Will These Ultimate Stock-Picker Stocks Outperform?
A deep dive into Davis NY Venture's portfolio construction and top holdings.
By Swami Shanmugasundaram | Stock Analyst
Aside from sifting through the holdings, purchases, and sales of our top managers, members of The Ultimate Stock-Pickers Team keep tabs on the commentary put forth by these managers to get a better feel for the thinking that went into their buy, sell or hold decisions. While some managers--like Oak Value (OAKVX) fund--provide detailed updates about their recent purchases and sales, as well as additional commentary about their top holdings, many managers prefer to hold their cards closer to their vests. In some of these cases, we're able to augment the lack of direct portfolio commentary by our top managers through other means--such as interviews with Morningstar's stock and fund analysts--but even then we're often times missing some aspect that would help us to better understand the decision to buy, sell or hold a particular security (similar to the issues we came across last time around when we dug deeper into Bruce Berkowitz's big sale of Pfizer (PFE) from his Fairholme (FAIRX) fund during the fourth quarter of 2009).
We're encouraged when managers go above and beyond to provide us with an in-depth look at how they not only think about their stock portfolios but the securities they've been buying, selling or holding. In that regard, we've been big fans of the work done by Chris Davis and Ken Feinberg, who manage the Davis NY Venture (NYVTX) fund. They regularly provide investors with updates on the markets and the moves that they're been making within their own fund. That's not to say that they're short-term oriented. The managers continue to believe that the keys to outperforming the market are "to think long-term rather than get caught up in short-term cycles, to exercise a highly selective and disciplined approach with respect to business quality and valuation, and to remain focused on in-depth, bottom-up research."
While Davis NY Venture may have stumbled in 2008, posting a 40% decline in the wake of the bear market (compared to a 37% drop for the market, as represented by the S&P 500 Index (SPX)), the fund gained more than 32% during 2009 (relative to a 27% return for the market). While Davis and Feinberg's long-term performance may not be as stupendous as the three Ultimate Stock-Pickers--Fairholme, Amana Trust Growth (AMAGX), and Yacktman (YACKX)--we highlighted coming into 2010, the fund has beaten the market on an annualized basis over both the last five- and ten-year periods. Like many other value fund managers, Davis and Feinberg took a beating during the bear market due to an overweight position in financial services stocks.
Within the sector, the duo had a few notable blow-ups-- American International Group (AIG), Merrill Lynch, and Wachovia--which only amplified the impact of the credit and equity market implosions on the fund's holdings. According to the two managers, Davis NY Venture's losses from its investments in AIG and Merrill Lynch (through the end of 2008) subtracted about 1.4% per year from the fund's trailing five-year returns. The key lesson they learned from these two big blow-ups was that "liquidity, reasonable limits on leverage, franchise durability, and management quality are critical to companies weathering the inevitable yet unpredictable periods of crisis." It was a lesson they applied to the rest of the fund's financial services holdings, which accounted for 30.8% of Davis NY Venture's stock portfolio at the end of January 2010.
In management's defense, it should be noted that conglomerates such as Berkshire Hathaway (BRK.A) / (BRK.B) and Loews (L), which accounted for 7.5% of total stock holdings, are counted as financial services firms by Morningstar, and that our sector designations may not always line up with those used by the S&P 500 Index. That said, any way you look at it, Davis and Feinberg continue to overweight financial stocks, with close to one quarter of their portfolio invested in the sector at the end of the most recent period. The next closest sector is energy, a sector which the fund is also overweight, committing 14.8% of the stock portfolio to key energy holdings such as Occidental Petroleum (OXY), EOG Resources (EOG), and Devon Energy (DVN).
Top Ten Holdings of Davis NY Venture Fund on 01/31/10Star RatingFair Value UncertaintyMoat SizeCurrent Price ($)% of Stock HoldingsBrkshrHthwy (BRK.B)3MediumWide80.494.9Wells Fargo (WFC)3HighNarrow32.304.6American Express (AXP)3HighWide43.884.0Costco (COST)3MediumNarrow61.213.8Bank of NY Mellon (BK)3MediumWide31.953.5Occidental Ptrlm (OXY)3HighNarrow86.563.4EOG Resources (EOG)3MediumNarrow104.773.4Devon Energy (DVN)4HighNarrow67.263.1Merck (MRK)4MediumWide36.973.1CVS Caremark (CVS)3MediumNarrow37.232.8
Stock Price and Morningstar Rating data as of 04-09-10 unless otherwise noted.
It shouldn't come as much of a surprise, then to see four of the top five holdings--Berkshire Hathaway (based on a combination of Class A and B shares), Wells Fargo (WFC), American Express (AXP), and Bank of New York Mellon (BK)--in the fund focused on financial services, and three of its top ten holdings in energy names. With just 23 (out of more than 1,700) stocks currently rated by Morningstar trading at prices that our analysts would consider buyable, it was also not too surprising to see just two holdings--Pfizer and Monsanto (MON)--in Davis NY Venture's total stock portfolio rated 5-Stars.
