All-Cap Portfolio Commentary
Winter Update 2020

Market Perspectives

In 2019, the Davis All-Cap SMA Portfolio generated strong, double-digit returns. The S&P 1500 Index returned 30.90% by comparison. Both the portfolio’s results, as well as the broad-based returns of the market, are reflective of relatively strong underlying fundamentals in the U.S.

The robust full-year performance of the U.S. stock market in 2019 occurred against a relatively healthy economic backdrop. With the unemployment rate at an historic low below 4%, a healthy consumer who continues to spend, reasonable Gross Domestic Product (GDP) growth, a foundation of well-capitalized financial institutions, low interest rates, and very modest inflation, we believe that conditions remain favorable in general in the U.S.

Market volatility during the year was rather pronounced. We believe that such gyrations have been driven by and large by shifts in macro sentiment to date, based on uncertainties ranging from trade disputes to geopolitical tensions. However, underlying business fundamentals for most of our holdings have been far less volatile than market prices, and we believe that progress is manifested in higher revenues and earnings power. It is significant that many companies are able to flourish despite (and through) periods of heightened macro concerns of the moment, both in terms of earnings growth as well as share price performance. Historically, there has been no set rule that macro concerns must categorically hold back the progress of businesses or the market as a whole. Quite to the contrary, the market’s best years over the last half-century—which exceed 30% in a 12-month period —have always coincided with worries and negative headlines of the day. What matters most over the long term, in our experience, is the longevity and growth of corporate profits.

In other words, however volatile markets may be in the near term, we are more interested in the stability and durability of long-term earnings power rather than swings in short-term market pricing that, in many instances, do not directly or materially impact our businesses’ capacity to generate cash earnings.

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.

Portfolio Review

Our current portfolio breaks down into various areas that express where and in what businesses our highest convictions lie. These areas include:

  • Intensely innovative, fast-growing market leaders engaged in software (both enterprise and consumer), e-commerce, cloud computing, or other large and rapidly expanding end markets tied to semiconductors and other communications-related areas. In all cases, our technology holdings are in leadership positions that we believe will play to their advantage competitively in vast new profitable fields. Among the businesses we hold is Microsoft, a diversified global leader in the technology sector that has long held a strong competitive position in areas such as personal computer and server operating systems.1 In more recent years, the company has been investing heavily behind its cloud computing business, which places it second only to one other competitor in the U.S. in what is still a fast-emerging global field of opportunity. Qorvo is another business among our technology-related holdings. With deep customer relationships, this company’s radio frequency products have historically been key components for wireless and broadband applications as well as for a number of defense-related applications.
  • High-grade financials that, while mundane, offer some of the best value of any sector, in our view. We hold investments across different types of financial businesses, including national giants in banking, as well as select consumer finance companies. Our largest financial position is one of the largest banks in America that is re-emerging from scandals from years past. It pays nearly a 4% dividend yield, has repurchased shares at roughly eight times our estimate of normalized earnings, and continues to generate steady cash earnings in excess of $20 billion over the most recent year—all of this despite the headwind of low interest rates, a relatively flat yield curve, and a regulatory cap on the company’s assets. Taken together, these facts demonstrate the staying power and cash-generative nature of this major financial institution and others like it. Overall, between very attractive valuations, strong balance sheets and capital ratios, and a healthy economic backdrop, we believe our select financial companies’ earnings power is underestimated and therefore underpriced in our view.
  • Select industrial companies with competitive advantages. For example, our industrial position is one of two major manufacturers of narrow-body jet engines globally and is reflective of an aerospace-related theme in the portfolio. The company serves the aerospace industry, which is poised to benefit for decades, in our estimation, from strong global demand. The world’s logistical networks, the number of airlines and the number of overall air travelers are all expanding rapidly. The primary global manufacturer of planes that our aerospace-related business serves has an order backlog spanning years, and in addition to selling engines at the point of installation or replacement, the company in question earns very high-margin revenues from ongoing service and maintenance requirements over the life of the plane—normally more than 20 years, based on today’s generation of passenger aircraft.
  • Select businesses in the healthcare sector. Our largest holding in this sector is Quest Diagnostics, a leader in independent lab and diagnostics services. We find the company attractive because its business model addresses the important task of lowering lab testing and analysis expenses for its customers. This healthcare business can deliver its services at a fraction of the cost associated with hospital labs, for example. The low-cost value proposition it offers positions the company well, in our opinion, as part of the cost solution in the U.S., where healthcare inflation remains a key long-term issue.
  • Allocation to energy companies that were detractors to performance in recent periods, but are trading in our view at depressed multiples today. Our thesis in this area rests on an assumption that our specific companies should be able to earn an above-average return on capital over a cycle, which in turn should allow them to grow production and free cash flow at significantly higher rates than most of the sector. With a long-term view that energy prices may eventually stabilize and recover somewhat—owing to supply and demand factors and/or geopolitical developments—the significant “option value” inherent in these North American-contained businesses is meaningful. While the current weak price environment persists, we believe our holdings have staying power, based on a stable funding profile and flexible capital programs. Should the commodity price environment improve from here, we believe these energy-related investments could potentially become a contributor to our results rather than a headwind. Within the sector, we exited Encana recently to redeploy the capital into other holdings based on relative risk-and-reward considerations.

