In first quarter 2023 the MSCI ACWI (All Country World Index) ex US returned 6.87%. Davis International ADR SMA portfolio underperformed the benchmark during the period.

Headlines during the quarter highlighted issues in the banking sector both at home and abroad that saw the collapse of a commercial bank in the U.S. and the emergency takeover of a global investment bank in Switzerland.

While historically, the exact circumstances of bank failures have tended to be unique, we believe the common thread running through this year’s regional banking crisis in general is that excessive risk taking by aggressive managements led to outright failure. In our opinion, this appears for the time being to be a predominantly micro, company-specific phenomenon 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 businesses may be reduced for the time being.

The market has been volatile in response to evolving policy guidance from central banks in different regions of the world. In the U.S., the U.K., continental Europe and Japan, interest rates have moved up steadily based on central bank measures to tamp down inflation. Central bank policy in the U.S. and elsewhere could, of course, evolve differently in the future depending on banking stresses caused by rising interest rates. But for the time being credit conditions are poised to tighten by policy.

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 above-trend inflation. This expectation has influenced our positioning of Davis International ADR SMA portfolio. For instance, the portfolio’s largest sector exposure currently is well-researched financials, which may benefit overall from a higher rate environment.

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.

We like the overall positioning of Davis International ADR 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 International ADR 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 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.

We invest on a bottom-up, company-by-company basis and fully exercise our right to own certain businesses but not others. The portfolio holds exceptionally strong businesses primarily in the financial, technology and industrial sectors. We believe we own very strong companies that, given their deep resources and know-how, likely could become much stronger in their respective industries through any downturn. Whether or not short-term share price changes or bottom-line results reflect this path immediately, we expect these competitive features could enable better profit generation over the next several years, all else equal.

The portfolio’s financial holdings—such as Copenhagen-based Danske Bank—are built to withstand the current set of crises, in our opinion. We apply our knowledge of financial business models to global markets and own financial enterprises in multiple jurisdictions including banks and insurers in Singapore, Switzerland, Bermuda and Hong Kong.

In the broadly defined technology space—in which we include communication services, some consumer discretionary (e.g., e-commerce), and online food delivery companies, our holdings canvass segments of the sector that we believe should experience more durable and attractive growth than the market in the coming decade, yet are trading at reasonable valuations. These areas encompass cloud computing, e-commerce, online search and advertising, online food delivery, and semi-conductors—all of which are large, growing and fertile markets for expansion in the coming decade. During the quarter we added Baidu, a leading online search company in China, to the portfolio’s holdings.

One of our prominent holdings is Meituan, a technology-based food delivery company in China. Our research team likes this food delivery giant because we believe its business model only gets better with scale, both financially and competitively. Moreover, in China, as in other major regions, food delivery tends to favor the larger players, as they benefit from economies of scale and networking effects. In a sense, the behind-the-scenes logistics of food delivery may be a key differentiator between the long-run winners and losers in that industry.

On the other side of the globe, a distribution company called Ferguson is the largest distributor of heating, plumbing and water supplies in the U.S. but is based in the United Kingdom. Ferguson’s brand strength among contractors, coupled with a strong network effect in logistics, explains why this company in a seemingly mundane industry is, in our view, capable of remaining a relatively durable, high return-on-capital business as it has been historically.

Outside of financials and technology, we own select industrial and materials companies, which in our opinion, likely could see their incremental returns on capital rise in coming years. This compounding—the dynamic of iteratively reinvesting recycled capital and earnings over many future periods—is at the heart of our expectations for certain businesses to grow in value given time. Schneider Electric, a global multinational headquartered in France, is an example of the businesses we favor in the industrial space. The company is a leader in electrical equipment, particularly in the low voltage market, and we believe it can earn relatively high returns on capital over the coming decade. Furthermore, Schneider Electric is a truly global company with a strong brand and operations in both developed and emerging markets.

Overall, we have built the portfolio for inclement times but have also positioned it well for fairer conditions ahead.

The stock market has been volatile recently, vacillating within a wide trading range. It is not always the case that price “noise” in the short run accurately reveals which companies are stronger than their peers far into the future. We believe 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.