Positioning for a Market in Transition

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Transcript

Chris Davis: 

One of the fundamental principles that Davis advisors is to provide our investors with the information that we would want if our seats were reversed.

So today, I'd like to spend a little time looking backwards at the past and give you a review of our results.

I'd like to spend more time talking about the present, about perspectives on this fast-changing environment, both economic and geopolitical environment, and above all, I want to spend time on the future. On the way in which our portfolios are positioned, and in particular, our large cap separately managed portfolio is positioned to make progress in the future.

The most important data point that I can give you is captured on this slide.

What we have in the portfolio today is what my father once called a value investors dream.

By being highly selective, we've been able to identify companies that have this extraordinary combination of evaluation that is significantly lower, not just than the S&P 500, but significantly lower than the value indices against which we're most commonly judged.

And yet, despite having companies that trade at such a discount, our portfolio companies have actually achieved growth that it significantly exceeds The S&P 500 and dramatically exceeds the value, uh, the companies that make up the value index.

I'd like to begin by looking backwards at our results and giving you an accounting of how we've been doing. Now most of our clients for our separately managed accounts judge us versus the Russell 1000 value and as you can see here we've outperformed in all of these periods.

Now we never want to hide from the fact that we still have ground to make up against the S&P 500.  And we have outperformed the S&P 500 over the long term, but in more recent periods we have ground to make up.

As you can see here, the margin of our outperformance compounded over a long period of time is simply studying when you weigh in the effects of compounding.

In other words, $100,000 account created at our inception is now worth about $66 million. Sort of staggering advantage relative to if that money had just been invested in the S&P 500 and even more importantly look at the very bottom of this chart at what it would have been if it had sat in T-bills.

And in a sense, the real lesson is that you can't sit on the sidelines, you need to be invested in equities and that active management can add significant value compounded over a long period of time.

Now let's talk about the context in which we're investing today. Because we have this unusual confluence that's characterized by both transition and by complacency.

And I want to unpack each of those separately. So let's start with this idea of transition. What's so extraordinary, uh, in the today's investment environment, is that investors, the market and the economy, are facing a three-pronged transition.

Every one of these is enormously significant. The first is an economic transition, as we've moved from almost 15 years of easy money, really what we call the free money era, where interest rates for the first time in recorded history approached zero and stayed there for a prolonged period of time.

That began unwinding when the Fed started raising interest rates two years ago, but the consequences of that unwinding are going to grind through the economy slowly over the decade ahead, but they're enormously important consequences.

The second transition is technological transition. There is so much hype about, uh, AI that is out there that you're getting bombarded with every day.

But this is a transformation in the underpinnings of our entire, uh, country and economy. And understanding how that will roll out, how business models will be disrupted, how new businesses will be created, as this powerful tool gets rolled out, is an important transition that is easy to overestimate in the short term, but underestimate in the long term.

And then the third transition of these three-pronged transition is the geopolitical transition.

Obviously, every day you wake up, you turn on the news, you open the newspaper, and you're aware of this massive geopolitical transition.

And I'm not just talking about, you know, a pronouncement out of DC, I'm talking about the unwinding of almost 40 or 50 years of globalization.

And all of the economic consequences, they come from that as countries think about supply chains of tariffs, of reshoring, uh, their enormous consequences from these geopolitical transitions, these changes in alliances, these changes in trade patterns, these changes in tariffs.

So those three transitions are the first part of the backdrop that investors are facing today. But what's really unusual is normally when there's a time of transition and uncertainty, it's coupled with fear.

And fear tends to create lower valuations. So when you have massive change, huge uncertainty, investors would generally expect low valuations.

And instead, of uncertainty. Investors have faced this market with enormous complacency in denial. Now, people are all the days talking at cocktail parties about anxiety and uncertainty, but it's not reflected in valuations.

Before we turn to the details of the companies that make up this portfolio that couples above average growth with below average valuation, I want to unpack a little bit the idea of the complacency and denial that we see in the market averages with the indexes at today's level. So let's start with valuation. When you simply look at the PE of the market, you see this extraordinary pattern of just how far outside of the norm we are.

Now, we're going to talk a little bit about the concentration in the largest companies in the index, and there I would say, just as a thought to file away, that the market seems expensive. The market is expensive. And it is true that the market is not as expensive as it seems. But even removing the largest companies, the market remains at the high end of its historic range of valuation, including those companies, and it blows out of the top as it did in the late 90s, and then all the way to the late 60s before that.

Now let's look at another cut  on this question of valuation. And let's look at the so-called Buffett indicator, which looks at stock market cap as a percentage of GDP.

And again, with this different slice of the data, you still see the same pattern. We are at the very, very high end of anything that is recurred in recent history. You go back again to the late 90s, and then all the way back to the 60s, uh, to understand just how far above the averages we are.

Now, I talked a little bit about concentration and often concentration has also been an indicator of extremes in the market. And here you can see the same pattern recurs that we are at a level of concentration that has only been seen at other market tops in the past. In the late 90s and again back to the late 60s. So these are all three different indicators. Of a type of complacency and denial that is in the market.

Now, I want to spend a minute on those largest companies because, of course, investors who are bullish about the market as a whole are quick to point out those magnificent seven are wonderful companies.

And we have no argument with that. The real question is the presumption of the durability of both sales growth And of margins, both of which are very difficult to maintain for very long periods of time. So here you can see how sales growth over time fewer and fewer companies have been able to maintain high levels of sales growth.

So again, when somebody is discounting in another decade of very high sales growth, you can see how extraordinarily unlikely that is. Now, what makes it even more extreme is that it's not just that investors are modeling in the sales growth rate continuing for another decade, but they are also modeling in that somehow margins will also be sustainable for that decade.

So here you can see how sales growth over time fewer and fewer companies have been able to maintain high levels of sales growth.

So again, when somebody is discounting in another decade of very high sales growth, you can see how extraordinarily unlikely that is.

Now, what makes it even more extreme is that it's not just that investors are modeling in the sales growth rate continuing for another decade, but they are also modeling in that somehow margins will also be sustainable for that decade.

And as you can see here, there's the same pattern, enormous, uh, enormously low probability of being able to sustain such very high margins for another decade ahead.

So as, uh, uh, what have I favorite market commentators once said, you know, the race is not always to the swift, uh, nor the fight to the strong, but that's the way to bet.

The probabilities here point to a complacency in presupposing that both high revenue and high sales will continue to prop up that very high end of the market.

 

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