumer, technology, industrial and financial companies—has not changed overnight.
The Chinese government’s focus on a growing healthy economy that creates jobs and a growing standard of living remains the same. Regulating market competition and a desire to narrow income inequality are goals that most governments share. Regulating the large consumer technology companies has led to a number of government actions over the past two years designed to curb anti-competitive practices, such as exclusive supplier contracts, and to limit overly aggressive and wasteful marketing practices, such as selling goods and services below cost. Given the speed of such actions and the opaque decision process, the market reaction has been very fearful. We believe the market reaction, with some exceptions, has been overly negative, relative to the market impact of these regulations. There have been, of course, other factors at work, such as the impact of COVID disruptions, supply chain issues and the Ukraine war. These other worries, however, are short-term challenges that are unlikely to have long-term effects on the business prospects of our portfolio companies.
There are also good reasons to believe that the regulatory cycle is nearing an end. In April and May 2022, President Xi, Premier Li Keqiang and Vice Premier Liu He all voiced their support for the economy and for the technology sector. Since the government’s public support for leading technology companies, there have been a number of actions that have been promising. The months-long freeze on new video game approvals ended; online delivery companies are partnering with cities to solve the logistical challenges of supplying households during COVID lockdowns; negotiations with the SEC to avoid the delisting of Chinese companies from U.S. exchanges have made progress, and expectations are for trial audits to occur over the summer.
In addition to supporting private companies, the Chinese government is also lending support to the economy. The government is supporting economic growth by cutting the reserves that banks are required to hold, easing restrictions on lending to the property sector and announcing a robust infrastructure stimulus plan funded by issuing $220 billion of local government bonds. Given that China’s central bank has maintained a more traditionally conservative approach and not pursued a zero-interest-rate policy (ZIRP) or quantitative easing (QE), it now has the ability to lower interest rates to support economic growth.
Current forecasts are for China’s consumer demand and economic growth to be impacted by COVID lockdowns, but GDP growth is expected to still be 3-4% in 2022. Over the past 20 years,5 the S&P 500 Index has performed well, with a cumulative return of 468.55%, but the MSCI China Index, even including the recent challenging two-and-a-half years, has generated a cumulative return of 630.98% for an outperformance of 162.43%. The foundations of this long-term outperformance remain in place with a well-educated workforce, continued rising urbanization,6 a research-driven economy (as China is the country with the most international patent applications for the third year in a row)7 and a strong entrepreneurial business culture.
While the regulatory cycle seems to be easing and the economic outlook looks reasonable, we know what matters for the value of our companies over the long run is how the businesses are executing. The four largest Chinese consumer internet firms in Davis International Fund are Tencent (owned via Prosus and Naspers), JD.com, Alibaba and Meituan. On average, these four firms grew revenues 29.7% in 2021 and are forecast to continue to grow revenues in 2022.8 Business was strong in 2021 despite regulatory concerns, and in 2022, while COVID lockdowns led to a slowdown in the economy, these businesses continue to grow revenues in the double digits. Moreover, company managements are taking advantage of the very low valuations and strong cash generation by repurchasing their own shares. In addition to buying its own stock, JD.com also issued a special cash dividend to shareholders. We view the return of cash to shareholders via share repurchases and dividends as a sign of the conviction management has in their businesses.
In Davis International Fund, we continue to be highly selective in identifying companies that meet our criteria of well-managed, durable, cash-generative businesses trading at attractive valuations. Over 60% of Davis International Fund is not in China, and among these companies, I would highlight our financial holdings as particularly attractive. Financials, including select conservatively well-managed international banks, combine durability, potential profitability and low valuations. DBS Group in Singapore, Danske Bank in Denmark, DNB Bank in Norway, Julius Baer in Switzerland and Bank of Butterfield in Bermuda share strong balance sheets, high cash generation and what we believe are very attractive valuations. The pullback in the price of bank shares in the last several months reminds us of the early days of the pandemic, when bank shares dramatically underperformed, only to snap back to new highs as investors realized that they were well prepared for a recession. Today, banks are trading at or near their lowest relative valuation in history.
Market expectations of an impending recession are very high, but we should remember the words of the economist John Kenneth Galbraith: “The function of economic forecasting is to make astrology look respectable.” What we can say is that while the timing is highly uncertain, we fully expect a recession to occur within the holding period of our portfolio companies. When a recession eventually unfolds and banks demonstrate their resilience and continue to pay dividends, we anticipate our bank holdings may become a powerful driver of future potential returns.
