What Is The Backdrop For The Current Market?

Davis: In the United States, we’re in a period of low inflation, low interest rates, relatively full employment, fair valuations and moderate growth—a pretty good landscape. But inflation and interest rates are normalizing and the long­-term deficit will have implications sooner or later. We have these unclear trade policies, and we’re in an environment where margins are unquestionably near peaks. When you put that together and ask where the opportunities in the United States are, we say: selectivity is key, and it’s going to be the theme over the next five to 10 years.

Selectivity is going to matter because the averages aren't going to work as well. If you can find wide­-moat busi­nesses with room for margin expansion and earnings growth—at a time when the average company could be facing falling margins because of higher labor costs, higher raw material costs and higher interest costs— those businesses are going to be differentiated. We also should be looking for out­-of­-favor businesses for what I would call “a return to classic value.”

The last thing is just simply to say we always like looking at where the headlines are bad. (Davis Advisors may invest in a company when the company becomes the center of controversy. The company’s stock may never recover or may become worthless.) That has drawn us to financial services in particular, as well as energy.

What Do You Think Is In Store For Financials?

Davis: I think we’re a few years into what is going to be a decade­-long rotation. This rotation is really going to drive financials to where they should be and how they should be perceived—which is relatively safe, high dividend growth, high value, boring. This is not just a U.S. theme; we’re finding select opportunities in financials around the world.

Following the Great Depression in the 1930s, nobody wanted to own bank stocks for another 20 years, but after the first decade had gone by, the businesses themselves were performing quite well. Of course, the businesses do well because after something like the Depression, or in more recent times, the financial crisis, you have less compe­tition, more capital, more regulation and wider moats.

The first thing that changes is people start realizing that the businesses that survived are actually pretty good. So people start to say, “Well, the businesses are doing well.” We're seeing that as earnings are coming out year after year, enormous earnings, rising dividends, great credit quality, fattening interest rate spreads, a lot of things are moving the right way—except for one: Valuations remain at a 30 percent or 40 percent discount to the averages.

We’re now in transition to what I believe may be the next decade of good performance, which will be driven by people coming to recognize that financials are boring, compounding machines. Not all financials, but, again, being selective and recognizing that they could be the next decade’s dividend darlings.

These companies had to amass an enormous amount of capital for a decade. Now, they have built up their capital ratios. Now, we can gradually move into distribution mode. Not all at once, but I think we will see dividends for some of these companies rising 10 percent a year or so on average for the next five to seven years. This is in addition to the fact that financials were big beneficiaries of the recent tax code changes.