Update from Portfolio Managers
Christopher Davis and Danton GoeiFall Review 2022
- Looking over the last 10 years beginning July 31, 2012, Clipper Fund built shareholder wealth at 10.65% per year, turning a $10,000 investment into more than $27,000.
- Clipper Fund is well positioned to navigate the current period of uncertainty, which includes a bear market, recessionary fears and higher inflation.
- Our carefully selected companies have grown earnings per share at almost 22% per year over the last five years, a remarkable 4% per year faster than the S&P 500 Index. Yet they are currently valued at less than 10x earnings, a 43% discount to the S&P 500 Index.1 Higher growth at lower valuations is a rare combination and one that positions us well for the years and decades ahead.
- The majority of our portfolio is invested in companies with strong, liquid balance sheets and little or no short-term funding needs.
- We see significant opportunity in growth companies trading at value prices and value companies with durable growth prospects.
- We believe the banking sector represents a significant opportunity given high capital levels, proven resilience, high dividends and record low relative valuations.
- Because of their power, stability and scope, we remain confident in the great tech platforms, particularly Alphabet, Meta and Amazon.
- With more than $2 billion of our own money invested alongside clients, our interests are aligned, and our conviction is more than just words.2
The average annual total returns for Clipper Fund for periods ending June 30, 2022 are: 1 year, −21.72%; 5 years, 5.19%; and 10 years, 10.10%. The performance presented represents past performance and is not a guarantee of future results. 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.
As we write this review, there is war in Ukraine, a bear market in U.S. stocks, soaring global inflation and implications of a recession.
So why is this a good time for long-term investors?
As anyone who watches the news can see, the struggles that individuals, families and our country face are not to be taken lightly. As citizens, we do not wish for times of fear and suffering. As investors, however, we know that remaining unemotional through turbulent times is a requirement for success.
To understand why, we recognize two simple truths. First, fear lowers prices. Second, lower prices increase future returns. The first is learned from experience and the second from arithmetic. Imagine you had a neighbor who owned a local car wash business that reliably produces $100,000 per year of income. Buying this business for $1 million would give you a 10% future return. If, instead, your neighbor was panicking and offered you the business for $500,000, your return would double to 20%. The same business purchased at a lower price will mathematically produce a higher return. We do not welcome times of fear; rather, we welcome the lower prices that such times produce, a concept succinctly captured in Shelby Cullom Davis’ famous observations: “You make most of your money in a bear market, you just don’t realize it at the time.”
In the text that follows, we will look backwards at results. More importantly, we will look ahead at how we believe the actions we are taking in today’s bear market will affirm this wisdom. Specifically, we will provide a longer-term context for current events, share with you how we have prepared the portfolio for market and economic downturns, outline our thoughts concerning systemically higher inflation, and most importantly, describe the investment opportunities created for long-term investors who can remain rational when fearful sellers race for the exits.
Clipper Fund was launched by our predecessor in 1984. Since then, our country has endured periods of growth and contraction, crises and complacency, bubbles and busts. These include the crash of 1987, the S&L crisis, the (first) Russian bond default, the Asian Contagion, the invasion of Kuwait, the dot-com bubble, September 11th, wars in Iraq and Afghanistan, the financial crisis, the Great Recession, the Euro Crisis, COVID, the Russian invasion of Ukraine and more. If, at Clipper Fund’s inception, an investor had been able to predict the litany of crises and calamities that lay ahead, they may well have decided to remain on the sidelines rather than invest at such an uncertain time.
They would have been wrong.
As the graph below shows, $10,000 invested at Clipper Fund’s inception would be worth more than $520,000 as of June 30, 2022, more than 15 times the amount the investor would have received sitting on the sidelines earning the risk-free rate.
Looking at results over different time periods, we can see that for all periods over one year, the longer a shareholder in Clipper Fund has remained invested with us, the more wealth has been built.
Our long-term record of building generational wealth includes periods like today when our investment approach was out of sync and relative results lagged the market. For example, looking over the last 10 years beginning July 31, 2012, Clipper Fund built shareholder wealth at 10.65% per year, turning a $10,000 investment into more than $27,000. Importantly, this result includes the negative returns of the current bear market. If you stopped the clock almost six years into this 10-year stretch on February 1, 2018, we would have generated a cumulative 139%, a result that slightly beat the S&P 500 Index’s return (by 0.80% per year, to be precise).
