Overview
Q: Has the stock market made a bottom?
Q: Why should investors be in stocks at all?
Q: Why should the next 10 years be better for investors than the last?
Q: What if we are in a new Great Depression?
Q: If a portfolio manager underperforms for three or more years, isn't it time to switch managers?
Q: What were the Fund's biggest mistakes?
Q: Why do you have so much in financials?
Q: Why don't you have more in financials?
Q: What are the biggest changes in the Portfolio?
Q: How have current events affected your firm?
Overview
The table below summarizes results through June 30, 2009 for the Davis New York Venture Fund compared with the S&P 500 Index, against which my co-manager Ken Charles Feinberg, our colleagues and I judge ourselves. Our objective is to outperform this Index after fees over the long term as we have done in every rolling 10 year period since our inception in 1969.
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Total Returns as of June 30, 2009
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YTD3
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1
Year
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3
Years
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5
Years
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10
Years
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15
Years
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20
Years
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25
Years
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30
Years
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40
Years
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Inception
(2/17/69)
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DNYVF Class A without a sales charge
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6.39%
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-27.66%
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-9.26%
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-1.70%
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0.41%
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8.27%
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9.74%
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12.09%
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13.43%
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11.42%
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11.44%
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with a maximum 4.75% sales charge
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1.33%
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-31.09%
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-10.72%
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-2.65%
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-0.08%
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7.92%
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9.48%
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11.87%
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13.24%
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11.29%
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11.31%
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S&P 500® Index
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3.16%
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-26.21%
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-8.22%
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-2.24%
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-2.22%
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6.93%
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7.77%
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10.13%
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10.76%
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9.19%
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9.01%
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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 0.85%. 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 quoted. For most recent month-end performance, click here or call 800-279-0279.
However, implicit in our goal of beating this Index is our expectation that the S&P 500 Index should produce positive returns over the long run. This has not been the case for the last decade, during which the Index actually declined by more than 20%, or -2.2% per year, making the last 10 years some of the worst on record for stock investors. Although the Davis New York Venture Fund exceeded the Index by more than 24% cumulatively, or 2.6% per year, over this time period, we do not consider an absolute return of about 4%, or 0.4% per year, satisfactory.
Our focus on both absolute and relative returns stems from the simple fact that our colleagues, families and directors are large investors in the Davis New York Venture Fund. As co-investors alongside our clients, we eat our own cooking and know the truth of the old saying: "you can't eat relative returns." For reasons outlined below, rather than shake our conviction, this decade of poor absolute returns strengthens our firm belief that in the decades ahead the Index should produce satisfactory absolute returns. As a result, gaining any advantage over this Index after expenses should result in decent long-term returns for our shareholders.
In the pages that follow, we will provide perspective and context for our trailing results but we will not try to excuse them. Negative absolute returns over shorter time periods and relative returns that slightly underperformed the market over the last one and three years, and slightly outperformed the market over the last five years, fall short of our goals. We have ground to make up and will try our very best to do so.
Given the tremendous market and economic turmoil of the last year, we have received many questions from shareholders on a wide range of topics. To respond to these questions, we have chosen a somewhat different format for this midyear report, structuring it as a series of answers to the most common questions we have been asked. We have organized the questions from the general to the specific and, as always, will include a review of our mistakes as well as our successes. We hope you find this format useful and would welcome your feedback.
Q: Has the stock market made a bottom?
A: Questions about the overall market are the most common we receive. Unfortunately, the only answer we can give to such questions is, "We don't know." While hundreds, if not thousands, of people make a living as market and economic forecasters, there is overwhelming evidence that such short-term forecasting is impossible. As John Kenneth Galbraith observed, "The function of economic forecasting is to make astrology look respectable." The chart below illustrates this point by contrasting the top Wall Street economists' forecasts of the direction of interest rates over the following six months with what actually happened. As the chart shows, there is no correlation between their predictions and the outcomes.
The same is true of stock market forecasts. The chart below shows Wall Street strategists' predictions of the following year's stock market returns, which also appear uncorrelated with what actually happened.
