Performance Overview
Our Strategy
The Markets
Understanding Fund Performance
Performance Overview
The Davis Appreciation and Income Fund's Class A Shares delivered a total return on net asset value of 49.68% for the one year period ended December 31, 2009, compared with a return of 26.46% for the S&P 500 Index. Over the same time period, the average convertible securities fund tracked by Lipper returned 41.09%, and the average moderate allocation fund tracked by Morningstar returned 24.23%. Because short-term results are less interesting to us than long-term results, we find it more meaningful that over the long term the Fund has generated a somewhat better return than the market with less risk. Since the Fund's inception on May 1, 1992, its Class A Shares have generated an average annual total return on net asset value of 8.29% versus an average annual total return of 7.92% for the S&P 500Index. At the same time, since May 1992, the Fund has had an annualized standard deviation (a commonly used statistical proxy for risk) of 13.66% versus 14.89% for the S&P 500 Index.
Davis Appreciation &
Income Fund Class A,
Total Returns
as of December 31, 2009
|
1
Year
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5
Years
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10
Years
|
Since
Inception
(5/1/92)
|
|
without a sales charge
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49.68%
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1.69%
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3.51%
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8.29%
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with a maximum 4.75% sales charge
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42.53%
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0.71%
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3.00%
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7.99%
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S&P 500® Index
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26.46%
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0.42%
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-0.95%
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7.92%
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The performance presented represents past performance and is not a guarantee of future results. Total return assumes reinvestment of dividends and capital gain distributions. Investment return and principal value will vary so that, when redeemed, an investor's shares may be worth more or less than their original cost. The total annual operating expense ratio for Class A shares as of the most recent prospectus was 1.07%. The total annual operating expense ratio may vary in future years. Returns and expenses for other classes of shares will vary. Current performance may be higher or lower than the performance data quoted. For most recent month-end performance, click here or call 800-279-0279.
According to a Morningstar report on the Davis Appreciation and Income Fund, "This fund's returns have come roaring back. . . . enabling its 10-year annualized return to remain better than most peers'. . . . Managers Andrew Davis and Keith Sabol buy out-of-favor stocks trading well beneath what they deem to be their fair values. The team usually requires that the holding offer some sort of income during the time it takes for the stock to realize its value. Consequently, the fund invests in real estate investment trusts, which are required to distribute nearly all their income, or a variety of high-yielding securities from across the capital structure--including high-yield common stocks and convertible bonds. . . ."
Our Strategy
Our long-standing investment goal is to capture most of the market's upside performance while participating in less of its downside. We use the Davis investment discipline to identify the businesses we wish to own, and then we seek to achieve our objective by investing in convertible bonds, equity, preferred stock, and straight debt of these target companies. We blend securities from these categories, taking into account valuations and other attributes of the particular securities employed. Because of the favorable return profile of many convertible securities, we like to include them when they are available from particular issuers at acceptable prices. In constructing our Portfolio we consider the risk versus reward trade-off at both the issuer and portfolio levels. At purchase, we size the issuer exposure and equity sensitivity of our positions to match our view of that issuer's fundamentals and valuation and our return expectations. These blends are adjusted over time on an event-driven basis to reflect changes in our outlook.
In the second half of 2009, the Fund returned 25.79%, which compares favorably with the 22.59% return of the S&P 500 Index. This result puts the Fund slightly ahead of the S&P 500® Index since December 31, 2005 and with a positive return as compared with the Index's negative result. Even though we wound up in a good place, the path was more challenging than we would have liked. While we remain confident in our approach to evaluating businesses, we believe there are opportunities for us to think more comprehensively about risk. As always, we seek to apply what we have learned from past mistakes in order to become better investors.