In contrast to our approach, panicked investors are selling banks and flocking to a small handful of companies and industries that have historically been recession-resistant. We consider such a strategy highly risky for two reasons. First, we believe it overvalues short-term earnings prospects over long-term cash generation. Earnings of $2 million this year, zero next year and $2 million the year after are more valuable than earnings of $1 million this year, $1.1 million next and $1.2 million the year after. Second, we also believe many companies that have historically been recession-resistant may face other challenges that make their futures bleaker than their past. In industries like consumer staples, the erosion of once-dominant consumer brands, when paired with increasingly leveraged balance sheets, may make companies that were once safe havens far riskier in the future.
Putting these two thoughts together, investors who fear a recession will often pay silly prices for smooth earnings from companies with competitively disadvantaged futures, while significantly undervaluing our durable and growing banks, simply because they happen to exhibit more short-term earnings volatility.
As we invest through a time of recession, the enormous valuation discount presented in the chart below should begin to close, creating a double play of rising earnings on rising valuations. In the meantime, high dividends and steady share repurchases, in our opinion, make select banks one of the best investment opportunities facing patient investors in today’s market.
The average annual total returns for Davis International Fund’s Class A shares for periods ending June 30, 2022, including a maximum 4.75% sales charge, are: 1 year, -36.31%; 5 years, -2.64%; and 10 years, 3.17%. 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 most recent month-end performance, click here or call 800-279-0279. performance may be lower or higher than the performance quoted. The Fund is subject to a 2% short-term redemption fee for shares held for fewer than 30 days. The total annual operating expense ratio for Class A shares as of the most recent prospectus was 1.00%. The total annual operating expense ratio may vary in future years. Returns and expenses for other classes of shares will vary. The Fund’s performance benefited from an IPO purchase in 2014. After purchase, the IPO rapidly increased in value. Davis Advisors purchases shares intending to benefit from long-term growth of the underlying company; the rapid appreciation of the IPO was an unusual occurrence.
We have invested in sound enterprises such
as Teck Resources, a Canada-based mining
company, which trades for an attractive
multiple; and Julius Baer, the leading pure-play
private bank in the world.
Teck Resources has operations in Canada, Alaska, Chile and Peru. Its primary products include copper, metallurgical coal (met coal) and zinc, with a minority interest in an Alberta oil-sands operation.
Met coal—used for steel production—is the largest profit generator for Teck at the moment, aided by pricing that has been bolstered by various global supply disruptions. We assume pricing declines materially from current levels, but note that, unlike thermal coal, the type of coal Teck produces does not have any economic substitutes and is used to produce approximately 70% of global steel (the rest comes primarily from recycled steel). The high-quality seaborne met coal that Teck produces is likely to be an essential input to steelmaking for decades to come, possibly longer, if blast furnace carbon capture technologies are adopted.
Most of Teck’s growth capital is being deployed on copper, and it has a handful of promising mine sites in development, including a large project in Chile (called QB2) that is nearing completion and will roughly double Teck’s consolidated tonnage. Copper is an essential component of the decarbonization push we are seeing, given electrification is at the heart of most of the solutions and copper is a superior electrical conductor. Electric Vehicles (EVs) and renewables (wind/solar) are much more copper-intensive than their fossil alternatives, and demand for these applications is inflecting fast—faster than new mine supply is likely to be able to respond—given greenfield mines often take more than a decade from start to finish.
Teck trades for an attractive multiple—approximately 3-5x in 2022 and approximately 4-6x in 2023. Admittedly, this is being flattered by the rich margins in its met coal business at the moment, but we believe the multiple discount, compared with pure-play copper companies, ought to narrow over time, as copper increasingly dominates Teck’s portfolio. We like the undemanding valuation and the shareholder-friendly capital return policies the company has adopted, which include returning excess capital to shareholders through dividends and buybacks.
Julius Baer is the leading pure-play private bank in the world, focusing exclusively on providing wealth management services to high and ultra-high net worth individuals. While the DNA of the 130-year-old private bank is Swiss, it serves clients globally through approximately 1,300 relationship managers in 25 countries and currently manages over $450 billion Swiss Francs in assets. It is a wide-moat, high-touch business driven by relationships and supplemented by technology and investment capabilities.
Julius Baer is a rare combination of a high-growth and high-return business. Over the last decade, revenue has compounded at 8% CAGR, and owner earnings at 11% CAGR. It does not operate in high-capital consumption businesses like investment banking, so the return on tangible equity has been north of 30%. Julius Baer has enough scale to be competitive, but it is not large enough to suffer from diminishing growth. Furthermore, it has a meaningful presence in high-growth markets like India, Brazil, China, Hong Kong and Singapore, where wealth creation has a long runway. On average and over time, we anticipate continued earnings growth for the foreseeable future.
