How we outperformed the benchmarks in 2025 while underweighting the “Mag 7”; where we see biggest opportunities now and bubbles to avoid
Transcript
Chris Davis:
Hi, everyone. I'm Chris Davis, the co-portfolio manager of the Davis Select US Equity ETF, DUSA. This is our flagship actively managed ETF that we launched almost 10 years ago. We've just crossed a billion in assets under management, and we're proud to say it is the #1 performing active or passive large cap value ETF over the last three years.
So what I'd like to do today is take a few minutes of your time to provide an update on how the portfolio is positioned to results, to discuss contributors and detractors, to highlight some of the recent portfolio allocation decisions, and really most importantly, unpack why we believe DUSA is so well positioned in today's dynamic and fast changing market. And to that end, I'll also share some perspective on the economic and investment landscape, which is so much at the top of people's minds today. So let's start with results.
As you can see here in 2025, DUSA outperformed the Russell 1000 Index by more than 600 basis points, and this adds to a record of out-performance over the last three, five, seven years, and really since we launched now almost 10 years ago. In fact, over the last three years, DUSA has been the #1 active or passive large cap value ETF, outperforming the index by over 1,100 basis points. Now, what's important to realize is that we've achieved these results without a massive overweight in the market darlings or the Mag 7. In fact, we actually have less than half of the market exposure to this. So achieving those results at a time when the market has been so concentrated in that Mag 7, we think is particularly notable. We've received four stars from Morningstar, and like the true structure of the ETF, paid no capital gains in 2025.
Now, after a period of such strong results, investors often worry, have they missed out? And what I really want to spend time on is outlining why we believe DUSA is so well positioned in today's market looking forward. Now, here's why. The whole philosophy of DUSA is about selectivity. We don't have to own the index. We don't have to own the companies we think are overvalued or competitively challenged. We can be highly selective. And by owning only a tiny fraction of the index, we're able to achieve this very powerful combination of attractive growth at deeply discounted valuations.
Here you can see the growth rate and earnings of our portfolio companies over the last five years has been very attractive, especially when compared to the Russell 1000 Value. And yet, despite this attractive growth, look at the valuations. We have a portfolio that's currently trading at an enormous discount, not just to the S&P 500, but also a significant discount to the Russell 1000 Value. That combination of attractive growth and deep undervaluation, we think is what positions us so well looking ahead.
Okay. I'd like to start by taking a look at the contributors and detractors to recent results. And here, the real watch word is selectivity. For example, financials as a sector were good performers last year but the selective financials that we owned outperformed even those. So companies like Capital One, Wells Fargo, and Markel were really strong performers and contributors to our 2025 results. In technology, again, we have a significant under-weighting in the Mag 7 as a whole, but we very selectively own companies like Applied Materials, Google, and Amazon that were big contributors to results.
And then in healthcare, a sector marked by enormous volatility last year, we had great contributions from our longtime investment in CVS as well as Quest Diagnostics, the laboratory testing company.
Now, turning to the other side of the ledger, the detractors. Some of the detractors were really companies that we have been inclined to add to because we view them as oversold and under-earning. These are durable businesses like ConocoPhillips, Tyson Foods, MGM, and Viatris, a maker of branded generics. And we think that although they detracted from short-term results, they're positioning us well for the years ahead.
Now, I'd like to get more granular and talk a little bit about some of our recent capital allocation decisions. We've been adding to energy and in particular to a company, Coterra, which is known for its strong presence in natural gas in the Marcellus Shale in Pennsylvania, as well as its core holdings in the Permian Basin.
On the strength of a lot of the Mag 7 and technology stocks, we trimmed companies like Meta and Applied Materials. Although we love these companies, we have to stick to our valuation discipline because there's less of a margin of safety as prices run ahead. We use those proceeds to add to some overlooked technology companies, including names like Pinterest.
Now, I mentioned earlier the strength in financials and the financial sector, and we use some of that strength again to trim some of the companies where the margin of safety was reduced, companies like JP Morgan, Capital One, and American Express.
And finally, as I mentioned earlier, we've been building positions in a sector that we call oversold and under-earning. These are companies that have enormous durability. They're not cigar butt investments, but yet they might be under some temporary or cyclical earnings pressure. And so in our mind, they're selling at a low valuation of depressed earnings. That gives us two ways to win. So companies like ConocoPhillips, Tyson Foods, MGM, and Viatris fill out that idea.
One of the key characteristics to understand about how our portfolio is positioned is to recognize its differentiation. We say simply you can't do what everybody else does and expect a different result. If you want to outperform the index, you can't look like the index. So here you can see based on sector weightings, our enormous differentiation. But you can also see when you look at our individual holdings that we are selective within those sectors. Now, the way this is talked about in the industry is the idea of active share. In other words, how different do you look than the index? And you can see we had historically a very, very high active share.