Furthermore, what is true of forecasters as a group is also true of individuals. Although the media is now filled with fawning interviews with those strategists who correctly predicted the bear market, these are not the same strategists who were lionized for predicting the bull market. Reputations for astute forecasting tend to be short-lived. A dramatic example of the ephemeral nature of such reputations came in Alan Greenspan's admission that "I've been in the forecasting business for 50 years, and I'm no better than I ever was, and nobody else is either." (Now he tells us!)
While we cannot predict the short-term direction of the market or economy, we do know that the market is likely to recover well before there are clear signs of the economy improving. As Warren Buffett wrote last fall, "I can't predict the short-term movements of the stock market. . . . What is likely . . . is that the market will move higher, perhaps substantially so, well before either sentiment or the economy turns up. So if you wait for the robins, spring will be over." The same point is illustrated in the chart below, which reviews average cyclical patterns since 1970 and shows that the market has tended to bottom months before the economy.
Q: Why should investors be in stocks at all?
A: Given the market's negative return over the last decade, some shareholders have begun to question the wisdom of owning stocks. They particularly highlight the fact that bonds have produced far higher returns over the last decade and with far less risk. However, the very fact that bond returns exceeded stock returns over the last decade is exactly why investors should now avoid bonds in favor of equities.Over very long periods of time, but especially those in which interest rates were as low as they are today, stocks have produced better real returns than bonds. As the chart below shows, there has never been a 20 year period in which stocks produced a negative real return. Please note that this chart is based on data that goes back 200 years. While some credibly argue that the data from before 1920 should not be relied upon, the data since 1920 is more reliable and supports the same conclusion.
The fact that we have just come through an anomalous long period in which bonds outperformed stocks is explained by the fact that at the beginning of this period interest rates were very high. Thus, bondholders earned not just a high coupon but also price appreciation from falling interest rates. When interest rates are very low, as they are today, bondholders stand to lose on both fronts. Their starting coupons are low and they face the prospect of price erosion should interest rates rise. Such conditions in the past led to 20 and even 30 year periods in which bondholders suffered negative real returns. Thus, if we define risk as the possibility of having a negative real return over a long period of time, then bonds at today's interest rates are far riskier than stocks. While investors may feel safer in bonds, the toxic combination of low coupons and the likely prospect of higher future inflation means bondholders are likely to be more vulnerable to long-term wealth destruction than stockholders.
Q: Why should the next 10 years be better for investors than the last?
A: Although commentators and the public are more pessimistic than ever, it has historically been profitable to invest in the stock market after a decade of poor returns. Specifically, there previously have been 10 rolling 10 year periods since 1928 when the S&P 500Index (and, before the inception of the S&P 500 Index in the 1950s, the Dow Jones Industrial Average) returned less than 5% per year. In every case, the 10 years that followed produced satisfactory returns averaging approximately 13% per year and ranging from a low of 7% per year to a high of 18% per year.While we cannot know for sure what the next decade holds, it is highly likely to be far better than what we have suffered through in the last 10 years. Past market performance is not a guarantee of future results.
The reason that satisfactory decades for investors tend to follow poor ones is that low prices increase future returns. In other words, because stocks represent ownership interests in underlying businesses, investors who buy at lower prices should enjoy better results than if they bought at higher prices. Consider a business that generates $100,000 of income per year. A buyer who pays $2 million for this business should only expect a 5% return on investment. But if a buyer could get that same business for half price, then the buyer's return on investment would double to 10%. This same math applies at the level of the stock market, which is, after all, simply a collection of businesses, the majority of which we believe should earn more money 10 years from now than they do today. Ten years ago, when the S&P 500 Index was trading at 1,372, underlying operating earnings were approximately $47, implying a return of about 3%. With the S&P 500Index trading at 919, underlying operating earnings should be around $55 this year and $74 next year, implying an earnings yield of 6% to 8%, or twice what it was a decade ago.What's more, these earnings figures are cyclically depressed by the weak economy, giving investors additional upside if the global economy recovers as we expect.
