In 2023 the S&P 500 Index returned 26.29%. This was a strong result given the number of material headwinds and uncertainties investors faced during the year. These included the regional bank crisis in the early part of the year, rising interest rates, two overseas wars, and relatively elevated valuations for major stock indexes.

While there were indeed challenges, there have been favorable factors at work as well. These include a rather full employment picture with the unemployment rate down to historic lows (3.7%), the economy still expanding at a rate of about 5% on an annualized basis, and immensely greater financial stability than in past decades owing to strict regulations, more disciplined underwriting practices by the largest financial institutions in the country, and relatively low leverage.

While the so-called Magnificent Seven mega-cap tech companies dominated the financial headlines last year, contributing an outsized portion of index performance, many stocks traded at much more reasonable valuations than those particular technology giants. The Seven represent a very large percentage of the index’s total value today which means that they lend their high valuations to the overall index as well. They have caused distortions such that the weighted average price-to-earnings (P/E) multiple on the S&P 500 Index is over 20x while the average valuation excluding the Magnificent Seven is much lower in our estimation. Davis Large Cap Value SMA portfolio is truly actively managed—we handpick the companies in the portfolio, and set the weightings of each position based on its risk and reward profile—the portfolio has a P/E multiple of only 13x.

In short, despite all predictions to the contrary, the U.S. stock market managed to climb the “wall of worry” standing in its way and delivered returns in 2023 that were far above the long-term average return for equities and on par with a number of record historical years.

Davis Large Cap Value SMA had a strong year performance-wise, and its results were driven by a broad cross-section of holdings. Companies as far-ranging as Capital One Financial (consumer finance), Teck Resources (copper production), and Amazon.com (e-commerce and cloud) delivered double-digit returns in the period. As such, despite a high market multiple due to weightings distortions within the index, there were many attractive opportunities available across a wide swath of stocks and sectors to active managers willing to depart from benchmarks.

The portfolio holds 26 different investments with the largest sector exposures being financial services, technology and healthcare.

Financials: The Strong Versus the Weak

Financial services surprised many on Wall Street last year, not least because the group defied the notion that the sector must underperform in periods of potential or real economic slowdowns. What was perhaps the most remarkable feature of last year’s financial stock performance is that the market appeared to make fairly stark distinctions between the stronger and weaker institutions, in sharp contrast to 2008–2009 when we saw a unilateral sell-off across the entire group.

We do not have a monolithic view of the financial sector. The performance and drivers that make up our financials allocation are very distinct. What they have in common for the time being is that the market has accorded them a low multiple of earnings and book value, suggesting widespread skepticism.

Capital One Financial, best known for its credit card products, was one of our top performers, up over 40% in 2023. This was the case even though consumer finance—particularly companies that engage with mid- and lower-tier FICO-score customers—is casually thought of as an epicenter of crises. Capital One Financial has a strong, extremely data-driven underwriting operation, in our opinion, and is greatly underestimated in both its profitability and its risk profile. The company raised provisions for potential credit costs in 2023, but that is appropriate at this point in the cycle and prudent risk management. Meanwhile, net charge-offs remain very manageable thus far, and we believe the company’s cumulative reserves plus ongoing earnings streams should be able to absorb net realized credit losses even if they rise somewhat. At the end of the year, the stock was still trading at or slightly below book value, meaning it remains very attractively priced relative to our expectations.

Technology: Five Key Themes

Our investments in the broad technology sector span five main areas currently—e-commerce, social media, online search, cloud computing and semiconductors. This portion of the portfolio generally fared well, with social media contributing outsized investment results in the period.

Our belief is that these industries, while well-established and enormous in size already, are still in the early stages of realizing their full global potential. In e-commerce, the opportunity set has grown beyond the business of selling products ubiquitously around the globe to include, in addition, revenue-generating opportunities in online advertising and third-party fulfillment and distribution services.

Social media is not always appreciated for its global reach, but the worldwide leader in the space has about 2 billion monthly average users, 90% of which are outside of North America. An opportunity for the company is not only to continue growing its platform and user base, but also to ramp up advertising revenues generated in non-U.S. markets where typical advertising revenue per user is still less than 1/10 of the level in the U.S.

Online search is still dominated today by a major global technology company which we own. Its hegemony could, in theory, be challenged by new advances in artificial intelligence (AI). That stated, AI is generally smarter and more robust when applied to larger populations of information and data, and this company, by dominating search, boasts more than a 90% market share in many regions of the world. This gives it significantly more data to utilize and process, and a significant competitive advantage over AI newcomers.

