In the last five years, many well-established asset managers joined the ETF market, including Capital Group, DoubleLine, Federated, Harbor, Neuberger Berman, and Matthews Asia. But Davis Advisors was ahead of them, launching its first three ETFs in January 2017 and its fourth in March 2018. Combined, these ETFs have nearly $1 billion, even as Davis Advisors has long offered active mutual funds favored by advisors such as Davis New York Venture Fund and Davis Financial Fund.
VettaFi recently connected with Chris Davis, chairman and portfolio manager of Davis Advisors’ active ETFs, to learn more about the company’s approach.
VettaFi: Chris, it’s been more than five years since Davis launched active equity ETFs, ahead of some of your asset management peers. As you look back, what has gone as you expected, and what is a bit different?
Davis: Since January 2017, we have been pleased to offer investors our time-tested strategies through Davis ETFs. They were among the first actively managed equity ETFs offered by a manager with decades of experience investing in the Davis Select Worldwide (DWLD), the Davis Select U.S. Equity (DUSA), the Davis Select International (DINT), and the Davis Select Financial (DFNL) stocks. From an industry perspective, we anticipated the enormous opportunity to offer proven active strategies in a traditional ETF structure and have been gratified to see strong investor interest. The potential tax advantages, trading flexibility, and transparency ETFs offer are compelling features that attracted many investors.
One of the things that we didn’t expect to see over the nearly six years since we launched our ETFs has been the relatively small share of investors to date that embraced actively managed equity ETFs. Recently, however, this trend has shifted, and more investors are beginning to recognize that ETFs are not just about indexing but rather they are efficient vehicles to gain exposure to asset classes, markets, and active strategies. With more managers now offering ETFs and the recent surge in new strategies being issued over the past year, the active equity portion of the ETF industry is evolving quite rapidly.
VettaFi: What are some of the benefits to an active ETF approach compared to a market cap weighted index ETF that advisors are more familiar with?
Davis: We have observed historically the factors contributing to index outperformance can also often turn to headwinds when market conditions change. A passive indexing approach must invest in every single company in the index, regardless of the company’s future growth prospects or valuation. There is an inherent element of momentum within market cap-weighted indexes as an increasingly disproportionate amount of capital is allocated to the larger companies based on indiscriminate inflows into such indexes. The benefits of active management may not be apparent at all times during the market cycles, but over the long term, we believe human judgment and selectivity can add meaningful value.
With that said, investors need not commit entirely to either active or passive approaches. Many sophisticated investors combine investments in both strategies to their advantage. We believe there are compelling reasons to consider active management in the current environment.
VettaFi: You have four ETFs, but let’s focus on DUSA. Can you share what the team’s investment approach is and how to sort through the U.S. equity universe to end up with a relatively focused portfolio?
Davis: With more than 50 years of investment experience and more than $20 billion in assets under management, our goal has always been to provide our research expertise to investors in the vehicle of their choice, which now include ETFs. Each of our ETFs is managed using the Davis Investment Discipline. They are research-driven, high-conviction, benchmark-agnostic portfolios with low turnover and a strategic long-term time horizon.
In terms of our approach, our team looks for attractive business at value prices. We are value investors. Lack of visibility or jarring headlines can cause prices to be dislocated. We are long-term investors and believe that business results will be the long-term determinant of results and therefore seek companies with durable long-term earnings power, long cycle stable margins, strong balance sheets, lasting competitive advantages, and capable management. The selectivity and rigorous investment process behind Davis ETFs results in portfolios that emphasize durable businesses with above-average earnings growth that trade at attractive valuations.
VettaFi: While DUSA owns Amazon, Alphabet, and Berkshire Hathaway, which advisors can find in most U.S. equity ETFs, what’s an example of a differentiated, yet meaningful exposure within DUSA?
Davis: While DUSA currently owns some large-cap names that are also in most U.S. equity indexes, our portfolio is highly differentiated, with active share nearly 90%. One area of the market that we currently see long-term opportunity and have meaningful exposure is financials. In our experience, there are times when investors often overlook companies that appear risky or mundane. Today, this appears to be pronounced, as near-term recession fears remain elevated.
The natural knee-jerk reaction for so many investors is to try to sidestep companies that might see credit losses in the event the economy weakens. In our view, when anticipating the impact of credit losses, the key question to ask is how much liquidity and support a company has to absorb to earn their way out of a tough credit environment. There is a reason why over many economic cycles, financials have proven they are survivors.
VettaFi: What makes financials appealing to you in 2022?
In our view, U.S. banks are very well positioned to weather the next recession, whenever it may come. Banks are holding almost twice as much capital as before the 2008 financial crisis, and their credit underwriting appears to be considerably more disciplined. The eight largest banks in DUSA are collectively valued at 1.4x 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.
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. 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.
Financials are trading at a significant discount to the market with a forward P/E of 11.2 versus 15.6. As we invest through a time of recession, the enormous valuation discount to the market 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.
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