Chris Davis : New York Venture Fund Annual Review 2006

When Chris and Ken buy a company for the Davis New York Venture Fund, they do so on the basis of what is often called bottom-up, as opposed to top-down, research. This means they do fundamental research and analysis on each individual company they consider, with the goal of arriving at an estimated range of each company's intrinsic value. This process includes studying the company's financial statements, regulatory filings, competitive advantages, management, and corporate culture. Having completed this work, they invest only when we believe that the company's stock price is below the low end of their estimated range for the company's intrinsic value.

Nevertheless, in studying individual companies on a case by case basis, more general investment themes sometimes emerge. Such themes then inform our thinking and often lead them to look for more opportunities in a given sector. This part of the investment process is often referred to as top-down. Over the years they have discussed such top-down themes as the aging of the baby boomers, the ascendancy of China and the long-term rise in health care spending. Two such themes that they have discussed in the past are worth revisiting today for opposite reasons: the first because it seemed to play out for several years until late 2006 when it appeared to reverse; and the second, because it seemed not to play out for several years until late 2006 when it appeared to begin.

The first theme is energy. In the late 1990s, Chris and Ken started buying shares in a few well-managed energy companies that had been able to consistently and profitably grow the value of their company's reserves in all different energy price environments. As a result of our bottom-up research they noted that most energy companies were having great difficulty replacing reserves at an attractive cost. Many were reducing their exploration budgets because they believed the conventional wisdom that low energy prices were here to stay. They also noted that demand for energy was rising in the United States as American consumers and businesses had grown so accustomed to cheap energy that conservation was less relevant and people were lining up to buy SUVs and Hummers. Globally, Asia's enormous growth as a manufacturing center was driving up the demand for oil to satisfy the needs of both growing industries and newly wealthy consumers. Putting these observations together, they developed a top-down theme that energy prices in the coming decades were likely to be much higher than in the past.

A second theme that they described at length in their last two reports predicted a widening of quality spreads. In our work on individual companies, they noted that the shares of large, high-quality, global growth companies seemed unusually cheap compared with the rest of the market, particularly smaller, more cyclical, slower growth companies, often described as value stocks. Through the first half of 2006, instead of widening, this gap seemed to narrow further. This outperformance of the so-called value sector has had the usual effect of attracting more and more interest.

Then as now, investors are mistaken to think of growth and value as two different approaches to investing. Growth is simply a component of value. Companies that grow profitably are more valuable than companies that don't. As a result, to the extent that investors are overweighting one component of the equation, there are often opportunities. In the late 1990s, the market overweighted the growth side and underweighted the value side. In recent years, the market seems to be doing the opposite.

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