Chris Davis' Davis New York Venture Fund Annual 2022 Review

• Davis New York Venture Fund returned 12.5% in 2021.
• By being highly selective, we have identified a portfolio of companies that can grow at above-average rates and yet trade at a below-average valuation on current earnings.
• While we always ensure that our portfolio companies have the durability and strength to withstand unexpected shocks and crises, we also select those that can innovate, adapt and build wealth in an ever-changing and unpredictable world.
• Although the earnings of our portfolio companies have grown 1% per year faster than the benchmark S&P 500 Index, they can currently be purchased at a 52% discount to the index. We consider this a value investor’s dream that positions us to build on our long record of outperformance in the years and decades ahead.

• Areas of opportunity include several dominant internet businesses, (Amazon, Alphabet and Meta [formerly Facebook]), financials (American Express, Bank of New York Mellon,Berkshire Hathaway, Capital One, JP Morgan, and Wells Fargo), overseas companies that serve the fast-growing and enormous Chinese middle class (Alibaba, JD.com and Tencent [via Naspers/Prosus]), and bargain-priced growth companies in the technology ecosystem that supply today’s hardware infrastructure (Intel, Texas Instruments and Applied Materials).
• In today’s uncertain economy, select financials represent the best combination of proven durability and low valuations. Throughout the pandemic, high-quality financials demonstrated their resiliency. As investors consider the possibility of higher interest rates in the years ahead, financials should remain in favor, as most will earn higher profits while rates rise.
• With more than $2 billion of our own money invested alongside clients, our interests are aligned, and our conviction is more than just words.¹

The chart below shows the growth in the value of an initial $10,000 investment over various periods.

Since the Fund's inception, our results have also exceeded the return investors would have received in a passive index fund. For example, $10,000 invested when we started Davis New York Venture Fund would now be worth $1,248,237 more than the same amount invested in the S&P 500 Index.

Furthermore, just as we have generated more wealth for shareholders the longer they have remained invested with us, we have also increased the likelihood of outperforming the passive indices. As shown in the chart below, the percentage of rolling periods where we have outpaced the index increases the longer an investor’s time horizon.

Commentators often divide investment approaches into two different categories: value and growth. Under this taxonomy, value investors tend to place a greater emphasis on a business’ current earnings, while growth investors tend to stress its future prospects. Because all businesses are worth the present value of current and future cash flow, any rational valuation methodology must incorporate both current earnings and future prospects. As a result, we have often argued that the division between growth and value can create real opportunities for investors willing to look beyond the categories, particularly when investors are flocking to one approach and dismissing the other. For example, as can be seen in the graph below, from 1995–2000, the S&P 500 Growth Index dramatically outperformed the S&P 500 Value Index by more than 11% per year.²

Now as then, we believe that speculative growth has become overvalued and presents risk not just of relative underperformance, but also of absolute losses. Just as importantly, we also see enormous opportunity for those who recognize this risk and are willing to search for opportunities in the unpopular side of the market. Historically, such periods of extreme dispersion have always come to an end. Although predicting timing is never easy, we believe this game is already in extra innings and that the inevitable reversion may be imminent.

This conviction is not just informed by graphs and history, but by the underlying fundamentals to which we now turn.

While the above discussion of broad investment categories provides useful context, we always emphasize the old adage that investing is the art of the specific. With this in mind, an example may be helpful. Tesla (TSLA, Financial), Nvidia (NVDA, Financial) and Shopify (SHOP, Financial) are three of the hottest momentum stocks in today’s market, each having compounded at triple-digit-rates over the last three years. Combined, these three have a market capitalization of roughly $2.3 trillion. In other words, should an investor happen to have a couple of trillion dollars lying around, one investment option, which we will call the Market Darlings portfolio, would be to buy 100% of these three remarkable growth companies and live off their current and future earnings.

