Davis International ADR Portfolio Commentary
Summer Update 2020

Market Perspectives

In the first half of 2020, the MSCI ACWI (All Country World Index) ex US returned -11.00%. In the period, Davis International ADR SMA Portfolio outperformed the benchmark by a wide margin.1

We are neither optimists nor are we pessimists. Rather, it is a time to be realistic, both about the near-term uncertainty and challenges economically that we face, but also taking into account how the future may improve from here in iterative fashion.

There are a number of guideposts and parameters that can prove useful in navigating crisis periods while one is in them, precepts we have learned over our more than 50 years navigating the stock market through all manners of conditions and crises:

The first lesson is to focus intensely on each and every investment one holds and to be positioned in highly durable, defensible businesses. Surviving through the period of near-term stress is the paramount goal at the outset. Invaluable attributes in environments like the present include balance sheet strength (with net cash preferably) and stable sources of funds and cash flow to support operations and necessary capital expenditures.

Second, it is important to revisit the long-term and perennial relevance of different businesses—and whole industries—looking out some number of years. Some may fit squarely in the paradigm of how consumers and businesses interface (e.g., e-commerce, cloud computing, for-profit, after-school learning programs in China, etc.). In other cases, businesses may prove more ephemeral and non-essential in leaner economic times where consumers have to make more choices. Casinos, certain areas of travel, brick-and-mortar retail (already under secular pressure from online competition) and luxury goods, for example, could in theory take longer to recover, and some of those businesses may not recover fully for a long time as they engage in “nice-to-have” products and services versus non-discretionary, "must-have" categories.

Finally, diversifying one’s portfolio with a varied set of businesses and across multiple geographies can be beneficial in our experience both to capture a broad range of opportunities and to avoid putting all of one’s eggs in a single basket.

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. Equity markets are volatile and an investor may lose money. Past performance is not a guarantee of future results. 1International Equity SMA Composite. Past performance is not a guarantee of future results. The outbreak of COVID-19 has negatively affected the worldwide economy, individual countries, individual companies and the market in general. The future impact of COVID-19 is currently unknown, and it may exacerbate other risks that apply to the Fund.

Portfolio Positioning

Building an “all-weather” portfolio requires three key elements. First and foremost, we want to invest in companies with the balance sheet and cash generation to weather the inevitable financial storms. Every recession is a reminder of the dangers of leverage, and we expect this one to be no different. Secondly, we want the long-term trends in our favor. Companies where time is their friend and that benefit from secular changes, such as those due to technology, consumer preferences or regulatory shifts, are in a position to grow their business and build value over time. Finally, a portfolio can stumble if you pay too high of a price. The attractive valuation of our portfolio is not only what enables us to earn above average returns, but is also our margin of safety in case the future is bleaker than forecast.

At Davis, we prioritize owning businesses that generate strong levels of cash flow and that can reinvest this cash at high rates of return. Inevitably, to do so requires having a competitive advantage. Brands, lean cost structures with great efficiencies and, in the case of financial services, a low-cost deposit funding base are examples of advantages that can translate into both higher earnings power and competitive market share gains over time.

As a case in point, we hold a number of technology and consumer-related businesses serving a wide range of industries in China from e-commerce to cloud computing, for-profit education, food delivery and classified advertising, among other areas. We believe our companies in these industries have tremendous competitive advantages that cannot easily be competed away, possibly for years to come. It is imperative with these types of businesses to adhere to a valuation discipline and to establish why one should feel confident those companies are likely to sustain their leading edge in the face of formidable competitive forces.

At the other end of the spectrum, we own positions in a number of staid, fairly mundane cash-generative industries, such as financial services and certain types of industrials, many of which have a long history of returning capital to shareholders through dividends and share repurchases, while also reinvesting at attractive, if not exceptional, returns on equity. Bank of N.T. Butterfield & Son, a Bermuda-based trust and lending institution serving the reinsurance, high-net-worth and community mortgage markets, is one such example.2 Other financial holdings in the Portfolio include DBS Holdings of Singapore, two major Nordic banks and a Swiss-based private bank, among others. These tend to be slower growth in nature, but extremely proven, durable, established and cash-generative.

From a diversification standpoint, the Portfolio is diversified consciously across 21 differentiable businesses in 11 countries and spans sectors from communication services and technology to consumer discretionary (including certain on-line businesses), financial services and industrials.

2Holdings discussed in this commentary are selected according to objective, non-performance-based criteria. They are chosen each quarter according to a consistent methodology based on their weight in the Davis Advisors International SMA model portfolio as well as recent purchases and recent sales and are intended only as illustrations of the Davis Investment Discipline. They are not recommendations to buy, sell or hold any security. Individual account holdings may vary.

Portfolio Review

In the first six months of 2020, Davis International ADR SMA Portfolio outperformed the -11.00% return of the MSCI ACWI ex US benchmark by a wide margin.