The Markets6
During the first half of 2009 both high yield and investment grade bonds outperformed the S&P 500® Index in large part due to dramatically improving credit conditions. In our mid-year commentary we cautioned that the pace at which the Fund outperformed the S&P 500 Index would not be sustainable in the long run. Credit spreads cannot shrink to zero and the closer spreads get to normal the less likely capital appreciation becomes. Nevertheless, despite the strong rally in the credit markets in the first half of 2009, bonds of all types continued their advance in the last six months of the year. The Barclays Capital U.S. Credit Index, an investment grade bond index, rose 8.6% and the Barclays Capital U.S. Corporate High Yield Index rose 21.3% from July through December, although both lagged the S&P 500 Index. With the credit tailwind persisting but weakening, we were not surprised to see the Fund perform more in line with the S&P 500 Index in the second half of 2009.
With credit conditions improving beyond our expectations, the Hedge Fund Research (HFRX) Convertible Arbitrage Strategy wound up as the best performing hedge fund strategy of the year. The expansion of bond premia that drove the results of arbitrage-based strategies continued to drive the performance of convertible bonds relative to their underlying stocks, which had positive implications for our Fund as well. It is interesting to note that the Barclays U.S. Convertibles Composite rose enough in 2009, up 50.72%, to almost fully recover the prior year's 34.59% loss. The HFRX Convertible Arbitrage Strategy rose 42.46% in 2009 after posting a 58.37% loss in 2008. Even so, an investor who put a dollar in the index two years ago would have just $0.59 today. This is a clear example of the permanent loss of capital that can result from forced deleveraging.
According to Barclays Capital, the size of the convertible securities market shrank from $294 billion in face value in 2008 to $249 billion in face value near the end of 2009. A combination of factors, including the normal cycle of puts, calls and maturities exacerbated by several tender offers, was responsible for reducing the size of the convertible securities market. At the same time, the scarcity value of convertible bonds seems to be propelling valuations higher relative to the underlying stocks. The need to be selective in such an environment is why the Fund maintains flexibility to invest outside of the convertible securities market.
One aspect of this valuation environment is that the implied volatility of convertible bonds has not collapsed as quickly as the market's implied volatility, as measured by the Chicago Board Options Exchange Volatility Index (VIX). All else being equal, one would expect the implied volatility of convertible securities to ultimately follow the market's, which would mean reduced bond valuations. With bond yields low, equity valuations near normal and implied volatility on the high side, one might characterize this as an issuer's market. We will be surprised if we do not see a significant number of new convertible issues. An increased supply of bonds will ultimately be beneficial as it will both lower valuations and result in more investment opportunities. Nevertheless, these new bonds are unlikely to perform as well as those issued in early 2009 by companies needing to raise capital in a buyer's market.
With the economy apparently stabilizing and equity and credit markets behaving more normally, underlying stock price performance should resume its place as the dominant driver of performance for most convertibles. In that event, it is unlikely that the Fund will continue to outperform the S&P 500 Index. As a reminder, our objective is not to beat the S&P 500 Index, but rather to capture most of the market's upside while mitigating risk. With that in mind, we expect future returns to be more tempered.
Understanding Fund Performance
In our 2009 mid-year commentary we noted that we seek to incorporate information from across markets to strengthen our analysis. For instance, one shortcoming in the past was failing to explicitly consider credit market assessments of companies when we reviewed their equity. Under standard operating conditions most companies' balance sheets present relatively modest risk to the company's equity. This is why credit and equity markets are said to be uncoupled. Under stress like we witnessed in 2008 and into the first quarter of 2009, however, the markets couple. When that occurs, correlations increase and credit risk can go from meaning almost nothing in the equity markets to meaning everything. No one could have predicted the magnitude of the meltdown in the credit market, but the worst performing stocks and bonds on the way down tended to be those with the highest credit spreads before the crisis unfolded. By evaluating credit information more rigorously, as we are doing now, we believe we could have moderated risk in the Portfolio in the past and we hope to moderate risk in the future. One way we make better use of credit information now is to assign higher discount rates to companies with higher credit spreads. This approach will naturally lead us to take an increasingly conservative view of the equity value of companies that the fixed income markets consider more risky.