Q: What if we are in a new Great Depression?
A: More and more, we hear from shareholders who are concerned that we are not in a recession but rather a new Great Depression. While there are many substantial and structural reasons why it is unlikely that the United States economy will contract anywhere near as much as it did in the 1930s, the key question from our perspective as investors, rather than economists, is what happened to the stock market during this bleak period. At first glance, the answer is disheartening. It took 25 years for the stock market to return to the level it reached at the peak in 1929. When we look at what was happening in the world during this period it is no surprise that the market did so badly. After all, this 25 year period included unemployment that rose as high as 25%, a 46% peak-to-trough contraction of GDP, and a world war to boot, all three of which we consider unlikely to recur. Nevertheless, rather than debate whether or not the conditions are in place for a similar terrible period, let us just suppose that they are. In other words, let's assume that the market will not reach the highs that it reached in 2000 for 25 years, or until 2025. (Although the S&P 500 Index very slightly exceeded this level in late 2007, few would dispute that the peak of the stock market bubble in terms of valuation and other factors was March of 2000.) Even in granting this horrendous possibility as a worst-case scenario, it should be noted that from 1929-1954, investors did not earn a zero return. After all, the return an investor gets comes from price appreciation plus dividends. Over long periods of time, the returns from dividends can be substantial. In fact, from 1929-1954, although the stock market itself made no headway, investors earned a compound annual return of roughly 5% per year from dividends. It should be noted that this 5% return does not mean that the dividend yield on stocks was 5% throughout this period. In fact, just as today, at the start of the period, the dividend yield was a bit more than 3%. It also does not mean that dividends never get cut. During the early 1930s, dividends were essentially cut in half. Yet from the relatively low starting yield, and even allowing for the cuts, over the entire period dividends grew along with GDP and the result of this growing stream of dividends was a 5% return over this 25 year period.
Importantly, even if we are in the same scenario today, we are not starting at the March 2000 peak but rather well below it. In this example, if we assume that from 2000-2025 the market will perform as badly as it did from 1929-1954, then an investor who started at the 2000 peak should only expect to earn a return of about 5% per year from dividends alone with no price appreciation. (Once again, this 5% return implies that dividends will grow from lower yields at the starting point to much higher yields by the ending point, resulting in a 5% return for the entire period.) However, because the market is currently far below its peak, we would also expect price appreciation from the market simply getting back to the level it started from. This price appreciation from 919 back to the March 2000 high of 1,552 by 2025 would add about 3% per year to the 5% dividend returns, creating a total return of about 8%. While this example is obviously hypothetical, it is interesting to note that even in a scenario in which investor returns are as miserable from March of 2000 to March of 2025 as they were from 1929-1954, the worst period in stock market history, investors would still earn about 8% per year from here.
We dwell on such examples in order to provide a counterbalance to the pervasive pessimism that has investors getting out of equities in record numbers at exactly the time we believe they should be getting in. As Warren Buffett notes, "The most common cause of low prices is pessimism--sometimes pervasive, sometimes specific to a company or industry. We want to do business in such an environment, not because we like pessimism but because we like the prices it produces. It's optimism that is the enemy of the rational buyer." Unfortunately, it remains true that people are pessimistic when prices are low and optimistic when prices are high. The result of having sentiment correlated with prices is that investors (aided by stock market promoters and certain financial media commentators) have incurred a significant self-inflicted penalty by getting in after prices are up and getting out after prices are down. The cost of this penalty over the last 20 years is estimated to be about 6.5% per year, a staggering figure that dwarfs any other investment expenses.
While it may run counter to human nature to suggest that people invest more in times of panic and less in times of euphoria, a simple program of disciplined dollar-cost averaging would greatly improve most investors' results.Looking back at the same bleak period described above provides a staggering example of the effectiveness of just such an approach. Imagine a seemingly unlucky investor started in 1929, investing $10,000 per year each year throughout that terrible bear market until 1954 when the market finally regained its previous high. In other words, this poor investor started investing when the market was at a peak that it would not reach again for 25 years. But amazingly, if this investor had stuck with the discipline of investing $10,000 each year during this bleak 26 year period, the $260,000 invested would have grown to $1.7 million by the end of 1954, a compound annual growth rate of 12% year. The combination of dividends and the return on the investments made each year at lower prices than the first year resulted in this very good performance. But this result was only achieved with the discipline of adding to investments each year, especially when things looked their worst.
