Opportunity Fund

Market Perspectives:
Volatility vs. Risk

In the first half of 2025, Davis Opportunity Fund (DOF) returned 9.50%, outperforming its benchmark, the S&P 1500 Index, which returned 5.61%.

While the market’s performance was positive for the year-to-date period, those results did not occur in a straight-line fashion. Indeed, from late February through early April the market indexes fell close to 20% from high to low before rebounding by more than 20% (albeit off a lower base) to their current levels in positive territory.

In other words, despite a very strong long-term record of appreciating, stock prices can be volatile in the short run, and the first half of 2025 was no different in that respect.

The market’s behavior over this period highlights the very real difference between stock price volatility and risk. Volatility, by definition, consists of both up and down price movements. We think that investors tacitly seek and expect volatility as long as the overall path produces a satisfactory return over time and is skewed to the positive. Given the market’s rise over the last century, this seems a reasonable expectation for stocks. On the other hand, risk implies a permanent and significant loss of capital. This could be due to a real decline in the intrinsic worth of the businesses in a portfolio (as measured by earnings power) or to a meaningful contraction in their stock price-to-earnings multiples, or both.

It seems nearly inconceivable to us that the businesses making up the broader market could lose nearly 20% of their intrinsic worth, then quickly recover that value and more, all in the span of a six-month period. (In fact, earnings growth rates for the first half of 2025 have not even been determined given the quarterly reporting cycle of most U.S. public corporations.)

What have changed in the short run are news headlines and the daily pricing and repricing of uncertainties. These uncertainties range from mixed U.S. domestic economic data, including a modest contraction in the first quarter, to geopolitical events around the world like ongoing tariff negotiations and two major conflicts overseas.

“We believe we are operating in an environment with even greater uncertainty than usual, one where the range of potential outcomes is wide relative to the decades of the 1990s and 2000s.”

Our view is that what will matter most to the market’s progress in the long run is whether businesses experience growth in raw earnings power. The uncertainties of the moment make near-term predictions hard at best. However, our research suggests that many businesses are becoming more valuable over time based on their economic models, strategies, market demand and execution, even though their stock prices may decline at times.

As for the new macro environment, it is being shaped by three transitions underway that we describe below. In this environment, investors need to be open-minded, flexible and vigilant, with the willingness to adapt as circumstances evolve.

The first transition is that money now has a cost in terms of interest rates, whereas for most of the past decade that was not the case. Money was either very cheap or entirely free in the years following the 2008–2009 financial crisis. Higher rates means that interest expenses for businesses reliant on a significant amount of debt may be greater now and can eat into profit margins. All else equal, if revenues remain constant for a company with a material debt burden, its profit margins might suffer due to the now-higher interest expense.

The second transition underway is geopolitical in nature. It includes tariff uncertainty as well as the conflicts in Ukraine and the Middle East. This type of geopolitical uncertainty is always unpredictable. However, we believe we are operating in an environment with even greater uncertainty than usual, one where the range of potential outcomes is quite wide relative to the decades of the 1990s and 2000s, for example.

The third transition is the reversal in the drive towards globalization which had been in place since World War II. It is unlikely to revert anytime soon, in our opinion. America’s age-old alliances with European countries and with Canada and Mexico are in flux. Domestic tensions have boiled to the surface in the area of immigration. The rise of China as an economic and military superpower is a tectonic shift in the global balance of power compared to what it was through most of the last half century.

All three transitions amount to a great uncertainty factor. It is all the more important for investors to remain flexible and willing to adapt while also being reasonably conservative in the types of businesses they own and the prices they pay. Above all, they should understand and appreciate the businesses they invest in, consistent with the “know what you own” principle. A lower P/E multiple can theoretically compensate equity investors for added uncertainty. In the value investing paradigm, investors need to build in a margin of safety before proceeding.

Meanwhile, the S&P 1500 Index still trades at a forward P/E multiple of 22.5x which we regard as a rather aggressive valuation, given the unknowns. By contrast, DOF's forward P/E is under 14x, a full third cheaper than the index.¹

With only 45 holdings in the fund (versus over 1,500 securities in the benchmark), we feel we know every one of our businesses well enough to understand their principal pros and cons. That is, we seek always to maintain a standard of “knowing what we own.” When constructing portfolios, we weight positions both on business strength and attractiveness looking out several years, and on the relative merits of each company’s valuation. Over a typical year we will likely make several changes to the portfolio, given the market’s dynamism and the need for active repositioning. By contrast, index rebalances are rules-based and calendar-driven.

