Update from Portfolio Managers
Christopher Davis and Danton GoeiAnnual Review 2022
- Clipper Fund returned 17.8% in 2021.
- To find those select few companies that can grow at above-average rates and yet trade at a below-average valuation on current earnings, our research goes beyond simplistic categories to identify growth businesses with attractive valuations, as well as value businesses with attractive growth. By being highly selective, we have identified a portfolio of companies with this rare combination.
- Our disciplined portfolio reflects our conviction that the best way to build wealth is by finding those rare businesses that combine the best characteristics of both categories: substantial current earnings and bright future prospects.
- By being extremely selective, we have built a portfolio that has the best of both growth and value. While the earnings of our portfolio companies have grown more than 2% per year faster than the benchmark S&P 500 Index, they can currently be purchased at a 49% discount to the index. We consider this a value investor’s dream, as companies that grow profitably over time are more valuable than companies that don’t.
- Areas of opportunity include several dominant internet businesses, (Amazon, Alphabet and Meta [formerly Facebook]), financials (American Express, Bank of New York Mellon, Berkshire Hathaway, Capital One, JP Morgan, and Wells Fargo), overseas companies that serve the fast-growing and enormous Chinese middle class (Alibaba, JD.com and Tencent [via Naspers/Prosus]), and bargain-priced growth companies in the technology ecosystem that supply today’s hardware infrastructure (Intel and Applied Materials).
- With more than $2 billion of our own money invested alongside clients, our interests are aligned, and our conviction is more than just words.1
The average annual total returns for Clipper Fund for periods ending December 31, 2021 are: 1 year, 17.78%; 5 years, 11.46%; and 10 years, 13.14%. 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. For most recent month-end performance, click here or call 800-432-2504. Current performance may be lower or higher than the performance quoted. The total annual operating expense ratio as of the most recent prospectus was 0.71%. The total annual operating expense ratio may vary in future years. Clipper Fund was managed from inception, February 29, 1984, until December 31, 2005 by another Adviser. Davis Selected Advisers, L.P. took over management of the Fund on January 1, 2006.
For more than 35 years, Clipper Fund has built wealth through recessions and expansions, crashes and bubbles, fear and euphoria. In 2021, we added to this record, increasing shareholder wealth by more than 17%.
The chart below shows the growth in the value of an initial $10,000 investment over various periods.
Market Perspective: Looking Beyond Categories
Commentators often divide investment approaches
into two different categories: value and growth. Under
this taxonomy, value investors tend to place a greater
emphasis on a business’ current earnings, while
growth investors tend to stress its future prospects.
Because all businesses are worth the present value
of current and future cash flow, any rational valuation
methodology must incorporate both current earnings
and future prospects. As a result, we have often
argued that the division between growth and value
can create real opportunities for investors willing
to look beyond the categories, particularly when
investors are flocking to one approach and dismissing
the other. For example, as can be seen in the graph
below, from 1995–2000, the S&P 500 Growth Index
dramatically outperformed the S&P 500 Value Index
by more than 11% per year.2
This enormous dispersion created great risk for those who jumped in late and great opportunity for those (including us) who could recognize that growth had become overvalued and were willing to search for opportunities in the unpopular value side of the market. Sure enough, over the next five years, investors in the S&P 500 Growth Index lost almost a third of their savings, while investors in the S&P 500 Value Index earned a positive return, outperforming by approximately 10% per year.
Because the broader S&P 500 Index combines both approaches, growth and value tend to converge over the long term, as can be seen in the graph below, combining both periods.
This convergence (or reversion) reinforces the opportunity and risk created when the two approaches significantly diverge over shorter time periods. More importantly, although Clipper Fund significantly underperformed during the period when growth was in vogue, the Fund’s stellar results in the period that followed more than made up this lost ground, as can be seen in the graph below.
Today’s euphoric market and the enormous dispersion between growth and value bears striking similarities to the period of the late 1990s discussed above. As shown in the graph below, over the last five years, in an almost perfect echo of the second graph above, the S&P 500 Growth Index has outperformed by a staggering 12% per year.
Now as then, we believe that speculative growth has become overvalued and presents risk not just of relative underperformance, but also of absolute losses. Just as importantly, we also see enormous opportunity for those who recognize this risk and are willing to search for opportunities in the unpopular side of the market. Historically, such periods of extreme dispersion have always come to an end. Although predicting timing is never easy, we believe this game is already in extra innings and that the inevitable reversion may be imminent.