I'd now like to share with you some perspectives on today's investment landscape and how we're positioned to take advantage of it. Okay.
In describing the investment environment, I want to make clear that we're not interested in trying to make short-term forecasts, because these have no predictive value. Let me share with you an example of what I mean. In this chart, we simply keep track of the interest rate forecasts of the top Wall Street strategists. We score those forecasts as correct if they get the direction right. In other words, they answer the question, will interest rates be higher or lower six months from now correctly? As you can see, the forecasts of even these experts have no predictive value, and they were wrong almost 60% of the time. So we can't predict and make short-term forecasts, but what we can do is prepare for the inevitable. For example, investors should expect that a 5% market dip happens three times a year, 10% on average once a year, 20% or more on average every three and a half years. Such corrections are painful, but they are not a punishment. They're more an admission fee. They are an unpleasant but inevitable part of the investment landscape, so we need to be prepared.
Now, with those caveats, let's talk about our working assumptions as we look out at the investment and economic landscape today. We start with a view that we expect unemployment to trend higher over time. This is partly a reaction to the uncertain environment that we're in, and it's partly the impact that we'll see as AI rolls out across different industries through the economy.
We also believe that the biggest economic risk that we face is really about monetary inflation. We continue to have a mindset as a country that we can spend more than we make. We have a printing press, and that increases the risk of monetary inflation, and we keep our eye on that. We do believe AI is transformational We believe that technology is a key economic driver for the last 30 years, and AI is an accelerant. So the idea of how AI affects the investment landscape has to factor through all investment analysis. And yet, despite the high moves in the market and a lot of the excitement and euphoria, we really believe opportunities exist but the key in this sort of environment is to focus on quality, durability, and valuation. That is the way to manage uncertainty and risk in this sort of environment.
We do see a number of potential bubbles as we look out of the investment landscape. We think the momentum strategies and the enormous flow into passive strategies which are themselves have momentum, characteristics with that enormous concentration, that there's a real risk of a bubble emerging there. We think in some of the alternative markets that have less liquidity, whether it's private equity or private credit, we do think that there may be shocks and surprises and disappointed investors in that area.
Some of the dividend darlings where people feel safe when we look through at the fundamentals of the underlying businesses, we see a lot of risk there and some overvaluation. Payout ratios are stretched and the competitive position of many of those businesses that were once stalwarts are now being challenged. And another example where there may be a bubble is in some of the hyperactive growth assumptions that we see in this AI space. With the spotlight on AI, people are projecting growth deep into the future at high rates. And one of the things I'd like to share with you is how difficult and unlikely that is. Right?
Strange things can happen. It was once said that the race is not always to the swift nor the fight to the strong, but that's sure the way to bet. We are probabilistic investors and look here at how hard it is for companies to maintain very high growth rates for long periods of time. Similarly, many of these companies where analysts are projecting high growth rates, they're also projecting that somehow very high margins will be sustained rather than competed away. As you can see here, that is a very unlikely outcome. And when you put those two things together, we do see some investors that are headed for disappointment with their rosy outlooks for many of these AI companies.
So now in finishing out what we think in the investment landscape, we think it's important to prepare for all of the sorts of normal volatility and shocks that appear over a long investment cycle. In other words, we want to make sure that we stress test all of the companies that we own for a meaningful stock market correction, for an eventual recession. We don't know when a recession will come, but we know that one will come, and we need to be prepared for that.
We know that there can be geopolitical shocks, and by nature and definition, they are unpredictable. And of course, we're an environment with enormous political and fiscal uncertainty. So this is a time that investors shouldn't be pessimistic, but they should be realistic. They should be thinking about mitigating risk and focusing on durability and quality and the ability to get through the inevitable shocks that we'll face in the years ahead.
Given that investment backdrop, I'd like to talk about the specifics of our portfolio positioning and take you through some of the themes and sectors and companies in which we see the biggest opportunities in today's market. Let's start with a category of dominant disruptive tech giants and the companies that provide the picks and shovels in this AI gold rush
As I mentioned earlier, we've achieved good results despite being significantly under-weighted in some of the Mag 7 type of stocks that have been such drivers of the market. So the key is selectivity within this sector where there is so much hype. Our focus is on valuation. We don't want to buy the companies that are overvalued with hyperactive growth assumptions. We want to focus on the stalwarts versus the concepts versus the darlings. We're interested in the companies that have the raw material of big compute capacity, but also enormous data sets.
