Selected International Fund
Portfolio Manager Danton Goei
Annual Review 2022
- After materially outperforming in 2020, Selected International Fund underperforming in 2021 was disappointing.
- Concerns around the Chinese government’s stricter oversight of the internet sector led to falling valuations, despite resilient operating performance of the underlying businesses.
- Our research-intensive, highly selective investment process allows us to identify companies that can withstand unexpected shocks and crises, yet also possess the ability to innovate, adapt and build wealth in an ever-changing world.
- As a result, the earnings of Selected International Fund portfolio companies have grown at 24.1% compared to the index at 12.1%, yet are selling at a significant discount, 9.1x vs. 14.8x. This gives us conviction the Fund will help investors build wealth in the years ahead.
- Areas of opportunity include Chinese internet leaders trading at historic discounts (JD.com, Alibaba, Tencent [via Naspers/Prosus] and Meituan), wonderfully profitable manufacturers (Samsung and Tokyo Electron) and select well-capitalized financial companies (Development Bank of Singapore, Danske Bank, DNB Bank and Julius Baer).
- With more than $2 billion of our own money invested alongside clients, our interests are aligned, and our conviction is more than just words.1
The average annual total returns for Selected International Fund Class S share for periods ending December 31, 2021 are: 1 year, −21.94%; 5 years, 5.19%; and 10 years, 6.19%. The performance presented represents past performance and is not a guarantee of future results. Total return assumes reinvestment of dividends and capital gain distributions. Investment return and principal value will vary so that, when redeemed, an investor’s shares may be worth more or less than their original cost. For most recent month-end performance, click here or call 800-243-1575. Current performance may be lower or higher than the performance quoted. The Fund is subject to a 2% short-term redemption fee for shares held for fewer than 30 days. The gross annual operating expense ratio for Class S shares as of the most recent prospectus was 1.44%. [The Adviser is contractually committed to waive fees and/or reimburse the Fund’s expenses to the extent necessary to cap total annual fund operating expenses of Class S shares at 1.05%. The expense cap expires May 1, 2022.] The total annual operating expense ratio may vary in future years. Returns and expenses for other classes of shares will vary. The Fund’s performance benefited from an IPO purchase in 2014. After purchase, the IPO rapidly increased in value. Davis Advisors purchases shares intending to benefit from long-term growth of the underlying company; the rapid appreciation of the IPO was an unusual occurrence.
Update on the Fund’s current positioning, long-term performance and more recent results:
For the year 2021, Selected International Fund returned −21.94%, compared with a 7.82% return for the MSCI ACWI (All Country World Index) ex US, an underperformance of 29.76%. Following a year in 2020 when we outperformed the MSCI ACWI ex US by 10.12%, it is a disappointment to us that we significantly underperformed in 2021.
The principal headwinds to fund performance were linked to the regulatory actions taken by the Chinese government in 2021. In the first half of 2021, the government undertook major antitrust reviews of large Chinese internet companies, including Alibaba and Meituan. These reviews were performed in a pragmatic manner designed to eliminate and punish anticompetitive behavior. The fines of $2.8 billion for Alibaba and $530 million for Meituan were substantial, but also equal to less than 4% of the cash and investments on their balance sheets, so clearly, it was not designed to permanently handicap the companies. While the speed of the antitrust reviews was different than what we have seen in the West, the motivation of ensuring a competitive marketplace and the remedies employed were quite similar.
In the second half of 2021, however, the Chinese government undertook two regulatory actions with greater impacts on fund performance. In late July, the Chinese government declared that elementary and middle school after-school tutoring services must be performed on a not-for-profit basis, significantly impairing the earnings power of our two holdings in the education sector, New Oriental Education & Technology Group and TAL Education Group. While these two education leaders in China have adapted and actually benefited from past regulatory actions designed to improve the quality and limit the advertising of after-school tutoring, the new policies led us to reassess the future of the for-profit education industry and sell our positions in both names.
The second regulatory action took place shortly after the initial public offering of Didi Global, China’s ride-sharing leader, on the New York Stock Exchange (NYSE). In early July, the Cybersecurity Administration of China (CAC), implementing provisions from the new Data Security Law issued on June 10, announced that Didi will undergo a cybersecurity review, and further downloading of its app was suspended. Didi’s data privacy and collection policies, as well as data security considerations stemming from the company’s U.S. listing, were the focus of the review. On December 3, Didi announced that it planned to delist from the NYSE and relist in Hong Kong. The market understandably dislikes uncertainty, and it will take several months for the relisting process to be finalized. Over the long run, however, we believe a Hong Kong listing will resolve the CAC’s concerns around national data security, and it will provide a globally recognized primary listing venue, as it already does for other large Chinese internet companies such as Tencent and Meituan. Over time, the value of Didi, like any other company, will be determined by its business prospects and profitability rather than the location of its primary exchange listing.