This conviction is not just informed by graphs and history, but by the underlying fundamentals to which we now turn.
Market Darlings Versus Durable Compounding Machines
While the above discussion of broad investment categories provides useful context, we always emphasize the old adage that investing is the art of the specific. With this in mind, an example may be helpful. Tesla, Nvidia and Shopify are three of the hottest momentum stocks in today’s market, each having compounded at triple-digit-rates over the last three years. Combined, these three have a market capitalization of roughly $2.3 trillion. In other words, should an investor happen to have a couple of trillion dollars lying around, one investment option, which we will call the Market Darlings portfolio, would be to buy 100% of these three remarkable growth companies and live off their current and future earnings.
An alternative option, which we will call the Durable Compounding Machines portfolio, would have the investor pay the same price of $2.3 trillion, but instead use it to buy 100% of Berkshire Hathaway, JP Morgan, Intel, Wells Fargo, Texas Instruments, Raytheon, Bank of New York Mellon and live off current and future earnings of these companies. Not coincidently, the Durable Compounding Machines portfolio represents a good cross-section of the holdings in Clipper Fund.
Because our hypothetical investor is going to live off the earnings of these businesses, both current earnings and future prospects are important investment considerations and should be carefully evaluated.
Let’s start with current earnings.
As can be seen in the table below, for roughly the same price of $2.3 trillion, the Market Darlings produce about $20 billion of current earnings, while the Durable Compounding Machines generate about $133 billion per year, almost seven times more. Consequently, from a current earnings point of view, it is no contest; any rational investor would choose the Durable Compounding Machines over the Market Darlings.
But how about if we incorporate the bright future prospects of the Market Darlings? After all, few would argue that the Market Darlings, Tesla, Nvidia and Shopify, don’t have bright futures. The question is, how bright would their futures have to be to earn the $133 billion that the durable compounding machines are earning today.
Mathematically, the answer is simple. These companies would need to increase their earnings almost sevenfold which, while not impossible, is no easy feat. For example, a company would need to grow profits almost 21% per year for a decade to achieve this outcome. However, even if they accomplish this spectacular growth, the fact that the earnings wouldn’t be generated for many years requires that investors discount them back to the present. Using even a modest discount rate, the power of compounding reduces the present value of that $133 billion to a much smaller number. In the meantime, the owners of the Durable Compounding Machines are earning that amount today and given that these companies have had long records of growth through good times and bad, we believe they should have a bright future.
Selectivity, Growth and Value
As the above discussion makes clear, successful long-term investors must consider both a company’s current earnings and its future prospects when evaluating a potential investment. The Holy Grail is to identify those select few companies that are able to grow at above-average rates and yet trade at a below-average valuation on current earnings. By being highly selective, we have identified a portfolio of companies with this rare combination.
Selectivity means that we invest in fewer than one out of every 15 companies included in the S&P 500 Index. Just as with the best universities or best companies, the ability to select from a large pool of applicants creates the opportunity to choose only the most exceptional candidates and reject those that are average or worse. Our research efforts comb through hundreds of potential investments, seeking those whose business and financial characteristics can turn long-term investments into compounding machines.
In particular, we look for durable, growing businesses that can be purchased at attractive valuations and reject businesses that generate low returns, are stagnant, overvalued, overleveraged or competitively disadvantaged. While funds that passively mirror the S&P 500 Index are forced to invest in all companies, including those that we view as significantly overvalued or competitively challenged, our selective approach allows us to reject such companies. In this environment of wide dispersions, the ability to selectively reject certain companies and sectors from our portfolio may prove just as valuable as the ability to selectively invest in others.
By recognizing both the value of growth and the importance of value, our portfolio holds those select few businesses that combine the best characteristics of both categories: substantial current earnings and bright future prospects. After all, categories do not build wealth. Nor do average businesses. Instead, generational wealth is built by investing in those select few businesses that combine durable and resilient growth with attractive valuations. To find such an attractive combination, our research goes beyond simplistic categories to identify growth businesses with attractive valuations, as well as value businesses with attractive growth.
Within the traditional growth category, growing euphoria has led to bubble prices for many companies, most especially those with new and unproven business models such as those discussed above. In contrast, our research focuses on a select handful of proven growth stalwarts whose shares still trade at reasonable valuations. For example, because of concerns about future litigation and regulation, several dominant internet businesses, including Amazon, Alphabet and Meta (formerly Facebook), trade at steep discounts to many unproven and unprofitable growth darlings that, in our view, trade at euphoric prices. While we expect a continued barrage of negative headlines around these names, as well as increased regulation in the years ahead, we do not expect a significant decline in their long-term profitability.