Q: If a portfolio manager underperforms for three or more years, isn't it time to switch managers?
A: Although we would far prefer to answer this question at a time when our three year results are good rather than when they are poor, we can promise you that the answer will be the same in both cases and it's one we have given in good times as well as bad. Periods of underperformance are inevitable. As the legendary chairman of Capital Guardian Trust Company Bob Kirby observed, "The basic question facing us is whether it's possible for a superior investment manager to underperform the market three years in a row. The assumption widely held is 'no.' And yet, if you look at the records, it's not only possible, it's inevitable." While we know that making such a statement during a time of underperformance may sound like we are making excuses, the data supporting it is incontrovertible. The vast majority of topperforming managers over a long period of time will experience multi-year stretches of poor performance.
Specifically, as the chart below shows, 97% of all of the managers whose results over the last 10 years placed them in the top performance quartile still underperformed for at least a three year stretch during that decade of excellent relative results. More important, in almost half of these cases (41%, to be precise), the three year stretches were bad enough to place them in the bottom decile relative to their peers. While we are clearly in such a trough at the moment, we note that such periods of underperformance are an inevitable part of successful long-term investing rather than a reason for switching.
Some portion of this underperformance can be attributed to the managers' mistaken appraisals and declines in the value of the underlying businesses they owned. In the recent bear market, this was particularly common in the financial sector. We had our share of such mistakes, which we will discuss later in this report. However, another portion of this underperformance experienced by managers with good long-term results is simply attributable to the unpredictability and vagaries of short-term results. It is the nature of markets that value and price can diverge for long periods of time. In euphoric times, such as during the Internet bubble, the stock prices of many companies exceed their value. In times of panic and dislocation, the value of many companies exceeds their prices. In such periods, poor reported results may indicate deferred returns rather than permanent losses. For example, a company purchased at $10 per share that has an intrinsic value of $20 is a good investment even if its price falls to $5 for some period of time. Only time will tell what percentage of the recent weak returns were the result of temporary mispricings versus permanent mistakes.
Although inevitable, such periods of poor results can be doubly costly for clients. After all, as portfolio managers, we can focus on the value of the underlying businesses, but clients can only see the prices. As a result, clients often lose confidence and get out after they have already suffered through the period of bad performance but before benefiting from the recovery. In these inevitable periods of underperformance, it is often helpful to remember that poor results may not reflect a flawed investment discipline but rather the fact that prices and values can irrationally diverge for relatively long periods of time.
Before turning to the reasons that such divergences can create real opportunities, we must also recognize the cases in which falling stock prices reflect substantial declines in the value of the underlying business. In these cases, we were mistaken in our business appraisals.
Q: What were the Fund's biggest mistakes?
A: As always, we must begin a discussion of mistakes with some definitions. Most important, we do not label an investment as a mistake simply because it trades below our purchase price. In fact, given market volatility, it is probable that every company we buy will trade below our purchase price at some point, especially in a bear market. Rather, we identify an investment as a mistake when our work indicates a significant reduction in our assessment of a company's intrinsic value. In some fortunate cases, especially during bull markets, we are able to identify the mistake before the market does and sell the shares without incurring a substantial loss. However, over the last several years, our two largest mistakes have resulted in a permanent and substantial loss of capital, as we were not ahead of the market in identifying declining intrinsic value. Chief among these mistakes was our investment in American International Group (AIG), which cumulatively detracted roughly 6% from our five year returns, almost three times as much as any other mistake. In our 2008 year-end report, we provided a detailed review of this mistake, which we commend to your attention. (Please click here to read this report.) Virtually all of the shares were sold in the first half of this year. Though we believe there may be value in the shares that exceeds today's market capitalization, we are not convinced that this value will be permitted to accrue to shareholders given today's charged political environment.
