Large Cap Value Portfolio Commentary
Fall Update 2019

Market Perspectives

In the year–to–date period, the S&P 500 Index returned 20.55%. The Davis Large Cap Value SMA portfolio delivered double–digit performance as well, reflecting relatively healthy business fundamentals within our portfolio of companies overall.1

Our perspectives on the overall U.S. economy begin with the observation that the U.S. remains one of the most innovative, resilient, and diversified economies in the world. Economic growth is a positive 2%, operating margins for many businesses appear robust, and the multiple for the overall S&P 500 is 18.3 times earnings on a forward basis. In other words, fundamentals are solid on balance. It is a time for investors to be selective, as opportunities are available, and there are certain areas of the market that offer much better value than others, in our opinion.

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 world’s market leaders across multiple geographies. The companies we own are in many instances global in reach; thus it matters that there are many geographies where standards of living are rising quickly, 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. Global middle–class spending, which exceeds $35 trillion today, may reach $64 trillion by 2030.2 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 often born tremendous new business models and even new industries.

Despite headwinds to sentiment, this year has thus far produced a meaningfully better return than most, and that is not an isolated event. There is no set rule in investing that holds that bad news headlines must unequivocally equate to poor stock market performance.

Below are the five best years of returns for the S&P 500 Index over the last 50 years, accompanied by some of the news topics from those times.

We are not making a call on the market’s one–year return, but rather pointing out that the news headlines are almost perennially skewed to the negative. Yet, with time—and given profit growth—the market has time and time again been able ultimately to climb the “wall of worry” that may temporarily weigh on prices.

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

First, an overarching observation is that the stock market appears bifurcated along different axes presently. 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. The consumer staples sector has a forward price–to–earnings multiple of 20.5 times, well above the market’s multiple, and utilities trade at a forward multiple 20.7 times. Meanwhile, they have both 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. Among these businesses, we note that balance sheets and payout ratios appear stretched, leaving much less financial flexibility, and organic sales are essentially flat. As a sector, they have grown earnings per share at a meager rate of only 5% over five years. Utilities, trading at 21 times earnings today, carry more debt at the balance sheet level and have grown earnings per share at an average annual rate of only 4% over five years, a disconnect that we believe is likely to prove unsustainable. 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 and these defensive categories, 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 Large Cap Value portfolio versus the S&P 500 Index, the S&P Utilities sector and the S&P Consumer Staples sector.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 26 well–researched holdings, our portfolio holdings have grown earnings per share at a rate of nearly 23% over the past five years. Meanwhile, we are paying 14.5 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.

The S&P 500 Index has grown earnings per share over the last five years, by comparison, at a rate of 16.4%, which is decent, but far below our portfolio holdings’ growth rate of 22.6%, and today trades today at 18.3 times forward earnings, or 3.8 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.

What is most striking are the so–called “defensive” sectors of utilities and consumer staples, which figure prominently in the S&P Low Volatility Index, which we reference as a proxy for the type of defensive strategies available and popular in the marketplace today. Utilities have grown earnings per share at an average rate of 4.3% per annum over the last five years and trade at 21 times forward earnings. That means that the holdings have grown earnings per share at more than 5.2 times the rate of this market sector over the last half decade, but despite this fact, utilities remain in such great demand that they now trade at a 43% premium (i.e., 6.2 multiple points higher) than the companies in our portfolio as a whole. Similarly, the consumer staples sector has grown earnings per share over the last five years at a rate of 5.2% and trades today at a forward price–to–earnings multiple of 20.5 times, a 41% valuation premium to our portfolio’s holdings.

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 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 Large Cap Value portfolio is represented by Davis Advisors’ Large Cap Value (SMA) Composite. Past performance is not a guarantee of future results. 2. Source: Brookings Institution. 3. Source: Davis Advisors and Wilshire Atlas.