During the period, the COVID-19 pandemic and economic disruption significantly impacted businesses around the globe, yet we were generally satisfied with the performance of our portfolio companies through this difficult period. Among drivers of outperformance were many of our Chinese consumer-facing Internet, education and food delivery companies. Alibaba Group Holding, a dominant force in China’s e-commerce and cloud computing markets (among other industries), is an example of the caliber, scale advantages and sheer earnings power represented by such holdings in the Portfolio. Online retail has been rapidly taking share globally. In 2019, the online share of China’s retail sales surpassed 20% (versus approximately 11-12% for the U.S., by comparison). Although the lockdowns and travel bans employed to combat the spread of COVID-19 hurt consumer demand, they also accelerated the secular trends favoring e-commerce, working remotely and online learning, which are businesses where a number of our top holdings are leaders. These consumer Internet leaders are the “blue chips of tomorrow” with strong moats, good growth prospects, cash-generative business models and attractive valuations.

Among detractors were international financials. While these names detracted from first-half results, they represent very compelling value at these prices and offer the potential for much better returns over the long term, in our view, than meets the eye today. The market fears the impact of the looming recession on bank earnings. While loan losses will naturally rise in the coming recession, the banks are entering this recession with much higher capital ratios—often twice as high—as the last one in 2008-09. Strong balance sheets, conservative lending decisions in the years following the financial crisis and low valuations are why we see the banks as another area of opportunity. These banks have proven their durability by weathering numerous recessions, wars and some even past global pandemics. Meanwhile, a number of our international financial holdings are trading at a significant discount even to adjusted book value.

Among recent changes to the Portfolio, we have added to select international financials first and foremost, funding some of our purchases with the sale of Seven Generations Energy among other holdings.

Conclusion

The year 2020 will unfortunately always be remembered as the year the world experienced its worst pandemic in over a century. It will likely also be remembered, however, as the beginning of the period the world became much safer from future pandemics. Before 9/11, airports had security screening, but it took a major attack for the Transportation Security Administration (TSA) to be created in November 2001. Similarly, the U.S. banking system has long been regulated, but it took the financial crisis to pass the Dodd-Frank Act in 2010, raising banks capital ratios and establishing an annual stress test for large banks conducted by the Federal Reserve. Following these events, flying has become much safer, and the U.S. banking system more resilient to shocks. In some ways, we might have been lucky that COVID-19, while very infectious, is not as lethal as other epidemics, such as the 1918 influenza pandemic.

Nonetheless, the traumatic experience of COVID-19 will result in better early warning systems and better coordination of national healthcare systems and a more formalized protocol all countries can follow. These efforts, while not foolproof, will make the world better prepared for future pandemics.

The businesses in Davis International ADR SMA Portfolio have by and large performed very well during the first half of 2020, and in some ways just went through their own stress test of how they perform during a serious economic downturn while consumer demand is in freefall. Many of our top holdings such as Alibaba Group Holding produced outstanding results in a difficult environment. Banks in the portfolio are better prepared than ever for the current recession. Fear of a repeat of the financial crisis is so high that financials are by many metrics cheaper than they have ever been relative to the overall stock market—cheaper even than during the financial crisis. Both the “blue chips of tomorrow” in strong competitive positions that benefit from secular tailwinds and historically cheap financials, with very high capital ratios and conservative loan policies, are attractive, and they are why we are so optimistic looking ahead.

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 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.

Thank you for your confidence, and we wish all of our shareholders and their families well in this time.

This material may be shared with existing and potential clients to provide information concerning market conditions and the investment strategies and techniques used by Davis Advisors to manage its client accounts. Please refer to Davis Advisors’ Form ADV Part 2 for more information regarding investment strategies, risks, fees, and expenses. Clients should also review other relevant material, including a schedule of investments listing securities held in their account.

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 International 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 International Fund or any other fund.

Effective 9/23/14, Davis Advisors created an International Equity SMA Composite which excludes the institutional accounts and mutual funds. Performance shown from 10/1/14, through the date of this report, the Davis Advisors’ International Equity 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.

A time-weighted internal rate of return formula is used to calculate performance for the accounts included in the Composite. The net of fees rate of return formula is calculated based on a hypothetical 3% maximum wrap fee charged by the wrap account sponsor for all account services. For the gross performance results, custodian fees and advisory fees are treated as cash withdrawals.

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,” “feel,” 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.

Davis Advisors’ International Equity Composite includes all actual, fee-paying, discretionary International investing style institutional accounts, mutual funds and wrap accounts under management for each investment period from 1/1/05, through the date of this report, 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. 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. The companies we discuss are chosen in the following manner: starting at the beginning of the year, the holdings from an International 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, 11, 21, and 31 are selected and discussed. For the second quarter, holdings numbered 2, 12, 22, and 32 are selected and discussed. This pattern then repeats itself for the following quarters. Each of these holdings must come from a different country.); one recent purchase and one recent sale are also discussed. A sale is defined as a position that is completely eliminated from the portfolio before the end of the quarter in question. 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. If there are multiple purchases and/or sales on the same day, the one that is the largest percentage of assets will be discussed. If a holding to be discussed (excluding the buys/sells) is no longer in the model portfolio as of quarter end, the next listed holding is selected and discussed.

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 International 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) issued by both United States and foreign companies, including countries with developed or emerging markets. The global companies’ strategy may invest in large, medium, or small companies without regard to market capitalization. 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 Form ADV Part 2 for a description of these principal risks.

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. Investments cannot be made directly in an index.

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