We have also found opportunities to buy proven growth companies at attractive prices by looking overseas at companies such as Alibaba, JD.com and Tencent that serve the fast-growing and enormous Chinese middle class.
Finally, we have found bargain-priced growth companies in less glamorous parts of the technology ecosystem. Like the manufacturers of picks and shovels during the Gold Rush, outstanding companies such as Intel and Applied Materials generate wonderful profits manufacturing the underlying hardware that enables such exciting but speculative new fields as self-driving cars, cloud computing, artificial intelligence, machine learning, software as a service and the Internet of Things.
In the same way our research focuses on durable growth companies that are not overvalued, we also seek out value companies capable of long-term growth. In doing so, we seek to avoid risks inherent in companies that we would classify as value traps or speculative value. While the shares of such companies may trade at cheap prices, their businesses are often fragile, impaired, prone to disruption or highly sensitive to the timing of an economic recovery. Decades of experience have taught us the dangers of owning weak businesses unable to withstand unexpected shocks, even if they sell at cheap prices. Although such speculative gambles may hit from time to time, poor businesses do not build generational wealth. Instead, our attention within the value part of the market remains steadfastly focused on companies that combine strength and resiliency with long-term growth, profitability and competitive advantages. In today’s uncertain economy, select financials represent the best combination of proven durability and low valuations.
Throughout the pandemic, high-quality financials demonstrated their resiliency. While their share prices gyrated wildly, their strong capital ratios and conservative loan portfolios allowed them to be part of the solution, rather than part of the problem. As investors consider the possibility of higher interest rates in the years ahead, financials should remain in favor, as most will earn higher profits while rates rise. The combination of rising dividends, falling share counts, resilient profits and some inflation protection should finally lead to the revaluation of select high-quality financials in the years ahead.
Although financial stocks have enjoyed a sharp recovery from last year’s panic-induced lows, we believe investors need not worry that they missed an opportunity. As can be seen in the chart below, financials remain one of the cheapest sectors in the market. What’s more, the current valuation of the financial sector is low, not just relative to the market, but even relative to its own historic discount.
In sum, our willingness to look beyond simplistic definitions and categories has led to a portfolio that includes growth companies at value prices and value companies with long-term growth. As can be seen in the table below, by being extremely selective, we have built a portfolio that has the best of both growth and value. While the earnings of our portfolio companies have grown more than 2% per year faster than the benchmark S&P 500 Index, they can currently be purchased at a 49% discount to the index.
While the pandemic extracted an awful toll on so many families, it also highlighted the inventiveness, creativity and ingenuity of our society. From ecommerce to biotechnology, this has been a period of explosive innovation, adaptability and resiliency and a powerful reminder of two seemingly contradictory investment truths.
First, unexpected bad things can and will happen. Over our company’s history, we have navigated countless dire and unexpected crises, including the energy crisis, the hostage crisis, the inflation crisis, 9/11, the financial crisis, the COVID crisis and the ongoing climate crisis. As fiduciaries, we must incorporate both expected and unexpected challenges and crises into every aspect of our investment process.
Second, we must also recognize the incredible power of innovation and invention. In the early stages of the pandemic, the most optimistic forecasts called for a vaccine in three-to-five years. And yet, scientists developed one in a matter of months. Similarly, over the longer term, human ingenuity has led to stunning progress in addressing a vast range of horrific global challenges. The graphs on the next page offer a compelling, if incomplete, quantitative picture of this progress.
Betting against progress has been a losing proposition.
Thus, while we always ensure that our portfolio companies have the durability and strength to withstand unexpected shocks and crises, we also select those that have the ability to innovate, adapt and build wealth in an ever-changing and unpredictable world.
With more than $2 billion of our own money invested alongside clients, our interests are aligned, and our conviction is more than just words. This alignment is an uncommon advantage, given that 88% of all funds are overseen by managers who have less than $1 million invested alongside their clients.
Although our investment discipline may not be rewarded by the market over shorter periods, our proven active management approach has built wealth for our shareholders over many decades.
We value the trust you have placed in us and look forward to continuing our investment journey together.
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.