Portfolio Review

The Davis Large Cap Value SMA portfolio consists of 26 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. Our top five domestic financial positions—excluding a holding company that may be classified as financial but in fact is a diversified conglomerate—earned a combined $72 billion in net income in 2018 alone. That figure would be on par with entire market capitalization of well–known juggernaut Fortune 500 companies. The $72 billion in net income was generated despite the fact that low interest rates and an unfavorable yield curve are suppressing the full earnings power of our financials for the time being. The capacity to pay much higher dividends over time while engaging in massive share buyback programs is substantial. Our top five U.S. financial holdings paid $20.4 billion in dividends to shareholders in 2018 and repurchased more than $47.9 billion of common shares outstanding. As such, the total amount of capital returned through dividends and buybacks in 2018 was just over $68 billion out of a total of $72 billion in net income—and that is for a single year, complete with headwinds.4

Through this 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. By our math, a modest earnings growth assumption of 3% per annum for financials, starting at today’s multiple of approximately 10 times earnings, can deliver nearly double–digit total return on shares, if one assumes a meaningful contribution to performance through rising dividends and accretive share repurchases with no multiple expansion assumed. We believe financials today are attractively priced, in other words, even taking into account the known headwinds.

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 semi–conductor group, for instance, contains within it some very interesting opportunities to capture some of the long–term growth trends we see for different technology end markets. For instance, Texas Instruments, which we regard as a “workhorse” technology company, is well–positioned in our view not only to continue serving the analog chip market for computers and mobile devices, but is also experiencing an upsurge in demand from the automotive and industrial fields. The use of semi–conductors in automobiles and industrial factories is on the rise, pushed by sensor and connectivity technology as well as other, computer–based functions that go hand–in–hand with the electrification of devices and processes. We believe we are in the early stages of this long–term boom and own shares in market leaders in this industry. Other technology–based businesses in the portfolio such as Qurate, the owner of Home Shopping Network (HSN), and QVC, are more consumer–facing. Our contention overall is that technology has become a natural part of virtually every industry in the market, and investors should be open to its long–range impact on, and implications for, specific businesses and industries.

Within the industrial markets, we own businesses that specialize in aerospace (narrow–body jet engines, parts, and maintenance services) and automotive seating systems. Perhaps the most fascinating portion of that group is related to aerospace, where our position in United Technologies gives us very direct exposure to an explicit travel and transportation theme that could persist for decades.

Globally, there are approximately 26,000 commercial passenger aircraft.5 Much of that capacity has historically served developed markets, but the future is turning out very different from the past in the sense that enormous land–mass countries such as China and India are experiencing robust economic growth, rising standards of living, ever–expanding transportation networks (including the logistical and brick–and–mortar infrastructure supporting air travel), and growing demand for delivery services, as well as personal and business travel. This demand is pushing revenue passenger miles flown worldwide to a robust annualized rate of 5%.6 There are two main manufacturers of narrow body jet engines, a component of aircraft that is as difficult to design, manufacture, and service as it is mission–critical. That slice of the aerospace industry offers especially appealing economics relative to the rest of the plane and relative to the other businesses in the ecosystem, in our view. The engines, once installed, need to be serviced for the life of the plane, meaning that parts and maintenance will be ongoing, very high margin revenue streams over a multi–decade period for the two players in the space.

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.7 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.

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 (especially in aerospace), 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) that 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, whether they be the broader S&P 500 Index, the historically–defined “low volatility” sectors, or 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.8

8. As of June 30, 2019. 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 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.

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.

Returns from inception (4/1/69) through 12/31/01, were calculated from the Davis Large Cap Value Composite (see description below). Returns from 1/1/02, through the date of this report were calcu–lated from the Large Cap Value SMA Composite.

Davis Advisors’ Large Cap Value Composite includes all actual, fee–paying, discretionary Large Cap Value 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.

Davis Advisors’ Large Cap Value (SMA) Composite excludes institutional accounts and mutual funds. Performance shown from 1/1/02, through 12/31/10, 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’ Large Cap Value 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. The net of fees rate of return formula used by the wrap–fee style accounts is calculated based on a 3% maximum wrap fee charged by the wrap account sponsor for all account service, including advisory fees for the period 1/1/06, and thereafter. 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.

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 and 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).

Data provided herein and references to portfolio 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.

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 Large–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 wasadded 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 Large Cap Value 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) issued by large com–panies with market capitalizations of at least $10 billion. Historically, the Large–Cap Value strategy has invested a significant portion of its assets in financial services companies and in foreign companies, and may also invest in mid– and small–capitalization companies. The principal risks are: common stock risk, depositary receipts risk, emerging markets risk, fees and expenses risk, financial services 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 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. The S&P 500 Low Volatility Index measures performance of the 100 least volatile stocks in the S&P 500. The index benchmarks low volatility or low variance strategies for the U.S. stock market. Constituents are weighted relative to the inverse of their corresponding volatility, with the least volatile stocks receiving the highest weights. Investments cannot be made directly in an index.

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

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

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