Morningstar Magazine - April/May 2018 - 65

Reasonable fees help support a Positive
Parent Pillar rating for Davis Advisors. Morningstar
senior analyst Alec Lucas also points to the
firm's long-term thinking and significant investment alongside clients: the Davis family
and firm personnel invest more than $2 billion
in the funds. There have been some challenges: The financial crisis was a perfect storm for
a firm like Davis, which has a long and largely
successful history of investing in insurance
and bank stocks. Clipper investors were hammered
thanks to its concentrated allocation to
financial stocks. Though Clipper has outperformed
peers since the bottom of the crisis in early
2009, overall the fund and the firm have seen
a decade of outflows.
At the end of 2013, Chris Davis made an unexpected decision to replace his longtime
comanager, Ken Feinberg, who was also the lead
manager on the Financial fund. The dissolution
of this seasoned alliance and subsequent
disruption prompted Morningstar's analysts to
downgrade the overall analyst ratings on several
funds. However, the firm's flagship funds
retained Positive People Pillar ratings. Danton Goei,
who had been an analyst with the firm since
1998 and a portfolio manager on Davis Global and
the analyst-driven Davis Opportunity RPEAX
since the early 2000s, stepped into Feinberg's
comanager roles, and Chris Davis took on
the Financial fund. The shop has seen its share
of analyst turnover in recent years, but it
has a stable and experienced core. It has also
managed to retain and develop top talent,
including industrials and healthcare analyst Darin
Prozes, who now manages one of the bigger
sleeves of Davis Opportunity.
Those Davis funds with an analyst rating also
earn a Positive for the Process Pillar. In general,
the investment strategy begins by looking
for businesses that carry competitive advantages
such as dominant or growing market share,
proven management that includes a track record
of smart allocation of capital, and strong financials,
including high returns on invested capital.
They seek companies trading below "owner
earnings," or profits adjusted for option issuance,
pension fund assumptions, capital spending,
depreciation, and amortization.

The process leads to three primary categories
of holdings: firms that are market leaders
with strong balance sheets; "out of the spotlight"
businesses; and contrarian plays where the
managers believe that controversy has led the
market to overly discount a company's share price.
Laser Focused

All of the Davis funds have relatively compact
portfolios, but some are notably concentrated,
including the ETFs. Select U.S. Equity ETF held just
22 stocks as of the end of February, Select
Financial ETF had 29, and Select Worldwide ETF
held 40. That concentration sets them apart from
their typical ETF category peers.
Goei, who manages Select Worldwide ETF,
contrasts his high-conviction portfolio with that
of its benchmark, the MSCI ACWI Index,
which is tracked by popular competitor iShares
MSCI ACWI ETF ACWI. The MSCI benchmark
has nearly 2,500 names, and its average holding
is 0.04% of the portfolio, he says.
"There aren't 2,500 great or even good companies
out there," he says. "And there are a lot
of companies you would never want to invest
in and a lot of countries you wouldn't want
to invest in.
"We're investing in best-in-breed companies
and countries where we have confidence
in the rule of law and the accounting standards,"
Goei says.
Fewer holdings doesn't necessarily mean
less-diversified when compared with market-capweighted index peers. The most widely held
financial ETF, the $34.7 billion Financial Select
Sector SPDR ETF XLF, has a third of its
portfolio in four mega-cap banks, including top
holding JPMorgan Chase JPM at more than
11% of assets at the end of February. While Davis
Select Financial ETF has fewer holdings
than XLF, it is in fact more diversified when
it comes to subsectors.
"There's a huge opportunity in financial services,"
Davis says. "I love that we're starting with
a low valuation, high-payout ratio portfolio at a
time when the index is hyper-concentrated."

The question is whether the ETF portfolios
will take full advantage of the Davis process. They
are very similar to the holdings of their openend analogs, but there are significant differences.
For example, while all of the Select U.S.
Equity ETF's holdings are in Clipper, the open-end
fund also had nearly 3% of assets as of the end
of 2017 in a private placement investment
in ride-sharing firm Didi Chuxing, China's answer
to Uber.
Morningstar's Lucas says that "as a firm,
Davis is making a sizable bet on Didi Chuxing in
its open-end funds and the ETFs can't hold it. The
ETFs may be cheaper than their open-end
counterparts, but they do not represent the full
suite of the firm's investment convictions.
Investors have to ask themselves whether the
lower cost and convenience that comes with the
ETF vehicle structure is worth the trade-off."
Lucas adds that Goei's proclivity for investing
in private companies means significant differences
between Davis Global and its Select Worldwide
ETF. Including private placements and
publicly traded stocks, the open-end fund has
more than 10% of assets in names that aren't
in its ETF counterpart, including Didi Chuxing and
Singapore's Grab, another privately held ridesharing service.
For better or worse, the ETFs won't precisely
track the open-end funds; even the portions of the
portfolios that overlap have weighting differences
owing to timing and cash flows. (All three
of the ETFs launched in 2017 have outperformed
their open-end analogs from their inception a
little over a year ago through February.) That said,
the Davis ETFs are based on sound strategies
with long track records and are a rare opportunity
for investors to add active management via
an ETF wrapper.
While active U.S. stock funds have gotten a bad
rap in recent years, some ETF investors will
agree with Chris Davis' take: "Everybody knows
that active is dead, and people feel the most
efficient market in the world is the U.S.," he says.
"Here we just respectfully disagree." K
Tom Lauricella is the editor of Morningstar Direct.

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