Our second largest mistake, which subtracted about 2% cumulatively from our five year returns, reached its sad conclusion in our fourth quarter 2008 sale of virtually all our Merrill Lynch shares at a substantial loss. Although our first purchase was at $48 per share, we added to our investment at lower prices giving us an average cost of $35 for all shares acquired. On September 15th Bank of America offered $29 per share to acquire Merrill Lynch. We sold the shares in the weeks following the announcement at prices ranging from $13 to $29 per share. As we wrote in our last report, though this investment was a mistake, we remain convinced that Merrill's powerful network of financial advisors combined with decisive management reduced our downside and prevented the sort of catastrophic loss we experienced in AIG and others experienced in firms like Lehman Brothers and Bear Stearns.
From both these mistakes, we learned an important lesson about the dangers of even high-quality firms relying on short-term debt markets for financing. This insight led us to sell our position in General Electric at more than twice today's price. While we are great admirers of GE's management and businesses, we were not as comfortable with its capital structure after what we had seen happen to AIG and Merrill. The fact that the lesson learned from our mistakes helped us dodge a significant loss in another holding is the only positive outcome we can point to from our two largest mistakes.
Q: Why do you have so much in financials?
A: Although we meaningfully reduced the percentage of the Fund invested in financial companies over the past five to seven years, the Fund continues to have a large weighting in financials relative to the S&P 500 Index, representing approximately 28% for the Fund versus 14% for the Index. Given that the worst carnage of this bear market was centered in the financial sector, it would seem that this overweighting in such a poor performing sector would have contributed to the Fund's relatively weak results. However, the companies that make up the financial category are not monolithic, but include a wide range of business models, many of which performed far better than those in the headlines. This wide range of results is understandable when we consider that an automobile insurer like Progressive has little in common with a regional bank like Wells Fargo & Company or a charge card company like American Express and so on. In fact, the financial companies that we hold that have been in the headlines over the past year, including American Express, JPMorgan Chase, Wells Fargo & Company, The Bank of New York Mellon, and Goldman Sachs, make up only about 13% of assets. Also, although we did mistakenly own AIG and Merrill, we did not hold or we sold positions in a number of other financial companies that were wiped out, including Fannie Mae and Freddie Mac, Countrywide, Bear Stearns, Lehman Brothers, and Washington Mutual. As a result, the negative of being overweight in financials was more than offset by the relatively strong performance of the specific financials we held and our avoidance of most, but not all, of the largest disasters. Thus, somewhat counterintuitively, the Fund's aggregate holdings in financials actually helped our relative results over the last one and five years and only detracted 0.35% from our relative results for the three year period.
That said, we must emphasize again that we do not structure the Portfolio on the basis of top-down sector allocations. Rather we construct it from the bottom up, company by company. Furthermore, while it is clear that the financial sector is made up of a very diverse group of companies, we should also mention that financial companies tend to share certain characteristics that we find attractive. For example, most financial business models are not prone to obsolescence. Further, given the collapse of the securitization markets and what has been called the shadow-banking system of non-bank finance companies, traditional financial institutions now face far less competition. In short, having come through a financial hurricane, these companies now face the prospect of greater demand for their products and services with far less competition.
Q: Why don't you have more in financials?
A: We can truly say that in the depths of the March crisis, it was hard to imagine a shareholder asking this question. However, given the steep rebound in financial stocks in the last three months combined with some of the observations made above, it is now a question we are beginning to hear. While we would never rule out owning more, we have two main concerns that offset some of the positives just outlined: regulation and leverage. Interestingly, these two concerns could hurt companies in opposite ways. If the economy rebounds strongly, harmful regulation would likely have the effect of reducing the returns many financial firms would otherwise have earned. Conversely, if the economy does not get better, the leverage embedded in most financial firms increases the risk of losses or further dilutive share issuance. Although leverage is lower today, the fact that we continue to face rising credit losses and that these losses are amplified by leverage is a real concern. Put another way, while today's valuations discount a significant increase in credit costs, there is no certainty that actual losses will not exceed even these conservative estimates. The upshot of all of this is that while we may well have missed an opportunity to buy more in the depths of the March panic (Wells Fargo, for example, briefly traded under $8 per share,) we had and have a relatively large weighting in these companies already considering the risks described above.