Despite what we perceive to be a lack of buying opportunities, Davis and Feinberg continued to add to positions in Berkshire Hathaway, Wells Fargo, and Bank of New York Mellon during the most recent period. Aside from meaningful additions to the fund's stake in Pfizer and Johnson & Johnson (JNJ), as well as a new money purchase of Mead Johnson Nutrition (MJN), Davis and Feinberg were basically sticking with holdings that they felt the strongest about, given their positioning in the portfolio.
Davis NY Venture's primary focus is to purchase high-quality companies at value prices, and then hold them for a long period of time. The fund's definition of high-quality companies typically includes those with solid balance sheets, durable competitive positions, reasonable amounts of pricing power, decent returns on capital, and sustainable free cash flows. Given the fund's long-term focus, it also evaluates companies based on their risk of obsolescence, regulatory risk, geographic and product diversification, management incentives, and their ability to survive economic and market shocks (similar to what we've just gone through over the last two years). It's not too surprising to note that many of the stocks in Davis NY Venture's portfolio carry either Wide Moat or Narrow Moat ratings, as many of these same criteria go into our moat evaluation process here at Morningstar. Looking at the fund's most recent filing, nearly three-quarters of the companies in the portfolio had moats.
Davis and Feinberg also make a point of highlighting the fact that the fund holds three primary categories of investments. The first category, which makes up a sizeable chunk of the portfolio, revolves around market leaders with strong balance sheets. These companies share virtually all of the characteristics of high-quality companies the managers are looking for, and include such well known global franchises as Merck (MRK), Johnson & Johnson, Procter & Gamble (PG), Diageo (DEO), Philip Morris (PM), Heineken (HINKY), and Coca-Cola (KO). These businesses span a broad range of global industries from financial services to retailing to consumer products to technology, and provide a core foundation of stability within the portfolio.
Davis and Feinberg point to top holding Berkshire Hathaway as perhaps the least obvious but, nonetheless, most compelling example of a firm in this category. With a rock solid balance sheet, a market capitalization in excess of $100 billion and interests in insurance, reinsurance, utilities, manufacturing, retailing, and a host of other business lines, Berkshire Hathaway was able to not only survive the crisis of confidence that brought the credit and equity markets to their knees, but was able to take full advantage of opportunities created by the dislocation in the markets. Davis and Feinberg believe that Berkshire Hathaway is well-positioned through its operating businesses (and its investment portfolio) to increase earnings power considerably over the long term. That said, the fund paid no more than $75 per share for the stock during the most recent period, versus today's price of more than $80 per share, making it all the less likely that Davis and Feinberg were adding to their stake in Berkshire Hathaway since the end of January.
The second category in Davis NY Venture's portfolio is made up of "out-of-the-spotlight" businesses, which are lesser-known companies with attractive economics that the managers believe should eventually command a higher valuation than they are carrying today. According to Davis and Feinberg, these companies tend to be smaller, operate in mundane non-consumer-oriented industries, and can be boring but steady compounding machines. Top ten holdings Devon Energy and EOG Resources both make this list, as does Progressive (PGR), one of the largest auto insurers in the nation, and Iron Mountain (IRM), a leading provider of document management services.
The third category in the fund's portfolio revolves around companies with either headline risk or situations where the managers believe they can make a contrarian investment. While these types of situations tend to be smaller in nature, Davis and Feinberg did make a fairly strong bet on health care stocks over the course of the last year, increasing the fund's stake in the sector from 4.5% at the end of January 2009, to 8.5% at the end of January 2010. The two managers were more than happy to purchase shares of a number of high-quality pharmaceutical firms last year, including Merck (which acquired the fund's longstanding position in Schering-Plough in November 2009) and Pfizer, as investors fled these stocks over concerns about the impact that health care reform would have on their businesses.
As you may recall from our conversation last time around with Morningstar analyst Damien Conover, the drug manufacturers were probably the least impacted by the bill that was recently signed into law. Damien also continues to pound the table on Pfizer, which you may recall was one of only two 5-Star stocks left in Davis NY Venture's portfolio. While some have questioned the strength and durability of Pfizer's wide moat, Damien believes that it is still intact (albeit not as strong as it was a decade ago). In his view, the strength of Pfizer's moat is based not only on its patent-protected drugs, but on the firm's economies of scale, intellectual intangibles, and powerful sales force. While there will be some disruption from patent losses over the next couple of years, he expects the company's diversified product portfolio to mitigate these losses, with the enormous cash flows generated by its current product portfolio funding the ongoing discovery and development of next-generation drugs.
Disclosure: Swami Shanmugasundaram does not own shares in any of the securities mentioned above.
The Morningstar Ultimate Stock-Pickers Team does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.