However, as described in our 2021 annual update, the latter part of this decade was characterized by an enormous dispersion in which speculative growth companies surged into bubble territory, driving the S&P 500 Index up more than 58% from February 2018 to July 31, 2022 and leaving value investors like us with a cumulative return of only 15.36% trailing way behind. Putting these periods together has resulted in a decade in which absolute returns have been on track, but relative returns have lagged substantially, almost entirely due to the enormous dispersion of the last four years.
While this relative performance gap has persisted through the start of the current bear market despite the collapse of some of the risky high flyers we predicted in our last report, we believe we have set the stage to meaningfully make up this ground. This conviction is driven by the characteristics of the carefully selected companies that make up Clipper Fund.
In addition to the resiliency, durability and ability to prosper in times of inflation (all of which will be discussed below), these high-quality companies have grown earnings per share at almost 22% per year over the last five years, a remarkable 4% per year faster than the S&P 500 Index. As shown in the table below, however, despite this outstanding record of growth, these high-quality companies are currently valued at less than 10x earnings, a 43% discount to the S&P 500 Index as of June 30, 2022. Higher growth at lower valuations is a rare combination and one that positions us well for the years and decades ahead.
The Futility of Forecasts
Clipper Fund’s long record of building generational wealth through so many different economic and political environments does not result from our ability to make economic, monetary or political forecasts, but rather our ability to identify durable, growing and undervalued companies, prepare for uncertainty and adapt to changing times, a discipline that can be distilled to three words: Don’t predict. Prepare.
While this may sound obvious, given that none of the crises highlighted in the graph on page 3 were predicted by the experts, one need only turn on the news to see the same experts who failed to predict what has already happened boldly predicting what is going to happen next. As John Kenneth Galbraith famously said, “The function of economic [and, we would add, political and market] forecasting is to make astrology look respectable.” As can be seen in the graph below, for example, the forecasts of Wall Street’s top strategists (shown in blue) are essentially uncorrelated to what actually happened. (We could easily show similar charts for political, interest rate and economic forecasts.)
Reacting to such forecasts is a recipe for disaster. Instead of trying to make short-term predictions, we prepare for uncertainty by identifying a select portfolio of high-quality, durable companies that can withstand corrections, recessions and inflation and build generational wealth for shareholders over the long term.
Investing Through Market Corrections
Market corrections like the one we are experiencing are an unpleasant but inevitable part of the investment landscape. As shown in the table below, over the last 100 years of market history, a 10% correction occurs roughly once per year and a 20% bear market roughly every three years.
Although knowing when a correction or market shock will occur is unpredictable, knowing that one will occur is certain. Because we will certainly be investing through such episodic times of market dislocation, we avoid companies that require short-term access to capital markets. As became clear during the junk bond crisis of the late ‘80s, the dot-com bust of the early 2000s, the financial crisis and, most recently, in today’s downturn, capital markets can be fickle. When the market window is closed, even decent businesses can be forced into a distressed sale and even bankruptcy if they require funding.
In contrast, we prepare for market corrections by focusing on two types of companies. First, we invest the lion’s share of the portfolio in companies with strong, liquid balance sheets and little or no short-term funding needs. These companies could be described as resistant or even indifferent to dislocations in capital markets. Examples of such holdings include companies like Applied Materials and many of our internet platform companies that have net cash positions. Second, we invest in a select handful of companies that we would describe as “anti-fragile”, a phrase coined by Nassim Taleb to refer to companies that actually gain from market disorder. In saying this, we are not predicting that the stock prices of such companies will go up in a bear market, but rather that their business models and strategies are designed to create value when markets are in turmoil. Examples in our portfolio include Berkshire Hathaway and Markel, both of which have a contrarian record of putting money to work when others are panicking.
To this list, we might also give partial credit to companies with trading operations that benefit from market volatility, such as JP Morgan, and companies with the capacity and history of repurchasing their own shares as they fall, a rare characteristic that we particularly value. Because repurchasing shares at lower prices increases return on capital, a number of our tech and financial holdings (discussed further below), as well as the handful of Asian technology platform companies (like JD.com and DiDi Global) that we own, may also share this valuable anti-fragile characteristic.
Investing Through Recessions
Though less frequent than market declines, economic recessions are similarly inevitable. However, they present significantly more risk and opportunity for investors.
