Since its inception in 1991, Davis Financial Fund has invested in durable, well-managed financial services companies at value prices that can be held for the long term. In 1991, financial stocks were deeply unpopular. The scandals of the savings and loan crisis and the steep decline in commercial real estate that occurred in the late 1980s and early 1990s were fresh in investors’ memories. However, where others saw unfavorable news, we recognized opportunity for the simple reason that even as investors were avoiding financial stocks, many underlying financial businesses were both durable and improving. By focusing on economic reality rather than investor sentiment, Davis Financial Fund has compounded shareholder wealth at 10.89% over the 30+ years since then, outpacing both the S&P 500 Index and the S&P 500 Financials Index.
In the first seven months of 2022, Davis Financial Fund returned -11.39%, painful in absolute terms though relatively better compared with the S&P Financials Index at -12.86% and the S&P 500 Index at -12.58%. The price declines among financial stocks was fairly consistent among subsectors, with the notable exceptions of insurance, which held up better and was the primary source of the Fund’s relative outperformance.
The Current Environment for Financials
The macroeconomic environment has changed dramatically since the start of the year. Discussion has to commence with the re-emergence of inflation, which stood at 8.5% year-over-year as of July 2022.1 Depending on whom you ask (and your political leanings), the drivers of this inflation are supply chain disruption, expansionary monetary policy, excessive fiscal stimulus, the war in Ukraine and underinvestment in energy production and refining capacity. All of the above seems likely to be the answer to us.
Energy is undoubtedly the epicenter of the price increases. In aggregate, it accounts for approximately 9% of the Consumer Product Index (CPI) and increased by +33% over the past year. Gasoline alone increased +44%, but utility bills for electricity and natural gas are higher by double digits also. Vehicles are another notable source of the observed price inflation, with new and used vehicles up +13% and +16%, respectively. They account for another 8% of the CPI. To a large extent, we would classify these as relative price increases, which is to say that they would have occurred even in the absence of general inflationary pressure, due to what our university professors called adverse supply shocks.
There is no reason to assume that these goods should see their prices continue to increase at the same pace. But it certainly does mean that, all else equal, consumers are poorer as a result, and consequently, there should be a depressing effect on the economy.
But importantly, the observed price inflation is no longer limited to those goods experiencing such supply shocks. Price inflation for all consumer purchases other than energy, food (which also tends to be volatile, has been subject to its own supply constraints, and increased +11% year-over-year) and vehicles has accelerated to approximately 5.5% compared to less than 3% a year ago,2 and well above the Federal Reserve’s stated target average of 2%. This “across the board” increase in prices is of the pernicious kind that can get built into expectations, potentially leading to a wage/price spiral.
The Federal Reserve, not surprisingly, has responded to the re-emergence of inflation by raising short-term rates more and faster than had been expected at the outset of the year to reign in aggregate demand. The futures contract for fed funds now implies that the effective rate will be around 3.25% by the end of 2022, up approximately 250 basis points since December 31, 2021. The ten-year Treasury yield is up approximately 115 basis points to 2.65%. Such increases in interest rates will be beneficial to banks’ revenue. To illustrate the point, JP Morgan Chase (JPM, Financial) disclosed during the quarter that it now expects to exit 2022 with annualized net interest income of $66 billion, up more than $20 billion from 2021, and all else equal, equivalent to approximately 40% of 2021’s net earnings.3 Our view has consistently been that interest rates would normalize in time, but we couldn’t know when. In that same vein, the impact of higher interest rates on banks’ earnings should not be conflated with a change in our estimate of intrinsic values, other than that sooner is better on the margin, but it does illustrate the “coiled spring” that was awaiting release while interest rates were so low, which we felt was not fully captured in banks’ valuations going into the year.
However, bank stocks have performed poorly in 2022, with the KBW Bank Index down 16.6% through the first seven months. Investors’ concern about banks has shifted from the depressing impact of low interest rates on bank profitability to the likelihood of the economy falling into recession and the loan losses that would follow. We aren’t macro forecasters, but the combination of the above-noted adverse supply shocks and the Federal Reserve’s desire to rein in aggregate demand to check inflation does put downward pressure on our economy. A recession in the next year or so is certainly plausible. But more important in our view is that a recession was always inevitably going to occur at some point in the future, even when there was no sign of it on the horizon. The question for investors then is, what is priced into valuations?