An alternative option, which we will call the Durable Compounding Machines portfolio, would have the investor pay the same price of $2.3 trillion, but instead use it to buy 100% of Berkshire Hathaway (BRK.A, Financial)(BRK.B, Financial), JP Morgan (JPM, Financial), Intel (INTC, Financial), Wells Fargo (WFC, Financial), Texas Instruments (TXN, Financial), Raytheon (RTX, Financial), American Express (AXP), Applied Materials (AMAT), Capital One (COF) and Bank of New York Mellon (BK) and live off current and future earnings of these companies. Not coincidently, the Durable Compounding Machines portfolio represents a good cross-section of the holdings in Davis New York Venture Fund.

Because our hypothetical investor is going to live off the earnings of these businesses, both current earnings and future prospects are important investment considerations and should be carefully evaluated.

Let’s start with current earnings.

As can be seen in the table below, for roughly the same price of $2.3 trillion, the Market Darlings produce about $20 billion of current earnings, while the Durable Compounding Machines generate about $133 billion per year, almost seven times more. Consequently, from a current earnings point of view, it is no contest; any rational investor would choose the Durable Compounding Machines over the Market Darlings.

But how about if we incorporate the bright future prospects of the Market Darlings? After all, few would argue that the Market Darlings, Tesla, Nvidia and Shopify, don’t have bright futures. The question is, how bright would their futures have to be to earn the $133 billion that the durable compounding machines are earning today.

Mathematically, the answer is simple. These companies would need to increase their earnings almost seven-fold which, while not impossible, is no easy feat. For example, a company would need to grow profits almost 21% per year for a decade to achieve this outcome. However, even if they accomplish this spectacular growth, the fact that the earnings wouldn’t be generated for many years requires that investors discount them back to the present. Using even a modest discount rate, the power of compounding reduces the present value of that $133 billion to a much smaller number. In the meantime, the owners of the Durable Compounding Machines are earning that amount today and given that these companies have had long records of growth through good times and bad, we believe they should have a bright future.

As the above discussion makes clear, successful long-term investors must consider both a company’s current earnings and its future prospects when evaluating a potential investment. The Holy Grail is to identify those select few companies that are able to grow at above-average rates and yet trade at a below-average valuation on current earnings. By being highly selective, we have identified a portfolio of companies with this rare combination.

Selectivity means that we invest in fewer than one out of every 10 companies included in the S&P 500 Index. Just as with the best universities or best companies, the ability to select from a large pool of applicants creates the opportunity to choose only the most exceptional candidates and reject those that are average or worse. Our research efforts comb through hundreds of potential investments, seeking those whose business and financial characteristics can turn long-term investments into compounding machines.

In particular, we look for durable, growing businesses that can be purchased at attractive valuations and reject businesses that generate low returns, are stagnant, overvalued, overleveraged or competitively disadvantaged. While funds that passively mirror the S&P 500 Index are forced to invest in all companies, including those that we view as significantly overvalued or competitively challenged, our selective approach allows us to reject such companies. In this environment of wide dispersions, the ability to selectively reject certain companies and sectors from our portfolio may prove just as valuable as the ability to selectively invest in others.

By recognizing both the value of growth and the importance of value, our portfolio holds those select few businesses that combine the best characteristics of both categories: substantial current earnings and bright future prospects. After all, categories do not build wealth. Nor do average businesses. Instead, generational wealth is built by investing in those select few businesses that combine durable and resilient growth with attractive valuations. To find such an attractive combination, our research goes beyond simplistic categories to identify growth businesses with attractive valuations, as well as value businesses with attractive growth.

Within the traditional growth category, growing euphoria has led to bubble prices for many companies, most especially those with new and unproven business models such as those discussed above. In contrast, our research focuses on a select handful of proven growth stalwarts whose shares still trade at reasonable valuations. For example, because of concerns about future litigation and regulation, several dominant internet businesses, including Amazon, Alphabet and Meta (formerly Facebook), trade at steep discounts to many unproven and unprofitable growth darlings that, in our view, trade at euphoric prices. While we expect a continued barrage of negative headlines around these names, as well as increased regulation in the years ahead, we do not expect a significant decline in their long-term profitability.

We have also found opportunities to buy proven growth companies at attractive prices by looking overseas at companies such as Alibaba, JD.com and Tencent that serve the fast-growing and enormous Chinese middle class.

