Davis International ADR Portfolio Commentary
Fall Update 2019

Market Perspectives

In the year-to-date period, the MSCI ACWI (All Country World Index) ex US returned 11.56%. The Davis International ADR SMA portfolio delivered solid performance as well, reflecting relatively healthy business fundamentals within our portfolio of companies overall.1

The portfolio is diversified across companies based in Europe and Asia-Pacific primarily with select holdings in other geographies such as Brazil and South Africa.



In Europe, we are invested to a large degree in global multinationals with roots in Europe but that have truly global businesses. Overall, we continue to note the sluggish economic growth and consumer demand throughout much of Europe, not to mention unfavorable long-term demographics, and pockets of overvaluation in leading consumer businesses that we have historically favored for investments. To the extent we are invested in local European companies, they tend to be undervalued financials in the Nordics, where company-specific opportunities and local economies combine to offer more attractive potential returns than most other parts of the continent. We also hold two U.K.-listed businesses whose individual prospects are tied more to company-specific features, such that they are attractive in our view despite Brexit.

With respect to Asia-Pacific, and China more specifically, the headlines around the U.S.-China trade tensions have been categorically negative. A cloud of uncertainty is weighing on shares of Chinese companies—even many businesses that are growing at very attractive rates—but it is important to note that share prices have been far more volatile than underlying company fundamentals. In the case of most of our Chinese holdings, it is significant that after more than a year of the ongoing trade dispute, their fundamentals continue to be strong, a fact that, coupled with our holdings’ lack of direct exposure to trade, bolsters our conviction in a number of these world-class entrepreneurial businesses.

Stepping back further, we note that a broader positive conspicuously missing from daily headlines today is the sheer, fundamental dynamism we perceive in a significant number of the market leaders within China. The companies we own are in most instances consumer-facing; hence it matters greatly that standards of living are rising quickly still in China and elsewhere in Asia, incredible innovation is taking place, travel is on the rise, and the legions of consumers are growing in number, not shrinking. There is a burgeoning middle class that is ready and willing to make purchases, with total spend exceeding $35 trillion already and forecast to reach $64 trillion by 2030.2 The majority of the growth is expected to occur in Asia. The addressable size of new end markets ranging from cloud computing and artificial intelligence to 5G can be estimated in the trillions of dollars, globally. The point is that we may well be in the midst of one of the greatest technological and social revolutions in modern history, and out of such times of rapid innovation are usually born tremendous new business models and even new industries, and the market leaders in China tend to be strong across these areas.

There are very specific opportunities and risks that we see in the environment today.

First, an overarching observation is that the global stock market appears bifurcated along different axes presently—for instance, U.S. shares have dramatically outperformed international equities over the last decade, different market sectors have diverged in their recent results, and developed markets have outperformed so-called emerging markets. These distinctions reflect broad macro sentiment and investor attitudes towards different geographies and sectors, often reflecting the news headlines, but the reality around the world is far more nuanced and it is worth taking time to size up the individual opportunities based on fundamental growth, valuations and competitive factors, among others.

Across geographies, we have chosen to pursue investments that offer what is in our view an attractive combination of long-term durability and reasonable earnings growth, selling at a discount to intrinsic value. What we find especially attractive about our portfolio is the fact that it offers the twin benefits of earnings growth and low valuations, and we believe our companies are protected to varying degrees by balance sheet strength and competitive moats, which only raises our conviction level further. Other areas of the market offer less margin of safety and carry relatively more risk, in our view, given fundamental trends and valuations.

In recent periods, the sectors that have been most in favor include those that may be conventionally viewed as “defensive” and widely believed to offer the possibility of lower volatility than the overall market (e.g., consumer staples and utilities, in particular). These sectors held up better than other groups in the market’s declines in 2018 as well as in the 2008–2009 crisis. Consequently, they have become viewed as safe havens from uncertainty and market volatility. Their valuations now reflect that status, with consumer staples companies in both the U.S. and Europe trading at relatively high valuations. Utilities, similarly viewed as a relative safe haven in times of market uncertainty, trade at rich valuations in general, leaving little margin for error as well. Both sectors have produced (and continue to produce) anemic growth on balance. We believe they now carry more risk than meets the eye.

