Chris Davis shares his most recent thoughts on why to invest in financial stocks, why he believes active management can add significant value in this vast inefficient sector and why investing in financial stocks offers a unique opportunity today.

  “Given today’s low prices, we believe select financials will generate strong returns over the next decade because they combine what we feel are durable business models, the strongest balance sheets in half a century, resilient earnings, good returns on equity, the potential for rising dividends, falling share counts, and low valuations.”

-PM Chris Davis

Executive Summary

  • Currently, financial stocks are under­ appreciated and out of favor with investors, offering what we believe to be an attractive long-­term investment opportunity.
  • Selectivity and active management are the keys to outperformance in the vast, inefficient financial sector, in our opinion. Investing in stronger companies and avoiding weaker ones can make a significant difference in investor returns.
  • Davis Select Financial ETF (DFNL) holdings include: Markel, Chubb, Berkshire Hathaway, JPMorgan Chase, BNY Mellon, American Express and Capital One Financial.1

Davis has successfully invested in financial stocks for almost five decades. Why should investors consider this sector now?

In 1947, my grandfather, Shelby Cullom Davis, began investing in financial stocks. Known as the “Dean of Insurance Stocks,” he compounded a $100,000 investment into $800 million over his career, largely by investing in financials.2
 

The characteristics my grandfather looked for in financial companies included competitive advantages, experienced management and disciplined capital allocation. We use these same criteria to select all our investments as an equity research boutique.3 What is interesting and more specific to financials is we can find companies within the sector that have above­-average long­-term growth prospects but trade at below­-average price/earnings (P/E) multiples. This is the reason my grandfather called financials “growth stocks in disguise.”

More recently, investors have tended to consider finan­cial companies inextricably linked to the 2008 financial crisis, resulting in a lingering aversion to this out­-of­-favor group. However, our research shows certain high quality financial companies remained profitable during the worst financial crisis since the Great Depression, are currently trading at close to a 30% discount to the market and, most important, we believe they are less risky today as they have doubled their capital ratios. 

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In addition, a significant percentage of the assets on these companies’ balance sheets have been added since the financial crisis. Moreover, because of limited competition and extremely tight credit standards, these businesses have record earnings. Now, some financial companies are in a position to distribute an increasing percentage of their earnings. Lastly, should interest rates rise as a function of strong economic growth, select financials may be net beneficiaries as net interest margins expand. Put together, these developments are creating a cyclical opportunity in financial stocks in our view.
 
In addition to the current cyclical opportunity, we believe a strong case can be made that the right financial com­pany is by its nature a long­-term cash­-compounding machine. Such a business generates strong current earnings that can be reinvested as well as providing the potential for excellent long­-term growth because the industry is so vast and fragmented, and the products and services offered by financial institutions are as long lasting as they are ubiquitous. Almost everyone is a customer of at least one, two or three financial companies. In brief, financial companies offer products that generally do not become obsolete.

 

Why are financial stocks one of the few areas that can perform well even if we are in a low growth environment as many believe?

 
We see three possible scenarios for financial stocks going forward in which investors benefit from some combination of: earnings growth, P/E expansion, share repurchases and dividends.
 
In these scenarios, over the next five years we assume a reasonable initial P/E multiple of 12x and that the financial company has to retain 20% of its earnings to increase its capital ratio or strengthen its balance sheet. And, furthermore that the remaining earnings are distributed half as dividends and half as share repurchases.5
 

Scenario 1: No earnings growth and no P/E expansion

Under this scenario we see a 7% average annual total shareholder return. Despite no change in earnings growth and no P/E expansion, a satisfactory return is achieved from share repurchases and dividends.

Scenario 2: Modest earnings growth no P/E expansion

Under this scenario we see a 10% average annual total shareholder return. This return is driven by modest earnings growth of 3% per year, share repurchases and dividends, while the P/E stays flat.

Scenario 3: Modest earnings growth and modest P/E expansion

Under this scenario we see a 13% average annual total shareholder return. This returns is driven by modest earnings growth of 3% per year, modest P/E expansion from 12x to 14x, in addition to share repurchase and dividends.
 
Going forward, we expect an outcome between Scenario 2 and Scenario 3 to be the most likely. This would represent a very satisfactory return for shareholders.

Why have selectivity and active management generated outperformance for Davis Select Financial ETF?

 
Investing in stronger companies and avoiding weaker ones can make a significant difference over time. Because the returns of financial stocks are widely dispersed, selectivity is key. In fact, since 2005, the average difference between the best and worst performing financial stock in the S&P 500 Financials Index has been about 132%.6  What accounts for these wide differences in outcomes?
 
