Davis All-Cap SMA
Portfolio Commentary
Spring Update 2023
Portfolio Commentary
Spring Update 2023
Market Perspectives
Headlines during the quarter highlighted issues in the
banking sector both at home and abroad. We believe
the specific financial services businesses we own are
strong and represent good value at today’s prices.
In first quarter 2023 the S&P 1500 Index returned 7.16%. Davis All-Cap SMA strategy underperformed the broader market during the period, reflecting near-term declines in shares of healthcare and financial services companies in the portfolio, among other factors. We believe our selection of healthcare and financial services businesses should benefit from both macro forces and company-specific execution at a micro level over the next ten years. Both sectors are trading at very attractive valuations in our view, based on our team’s extensive firsthand research.
Problems in the banking sector both at home and abroad resulted in the collapse of a commercial bank in the U.S. and the emergency takeover of a global investment bank in Switzerland.
This year’s regional banking crisis presented a common thread: in general, excessive risk-taking by aggressive managements led to banks’ outright failure. Historically, however, the exact circumstances of bank failures have tended to be unique. In our opinion, these failures seem to be predominantly micro, company-specific phenomena even though there may be some macro implications—such as heightened sector volatility and internal dispersion insofar as stock prices are concerned. In addition, the lending appetite of certain financial-services businesses may be reduced for the time being.
There are a number of financial institutions with particularly long and storied histories of creating value for shareholders. In our opinion, the resiliency of banking institutions often entails a management and culture that prioritize risk management. Davis All-Cap SMA portfolio holds a number of large, strategically important banks and global giants in property casualty insurance and reinsurance. Given tens of billions of combined pre-tax pre-provision earnings, relatively high capital ratios, very prudent liquidity, and a strength in matching assets and liabilities, we believe our financial companies are exceptionally durable, and represent very good value at today’s prices.
The Federal Reserve’s evolving policy guidance made for a volatile market. In February 2023, the consensus view was clearly that the Fed would continue to raise interest rates throughout the year with multiple increases to come. In March, following the previously mentioned bank failure, the outlook changed significantly. Stress caused by rising rates—and a resulting mismatch between asset and liability duration at certain lenders— led to a modest 25-basis-point increase in the federal funds rate and a tempered outlook for further raises this year.
We have long regarded higher interest rates as probable, as we are coming off the heels of the longest ultra-low interest rate environment in modern history, and have been experiencing more pronounced inflation than we have seen in decades. That stated, at their current levels, rates are effectively normalizing—they are still lower than the peak of 6.5% in the Greenspan years— and at this point are far from presaging a Volcker-era level of borrowing costs.
That stated, inflation and rising interest rates tend to suppress economic growth and could function as a headwind in the near term. Our businesses can weather choppy conditions, in our view, and likely could continue to build on their competitive strengths even if revenues slow. They could also trim down their cost structure—a “shrink to greatness” strategy—to set up a more favorable margin structure when business eventually resumes at a faster pace.
Portfolio Review
Through bottom-up research, the portfolio holds
a collection of exceptionally durable and growing
businesses primarily in the financial services,
technology and healthcare sectors.
We like the overall positioning of Davis All-Cap SMA portfolio currently and prospectively. In our view, the companies we own can reach significantly higher levels of earnings power over the long term. Meanwhile, they are trading at relatively low valuations on balance when compared with the risk-free rate, peers and historical levels.
The table below shows that our portfolio combines the growth potential and very attractive valuations of carefully researched businesses. We believe this favorable starting point positions us well for the future.
We manage Davis All-Cap SMA portfolio with various market environments in mind. Our priority is to focus on the durability of business models. Crises and periods of stress are unpleasant but importantly, they provide a real-world sense of just how resilient certain companies can be. We are generally encouraged by the way our portfolio companies are weathering volatile conditions at the business level.
A company’s leadership is always critically important. But arguably, strong managements are even more vital in times of when the economy is facing greater headwinds than tailwinds. Companies can either create or destroy enormous value in lean times, as managements must work within tighter financial constraints when deciding where to allocate capital for optimal shareholder benefit. Reinvesting for growth, where it is mission-critical, is prudent but so is managing balance sheet strength and liquidity. If those two priorities are satisfied, then some of our companies should be able to return capital to us in the form of dividends and/or share buybacks. In short, the intelligent use of funds and the quality of decisions made in these times can prove decisive, even transformational, in determining which companies will likely pull ahead over the next cycle.
