Performance Overview
Our Strategy
Understanding Fund Performance
Looking Ahead
Performance Overview
The Davis Appreciation and Income Fund's Class A Shares delivered a total return on net asset value of 1.30% for the one year period ended December 31, 2007 compared with a return of 5.49% for the Standard & Poor's 500 Index. Over the latest one year period, the average convertible securities fund tracked by Lipper Analytical Services returned 7.50% and the average convertibles fund tracked by Morningstar returned 7.77%. 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 return similar to the market with significantly 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 10.32% versus an average annual total return of 10.52% for the S&P 500 Index. At the same time, since May 1992, the Fund has had an annualized standard deviation—a commonly used statistical proxy for risk—of 10.16% versus 13.36% for the S&P 500 Index.
According to Morningstar, ". . . veteran managers Andrew Davis and Keith Sabol genuinely take to heart the words of Davis' grandfather, famous investor Shelby Cullom Davis, that 'You make most of your money in a bear market, you just don't realize it at the time.' This is precisely how the team approaches current market conditions—as a buying opportunity. Therefore, Davis and Sabol are deploying cash using the long-term, concentrated, and high-conviction value style that Davis Selected Advisers is known for. They focus on purchasing securities (equities, convertibles, and occasionally bonds) of strong companies with proven management teams that are undervalued in the market."
Our Strategy
Our long-standing investment objective is to capture most (80%) of the market's upside performance while participating in less (50%) 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 across the capital structure, 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 an issuer and portfolio level. At purchase, we size the issuer exposure and equity sensitivity of our positions to match our view of that issuer's fundamentals, valuation and our return expectations. These blends are adjusted over time on an event-driven basis to reflect changes in our outlook.
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Understanding Fund Performance
Through the better part of 2007, Fund returns were broadly consistent with our objectives. Nonetheless, the latter part of November and the entire month of December proved extraordinarily trying and ultimately disappointing. We ended the year 419 basis points behind the S&P 500 Index. Such an outcome motivates introspection and a search for lessons to be learned.
The issuers in the convertible bond universe are predominantly smaller capitalization companies. While the S&P 500 Index gained 5.49% for the year, the Russell 2000 Index of small cap stocks actually fell 1.56%. Small cap companies are usually more domestically focused and as a result are affected more directly by the strength or weakness of our economy. They also derive less benefit from a depreciating dollar than large cap multinationals and global commodity players. We estimate that the Fund's smaller cap exposure reduced our returns relative to the S&P 500 Index by roughly 150 basis points.
Viewed from another perspective, the uncertain economic environment meant a relatively small number of stocks accounted for a disproportionate share of the S&P 500 Index's positive performance. The top 10 index point movers in the S&P 500 Index accounted for more than 130% of the Index's price appreciation, meaning that the remaining 490 companies in aggregate generated negative returns for the year. Two of our holdings, American International Group (AIG) and Citigroup, were among the S&P 500 Index's worst performers (measured by index point contribution).
Citigroup's decline cost the portfolio roughly 100 basis points of performance. While disappointed with the stock's performance, we are cautiously optimistic about the future. We believe the market largely anticipated the recent dividend cut and perhaps expected an even greater reduction. We also believe Citigroup's recent capital raising activities will be adequate to enable the company to restore and maintain its targeted capital ratios. If we are right and if we assign a historically higher end dividend yield of 3% to the current $0.32 quarterly dividend, then Citigroup's shares would trade around $42. Further, we are confident that former American Express CFO Gary Crittenden, now CFO of Citigroup, is the right person to evaluate Citigroup's portfolio of businesses and recommend appropriate course adjustments. Citigroup's poor financial results earlier in 2007 reflected poor initial risk management; now we are witnessing the unwinding of these poor decisions. Citigroup's new leadership has incentives to aggressively write down the old regime's excesses and anecdotal evidence suggests they are doing so. Actual cash losses will materialize, but could be smaller in magnitude than current accounting suggests. This could ultimately generate valuation gains and more importantly free up capital for growth investments. Credit losses are rising as one would expect at this point in the cycle, but net interest margin is turning up thanks to better balance sheet management, and most of Citigroup's revenue drivers are up by solid double digits year to year. In hindsight, we should have paid more attention to the pricing of collateralized debt obligation (CDO) and commercial mortgage-backed security (CMBS) indexes as a rough guide to likely write-downs; incorporating that information could have mitigated our losses. We should also point out that hedge fund sentiment contributes significantly to the trading of these securities and that the low water mark for the indexes will probably price in losses that exceed those ultimately realized by most investors. We will continue to monitor the indexes as an indicator of potential future losses, but always with an eye to avoiding rear-view mirror investing.
