The Case for Big Banks, Meta, And Berkshire -- Barron's

Dow Jones2023-06-03

By Lauren R. Rublin

Chris Davis makes a perfect pour-over coffee, swirling the hot water just so over Blue Bottle grounds. That shouldn't surprise: He tends Davis Advisors, the investment firm founded by his father in 1969, with the same sort of precision and care.

The firm, which oversees about $20 billion, has a stellar long-term record, but the near term has been rough. While growth stocks soared, Davis Advisors' value stocks, including many bank shares, languished. The company's $5.8 billion flagship, Davis New York Venture fund (ticker: NYVTX), underperformed the S&P 500 index in each of the past five years. This year, it is was up 9.6% (through May 30) but trailing the index slightly, according to Morningstar.

Past isn't prologue, however, and Davis expects a more rational market to embrace his companies: durable, resilient, cash-generating, and selling for much less than their intrinsic worth. He explained why in a May 22 interview at the firm's well-appointed Rockefeller Center digs, where he also discussed the future of Berkshire Hathaway (BRK.A, BRK.B), whose board he joined in 2021. Listen in, via these edited comments.

Barron's: You recently wrote, with apparent relief, that a decade of distortions caused by historically low interest rates has definitively ended. What makes you so sure it's definitive?

Chris Davis: That's a good editor's question. In his book about the history of interest, The Price of Time, Edward Chancellor presents a chart of interest rates going back to about 3,000 B.C. Other than very briefly in the 1920s, interest rates were never zero, let alone negative, until the past few years. Free money fueled incredible speculation. It was an anomalous era in human history, and it is difficult to imagine going back to a world where people would price money at zero.

That era didn't help Davis Advisors, but you stuck to your knitting. What do you look for in an investment?

We consider three factors: the nature of the business, the management, and the price. We don't spend a lot of time on things like sector rotation. We have built a portfolio of companies we consider durable and resilient. They are generating a huge amount of cash relative to their value. In the past five years [through March 31], companies owned by Davis New York Venture grew their earnings by 11.7%, versus 9.7% for the S&P 500. Yet, our companies sold for 10.1 times earnings, 44% less than the index's 18.1 times.

A zero-rate era provided cheap funding for speculative businesses, while penalizing good businesses with conservative balance sheets. It penalized companies reliant on interest income, such as insurers and banks. It penalized incumbents, and we own a lot of incumbents.

What is your economic outlook?

There is a high likelihood of a recession, whose impact will vary significantly by sector. Also, it is hard to see what will stop the trend toward deglobalization, which reduces productivity and returns on capital.

We expect that higher labor costs will persist, with pressure coming from the bottom up. Both deglobalization and higher labor costs point to structurally higher inflation. We assume that interest rates will be higher in the next decade than in the past. This scenario will benefit companies with near-term earnings. And, the disconnect between the strong performance of the market indexes and the weaker performance of most stocks is unlikely to persist.

Does more turmoil lie ahead for smaller banks after this year's string of bank failures?

We would expect that the vast majority will be fine and that in all cases all depositors will be protected. However, smaller banks' greater relative exposure to commercial real estate could lead to some unpleasant credit surprises should the economy continue to deteriorate. This risk, combined with their lower capital ratios and a lack of scale in both technology and regulatory compliance, makes us prefer to focus our investments on the largest banks.

Banks account for 25%-30% of our portfolio. They will earn more because of the rise in rates. Their deposit franchises are mostly insured, and aren't a flight risk. I didn't count on our bank stocks falling 15% or 20% this year, as some other bank stocks fell 80% or 90%. But I love the banks we own.

Let's take a closer look. What's to love about Capital One Financial [COF]?

Capital One has been a fintech company since the start. It uses data science to market financial services. It is still run by its founder, Richard Fairbank. The bank pays a high rate on its deposit base. It is a big issuer of credit cards, primarily to working people, not big spenders. The best analogy is Progressive [PGR], a data-science company disguised as an insurer. Progressive realized early on that there is no bad risk; there is only bad pricing.