Currently, healthcare represents the largest sector of the portfolio; it includes managed-care insurers such as Cigna, generic pharmaceuticals, and independent laboratory diagnostics and testing businesses. We believe these companies’ business models and revenue generation are a direct reflection of the value they deliver to patients, doctors, companies, hospitals and the public sector. A common theme of the portfolio’s healthcare companies is that they are in the business of delivering cost savings and efficiency to the system.
With nearly 20% of the country’s gross domestic product representing healthcare, it is understandable that controlling healthcare spend is a fiscal priority. We anticipate an increasing degree of scrutiny and sensitivity toward companies with exceptionally high gross margins and those viewed as potentially price gouging. We favor strong, but relatively cheaper companies with attractive economics that are low-cost producers as a way of mitigating potential future regulatory changes in the healthcare landscape.
The portfolio’s financial holdings are well-built for the current crisis, in our opinion. In financials, it may be that the strong become stronger and the weak are either consolidated, marginalized, or disappear altogether, with the sector as a whole consolidating further. Though this trend has been taking hold gradually over the past 40 years, historically this consolidation is apt to accelerate in crises.
Our holdings in the technology space canvass segments of the sector that we believe should experience more durable and attractive growth than the market as a whole for the coming decade, yet are trading at reasonable valuations. These areas include cloud computing, enterprise software, e-commerce, online search, advertising, social media, semi-conductors and artificial intelligence—all large, fertile markets that are poised to expand. We have confidence in leaders from the standpoints of financial strength, competitive position, management expertise and valuation.
Outside of healthcare, financials and technology, we also own select industrial (e.g., Darling Ingredients, a leader in processing waste into reusable products such as fuel); materials (e.g., Owens-Corning, the largest roof insulation business in America); and distribution businesses (e.g., Ferguson, the nation’s largest distributor of heating, ventilation, cooling and water supplies). We believe these companies can generate high incremental returns on capital over the coming cycle. This dynamic of iteratively reinvesting capital and earnings at attractive rates over many years is a common feature of businesses we have selected for the portfolio.
We sold our position in Raytheon primarily based on valuation considerations, as well as more attractive uses for the capital.
Overall, we built the portfolio to withstand inclement times, but also so that it can be well positioned for fairer conditions ahead.
Conclusion
The stock market has been volatile, vacillating within a wide trading range in recent periods. Stock price “noise” measures moment-to-moment changes in investor sentiment and psychology in the short run. In other words, it is a voting machine. Over longer time periods, we believe individual companies’ earnings power will be a primary driver of share price performance, all else equal. As such, we feel that distinctions can and should be made in this environment based on different business attributes and attractive valuations rather than stock price volatility.
We believe the portfolio reflects a thoughtful combination of companies with attractive earnings growth, low valuations and competitive advantages and believe further that we are well positioned for the decade ahead.
Above all, we never forget that we are stewards of our clients’ savings and that our most important job is growing the value of the funds entrusted to us. With more than $2 billion of our own money invested alongside that of our clients, we are on this journey together.3 This alignment with our clients is an uncommon advantage in our industry; our conviction in our portfolio of carefully selected companies is more than just words. While we do not welcome the pessimism and fear that have characterized our world recently, we are well prepared for it and, importantly, we are well positioned for the future.
We thank you for your confidence and look forward to continuing our investment journey together.
The performance of mutual funds is included in the Composite. The performance of the mutual funds and other Davis managed accounts may be materially different. For example, the Davis Opportunity Fund may be significantly larger than another Davis managed account and may be managed with a view toward different client needs and considerations. The differences that may affect investment performance include, but are not limited to: the timing of cash deposits and withdrawals, the possibility that Davis Advisors may not buy or sell a given security on behalf of all clients pursuing similar strategies, the price and timing differences when buying or selling securities, the size of the account, the differences in expenses and other fees, and the clients pursuing similar investment strategies but imposing different investment restrictions. This is not a solicitation to invest in the Davis Opportunity Fund or any other fund.
Davis Advisors is committed to communicating with our investment partners as candidly as possible because we believe our clients 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 Davis All-Cap Equity is represented by Davis Advisors’ Multi-Cap Equity Composite.
Performance shown from 1/1/99, through 12/31/05, is the Davis Advisors’ Multi-Cap Composite which includes all actual, fee-paying, discretionary Multi-Cap investing style institutional accounts, mutual funds, and wrap accounts under management including those accounts no longer managed. Effective 1/1/98, a minimum account size of $3,500,000 was established. Accounts below this minimum are deemed not to be representative of the Composite’s intended strategy and as such are not included in the Composite. A time-weighted internal rate of return formula is used to calculate performance for the accounts included in the Composite. For the net of advisory fees performance results, custodian fees are treated as cash withdrawals and advisory fees are treated as a reduction in market value. For mutual funds, the Composite uses the rate of return formula used by the open-end mutual funds calculated in accordance with the SEC guidelines adjusted to treat mutual fund expenses other than advisory fees as cash withdrawals; sales charges are not reflected.