Davis Advisors is committed to communicating with our investment partners as candidly as possible because we believe our investors benefit from understanding our investment philosophy and approach. Our views and opinions include “forward-looking statements” which may or may not be accurate over the long term. Forward-looking statements can be identified by words like “believe,” “expect,” “anticipate,” or similar expressions. You should not place undue reliance on forward-looking statements, which are current as of the date of this report. We disclaim any obligation to update or alter any forward-looking statements, whether as a result of new information, future events, or otherwise. While we believe we have a reasonable basis for our appraisals and we have confidence in our opinions, actual results may differ materially from those we anticipate.
Objective and Risks. Clipper Fund’s investment objective is long-term capital growth and capital preservation. There can be no assurance that the Fund will achieve its objective. The Fund invests primarily in equity securities issued by large companies with market capitalizations of at least $10 billion. Some important risks of an investment in the Fund are: stock market risk: stock markets have periods of rising prices and periods of falling prices, including sharp declines; common stock risk: an adverse event may have a negative impact on a company and could result in a decline in the price of its common stock; financial services risk: investing a significant portion of assets in the financial services sector may cause the Fund to be more sensitive to systemic risk, regulatory actions, changes in interest rates, non-diversified loan portfolios, credit, and competition; focused portfolio risk: investing in a limited number of companies causes changes in the value of a single security to have a more significant effect on the value of the Fund’s total portfolio; foreign country risk: foreign companies may be subject to greater risk as foreign economies may not be as strong or diversified; As of 12/31/21, the Fund had approximately 12.7% of net assets invested in foreign companies; headline risk: the Fund may invest in a company when the company becomes the center of controversy. The company’s stock may never recover or may become worthless; large-capitalization companies risk: companies with $10 billion or more in market capitalization generally experience slower rates of growth in earnings per share than do mid- and small-capitalization companies; manager risk: poor security selection may cause the Fund to underperform relevant benchmarks; depositary receipts risk: depositary receipts may trade at a discount (or premium) to the underlying security and may be less liquid than the underlying securities listed on an exchange; fees and expenses risk: the Fund may not earn enough through income and capital appreciation to offset the operating expenses of the Fund; foreign currency risk: the change in value of a foreign currency against the U.S. dollar will result in a change in the U.S. dollar value of securities denominated in that foreign currency; and mid- and small-capitalization companies risk: companies with less than $10 billion in market capitalization typically have more limited product lines, markets and financial resources than larger companies, and may trade less frequently and in more limited volume. See the prospectus for a complete description of the principal risks.
The information provided in this material should not be considered a recommendation to buy, sell or hold any particular security. As of 12/31/21, the top ten holdings of Clipper Fund were: Alphabet, 10.88%; Berkshire Hathaway, 8.98%; Wells Fargo, 7.82%; Capital One Financial, 7.50%; Bank of New York Mellon, 5.88%; Markel, 4.88%; U.S. Bancorp, 4.83%; Meta Platforms, 4.77%; Amazon.com, 4.58%; and Intel, 4.53%.
Clipper Fund has adopted a Portfolio Holdings Disclosure policy that governs the release of non-public portfolio holding information. This policy is described in the prospectus. Holding percentages are subject to change. Click here or call 800-432-2504 for the most current public portfolio holdings information.
Clipper Fund was managed from inception, 2/29/84, until 12/31/05 by another Adviser. Davis Selected Advisers, L.P. took over management of the Fund on 1/1/06.
Forward Price/Earnings (Forward P/E) Ratio is a stock’s current price divided by the company’s forecasted earnings for the following 12 months. The values for the portfolio and index are the weighted average of the p/e ratios of the stocks in the portfolio or index.
Five-Year EPS Growth Rate is the average annualized earning per share growth for a company over the past five years. The values for the portfolio and index are the weighted average of the five-year EPS Growth Rates of the stocks in the portfolio or index.
We gather our index data from a combination of reputable sources, including, but not limited to, Lipper, Wilshire, and index websites.
The S&P 500 Index is an unmanaged index of 500 selected common stocks, most of which are listed on the New York Stock Exchange. The index is adjusted for dividends, weighted towards stocks with large market capitalizations and represents approximately two-thirds of the total market value of all domestic common stocks. The S&P 500 Value Index represents the value companies of the S&P 500 Index. The S&P 500 Growth Index represents the growth companies of the S&P 500 Index. Investments cannot be made directly in an index.
After 4/30/22, this material must be accompanied by a supplement containing performance data for the most recent quarter end.
Shares of the Clipper Fund are not deposits or obligations of any bank, are not guaranteed by any bank, are not insured by the FDIC or any other agency, and involve investment risks, including possible loss of the principal amount invested.
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Davis Distributors, LLC, is the distributor of the Fund.