Capital One has matched its loans to its deposits. At around $100 a share, it is trading right around tangible book value, for a business that has had a low- to midteens return on equity for 35 years.

What is the case for Wells Fargo [WFC]?

Wells has been in regulators' crosshairs for seven years or so. It sailed through the financial crisis, but then behaved badly and had shame heaped upon it. [Wells created millions of fraudulent client accounts.] Under CEO Charles Scharf, the bank has had a relentless focus on improving operations. Like JPMorgan Chase [JPM], Wells took little interest-rate risk. To me, that shows it isn't managing earnings.

Wells has a high expense structure, but as the bank improves its compliance, it will be able to get costs closer to the industry average. Mostly, Wells can benefit from improving perceptions. The company has a lot of earnings power within its own control, and a low valuation. The stock trades for about 11 times per share.

What's ahead for Bank of New York Mellon [BK]?

BNY Mellon is a processing and services provider. It has almost no credit or interest-rate exposure. Higher rates are a tailwind. BNY, too, behaved badly for a time from a regulatory point of view, but current management is focused on executing. BNY generates probably 9% to 10% of its market cap in cash every year, so you'll see growing dividends and a shrinking share count.

I can't say anything about JPMorgan that you don't already know. We also own Development Bank of Singapore [ DBS Group Holding; DBSDY], which has a 5.3% dividend yield. It is known as the Fort Knox of Asia. We own a handful of international banks. Our criteria are that their home countries must have economies we consider sound, they have to be dominant in those countries, and they must be conservatively run. We own the largest banks in Norway and Denmark, and in Switzerland we own Julius Baer Gruppe [JBAXY].

What will it take for bank stocks to regain investors' favor?

People still remember the financial crisis and re-regulation. Then, we dealt with Covid, and then, small banks suffered interest-rate shocks. Bank stocks are cheap because people keep expecting another crash. Eventually, they will realize that the banks are durable and resilient, dividends are growing, share count is shrinking, and the biggest banks continue to gain market share.

There are some risks. Liquidity, credit, capital, regulation, interest rates, and technology are the six we look for in every bank. Credit, by and large, is the main risk now. The other is regulatory. After the recent bank failures, there is a heightened risk of what I would call unfair or reactionary regulation. Regulatory risk could hang over the industry for some time. I don't quite know how to handicap it.

Switching gears, you upped your Meta Platforms [META] stake last fall when the stock was depressed. That was a great call. What attracted you?

It was our biggest buy last year. The narrative was that the wheels were falling off and the CEO, Mark Zuckerberg, was spending like crazy. People said TikTok was killing them, and that nobody was on Facebook. Yet, the number of users on every one of their platforms was growing, as was the amount of time users spent on these platforms. Ad revenue was going the wrong way, but the company was trading for just nine times earnings, minus what I'll call discretionary spending on the metaverse and AI. It sold for 14 times earnings including those.

You are a longtime friend of Warren Buffett's, and now, a Berkshire Hathaway board member. The company pays no officers' or directors' insurance. Why take the risk?

It is a duty. Berkshire has been run with enormous transparency, integrity, a long-term orientation, and a culture of stewardship. It is run by the greatest investor in history. Who would say no to that opportunity? That's the present.

As for the future, every activist and investment banker will argue that in a world without Warren and Charlie [Berkshire Vice Chairman Charlie Munger], Berkshire's unorthodox structure shouldn't persist. I think Berkshire is worth defending. Warren has assembled a collection of long-lived assets that will produce cash flow for decades to come.

If we had a Latin motto in my family, it would be the Latin for work before play. Eat your vegetables, then you get dessert. Being on the board of Berkshire is a bit like getting dessert first: the chance to be with Warren and Charlie. The vegetables will come when they aren't there, when the job of the board will be to protect this precious culture.

Thank you, Chris, and thanks for the coffee.

Write to Lauren R. Rublin at lauren.rublin@dowjones.com

 

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June 02, 2023 21:30 ET (01:30 GMT)

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