A critical factor to recognize when researching financial companies is they are first and foremost human capital businesses. As a result, management judgment, underwriting practices, and management and employee incentives play a central role in determining which finan­cial companies should perform well through an entire business cycle versus those that might be structured to perform well in a specific environment but not necessar­ily to endure over time. As bottom-­up active managers, we have flexibility to invest more capital in those businesses we believe are best positioned to build long-­term wealth while avoiding those with less attractive prospects.
 
Contrast our carefully considered approach with many passively managed strategies that indiscriminately allo­cate the most capital to stocks with the largest market capitalizations. This approach can subject investors to the risk of concentration in the most vulnerable areas of the sector. For instance, many investors may not know The S&P 500 Financials Index has tremendous industry concentration as four of its top five holdings are banks and account for almost 30% of its assets.7
 
We build our Portfolio one company at a time. The Portfolio includes best­-of-­breed commercial banks, investment banks, insurance companies, wealth management firms, asset managers, credit card companies, diversified financial conglomerates, and rating agencies.
 

Davis Select Financial ETF Representative Holdings

Markel, a specialty property and casualty insurer, has generated excellent investment results for decades and grown book value per share more than 13% annually over the last 20 years.
U.S. Bancorp is the 5th largest U.S. commercial bank with more than $450 billion in assets. It generates returns on equity of more than 15% and is one of the most innovative banks focused on digital banking. The company has distributed nearly 75% of its earnings to shareholders through dividends and buybacks in the last year alone.
Chubb is a global insurance leader specializing in property and casualty insurance, reinsurance and Asia-­focused life insurance. It has a well­-regarded management team, strong balance sheet and disciplined underwriting culture.
BNY Mellon, the world’s largest custodian bank with more than $32 trillion of assets under custody, is a durable franchise that benefits from economies of scale.

Berkshire Hathaway is a collection of outstanding, profitable businesses. Exceptional world­-class capital allocation.

What are some of the perceived risks with financial stocks today?

 
One of the perceived risks with financials has to do with leverage within the banking sector. Leverage ratios are at historic lows, reflecting both a conservative posture by financial institutions themselves as well as stricter regulations on leverage that were instituted following the crisis. It is worth noting that all major U.S. banks now undergo annual stress tests which more or less control the degree of leverage they are willing or able to take on, implying that they should continue to operate with far lower overall risk and greater durability than in the pre­crisis period. In short, balance sheets for major financial institutions today look very strong.
 
A second question that relates to financials today is the prospect of higher credit costs than what we witnessed in recent years when the credit environment was particularly benign. Credit costs are an income statement expense and are the rule, not the exception, over any economic cycle. What was unusual in recent years was the near absence of credit losses, but that meant among other things that lending remained rather muted.
 
Now, with a stronger economy and relatively full employment, demand for loans has risen and credit costs are normalizing which is to be expected. We believe the credit environment remains both very manageable and quite favorable.
 

With all the positives, why is the opportunity in financial stocks underappreciated and not recognized by the market?

 
The biggest hurdles to investing in financials in this envi­ronment are psychological and emotional as investors still remember the aftermath of the 2008 financial crisis. While the overall market has more than doubled since then, financial stocks have not appreciated as much—even though select financial companies are delivering record earnings and have the strongest balance sheets in decades.
 
As always, investor fear is correlated with prices. When stock prices go down, people feel more fear and are less interested in buying, and when prices go up they feel reassured. This tends to result in an undesirable outcome.
 
We take the opposite approach. We search for compa­nies with stock prices that have lagged the companies’ true business value. We like to look in unloved or overlooked areas of the market where prices do not reflect true value. In today’s environment, the financial sector offers the opportunity we seek.

 

1

Individual securities are discussed in this piece. 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. The return of a security to the Fund will vary based on weighting and timing of purchase. This is not a recommendation to buy, sell or hold any specific security. Past performance is not a guarantee of future results.

2

While Shelby Cullom Davis’ success forms the basis of the Davis Investment Discipline, this was an extraordinary achievement and other investors may not enjoy the same success. Davis Selected Advisers, L.P. was founded in 1969.

3

While we search for those companies possessing these characteristics, there is no guarantee that the criteria will be met or that a given security will be profitable.

4

As of 6/30/19. Source: Credit Suisse.

5

This hypothetical example is for illustrative pur­poses only and does not represent the performance of any particular investment. Actual results will vary. The return of a stock is based on a number
of factors in addition to those discussed. Equity markets are volatile and there is no guarantee that these assumptions will prove to be correct.

6

As of 12/31/18. Source: Davis Advisors and Wilshire Atlas.