Q: What are the biggest changes in the Portfolio?
A: Because portfolio turnover in the Davis New York Venture Fund tends to be quite low, the Fund's holdings remain quite similar to what we have described in past reports and are divided very roughly into five subjective categories: global leaders or stalwarts; beneficiaries of the crisis in the capital markets or those companies whose business model or mindset allows them to take advantage of the chaotic environment; companies that are subject to "headline risk," most notably select financials (see above); energy, commodity and agriculture companies that benefit from the emerging middle class in China, India and Brazil; and a catch-all category of special situations including opportunistic investments.
Of these categories, we have been adding the most to the global stalwarts. In addition to holdings such as Procter & Gamble, Costco, Microsoft, Google, Schering-Plough, and Diageo, we initiated or added to our positions in Johnson & Johnson, Merck, Pfizer, Coca-Cola, and Becton, Dickinson. These companies are characterized by healthy balance sheets, strong competitive positions and durable business models. They generally have pricing power and the ability to pass through cost increases. Because such businesses produce excess cash, they are self-funding and have no need to regularly replenish capital. Beyond these factors, we place a particularly high value on the global aspects of these businesses for two reasons. First, only five percent of the world's population now lives in the United States. Further, although we remain bullish on the long-term prospects of our country, it seems likely that a number of other large economies will grow faster in the decades ahead. We consider it the best of both worlds to invest in proven U.S.-based companies that are well positioned to capitalize on these higher growth rates overseas. Second, although not certain, the likely long-term consequence of the dramatic increase in our federal budget and trade deficits will be a weaker dollar. Such an outcome will significantly increase the value of businesses with strong non-dollar earnings streams. It is amazing, for example, that by 2020, 90% to 95% of Coca-Cola's earnings may be generated from overseas.
Q: How have current events affected your firm?
A: Although the turmoil of the last year was dramatic, the fact that this year marks the 40th anniversary of the founding of our firm serves as a useful reminder that tumultuous periods in the market and economy have happened before and will happen again. Not long after our founding, the market declined almost 50% and unemployment soared to double-digit rates while our country remained mired in a deeply unpopular war. We have always managed our firm, like our funds, to get through such difficult periods. We are private, employee-owned, frugal, and well capitalized. We have no debt or derivatives. In this chaotic environment, we have hired three new research analysts. We remain committed to providing clients satisfactory long-term returns after expenses. We also are among the largest investors in the funds that we manage and have not sold a share throughout this downturn.
Looking ahead, Ken and I feel strongly that our team of analysts is the best we have ever had and we are often given credit for their work. Two that deserve special mention for their long-term contribution to returns are Danton Goei and Stephen Chen. We are proud to have such talented, dedicated and honorable colleagues.
Above all, we are privileged to have patient shareholders, the vast majority of whom have chosen to stay the course with us through this difficult time. For this we are sincerely grateful. We never forget the trust you have placed in us. ■
The Wisdom of Great Investors
Investing for the long term necessarily involves investing through periods of dislocation. Staying the course in such times can be difficult for investors. For this reason we have collected some useful lessons and insights from investors who managed successfully through challenging times in the past in The Wisdom of Great Investors:
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Avoid Self-Destructive Investor Behavior
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Understand That Crises Are Inevitable
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Don't Attempt to Time the Market
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Be Patient
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Don't Let Emotions Guide Your Investment Decisions
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Recognize That Short-Term Underperformance Is Inevitable
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Disregard Short-Term Forecasts and Predictions
For a copy of this brochure please contact your Davis Regional Representative at 800-717-3477. Click here to view the information online.
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DAVIS DISTRIBUTORS, LLC
2949 East Elvira Road, Suite 101
Tucson, AZ 85756
1-800-279-0279
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