As we look back at 2021, we do not believe it is a coincidence that the Chinese government decided to undertake a number of difficult and potentially disruptive regulatory actions following a year when it was seen by its people as having successfully managed the COVID crisis and was the only large economy to grow in 2020. Taking advantage of high levels of popular support entering 2021, the government tackled internet marketplace competition, data privacy and security concerns, income inequality and weak family formation, which included education, property and gaming sector reforms. Its stated goal is to create a more balanced and self-sufficient economy and put the country on the path for long-term sustainable growth. We expect that as these new policies become standard practice, the pace of regulatory reform will slow down. A more routine environment will be positive for companies and for investors’ outlooks.
While near-term underperformance driven by regulatory concerns in China is unpleasant, we believe it has created a large investment opportunity. The MSCI China Index is at approximately a 40% discount to the S&P 500 Index on a price-to-earnings (P/E) basis, and our Chinese holdings are trading at extremely attractive valuations. Companies such as JD.com, Meituan, Alibaba, Baidu and Tencent (which we own via Naspers and Prosus) continue to have strong balance sheets, generate large amounts of cash and have strong growth outlooks. For example, JD.com, a leader in e-commerce and the internet company with the largest logistics network, is trading at 12x 2022 normalized earnings with a trailing three-year revenue compound annual growth rate (CAGR) of 27%, and over the next three years, it has expectations of 20% revenue growth. Alibaba, the leader in both e-commerce and cloud computing, is trading at 14.5x 2022 normalized earnings, while the trailing three-year revenue CAGR is 42%, and over the next three years, expectations are for 30% revenue growth. As concerns of future regulatory actions abate, we believe the market will refocus on the fundamentals, which for these companies are very promising.
China remains a very attractive market for long-term investors due to its economic track record, size, growth potential, quality of companies and level of innovation. Since China pivoted toward a market-based economy in 1978, GDP growth has been nearly 10% a year for over 40 years, lifting 800 million people out of poverty.2 The unprecedented success of the economic track record has created strong public support for the Chinese government and the market-driven economic model. The private sector has been the engine of the economic growth and job creation, accounting for a majority of exports and nearly 90% of urban employment,3 and we believe it will continue to be the key driver of future growth.
Today, China is the world’s second-largest economy, accounting for 18% of global GDP,4 and it is already over 3x the size of the next largest economy, Japan, which it surpassed in 2010. Just like a global investor cannot ignore the United States, which accounts for 25%5 of the global GDP, we believe it is impossible to ignore China, especially as it accounts for such a large percentage of global GDP growth. In the 10 years through 2019, China accounted for one-third of global economic growth—larger than the combined share of global growth from the U.S., Europe and Japan.6 In 2020, retail spending in China was equal to 88% of retail sales in the U.S. In the decade through 2019, it was growing at 8.5% compared to 1.9% in the U.S., and it is poised to eventually become the world’s largest retail market.6
China’s large rapidly growing economy has created a large number of highly innovative and world-class companies. Alibaba and JD.com are leaders in the world’s largest and most vibrant e-commerce market, Alicloud is now a top five global cloud computing provider, Tencent is the world’s largest video game company and has built the world’s most comprehensive and innovative messaging ecosystem in WeChat and Meituan is the world’s largest food delivery company. With, on an annual basis, the world’s largest number of patents issued and graduates in the STEM field, the quality of doctoral PhD education in China rapidly rising7 and strong-growing capital markets to support entrepreneurship, we believe the country will continue to create innovative and world-class companies. With close to 1 billion internet users,8 China has pioneered innovations such as livestream shopping, social commerce and short-form video and is also a leader in technologies such as artificial intelligence and quantum computing. We expect China to remain an attractive market for long-term investors for a long time.
Of course, almost 65% of the portfolio is not in China, and a number of companies have performed well. Our significant financial sector weighting was a positive in 2021, as companies such as Development Bank of Singapore (+32%), Bank of Butterfield (+28%), Julius Baer (+19%) and DNB (+28%) performed well, as investors realized that despite economic uncertainties such as the COVID-19 pandemic, the banks’ earnings were solid and credit losses minimal. The banks started the year at such low valuations, that even after this year’s outperformance, their valuations continue to be attractive.