They have the customer base and they have the cash flow that allows them to make these investments without taking the risk of taking on debt or constantly issuing equity, as we see in some of the darlings. And of course, within that AI world, we want the picks and shovels companies. Think of companies like Applied Materials that make the equipment that makes the chips. And as we think about the companies that have all those raw materials and the durability and the cashflow, companies like Meta and Alphabet, Amazon that in a way is a beneficiary of the change to agentic AI as well as an enormous provider of compute, one of the best managed and most durable companies in this sector. And of course, companies like Texas Instruments, not the household name of the edge of tech innovation, but really making the nuts and bolts that are part of all of the systems that are being created as we move into this brave new world.
Within financials a sector that is increasingly getting attention, we have believed for more than three decades that the key is selectivity. This is not a sector that you want to index. It's a sector where you want to own those companies that are competitively advantaged and have the sort of characteristics that we call growth stocks in disguise. We think selectivity and differentiation really pay off, and you're continuing to see a tale of two cities in the financial services sector. Those companies that are positioned for the changes that are happening and those that will be disadvantaged.
We like the ones that are AI beneficiaries, the companies that have the scale and the mindset and the data to take advantage of it. Companies like Capital One and Wells Fargo, that have deep customer bases across the country like US Bank and that have the durability and breadth of companies like Berkshire Hathaway. So competitively advantage selective holdings and financials, not simply a sector bet.
In the healthcare sector the keyword is opportunistic. Healthcare is an industry where there's enormous volatility by sub-sector and by company, and we want to be opportunistic. We try to focus on those companies that are recession resistant, that have that characteristic of durability and strong durable demand. We like the sectors that are about services and generics, and we want to avoid the sort of companies that have big single drug risk.
We also believe that within this sector, we want to own companies where AI can be used to improve earnings by reducing costs and to improve the customer and patient experience by improving service. Companies like Viatris, which is a maker of branded generics. It's not a glamorous business, but this is very durable, reliable, steady sources of cash flow.
And Solventum, a recent spin out from the 3M company of their healthcare products business spun out into a separate company and given this unwieldy name of Solventum. But again, the theme of opportunistic and durable are really what capture our investments in the healthcare sector.
In a world where there's been a lot of excitement around certain commodities like gold, we're really focused on undervalued energy and materials companies. We're not trying to chase a bubble, but own companies that have durable sources of long-lived reserves. So we think oil has been overlooked somewhat in this commodity boom. So we've added companies like ConocoPhillips, for example. And then we think of Coterra as more and more demand for electricity is built, having deep, cheap sources of natural gas as a logical transition fuel can be a great advantage for a company like that.
And finally, as we think of the electrification trend unfolding, the increased demand for power driven by AI, we also think of the need for transmission. And of course, copper is the lifeblood of electrification, and a company like Tech Resources has some of the longest lived reserves and also the lowest cost reserves in the world.
And a last category that I'd like to discuss in our portfolio positioning is what we call oversold and under-earning. And we could also call these overlooked, but here in the so called traditional value space, what we want to avoid are the value traps and the cigar butts. We want to buy businesses that are characterized by durability, by the sense that they aren't being disrupted, that they have the strength to withstand cyclical downturns, and yet companies that are attractively valued on somewhat depressed earnings. So we have the double play of recovering earnings and a revaluation of those companies as a potential.
Two, poster children for this theme are Tyson Food, really the largest protein company in America, making both chicken and beef, for example. And then at the other extreme, MGM Resorts, one of the largest casino operators in the world, having properties in Las Vegas, Macau, and by the end of this decade, the most valuable property in Japan.
So that gives you a sense of how the portfolio is positioned both by themes, but more importantly, by the very specific companies that we own to take advantage of those themes in this fast-changing economy.
Putting it all together, one of the key characteristics of this current market environment is the bipolar nature of investor sentiment. There are people that are wildly optimistic, believing we're on a plateau of permanent prosperity, chasing momentum, chasing high growth, and they're taking enormous risk on one hand. On the other hand, we have the people that are terrified and bearish and pessimistic, that say the market has come too far, too fast, and they want to wait on the sidelines. They're taking enormous risk of missing out on being invested for the long term.
We try to build a portfolio based not on being optimistic or pessimistic, but being realistic, to be able to withstand the inevitable shocks, but also to make progress when times are good without taking the risk of the big momentum and go-go growth investors. So let's return to this fundamental picture of the portfolio because this is really the key.
The high selectivity allows us to identify just that handful of companies that combine truly attractive growth and durability with an enormous discounted valuation. To us, that puts in the best of both worlds of getting the growth that we seek in long-term investments, but not taking the risk of over-hyped high valuations, so to own above average companies at below average prices. That's the key to how we are positioning the portfolios in today's uncertain world.
So as you review our portfolios, as you meet with clients, I hope we were able to provide some information on why we can have some concern and skepticism and caution about the euphoria in today's market environment, and yet have enormous confidence, conviction, and optimism about how our portfolios are positioned for 2026 and beyond.
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