This larger risk is created by the fact that while market corrections only impact businesses that require access to capital, economic downturns affect virtually all businesses. As the economy contracts, falling revenue can have a magnified impact on a company’s bottom line, leading to significant losses and even distress. This is especially true for companies with high fixed costs and leveraged balance sheets. Such highly cyclical companies are especially fragile as they may ultimately be forced to raise capital at distressed prices (see above). Although companies with fixed costs and balance sheets leverage can be rocket ships in good times, we avoid them for the simple reason that recessions are inevitable. As a result, for our portfolio companies, we demand the strength and durability to get through such downturns without jeopardizing long-term earnings power or issuing more shares. That does not mean that the short-term earnings of our companies won’t decline, many will, but rather that their long-term earnings power, competitive position and capital structure will weather the storm.
Importantly, when investors are fearful of an impending recession, they tend to be aggressive sellers of all businesses whose earnings are economically sensitive, without discriminating between those that are durable and those that are fragile. While this lack of discrimination is a contributor to our lagging short-term results, it will be an accelerant to returns as the market’s perception changes and the durability of our companies becomes apparent. Because these companies may benefit from both recovering earnings and multiple expansion, we view their current underperformance like a coiled spring, primed for a future snap back.
Although this opportunity applies to several of our industrial holdings, it is the dominant theme for our investment in select banks like Wells Fargo, Capital One and U.S. Bancorp. The great financial crisis created a once-in-a-generation transformation of the U.S. banking system at all levels. At the regulatory level, banks are now required to hold more capital than any time in their history, making them far more resilient. Beyond increased capital, banks have also been subject to much stricter regulation, including an annual stress test that assures they can weather an economic catastrophe far worse than either COVID or the financial crisis.
At the company level, the financial crisis reinforced the importance of conservatism in lending. While there is unquestionably credit risk in the system, our research indicates that the risk is predominantly outside of the banking system, in areas like high-yield and private credit, rather than on our banks’ balance sheets. Finally, at the investor level, the demise of companies like Fannie Mae, Freddie Mac, Countrywide, WAMU, Lehman and Bear Stearns (none of which we owned) still lingers in investors’ minds, making them mistakenly think that banks are fragile when we believe they are in fact better capitalized and less risky than they have ever been. The poor performance of bank shares in the last several months reminds us of the early days of the pandemic when bank shares dramatically underperformed, only to snap back to new highs as investors realized that the sector was well prepared for a recession. Today, banks are trading at or near their lowest relative valuation in history. As the recession unfolds and banks demonstrate their resilience while continuing to pay handsome dividends, we expect our bank holdings to become a powerful driver of future returns.
In contrast to our approach, panicked investors
are selling bank holdings and flocking to a small
handful of companies and industries that have
historically been recession resistant. We consider
such a strategy highly risky for two reasons. First,
it overvalues short-term earnings prospects over
long-term cash generation. Earnings of $2 million
this year, zero next year and $2 million the year
after are more valuable than earnings of $1 million
this year, $1.1 million next and $1.2 million the year
after. Second, many companies that have historically
been recession resistant may face other challenges
that make their futures bleaker than their past.
In industries like consumer staples, the erosion of once-dominant consumer brands, when paired with increasingly leveraged balance sheets, may make companies that were once safe havens far riskier in the future.
Putting these two thoughts together, investors who fear a recession will often pay silly prices for smooth earnings from companies with competitively disadvantaged futures, while significantly undervaluing durable and growing businesses, such as our bank holdings, simply because they happen to exhibit more short-term earnings volatility.
As we invest through a time of recession, the enormous valuation discount presented in the chart below should begin to close, creating a double play of rising earnings on rising valuations. In the meantime, high dividends and steady share repurchases make select banks one of the best investment opportunities facing patient investors in today’s market.
Investing Through Inflation
No investor who has been in the profession for less than 40 years has ever seen a period of rising inflation. In this context, we view our long history as an enormous advantage. While many of today’s investors consider bonds low-risk investments, legendary investor Shelby Cullom Davis referred to them as “certificates of confiscation.”
To understand why we continue to hold this view, we must first recognize that the decision to invest rather than save is really a decision to put off buying something today with the expectation that you will be able to buy more in the future (otherwise, why defer the purchase?). As a result, what matters over time is that an investment increases the holder’s purchasing power. Over a long period of time, the erosion of purchasing power can be staggering. For example, over the last 50 years, purchasing power has fallen more than 88%. Even in periods of low inflation, investors are often surprised at the pernicious and relentless impact of price increases. As shown in the graph below, even in the low inflationary period we have enjoyed since 2000, purchasing power has fallen more than 40%.