Within the so-called defensive groups, we see both earnings-related and valuation risk presently. Earnings growth, especially for leading consumer staples companies, is challenged in the face of competition, or because, for the first time in decades, large-scale brand obsolescence risk has emerged as a key issue facing the once-dominant consumer brands globally. E-commerce and private label are eroding their price structure and disrupting traditional distribution for such companies’ products, portending what we believe to be even more trouble down the road. In regards to utilities, many are more levered than a decade ago and are not immune from operational issues and disruptions to earnings. Among these businesses, we note that balance sheets and payout ratios appear stretched, leaving much less financial flexibility, and organic revenues are essentially flat. This disconnect between price and value (in an unfavorable sense) is likely to prove unsustainable, in our view. At such multiples, we believe some of the more popular defensive sectors are particularly vulnerable to downside scenarios.3

To put the portfolio in perspective relative to the broader market, below we present the number of individual holdings, five-year earnings per share growth rates (historical) and forward price-to-earnings ratios for the Davis International ADR SMA portfolio versus MSCI ACWI ex US.3



Our portfolio stands out in that it is comprised of holdings that offer a powerful combination of selectivity, attractive earnings growth and low valuations. With 24 well-researched holdings, our portfolio holdings have grown earnings per share at a rate of 24% over the past five years. Meanwhile, we are paying 6.1 times forward earnings of the holdings for that privilege. In other words, we are paying a relatively attractive multiple to own companies with a history of generating above-average growth.

MSCI ACWI ex US has grown earnings per share over the last five years, by comparison, at a rate of 11.1%, which is decent, but far below our portfolio holdings’ growth rate of 24.1%. Today the index trades at 13.4 times forward earnings, or 7.3 multiple points higher than our portfolio companies on average. Investing in the broader market today may in fact mean paying a higher multiple for less growth, in other words. We believe the opposite relationship—higher growth at lower multiples—will be the more profitable positioning in the coming years.

In brief, we believe the market continues to offer a substantial number of growing, attractively valued companies, but they are not everywhere. We believe that some of the groups and geographies that have exhibited more share price volatility in recent periods—and have thus been eschewed by some investors—may contain today’s bargains. Meanwhile, the risks embedded in certain other sectors that have been in favor should not be ignored. As such, our conclusion is that the current market environment calls for a degree of selectivity and contrarianism among investors.

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. All performance discussions within this piece are as of 9/30/19 unless otherwise noted. This is not a recommendation to buy, sell or hold any specific security.Past performance is not a guarantee of future results. The Attractive Growth and Undervalued reference in this piece relates to underlying characteristics of the portfolio holdings. There is no guarantee that the performance will be positive as equity markets are volatile and an investor may lose money. 1. The Davis International ADR SMA portfolio is represented by Davis Advisors’ SMA International ADR Composite. Data herein is representative of a model account.Past performance is not a guarantee of future results. 2. Source: Brookings Institution. 3. Source: Davis Advisors and Wilshire Atlas.

Portfolio Review

The Davis International ADR SMA portfolio consists of 24 individual holdings. The breakdown of the portfolio largely indicates where we see the best value today:

  • High-grade financials
  • Consumer-facing e-commerce businesses
  • Communications services
  • Industrials
  • Workhorse technology companies
  • Select energy companies

The stalwart financials in the portfolio today are both cash- and capital-rich as well as cash-generative. Through a combination of heavy return of capital with just low single digit earnings growth, we believe we can generate nearly double-digit returns in this group, all things being equal. We believe select financials today are attractively priced, in other words, even taking into account the known headwinds. Bank Julius Baer, a leading Swiss private bank, is a representative example of a European financial that reflects our preference for well-capitalized, competitively strong, and highly durable businesses, in this instance, one that is focused on profitable wealth and asset management services.

The other broad area of the portfolio worth examining today is our investment in technology-related companies. These companies appear in sectors ranging from information technology to consumer discretionary (where e-commerce is included) to communications services, which include online search and advertising.

The modern digital age has begun to define new and vast global end markets. While 30 years ago we had opportunities to invest in up-and-coming semiconductor, software and server providers, those businesses were generally leveraged to the expansion of the personal computer market and then eventually the mobile device market, both of which have matured in terms of units sold.

Today, the number of end markets for technology companies has multiplied such that e-commerce, cloud computing, artificial intelligence, 5G, autonomous driving vehicles, industrial automation, and other new areas are placing demands on technology leaders like no other time in recent history. In a sense, we are in the midst of yet another technology revolution. Often, such innovation booms create attractive long-term growth opportunities for investors.