Due to its sensitivity to equity markets, Julius Baer is currently trading at only 8x earnings and over 14% internal rate of return (IRR). Its high capital generation means that shareholder return is currently attractive; the cash dividend yield is 5.7%, and the company has been repurchasing 3-4% of shares outstanding, while still retaining excess capital for disciplined mergers and acquisitions.
While the market faces challenging
headwinds—rising inflation, the Ukraine
war and the global pandemic—we know
full well that the market, like life, runs in
cycles, and we are prepared for the market
recalculation after this cycle terminates.
The crises that face us today seem so heightened because we are so uncertain how and when they will end. As we enter the third year of the global pandemic, witness rising inflation and are saddened by the mounting casualties from the war in Ukraine, we cannot help but be worried. And yet as we look back at previous crises such as Grexit, Brexit, 9/11, the two Iraq wars and the financial crisis, it is hard to remember that we were worried and concerned back then, as we are today, because we did not know how and when they would end.
With 20/20 hindsight, we can look back at these events and understand them as milestones, yet they all had a beginning and an end, and they soon became part of history. As we think of the current challenges of rising inflation, the Ukraine war and even the global pandemic, we all know that they too will come to an end, and as stewards of your capital, we need to ensure that the companies in our portfolio have the financial strength, business resilience and management teams in place to manage and sometimes even thrive in these uncertain times.
The fact that equities delivered compelling long-term results despite all the major crises experienced, should provide comfort for the long-term investor. For example, since 1929 the S&P 500 Index posted an average annual return of 9.16% per year. Of comfort as well are the characteristics of Davis International Fund, where a highly selective group of companies grow much faster on average, yet also trade at a significant discount to the market. We believe such fund characteristics bode well for future returns.
We understand that in uncertain times such as these, it is more important than ever to be able to entrust your savings to an experienced and reliable investment manager with a strong long-term record. Over the 50 years since the firm’s founding, the Davis investment discipline has demonstrated an ability to generate above-average returns, based on in-depth fundamental analysis, a long-term investment horizon and a strong value discipline. While the times have changed, these fundamental principles are timeless and proven. We thank you for your continued trust and interest in Davis International Fund.
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. The investment objective of Davis International Fund is long-term growth of capital. There can be no assurance that the Fund will achieve its objective. 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; foreign country risk: foreign companies may be subject to greater risk as foreign economies may not be as strong or diversified; China risk – generally: investment in Chinese securities may subject the Fund to risks that are specific to China including, but not limited to, general development, level of government involvement, wealth distribution, and structure; 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; depositary receipts risk: depositary receipts involve higher expenses and may trade at a discount (or premium) to the underlying security; 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; exposure to industry or sector risk: significant exposure to a particular industry or sector may cause the Fund to be more impacted by risks relating to and developments affecting the industry or sector; emerging market risk: securities of issuers in emerging and developing markets may present risks not found in more mature markets. As of 6/30/22, the Fund had approximately 51.5% of net assets invested in securities from emerging markets; 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; fees and expenses risk: the Fund may not earn enough through income and capital appreciation to offset the operating expenses of the Fund; and 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. See the prospectus for a complete description of the principal risks.
The Fund is subject to a 2% short-term redemption fee for shares held for fewer than 30 days.
The information provided in this material should not be considered a recommendation to buy, sell or hold any particular security. As of 6/30/22, the top ten holdings of Davis International Fund were: JD.com, 8.74%; DBS Group, 7.77%; AIA Group, 7.27%; Ping An Insurance, 6.79%; Danske Bank, 6.75%; Samsung, 6.05%; Meituan, 5.42%; DNB Bank, 5.36%; Prosus, 4.93%; and Alibaba Group, 4.72%.
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.
Forward Price/Earnings (Forward P/E) Ratio is a stock’s current price divided by the company’s forecasted earnings for the following 12 months. The values for the portfolio and index are the weighted average of the P/E ratios of the stocks in the portfolio or index.
Five-Year EPS Growth Rate is the average annualized earning per share growth for a company over the past five years. The values for the portfolio and index are the weighted average of the five-year EPS Growth Rates of the stocks in the portfolio or index.
CAGR stands for Compounded Annual Growth Rate.
We gather our index data from a combination of reputable sources, including, but not limited to, Lipper, Wilshire, and index websites.
The MSCI ACWI (All Country World Index) ex US is a free float-adjusted market capitalization weighted index that is designed to measure the equity market performance of developed and emerging markets, excluding the United States. The index includes reinvestment of dividends, net of foreign withholding taxes. 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.
After 10/31/22, this material must be accompanied by a supplement containing performance data for the most recent quarter end.
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