After decades of low inflation, we now face a period of systemically higher inflation. While there is debate about how long this period may last, we are confident that recent increases in wages, the most important contributor to inflation, will not reverse and that other contributors such as supply chain and commodities will take time to come back under control.
In times of inflation, investors must decide what to avoid as well as what to own. Speaking to the former, many investment classes previously viewed as safe, most notably cash and bonds, are almost certain to decline in value, perhaps substantially, especially when viewed in terms of purchasing power rather than notional price. Real estate investments are a mixed bag in inflationary times, depending on capital structure, lease terms and operating costs, not to mention the impact of work-from-home trends on office values and online shopping on shopping mall owners. Finally, companies with meaningful cost inputs (labor, energy and materials) and/or high required capital spending will see significant margin and return erosion if they are unable to pass along those higher costs to customers. (Given dollar appreciation, this is a particular worry for companies with lower-cost foreign competitors.)
Turning from risk to opportunity, businesses whose revenue and prices go up with inflation faster than their costs can be very resilient. In the 1970s, for example, advertising firms significantly outperformed. Today’s equivalent of the Madison Avenue ad giants of that era are the great tech platforms, particularly Alphabet and Meta. Similarly, while Amazon will see some pressure from higher labor costs, its scale gives it a huge leg up on traditional retail competitors, while its high margin and inflation-protected advertising and cloud services businesses should continue to grow significantly. Finally, we should mention that the earnings of several of our financial holdings, including Bank of New York Mellon, American Express and our bank holdings, will all benefit from higher interest rates.
The last 12 months have represented a complete change in market fundamentals and sentiment as we moved from a time of record-low interest rates, speculative bubbles and market highs to a period of inflation, recession and a bear market. However, the seeds for this change were planted in the excesses of the last five years. As we highlighted in our past reports, signs of speculative excess were apparent in so many different aspects of market and economy, from artificially low interest rates to Special Purpose Acquisition Companies (SPACs) to the fact that 73 companies in the S&P 500 Index traded at more than 10 times sales!
During that stretch, especially the last five years, our focus on durability, resiliency and valuation left us out of the hottest areas of the market, and though we grew the value of the assets entrusted to our stewardship, we significantly lagged the indices. As fear and pessimism have set in, investors have been selling indiscriminately, with the result that the prices of our companies have declined roughly in line with the market index, and we continue to have ground to make up.
So why are we convinced that now is an excellent time to invest in Clipper Fund? Because, as Warren Buffett famously said, in the short term, the market is a voting machine, and in the long term, it is a weighing machine. Our focus on durability, resilience and valuation has been unpopular and unimportant for most of the last decade, but especially the last five years. While others chased momentum, we prepared our portfolio to weather a bear market, a recession and the return of inflation. While the market has not yet rewarded us for this discipline, the strength, performance and competitive position of the select businesses we own gives us confidence that this is just a matter of time. If a picture is worth a thousand words, the table below says it all. The combination of resiliency and above-average growth along with a valuation at a 43% discount to the averages is a value investor’s dream.
In short, as the flood waters rise, we have built an ark. In the years ahead, we expect our discipline and patience will be rewarded. 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 85% of all funds are overseen by managers who have less than $1 million invested alongside their clients. We are well prepared for today’s fear and turmoil and grateful for the trust you have placed in us.
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. The investment objective of Clipper Fund is long-term capital growth and capital preservation. There can be no assurance that the Fund will achieve its objective. 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 problems affecting financial companies; 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 6/30/22, the Fund had approximately 15.0% 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 involve higher expenses and may trade at a discount (or premium) to the underlying security; 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 6/30/22, the top ten holdings of Clipper Fund were: Alphabet, 10.27%; Berkshire Hathaway, 10.22%; Wells Fargo, 8.00%; Capital One, 6.75%; Markel, 6.41%; Cigna, 5.42%; Bank of New York Mellon, 5.29%; U.S. Bancorp, 4.96%; Intel, 4.25%; and Meta Platforms, 3.72%.
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.
A Special Purpose Acquisition Company (SPAC) is a company without commercial operations and is formed strictly to raise capital through an initial public offering or the purpose of acquiring or merging with an existing company.
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. Investments cannot be made directly in an index.
After 10/31/22, this material must be accompanied by a supplement containing performance data for the most recent quarter end.
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