Effective 1/1/11, Davis Advisors created a Multi- Cap (SMA) Composite which excludes institutional accounts and mutual funds. Performance shown from 1/1/06, through 12/31/10, the Davis Advisors’ Multi-Cap SMA Composite includes all eligible wrap accounts with a minimum account size of $3,500,000 from inception date for the first full month of account management and includes closed accounts through the last day of the month prior to the account’s closing. For the performance shown from 1/1/11, through the date of this report, the Davis Advisors’ Multi-Cap SMA Composite includes all eligible wrap accounts with no account minimum from inception date for the first full month of account management and includes closed accounts through the last day of the month prior to the account’s closing. Wrap account returns are computed net of a 3% maximum wrap fee. For the gross performance results, custodian fees and advisory fees are treated as cash withdrawals. A list of Davis Advisors’ Composites is available upon request.
This report discusses companies in conformance with Rule 206(4)-1 of the Investment Advisers Act of 1940 and guidance published thereunder. Six companies are discussed and are chosen as follows: (1-4) current holdings based on December 31 holdings; (5) the first new position; and (6) the first position that is completely closed out. Starting at the beginning of the year, the holdings from a Multi-Cap Equity model portfolio are listed in descending order based on percentage owned. Companies that reflect different weights are then selected. For the first quarter, holdings numbered 1, 6, 11, and 16 are selected and discussed. For the second quarter, holdings numbered 2, 7, 12, and 17 are selected and discussed. This pattern then repeats itself for the following quarters. If a holding is no longer in the portfolio then the next holding listed is discussed. No more than two of these holdings can come from the same sector per piece. None of these holdings can be discussed if they were discussed in the previous three quarters. If there were no purchases or sales, the purchases and sales are omitted from the report. If there were multiple purchases and/or sales, the purchase and sale discussed shall be the earliest to occur. Other than the recent buy and sell, any company discussed must constitute at least 1% of the portfolio as of December 31.
The information provided in this report does not provide information reasonably sufficient upon which to base an investment decision and should not be considered a recommendation to buy or sell any particular security. There is no assurance that any of the securities discussed herein will remain in an account at the time this report is received or that securities sold have not been repurchased. The securities discussed do not represent an account’s entire portfolio and in the aggregate may represent only a small percentage of any account’s portfolio holdings. It should not be assumed that any of the securities discussed were or will prove to be profitable, or that the investment recommendations or decisions we make in the future will be profitable or will equal the investment performance of the securities discussed herein. It is possible that a security was profitable over the previous five year period of time but was not profitable over the last year. In order to determine if a certain security added value to a specific portfolio, it is important to take into consideration at what time that security was added to that specific portfolio. A complete listing of all securities purchased or sold in an account, including the date and execution prices, is available upon request.
The investment objective of a Davis Multi-Cap Equity account is long-term growth of capital. There can be no assurance that Davis will achieve its objective. Davis Advisors uses the Davis Investment Discipline to invest a client’s portfolio principally in common stocks (including indirect holdings of common stock through depositary receipts). The Multi-Cap Equity strategy may invest in large, medium, or small companies without regard to market capitalization and may invest in issuers in foreign countries, including countries with developed or emerging markets. The principal risks are: common stock risk, depositary receipts risk, emerging markets risk, fees and expenses risk, foreign country risk, foreign currency risk, headline risk, large-capitalization companies risk, manager risk, mid- and small-capitalization companies risk, and stock market risk. See the ADV Part 2 for a description of these principal risks.
The Attractive Growth and Undervalued reference in this piece relates to underlying characteristics of the portfolio holdings. There is no guarantee that the portfolio’s performance will be positive as equity markets are volatile and an investor may lose money.
Small cap companies have market capitalizations less than $3 billion. Mid cap companies have market capitalizations from $3 billion to $10 billion. Large cap companies have market capitalizations greater than $10 billion. Under normal circumstances, the Multi-Cap Equity Composite invests the majority of its assets in equity securities issued by companies with market capitalizations of less than $20 billion.
We gather our index data from a combination of reputable sources, including, but not limited to, Lipper, Wilshire, and index websites.
The S&P 1500 Index is comprised of the S&P 500, MidCap 400, and SmallCap 600, which together represent approximately 90% of the U.S. equity market.
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