We think U.S. banks are very well positioned to weather the next recession, whenever it may come. They are holding almost twice as much capital as before the 2008 financial crisis, and their credit underwriting appears to be considerably more disciplined. In the annual stress test just conducted by the Federal Reserve, the eight largest U.S. bank holdings in our portfolio are modeled in aggregate to lose (pre-tax) approximately 12% of their starting common equity capital in a “severely adverse scenario” that envisions unemployment peaking at 10%, a 3.5% decline in real GDP, residential housing down -28.5% and commercial real estate down -40%.4 Any recession is, by definition, likely to be far more moderate than this scenario, and we think it’s quite likely that these banks will actually generate capital over the next couple years, albeit not necessarily in a straight line. This same basket of banks is collectively valued in the market at 1.5x tangible book value, and we think they should earn a mid-teens return on equity on average and over time. It’s a powerful combination for investors, particularly if you also factor in even just a modest amount of business growth.
Property and casualty insurance and reinsurance (“P&C”) stocks performed well on a relative basis in the first seven months of 2022, with a median return for P&C companies within the S&P 500 Financials Index of 0%. This sector was the primary source of the Fund’s relative outperformance of the index in the first seven months of 2022, given our 19% position in P&C companies at the outset of the year.5 One of our holdings (since sold), Alleghany Corporation (Y, Financial), was the target of an all-cash acquisition offer at a 27% premium to its share price at the start of the year. The double-digit price increases over the last couple of years are showing through in their attritional underwriting profit margins.6 While the pace of price increases has slowed, the current outlook seems to call for this improved profitability to be sustained in the medium-term. We have reallocated some of the capital invested in P&C companies as the relative risk/reward has shifted in favor of our bank holdings.
Davis Financial Fund does not currently own any of the prominent so-called “fintech” companies, though we study them closely. At the right price, they could of course be attractive investments in their own right, but at minimum, we must be aware of the competitive risks they pose to the industry incumbents. Fintech stocks have been on a roller coaster in the last few years, climbing to incredible highs in mid-2021—a group of seven of them were valued then at more than $700 billion.7 For roughly the same price, an investor could have bought all of JP Morgan Chase, Charles Schwab (SCHW, Financial) and American Express (AXP, Financial). In theory, market prices should be discounting consensus expectations of all future cash flows. The market prices of mid-2021 were certainly implying a very bright future for these disruptive business models. Since then, as the chart below shows, the fintech basket has lost 74% of its value. Admittedly, we can’t say with certainty whether it’s the highs or the lows that are the “right” prices. There is, however, a real-world implication for the abrupt change in valuation: fintech companies’ previous high valuations and low cost of capital gave them the resources to invest heavily in their technology and marketing. They no longer have such a blank check.
To sum up, investors’ fears of a future recession are weighing on the stock prices of financial companies, notably banks. While such an event certainly could come to pass in the next year or two (indeed an eventual recession is inevitable), we believe banks are far better positioned to withstand it, and their valuations are so low that we think they should generate strong returns over the next decade
Our approach to assembling our portfolio has remained constant over time: We look for companies with durable competitive advantages, coupled with competent and honest management, priced at a discount to their intrinsic value. We invest under the presumption that we will own our companies through business cycles. We do not attempt to build a portfolio around a particular speculative forecast of where interest rates or the economy will go, but strive to construct a portfolio that will perform well over the long term across a range of outcomes. The resulting portfolio is diversified across leading franchises earning above-average returns on capital in banking, payments, custody, wealth management and property and casualty insurance.
We are excited by the investment prospects for the companies in Davis Financial Fund. Nothing provides a stronger indication of that than the fact that the Davis Family and colleagues have more than $70 million invested in the Fund alongside our clients.8 We are grateful for the trust you have placed in us.
1Source: Bureau of Labor Statistics.
2CPI inflation excluding food, energy and vehicles is calculated by DSA from the data disclosed by the Bureau of Labor Statistics.
3Source: JP Morgan Chase Investor Day on 5/23/21 and DSA analysis. Net earnings in this calculation are adjusted for changes to loan loss reserves.
4Source: 2022 Federal Reserve Stress Test Results. Basket of banks includes BAC, BK, COF, FITB, JPM, PNC, USB and WFC. Pre-tax losses exclude the modeled trading and counterparty losses attributable to market-making businesses.
5Excluding the 6.1% position in Berkshire Hathaway, which also has a sizeable insurance operation.
6Attritional underwriting profit excludes catastrophe losses and adjustments to loss reserves related to prior years.
7The fintech “basket” includes PayPal, Block, Adyen, Afterpay (since acquired by Block), Affirm, Robinhood and Coinbase. Aggregate market capitalization cited as of 8/31/21
8As of 6/30/22.
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. These comments may also include the expression of opinions that are speculative in nature and should not be relied on as statements of fact.