In addition, we continue to track investors' inflation expectations by examining the forward inflation rates implied by U.S. Treasuries and Treasury Inflation-Protected Securities (TIPS) as well as the market for inflation swaps. Based on our findings the decidedly deflationary outlook that prevailed at the end of 2008 and into the first quarter of 2009 has given way to much more normal inflation expectations. Indeed we think the market is expecting inflation beyond the next five years to be in the 3% to 3.5% range, broadly in line with long run averages of Consumer Price Index (CPI) growth. If inflation expectations increase further, we believe there is a risk the Fed might act swiftly to raise rates and reverse its quantitative easing strategy.
In the last half of 2009, the only major position added to the Fund was a mix of convertible bonds and common stock of Allegheny Technologies Incorporated (ATI), a producer of specialty materials including titanium, nickel and related alloys, and specialty steels. These products are used in a wide range of industrial applications such as aircraft and aircraft engine parts; health care products (including artificial joints and superconducting components used in magnets of MRI machines); specialty armors; energy services, particularly drilling; and electrical power transmission. The primary driver of the company's growth is its titanium business, which benefits from the long-term trend to use more titanium based materials in aircraft. The company is a big supplier to Boeing, a relationship that has proved troublesome in the short run as Boeing has struggled to keep its new 787 Dreamliner on schedule. Nevertheless, with the jet now in tests, the long awaited ramp-up in production should begin shortly, helping to drive several years of promising growth for ATI. In addition, ATI has long imported titanium sponge, a raw material, from Kazakhstan. In the near future the company should benefit from the start-up of its own sponge facility in Utah. Such vertical integration reduces both sovereign risk and transportation costs while providing key customers a higher degree of protection against supply disruptions.
Our investment in ATI serves to highlight our approach to building a position. In late August we tried without success to obtain convertible bonds at a good price relative to the stock. Wanting to build a position in the company, we acquired common stock initially to establish most of the equity exposure we wanted and then as some convertible bonds became available at what we considered the right price we bought those to achieve our desired aggregate position size. After a strong run-up the stock experienced a sell-off and more bonds became available at an attractive price. We swapped some of our ATI stock to make room for the stock equivalent of the convertible bonds we purchased. This allowed us to retain the equity exposure we wanted but improve the risk-reward balance by owning bonds in lieu of the stock. As always, we consider it important to not only purchase a company's stock at the right price, but also to pay a fair price for the bonds relative to the rest of the company's capital structure. To date we are pleased to report that this investment is working out well.
The next most noteworthy activity in the Fund in the second half of 2009 was a rebalancing of our Citigroup (C) position. On January 22, 2008 we traded all of our Citigroup common stock for a new issue convertible preferred with a conversion ratio of about 1.48. Those preferred shares subsequently converted into common shares, but at a conversion ratio that was adjusted to 13.07 when the U.S. Government converted its preferred shares in July 2009. As a by-product of this adjustment, our Citigroup position outperformed the Fund and the market from January 22, 2008 through July 30, 2009. In August we sold about 20% of our stock. In December the company issued another mandatory convertible preferred as part of its plan to exit the Troubled Asset Relief Program (TARP). We further reduced the risk of our position by replacing a portion of our common shares for the newly issued preferred. We readily admit that Citigroup is a company that made mistakes and has been tarnished by the exceptional assistance it received. Nevertheless, it has a solid international franchise, a recognized brand and a newly strengthened capital base. The improvement in the capital markets suggests that the businesses Citigroup seeks to sell will command better than book value pricing. It is possible the company may ultimately be viewed as having excess capital that could be reinvested in the business or be used to repurchase shares. The stock overhang related to the government's significant ownership clearly stifles appreciation potential in the short term. But we think that the Obama administration's emphasis on recouping TARP dollars quickly suggests that the government is likely to sell as soon as feasible. We believe removing the onus of government ownership could potentially be the catalyst to realizing significant value from our Citigroup position.
As fellow shareholders in the Fund, we understand what you expect from us: careful research, scrutiny and deliberation based on experience when investing your money and ours. We remain mindful of our responsibility and grateful for the trust you have placed in us, and look forward to continuing our investment journey together. ■
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Insights from One of the Most Successful
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Drawing from over 60 years of investing on Wall Street, the Davis family shares insights and wisdom on building wealth and the temperament needed to invest successfully.
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