Kohl's stock was also a disappointment in 2007. Its decline cost the portfolio approximately 100 basis points of performance. The stock fell on weaker earnings, both realized and projected, attributable to softening consumer demand in the face of higher energy prices and concern about the credit markets. Execution by Kohl's management remains solid in this very challenging environment. Inventory levels continue to be consistent with Kohl's plans, helped by the company's markdown optimization program. Intermediate-term plans that call for Kohl's to maintain a 10% square footage growth rate for the next several years remain on track. Margins are likely to come under pressure in the first half of 2008, but we expect them to normalize in the second half. Based on our analysis, the stock currently prices in zero to slightly negative comparable store sales growth as well as softer margins and thus offers significant appreciation from these levels once consumer and investor confidence rebound. One near-term catalyst could be Kohl's plans to make significant share repurchases with the proceeds of its September 2007 bond issue. Kohl's board authorized a $2.5 billion repurchase program at the end of September and we estimate that $2.3 billion in shares remain to be repurchased under this authorization. Perhaps more important, we believe the company has liquidity to support $750 million of repurchases in the near term. We also believe aggressive repurchases are likely. Our valuation work had pegged Kohl's as fairly—not richly—valued early in 2007. Given the heightened risk posed by turmoil in the credit markets and the relatively higher beta associated with a growth stock like Kohl's, we should have reduced the portfolio's equity exposure to Kohl's when we bought the company's bonds last September.
The most painful learning experience occurred when Cerberus abandoned its purchase of portfolio holding United Rentals in late December 2007. In a single day United Rentals stock collapsed from $34.40 to $23.50. Certainly no one likes to lose money, but what makes this incident particularly unsettling is that we had lived through a similar set of circumstances in the past, specifically when Bain abandoned its acquisition of School Specialty in late 2005. In both cases a deal that seemed certain to close fell apart at almost the last possible moment. Lulled by a false sense of security, we chose not to trade in order to avoid transaction costs, but in hindsight transacting at nearly any cost would have been a better decision. We should have established a quantitative metric to trigger the sell decision. When we conduct a discounted cash flow analysis we discount the business's free cash flows by the cost of equity (i.e., the minimum return a company must offer stockholders to compensate them for bearing the risks of ownership). In an acquisition, particularly a cash one, it is easy to think that the cost of equity should fall. However, that is not necessarily the case because many risks still remain. For example, the transaction might face regulatory hurdles or key members of the management team might leave if the transaction collapses. A collapse could also indicate the company's fundamentals are not what we expected. And the timing of the closing is uncertain as well. All of these factors can contribute to a heightened level of overall risk. An appropriate discipline would flash a sell signal when the current price of the acquisition target exceeds the cash takeout price reduced by our financial model's discount rate plus an additional arbitrary risk premium of around 100 basis points to adjust for the incremental risk posed. In the case of both failed transactions discussed here, this discipline would have prompted us to sell before the transactions finally collapsed, producing a much more favorable outcome for the Fund.