These themes represent the types of investments and the diversification we seek for the portfolio. As to recent changes, we exited our position in Encana.

1Holdings 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 All-Cap 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 Positioning:
Selective, Attractive Growth, Undervalued2

At a higher level, the portfolio’s current positioning starts with our selective, bottom-up approach, which focuses on core, high-conviction investments across different industries where we believe we can identify superior businesses with competitive advantages trading at attractive prices.

In terms of where the best “value” lies in the market today—along the growth-value spectrum, for instance—we believe that it resides, from a risk-and-reward standpoint, in a select list of durable, growing businesses that have above-average prospects that still trade at below-average multiples. In other words, we are combining the best and most effective features of growth and value, which we see as joined at the hip in our ideal investment opportunities.

To illustrate our current positioning with data, below we provide three sets of figures for both the Davis All-Cap SMA Portfolio and the S&P 1500 Index.3

Specifically, what the table shows is the following:

  • We are far more selective than the benchmark with only 32 holdings versus more than 1,500 securities in the S&P 1500 Index. The average position size for the portfolio is roughly 3%. In contrast, the benchmark’s average position size is 0.07%. We apply a high bar when selecting individual businesses and believe that our high-conviction, research-driven approach calls for a portfolio structure that allows for individual businesses to make a material contribution to long-term performance and should therefore be weighted as such.
  • Our historical earnings growth rate on a per-share basis has been superior to the benchmark on average.
  • These above-average businesses trade on balance at below-average starting multiples of earnings, as reflected in the lower forward price to earnings ratio of the portfolio versus its benchmark—a favorable setup and “springboard” from which the portfolio may, in our opinion, generate competitive results over the coming years.

2The Attractive Growth and Undervalued reference in this piece relates to underlying characteristics of the portfolio holdings. There is no guarantee that the Fund performance will be positive as equity markets are volatile and an investor may lose money. Past performance is not a guarantee of future returns. Performance may vary.  3Source: Wilshire Atlas and Davis Advisors.

Outlook

Looking ahead, we believe selectivity will be a key to generating above-average returns over the coming decade, both at the security and at the sector levels. The future prospects of many businesses are becoming cloudier—and certainly more challenged—based on the fact that competition continues to intensify, industry by industry, and both at home and abroad.

For this reason, in every holding in the portfolio, we believe there are competitive strengths that can allow them to take share and prosper over the long term, even if their “ecosystems” and industries become more difficult for the average player.

Beyond selectivity, we believe today’s market offers investors the possibility of owning durable, growing businesses at value prices and we are taking advantage of that opportunity.

Taken together, our selective approach to stock selection, the portfolio’s growth potential and the opportunity to own powerful, competitively advantaged businesses at such attractive valuations position the portfolio well, in our view, for the future.

At Davis Advisors, we seek to purchase durable businesses at value prices and hold them for the long term. The more than $2 billion Davis Advisors, the Davis family and Foundation, and our employees have invested in similarly managed accounts and strategies remains a true sign of our commitment to and conviction in this enduring philosophy.4

4As of 12/31/19.

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 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,” “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.

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. The companies we discuss are chosen in the following manner: starting at the beginning of the year, the holdings from a Multi-Cap 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. No more than two of these holdings can come from the same sector per piece.); 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. No holding can be discussed if it was discussed in the previous three quarters.

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 assets 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.

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 (SMA) Composite invests the majority of its assets in equity securities issued by companies with market capitalizations of less than $20 billion.

Definitions: Forward Price/Earnings (Forward P/E) Ratio is a stock’s current price divided by the company’s forecasted earnings for the following 12 months. The values for the portfolio and index are the weighted average of the P/E ratios of the stocks in the portfolio or index. Five-Year EPS Growth Rate is the average annualized earning per share growth for a company over the past five years. The values for the portfolio and index are the weighted average of the five-year EPS Growth Rates of the stocks in the portfolio or index.

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. Investments cannot be made directly in an index.

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