We seek businesses with attractive earnings growth. All else equal, they are worth more than those with flat or declining earnings growth. The average five-year earnings per share growth rate of the businesses held in DOF is over 20% per annum versus a more modest 15% for the benchmark.² Despite the higher earnings growth, the portfolio’s multiple is a third less than the index’s, reflecting our conservative posture in the face of current events and the transitions we discussed above.

As an active manager with a 56-year history of bottom-up stock picking, our firm has the ability to be flexible, adapt to change, make conscious decisions around risk and reward, and apply a deliberative portfolio construction process. This is in sharp contrast to rules-based passive alternatives.

Portfolio Review:
Capital Allocation

We select the fund’s holdings on an individual basis according to the Davis Investment Discipline—that is, we seek to purchase durable, well-managed businesses at value prices and hold them for the long term. This bottom-up process has served us well over the life of the strategy. It allows us to allocate capital rather surgically into specific businesses at specific prices, and lets us structure and shape the portfolio in a conscious fashion—with risk and reward both equally important.

The overall positioning of DOF can be described by its contrast with the S&P 1500 Index in terms of number of portfolio holdings, historical earnings per share growth, and forward price-to-earnings (P/E) multiples as follows:

The portfolio’s current focus is on businesses in four main areas of the economy: (1) dominant healthcare companies (predominantly healthcare services that are both cheap and underestimated in our view), (2) durable financial services, (3) leading technology-related companies, and (4) industrials.

Within healthcare, our holdings range over managed insurance, lab and diagnostics services, generic pharmaceuticals and medical supply businesses. What these businesses have in common is that they all participate in the large profit pool of the U.S. healthcare sector, with total healthcare spend representing close to 20% of our country’s gross domestic product. As the population ages, we expect aggregate healthcare spend in absolute terms will continue to climb over the coming decade. The healthcare areas where we have invested are relatively cheap, by our analysis, and we believe their growth potential is underestimated. Representative businesses include Quest Diagnostics, Viatris, CVS Health and Cigna Group, among others.

Financials mean different things to different people. Many investors see the financial sector as primarily banking. This is one facet of the industry but there are many others. They include credit cards and payments companies, global insurers and reinsurers, and various businesses driven by the capital markets—for example, investment banks, trust and custody institutions, or conglomerates with a financial arm. Our representative financial holdings include Capital One Financial, Markel Group and U.S. Bancorp.

“We look forward to measuring the results and witnessing the strengths of these businesses over the next five to 10 years as they become more widely apparent to the capital markets.”

Technology-driven companies³ have been meaningful allocations in DOF for decades. Meta Platforms is our largest holding in this group. It is pricier than it was at the time of our last major purchase in early 2023 but is still an attractive investment, in our view, given its rather extraordinary global growth. Meta is a true modern-day, next-generation media and advertising company that is highly innovative and dominant in social media.

Industrial businesses in the portfolio currently include Wesco International, which provides B2B distribution, logistics and supply chain solutions, and AGCO, a farm equipment manufacturer.

Our remaining holdings balance out and diversify the portfolio. They represent sectors as diverse as consumer-related businesses and materials.

Overall, we are very comfortable with our positioning. The portfolio, as noted earlier, has a forward P/E of less than 14x and a five-year EPS growth rate of approximately 20%, which we regard as an attractive combination of attributes. We look forward to measuring the results and witnessing the strengths of these businesses over the next five to 10 years as they become more widely apparent to the capital markets.

Outlook:
Balancing Risk and Reward

The equity market is really a vast market of individual stocks tied to thousands of individual businesses. In our experience, striking the right balance between risk and reward and consciously repositioning as circumstances change are critical to long-run success. We look forward to continuing our investment journey with our shareholders.

For more than 50 years at Davis Advisors we have navigated a constantly changing investment landscape guided by one North Star: to grow the value of the funds entrusted to us. We are pleased to have achieved strong results thus far and look forward to the decades ahead. With more than $2 billion of our own money invested in our portfolios, we stand shoulder to shoulder with our clients on this long journey.⁴ We are grateful for your trust and are well-positioned for the future.