Finally, we have found bargain-priced growth companies in less glamorous parts of the technology ecosystem. Like the manufacturers of picks and shovels during the Gold Rush, outstanding companies such as Intel, Texas Instruments and Applied Materials generate wonderful profits manufacturing the underlying hardware that enables such exciting but speculative new fields as self-driving cars, cloud computing, artificial intelligence, machine learning, software as a service and the Internet of Things.

In the same way our research focuses on durable growth companies that are not overvalued, we also seek out value companies capable of long-term growth. In doing so, we seek to avoid risks inherent in companies that we would classify as value traps or speculative value. While the shares of such companies may trade at cheap prices, their businesses are often fragile, impaired, prone to disruption or highly sensitive to the timing of an economic recovery. Decades of experience have taught us the dangers of owning weak businesses unable to withstand unexpected shocks, even if they sell at cheap prices. Although such speculative gambles may hit from time to time, poor businesses do not build generational wealth. Instead, our attention within the value part of the market remains steadfastly focused on companies that combine strength and resiliency with long-term growth, profitability and competitive advantages. In today’s uncertain economy, select financials represent the best combination of proven durability and low valuations.

Throughout the pandemic, high-quality financials demonstrated their resiliency. While their share prices gyrated wildly, their strong capital ratios and conservative loan portfolios allowed them to be part of the solution, rather than part of the problem. As investors consider the possibility of higher interest rates in the years ahead, financials should remain in favor, as most will earn higher profits while rates rise. The combination of rising dividends, falling share counts, resilient profits and some inflation protection should finally lead to the revaluation of select high-quality financials in the years ahead.

Although financial stocks have enjoyed a sharp recovery from last year’s panic-induced lows, we believe investors need not worry that they missed an opportunity. As can be seen in the chart below, financials remain one of the cheapest sectors in the market. What’s more, the current valuation of the financial sector is low, not just relative to the market, but even relative to its own historic discount.

In sum, our willingness to look beyond simplistic definitions and categories has led to a portfolio that includes growth companies at value prices and value companies with long-term growth. As can be seen in the table below, this portfolio combines the best of both growth and value. While the earnings of our portfolio companies have grown more than 1% per year faster than the benchmark S&P 500 Index, they can currently be purchased at a 52% discount to the index. We consider this a value investor’s dream that positions us to build on our long record of outperformance in the years and decades ahead.

While the pandemic extracted an awful toll on so many families, it also highlighted the inventiveness, creativity and ingenuity of our society. From ecommerce to biotechnology, this has been a period of explosive innovation, adaptability and resiliency and a powerful reminder of two seemingly contradictory investment truths.

First, unexpected bad things can and will happen. Over our Fund’s history, we have navigated countless dire and unexpected crises, including the energy crisis, the hostage crisis, the inflation crisis, 9/11, the financial crisis, the COVID crisis and the ongoing climate crisis. As fiduciaries, we must incorporate both expected and unexpected challenges and crises into every aspect of our investment process.

Second, we must also recognize the incredible power of innovation and invention. In the early stages of the pandemic, the most optimistic forecasts called for a vaccine in three-to-five years. And yet, scientists developed one in a matter of months. Similarly, over the longer term, human ingenuity has led to stunning progress in addressing a vast range of horrific global challenges. The graphs below offer a compelling, if incomplete, quantitative picture of this progress.

Betting against progress has been a losing proposition.

Thus, while we always ensure that our portfolio companies have the durability and strength to withstand unexpected shocks and crises, we also select those that have the ability to innovate, adapt and build wealth in an ever-changing and unpredictable world.

With more than $2 billion of our own money invested alongside clients, our interests are aligned, and our conviction is more than just words. This alignment is an uncommon advantage, given that 88% of all funds are overseen by managers who have less than $1 million invested alongside their clients.

Although our investment discipline may not be rewarded by the market over shorter periods, our proven active management approach has built wealth for our shareholders over many decades.

We value the trust you have placed in us and look forward to continuing our investment journey together.

¹As of 12/31/21 Davis Advisors, the Davis family and Foundation, our employees, and Fund directors have more than $2 billion invested alongside clients in similarly managed accounts and strategies.