The e-commerce group, for instance, contains within it very interesting opportunities to capture some of the long-term growth trends we see for different end markets. For instance, JD.com, which boasts more than 300 million active users and is the largest online retailer in the world, has immense scale in China and is well-positioned in our view to continue capitalizing on the broad and rapid shift from offline retail to online, as well as the impressive growth of overall consumer demand. The company also has another enormous long-term opportunity to grow revenues and profits: JD.com now offers its logistics capabilities, ranging from warehousing to fulfillment and delivery, as a service to third party e-commerce sellers, a valuable proposition for both the company as well as the customer.

Within industrials, we own shares of Brenntag, a major German multinational that is a global distributor of chemicals with operations in more than 70 countries. Brenntag has grown its business and geographic reach from Europe to the Americas and Asia-Pacific through organic growth as well as a series of disciplined strategic acquisitions. Given scale advantages and a broad, stable customer base, Brenntag is an extremely durable enterprise in our view and has demonstrated a proven ability to grow both organically and through consolidation of a highly fragmented global market.

A relatively small weighting in the portfolio is dedicated to North American shale energy producers that are out of favor by all measures. Meanwhile, our energy companies have the reserves, the technological know-how, and the capital allocation discipline to grow production and free cash flow over the next several years. With oil prices relatively weak, it is difficult for major-integrated energy companies to earn a return on their capital. However, our holdings can break even— meaning they could earn a 10% return on capital—in the $35–40 per barrel range, well below the global industry as a whole.4 With stable energy prices, our companies should be able to generate more cash as production grows. Should energy prices recover somewhat, our energy businesses have the potential to punch above their weight as investments, in our view, based on the fundamental characteristics, coupled with a firmer backdrop for the commodity.

As for recent transactions, in the most recent quarter, we exited our position in Multi-Choice Group of South Africa to redeploy that capital into other opportunities.

4. Source: Davis Advisors

Conclusion

The media’s focus changes from day to day, but often underscores the natural worries and concerns of the moment. Our perspective is that there are positive developments afoot, here and abroad, in well-defined areas of the market. High-grade financials, innovative technology-related companies, industrial leaders, and select positions in North American shale energy are areas that interest us for the coming years.

On the other hand, competitive forces are intensifying, and industries, like business models, are undergoing reconfiguration. In addition to pure financial analysis, we believe it is paramount that investors be able to identify some type(s) of competitive moat at the specific company level (and, if possible, its immediate ecosystem). This may help protect businesses from competitive pressures or, better yet, put them in a position to achieve leadership in a large and profitable industry.

Overall, we are excited by the portfolio today, as it combines our selective, bottom-up research approach with companies generating attractive growth at very reasonable valuations. We look at the alternatives, including the broader MSCI ACWI ex US and even the 10-year Treasury yield, and we have high conviction in what we own.

Since our firm’s inception 50 years ago, we have adhered to the same, time-tested investment philosophy and rigorous research process of buying durable businesses at attractive prices and holding them for the long term. The more than $2 billion Davis Advisors, the Davis family and Foundation, our employees, and Fund directors have invested in similarly managed accounts and strategies remains a true sign of our commitment to and conviction in this enduring philosophy.5


5. As of 6/30/19. Includes Davis Advisors, Davis family and Foundation, and our employees.

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 Advisor's 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.

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.

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.

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.

Active Share is a measure of the percentage of stock holdings in a manager’s portfolio that differ from the benchmark index.

The model account generally uses Global Industry Classification Standard (“GICS”) as developed by Morgan Stanley Capital International and Standard & Poor’s Corporation to determine industry classification. GICS presents industry classification as a series of levels (i.e., sector, industry group, industry, and sub-industry).

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 ADV Part 2 for a description of these principal risks.

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 attractive growth reference in this piece relates to underlying characteristics of the portfolio holdings. There is no guarantee that the portfolio performance will be positive as equity markets are volatile and an investor may lose money.

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 throughout the world. The Index includes reinvestment of dividends, net foreign withholding taxes. The S&P 500 Index is an unmanaged index of 500 selected common stocks, most of which are listed on the New York Stock Exchange. The Index is adjusted for dividends, weighted towards stocks with large market capitalizations and represents approximately two-thirds of the total market value of all domestic common stocks. Investments cannot be made directly in an index.

Data provided herein is representative of a model account. Data provided is as of the date indicated and is subject to change. This material should not be considered a recommendation to buy, sell or hold any of the securities mentioned.

We gather our index data from a combination of reputable sources, including, but not limited to, Thomson Financial, Wilshire Atlas, Lipper, and index websites.

After 1/31/20, this material must be accompanied by a supplement containing performance data for the most recent quarter end.

The Equity Specialists is a service mark of Davis Selected Advisers, L.P.

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