Additional positive contributors to results include the Japanese semiconductor chip equipment company Tokyo Electron and the French electrical equipment company Schneider Electric.
In addition to our Chinese holdings, detractors to performance included the South Korean technology leader Samsung Electronics and the South Korean athletic apparel manufacturer Fila. A leader in memory chip manufacturing, Samsung, with the world’s second-largest semiconductor foundry, is also a leader in smartphones and consumer electronics. It currently trades for only 9x 2022 owner earnings, and expectations are for 13–14% revenue CAGR over the next three years. Meanwhile, Fila trades at only 7x 2022 owner earnings, and in addition to the athletic wear business, it owns a majority of Acushnet, which in turn owns top golf brands such as Titleist and Footjoy.
Current perspective on global markets:
Despite a challenging environment, global economic growth was very strong in 2021, following the contraction seen in 2020. U.S. real GDP growth is expected to be a robust 5.6% in 2021,9 and global GDP is similarly forecast to rise a strong 5.7%.10 S&P 500 earnings are forecast to have grown 14% in 2021, and U.S. retail sales in November were up an unprecedented 18.2% year-over-year,11 JP Morgan shared that credit card swipes were up 50% over Cyber Weekend,12 The New York Empire State Manufacturing Index in December reached its highest level in over two decades.13 China’s economy is expected to have grown at 7.8% in 2021,14 a healthy level of growth, especially after it outperformed global averages in 2020. Forecasts for global GDP in 2022 are for a robust 4.5% growth, as activity further recovered from the declines seen in 2020. The impact from the rapid spread of the Omicron variant, however, will bear watching.
A growing concern among investors is inflation. In December, U.S. CPI inflation reached 7% year-over-year, which was the highest in nearly four decades.15 Global inflation is also on the rise, with Eurozone inflation up 4.1%, the highest in 13 years.16
As we look back, the current inflation levels in the developed world argue that the long-dormant inflationary pressures have returned. Whether a high level of inflation persists or is transitory will depend in large part whether wages, which are less volatile than commodity prices, start rising. If U.S. business expectations are any indication, wages look set to see significant increases. Businesses are expected to increase pay an average of 3.9% in 2022, according to the Conference Board report. That’s the fastest rate of growth since 2008. Such high wage increase expectations follow already high wage increases in 2021. In November 2021, average hourly wages were up a strong 4.8% year-over-year.17
Also supporting the idea that inflation will be sticky is the fact that the Federal Reserve’s balance sheet rose an unprecedented 77% in 2020, followed by another 20% increase in 2021. Similarly, the M2 money supply rose 24% in 2020, followed by a 13% increase in 2021. In response to the higher CPI figures, rising wage pressures and falling unemployment forecasts, the Federal Reserve tapered its monthly bond purchases in November 2021 and will accelerate the reduction in January 2022. The Fed also indicated it sees as many as three interest rate hikes in 2022, followed by two in 2023 and two more in 2024.18 The risk exists that just as the Fed is forced to rapidly adjust its monetary policies as inflationary pressures build, it will have to be even more aggressive if wage increases lead to a wage-price spiral developing.
To adapt to an inflationary environment, companies must have pricing power. Selected International Fund holdings, such as the internet leaders Meituan, Alibaba and Tencent, all have the ability to raise their prices and maintain profitability. Advertising businesses, such as WeChat at Tencent and Taobao and TMall at Alibaba, will see their rates automatically increase, as advertisers bid up ad rates while they increase the price of their goods and services. The banks will also be beneficiaries of rising interest rates as their net interest margin will increase, leading to higher profitability. Proven and profitable internet leaders, along with well-capitalized financials trading at discounted valuations, are the two overweight sectors in Selected International Fund, and as such, we believe our portfolio will manage to adapt, should inflationary pressures persist and interest rates rise faster than expected.
By being highly selective and rejecting the vast majority of companies in the index, we have built a portfolio that has grown faster than the companies in the index, yet is significantly less expensive. In fact, the gap between price and value is among the widest we have ever seen. We believe this sets the stage for attractive returns in the years ahead.
Discuss some of the businesses Selected International Fund owns and any notable changes during this period:
Tokyo Electron (TE) is a leading supplier of production equipment and services to the semiconductor and panel display markets. The company provides production tools to a vast yet concentrated $550 billion semiconductor device market and $150 billion display market that both are entirely dependent on a small number of production tool vendors. Just as the recent global shortages have demonstrated how dependent global economies have become on chips, the companies that manufacture the chips, like TSMC, Intel and Samsung, are no less dependent on the vendors that supply them with production tools. By revenue, TE is the world’s third-largest supplier of semiconductor and panel display production tools, though in the company’s particular areas of specialization, like manufacturing coater developer processors and other batch-processing tools, it enjoys substantial market leadership.