Cloud computing is the new paradigm for computational data and storage and makes for a seamless experience for end users. The addition of new cloud services has been somewhat more challenging for the three technology giants that dominate the space, both in terms of new subscriptions and price negotiations. However, the fact remains that cloud is a business with a remarkable margin structure and, based on the amount of capital and technological know-how it requires, a high barrier to entry.

Semiconductors offer a way for investors to access the technology sector, especially if they are seeking to gain exposure to very long-tailed opportunities such as electrification of vehicles, industrial Internet-of-Things (IoT), communications, consumer electronics, and computational processing.

Overall, we believe that the businesses we own in technology are an important facet of the portfolio. We are being disciplined about managing the weightings of companies in this sector as well as the valuations we are willing to pay.

Healthcare: Cost Efficiency in a High-Cost System

Healthcare was a relative laggard in the portfolio. Still, we are excited about our investments in the sector, each of which we believe plays an important role in bringing efficiencies to a system burdened with high costs. Healthcare spending now represents roughly 20% of U.S. gross domestic product, and the U.S. population is only getting older on average. In our minds, this means that demographics and budgetary considerations will drive efforts to curb the rate of healthcare inflation in this country.

Our healthcare investments deliver drugs and services with comparatively greater cost efficiency. We are avoiding companies that may be perceived as overcharging the system, meaning branded pharmaceuticals manufacturers as well as certain biotech companies. This is reflected in the margins of such businesses. The largest branded pharmaceuticals companies in America have gross profit margins of more than 60%. That is effectively their “mark-up” on the products they manufacture. While we want to invest in companies that enjoy attractive margins, in this instance such high margins can make those businesses very vulnerable, especially as we are entering a period of price negotiations between the drug manufacturers and the U.S. government.

“ Our top healthcare holding is both underestimated and misunderstood, partly because its management strategy of ‘shrinking to greatness’ is very rare among large corporations.”

Thematically, our healthcare investments share in common the fact that they aim to drive cost efficiencies through the system relative to the alternatives. In addition, they have margin structures that we feel are more sustainable than the peak margins we see in the more expensive pharma companies.

One of our largest positions in the portfolio manufactures mostly generic pharmaceuticals, which is an important way to contain healthcare costs. This company is one of the cheapest in our universe on a free cash flow basis and is both underestimated and misunderstood, partly because its management’s strategy for creating value is very rare among large corporations. The approach in this case involves effectively “shrinking to greatness”—that is, seeking to achieve better per-share economics by shedding certain assets, paying down debt, and returning capital. It is a highly management-intensive strategy and depends very much on the effectiveness of capital allocation decisions. We believe the right conditions are in place and that the value in the company can be effectively unlocked.

Other healthcare investments in the portfolio include independent lab and diagnostics company Quest Diagnostics as well as managed insurers.

Outside of the above areas, the portfolio’s performance last year benefited from businesses whose principal activities include roofing and insulation, copper production, gaming and hospitality, and biofuel, respectively. Meanwhile, and despite strong performance in 2023, these businesses continue to trade at cheap valuations.

During the period we initiated a position in AGCO, a major manufacturer of agricultural machinery.

Overall, we believe the portfolio is both quantitatively and qualitatively well-positioned. We have invested across 26 holdings, each of which in our view represents attractive opportunities at today’s prices. The combined forward P/E multiple for the portfolio is a mere 13x versus a much higher 22x for the benchmark. We believe this positions us well, especially because, as we have highlighted in this review, we think the market underestimates the future earnings power of many of these companies. Last but not least, we believe that competitive moats often dictate winners versus losers in business, and competitive advantage is a key, albeit intangible, feature of our portfolio’s holdings.

A key takeaway from 2023’s strong stock performance is that what matters is not whether the news flow is positive or negative but what the market is discounting in prices. Our portfolio of companies remains significantly undervalued even after last year’s strong performance, in many cases because these investments by and large started at very depressed valuations. If asked what the catalyst is for those securities, we would point out that value can be its own catalyst as long as investors are patient.

Whatever the market environment, our goal is to have a portfolio that we believe is well-prepared and resilient through inevitable challenges. We maintain our discipline of looking at the changing landscape of businesses and valuations as objectively as possible, and with fresh eyes each day, in order to build value over time.

In conclusion, as stewards of our clients’ savings 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.¹ This alignment with our clients is uncommon in our industry; our conviction in our portfolio of carefully selected companies is more than just words.