The contribution of real estate investment trust (REIT) investments to portfolio returns has been a recurring theme in previous Fund reviews. As noted in our 2007 semi-annual review, we reduced our REIT exposure rather dramatically in the first half of last year. The sale of our common stock position in SL Green, which specializes in Manhattan office properties, generated the vast majority of our long-term gain distribution in 2007. The decision to reduce real estate related exposure proved to be a good one, as the Bloomberg REIT Index underperformed the S&P 500 Index from February 7 through August 17 by about 21 percentage points. By mid-August the common stocks underlying our REIT convertible bonds had sold off significantly and, as a result, the bonds lacked the targeted equity sensitivity we typically seek. Revisiting our models, we added equity exposure where valuations could be justified based on a 12% cost of equity. Until November this looked like a good decision, but by year-end it proved incorrect with REITs sliding a further 9% relative to the market. Having taken more downside risk than we expected, we sought to discover what we had overlooked. The missing link seems to be the high degree of sensitivity of REIT stocks to credit spreads in markets where REITs seek to finance their projects. Defining the spread as the difference between the yield on an average REIT 10 year par bond with a BBB+ rating and the yield on a 10 year LIBOR swap reveals a significant fact. In August, the spread was barely wider than in February, despite the sell-off in REITs. Granted, the 67 basis point spread in August was wider than earlier in the cycle, but nothing like a cyclical high. However, by December the spread had widened to 170 basis points. This compares to 105 basis points in December 1999 when the market neglected most nontech investments and 140 basis points in the week following September 11, 2001. This analysis suggests to us that sentiment in the sector is "bullishly bearish" and we continue to increase our equity sensitivity to good companies like General Growth Properties whose stock price is trading at early 2006 levels even though the company now generates nearly twice the funds from operations that it did then.
In the early part of 2007, the Chicago Board Options Exchange Volatility Index (VIX), which measures market expectations of near-term volatility, was around 12. Historically, 12 is a fairly low level of volatility and it was reasonable to expect that higher levels were likely in the future. What surprised us to our detriment was the subsequent tripling of the VIX later in the year. Convertible bonds contain a conversion option whose value is in part determined by the expected volatility level of the underlying stock. Bonds whose stock price is very far from the conversion price have relatively little sensitivity to changes in this expected volatility; these bonds are known as low vega bonds. Smaller changes in volatility are likely to be relatively inconsequential even for bonds with higher vegas. For example, a bond with a fairly high vega might gain 0.5% in value with a one point increase in the volatility of the underlying stock, all else being equal. On the other hand, an outsized move in expected volatility, like the approximately 20-point increase we saw in the VIX in 2007, can have a rather dramatic effect. A volatility increase of that magnitude could potentially offset nearly 10 percentage points of stock price decline, all else being equal. Low vega convertible bonds capture very little of this benefit. While 45% of our Portfolio is invested in convertible bonds, a relatively small portion of that is in high vega bonds. Our Portfolio's downside protection would have been better if we had owned a greater concentration of higher vega bonds. The market now places a premium on these high vega bonds due to this spike in market volatility, so this is not the best time to increase this type of exposure. However, in the long run we expect to increase our emphasis on these bonds.
Looking Ahead
Currently unsettled markets have provided investment opportunities for those with cash to spare and the right temperament. We are pleased to report that the Fund's outsized cash balances have been rightsized and we view the present portfolio as fully invested.
We choose to gauge our results in terms of the S&P 500 Index because, to paraphrase former General Electric Chairman Jack Welch, it represents a stretch objective and we are always pushing ourselves to generate the best possible risk-adjusted returns for our investors. Merrill Lynch produces an index designed to measure the performance of the universe of convertible bonds that it calls Total Return Alternatives, which is to say bonds that in aggregate look like our Fund. Because its investment objective is similar to ours, we look to that index to provide a sanity check on the Fund's performance. For 2007 the Total Return Alternatives Index generated a return of 1.60% compared with 1.30% for the Fund. Clearly we need to stretch a bit further, but viewed in this context the lessons learned were not as painful as they seemed.
We find many stocks today priced to reflect near recessionary scenarios and indeed it is possible that economists will eventually determine that we have experienced a recession. But we will not know that with certainty until we are climbing out of the far side of the valley. Meanwhile we believe that this market disruption is likely to be one of the few of such magnitude that we will experience in our investing careers. As a consequence, we are aggressively seeking the similarly rare opportunities that we know are lurking in the disarray. We continue to focus on companies, not industries, and we look for stable businesses that we believe can perform well in a variety of economic environments. We appreciate your continued support and we thank you for your trust and confidence in us as we move ahead. ■
For more information, please contact...
DAVIS DISTRIBUTORS, LLC
2949 East Elvira Road, Suite 101
Tucson, AZ 85706
1-800-279-0279
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