Against the challenging backdrop of recent global chip shortages, the semiconductor market itself continues to experience significant end market diversification and expansion. It is precisely for this reason that the recent shortages have brought so many industries to a point of desperation. In response to these shortages, governments around the world are proposing subsidies and other incentives to build local chip production, realizing just how dependent their economies in fact are on chip production. This dependence only increases with industrial and corporate productivity largely being driven by semiconductor-intensive technologies like cloud computing, artificial intelligence, machine learning, electric/ driver assisted cars, factory automation, robotics, so-called 5G wireless and the Internet of Things (IoT). An expanding market, together with vastly more complex technical challenges, is the perfect scenario for equipment vendors like TE, a scenario that should inevitably result is an addressable market structurally much larger than today. By 2030, we see the semiconductor market reaching over $1 trillion (a CAGR of 7%), and a market that size will require an equipment market of $150–200 billion (a CAGR of 10–12%).
Since the election of Shinzo Abe as prime minister of Japan in 2012, there has been a gradual thaw in Japanese corporate governance. TE has increasingly been responsive to these changes, and the company’s chairman, Tetsuo (“Tom”) Tsuneishi, is proving himself to be more interested in cultivating global investors, especially in the U.S. In its 2020 March fiscal report, for instance, TE returned over 100% of free cash flow to shareholders in dividends and repurchases. Although TE’s share price has more than doubled since we initiated our position just over a year ago, at 23x next year’s owner earnings, we still see the shares as attractive. Given a range of outcomes for the global equipment market at between about $150 and $200 billion by 2030, we estimate internal rate of return (IRR) within a range of 6–8%.
Bank of Butterfield is a financial holding we purchased nearly four years ago, and while it is not a household name, it is quite unique. Butterfield is the largest community bank in Bermuda and the Cayman Islands (just under $2 billion market capitalization), providing retail banking and mortgage services to the domestic population. It is also one of the largest private trust companies, with over $140 billion in assets under administration and custody. Its balance sheet is extremely liquid; it has $14 billion in very low-cost and relatively sticky deposits that support a loan book of only $5 billion. The majority of its excess liquidity is deployed in AAA-rated U.S. government agency bonds that allows it to earn a nearly risk-free spread in excess of 150 bps. While Butterfield’s organic growth is low, its business model results in a bank that is highly profitable. In a near-zero-rate environment, Butterfield earns a mid-to-high teens return on tangible equity, and at normalized interest rates, it earns a mid-20s return on tangible equity.
The bank is very conservatively managed, with low leverage and high core capital ratios. The management pays a steady cash dividend that currently yields 4.7%, while the majority of the remaining excess capital generation is deployed towards buybacks in the absence of inorganic growth. For acquisitions, Butterfield has mostly been focusing on trust assets that pass its high standards and bring a steady fee income and more low-cost deposits.
Bank of Butterfield trades on 10x 2022 owner earnings and an attractive 11% internal rate of return (IRR). We like Butterfield for its high sensitivity to rising rates (because of its bond portfolio) and attractive shareholder returns. Over our nearly four-year holding period, Butterfield has returned approximately a third of its current market cap to shareholders in the form of buybacks and dividends.
Looking ahead, what is your outlook for Selected International Fund?
The underperformance of the Fund seen over the last year has been driven by a significant drop in the multiples that investors have assigned to the businesses of the large Chinese consumer internet companies, rather than a dramatic drop in their earnings power. The revenue and earnings generation of Tencent, JD.com, Alibaba and Meituan have remained good, and their outlooks continue to look promising. Rapid regulatory actions by the Chinese government can, of course, be disconcerting, but we believe regulation of the internet sector is an inevitable global trend, and if performed in a pragmatic manner, it is desirable for the long-term stability and growth of the industry. Other industries such as financial services, healthcare and media have all undergone at different moments intense regulation, and over time, we have seen the industry leaders flourish. Given the strategic importance of the internet industry and the Chinese government's focus on growing the domestic consumer sector, we believe that these industry leaders, over time, will flourish as well.
Potential economic risks on the horizon include the evolving difficulties of the COVID pandemic, rising inflation and the accompanying higher interest rates. As we think of the different investment options for investors, including fixed income securities, commercial or residential real estate, commodities or even cryptocurrencies, we continue to believe a global diversified portfolio of well-capitalized cash-producing companies trading at attractive valuations is the best option to both grow capital over time and adapt to an uncertain future.