7

As of 6/30/19. Holdings are subject to change.

This report is authorized for use by existing shareholders. A current Davis Select Financial ETF prospectus must accompany or precede this material if it is distributed to prospective shareholders. You should carefully consider the Fund’s investment objective, risks, charges, and expenses before investing. Read the prospectus carefully before you invest or send money.

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.

Shares of DFNL are bought and sold at market price (not NAV) and are not individually redeemed from the ETF. There can be no guarantee that an active trading market for ETF shares will develop or be maintained, or that their listing will continue or remain unchanged. Buying or selling ETF shares on an exchange may require the payment of brokerage commissions and frequent trading may incur brokerage costs that detract significantly from investment returns.

Objective and Risks. Davis Select Financial ETF’s investment objective is long-­term growth of capital. There can be no assurance that the Fund will achieve its objective. Under normal circumstances the Fund invests at least 80% of its net assets, plus any borrowing for investment purposes, in securities issued by companies principally engaged in the financial services sector. Some important risks of an investment in the Fund are: authorized participant concentration risk: to the extent that Authorized Participants exit the business or are unable or unwilling to proceed with creation and/or redemption orders with respect to the Fund and no other Authorized Participant is able to step forward to create or redeem Creation Units, Fund shares may trade at a discount to NAV and could face delisting; 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; credit risk: The issuer of a fixed income security (potentially even the U.S. Government) may be unable to make timely payments of interest and principal;cybersecurity risk: a cybersecurity breach may disrupt the business operations of the Fund or its service providers; depositary receipts risk: depositary receipts involve higher expenses and may trade at a discount (or premium) to the underlying security; emerging market risk: securities of issuers in emerging and developing markets may present risks not found in more mature markets; exchange-traded fund risk: the Fund is subject to the risks of owning the underlying securities as well as the risks of owning an exchange-traded fund generally; fees and expenses risk: the Fund may not earn enough through income and capital appreciation to offset the operating expenses of the Fund. See the prospectus for a complete description of the principal risks; 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; 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; 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; interest rate sensitivity risk: interest rates may have a powerful influence on the earnings of financial institutions; intraday indicative value risk: the Fund’s INAV agent intends to disseminate the approximate per share value of the Fund’s published basket of portfolio securities every 15 seconds. The IIV should not be viewed as a ‘‘real-time’’ update of the NAV per share of the Fund because the IIV may not be calculated in the same manner as the NAV, the calculation of NAV may be subject to fair valuation at different prices, the IIV does not take into account Fund expenses, and the IIV calculations are based on local market prices and may not reflect events that occur subsequent to the local market’s close; 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; market trading risk: includes the possibility of an inactive market for Fund shares, losses from trading in secondary markets, periods of high volatility, and disruptions in the creation/redemption process. ONE OR MORE OF THESE FACTORS, AMONG OTHERS, COULD LEAD TO THE FUND’S SHARES TRADING AT A PREMIUM OR DISCOUNT TO NAV; 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; and stock market risk: stock markets have periods of rising prices and periods of falling prices, including sharp declines. See the prospectus for a complete description of the principal risks.

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.

The information provided in this material should not be considered a recommendation to buy, sell or hold any particular security. As of 6/30/19, the top ten holdings of Davis Select Financial ETF were: U.S. Bancorp, 7.56%; Capital One Financial Corp., 7.42%; Berkshire Hathaway Inc., 7.42%; American Express Co., 6.52%; Markel Corp., 5.53%; JPMorgan Chase & Co., 4.99%; Wells Fargo & Co., 4.74%; Chubb Ltd., 4.68%; Loews Corp., 4.39%; Bank of New York Mellon Corp., 4.35%.

Davis Fundamental ETF Trust has adopted a Portfolio Holdings Disclosure policy that governs the release of non­public portfolio holding information. This policy is described in the prospectus. Holding percentages are subject to change. Visit davisetfs.com or call 800-­279­-0279 for the most current public portfolio holdings information.

The Forward P/E ratio is the aggregate of the Forward P/E ratios of the holdings. The ratio is not a forecast of performance and is calculated for each security by dividing the current ending price of the stock by a forecast of its projected Earnings Per Share (EPS). Historical 5 Year EPS Growth represents the annualized rate of net­-income­-per­ share growth over the trailing five-­year period for the stocks held by the Portfolio.

We gather our index data from a combination of reputable sources, including, but not limited to, Thomson Financial, Lipper and index websites.

The S&P 500 Financials is a capitalization­ weighted index that tracks the companies in the financial sector as a subset of the S&P 500 Index. Investments cannot be made directly in an index.

Shares of the Davis ETFs 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.