We understand that in uncertain times such as these, it is more important than ever to be able to entrust your savings to an experienced and reliable investment manager with a strong long-term record. Over the 50 years since the firm’s founding, the Davis investment discipline has demonstrated an ability to generate above-average returns, based on in-depth fundamental analysis, a long-term investment horizon and a strong value discipline. While the times have changed, these fundamental principles are timeless and proven. We thank you for your continued trust and interest in Selected International Fund.
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.
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.
Objective and Risks. Selected International Fund’s investment objective is capital growth. There can be no assurance that the Fund will achieve its objective. Some important risks of an investment in the Fund are: stock market risk: stock markets have periods of rising prices and periods of falling prices, including sharp declines; 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; foreign country risk: foreign companies may be subject to greater risk as foreign economies may not be as strong or diversified; 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; depositary receipts risk: depositary receipts may trade at a discount (or premium) to the underlying security and may be less liquid than the underlying securities listed on an exchange; 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; exposure to industry or sector risk: significant exposure to a particular industry or sector may cause the Fund to be more impacted by risks relating to and developments affecting the industry or sector; emerging market risk: securities of issuers in emerging and developing markets may present risks not found in more mature markets. As of 12/31/21, the Fund had approximately 55.8% of net assets invested in emerging markets; 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; fees and expenses risk: the Fund may not earn enough through income and capital appreciation to offset the operating expenses of the Fund; and 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. See the prospectus for a complete description of the principal risks.
The Fund is subject to a 2% short-term redemption fee for shares held for fewer than 30 days.
The information provided in this material should not be considered a recommendation to buy, sell or hold any particular security. As of 12/31/21, the top ten holdings of Selected International Fund were: DBS Group, 9.16%; Danske Bank, 7.05%; JD.com, 6.64%; Tokyo Electron, 6.42%; Meituan, 6.32%; Samsung Electronics, 6.31%; Bank of N.T. Butterfield & Son, 5.56%; AIA Group, 5.49%; Ping An Insurance Group, 4.94%; and Hollysys Automation Technologies, 4.89%.
Selected Funds has adopted a Portfolio Holdings Disclosure policy that governs the release of non-public portfolio holding information. This policy is described in the prospectus. Holding percentages are subject to change. Click here or call 800-243-1575 for the most current public portfolio holdings information.
Davis Advisors began active daily management of Selected International Fund on 6/1/01. From 5/1/93 until 5/31/01, Davis Advisors had a subadvisor that handled the active daily management of the Fund.
Effective 5/1/11, Selected Special Shares was renamed Selected International Fund. The Fund’s investment strategy was modified to invest primarily in a diversified portfolio of common stocks issued by companies outside the U.S., including countries with developed or emerging markets. The Fund was otherwise unchanged.
Forward Price/Earnings (Forward P/E) Ratio is a stock’s current price divided by the company’s forecasted earnings for the following 12 months. The values for the portfolio and index are the weighted average of the P/E ratios of the stocks in the portfolio or index.
Compound Annual Growth Rate (CAGR) is the rate of return that would be required for an investment to grow from its beginning balance to its ending balance, assuming the profits were reinvested at the end of each period of the investment’s life span.
New York Empire State Index is the result of a monthly survey of manufacturers in New York state. Known as the Empire State Manufacturing Survey, it is conducted by the Federal Reserve Bank of New York. The headline number for the NY Empire State Index refers to the main index of the survey, which summarizes general business conditions in New York state.
We gather our index data from a combination of reputable sources, including, but not limited to, Lipper, Wilshire, and index websites.
The MSCI ACWI (All Country World Index) ex US is a free float-adjusted market capitalization weighted index that is designed to measure the equity market performance of developed and emerging markets, excluding the United States. The index includes reinvestment of dividends, net of foreign withholding taxes. The MSCI China Index captures large- and mid-cap representation across China A shares, H shares, B shares, Red chips, P chips and foreign listings (e.g. ADRs). With 698 constituents, the index covers about 85% of this China equity universe. Currently, the index includes Large Cap A and Mid Cap A shares represented at 20% of their free float adjusted market capitalization. The S&P 500 Index is an unmanaged index of 500 selected common stocks, most of which are listed on the New York Stock Exchange. The index is adjusted for dividends, weighted towards stocks with large market capitalizations and represents approximately two-thirds of the total market value of all domestic common stocks. Investments cannot be made directly in an index.
After 4/30/22, this material must be accompanied by a supplement containing performance data for the most recent quarter end.
Shares of the Selected Funds 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.
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