By Randall W. Forsyth

More than a few eyebrows were raised and foreheads furrowed when Goldman Sachs recently forecast that stocks could return a paltry 3% a year over the next decade. To U.S. equity investors who have seen 17% annual returns over the past decade and have come to expect double digits to persist into perpetuity, that prediction was greeted with widespread doubt and even disdain in some quarters.

Yet there have been past periods when the major equity indexes did nothing for extended stretches. Among them was 1972-82, observes Chris Davis, who heads Davis Advisors, the money-management firm founded by his father back in 1969. Davis, the firm, has hewed to the value-investing approach espoused by Benjamin Graham and practiced by Berkshire Hathaway, famously chaired by Warren Buffett, where Chris also serves on the board of directors.

In an interview the past week, he recalled that this long span, during which the broad indexes flatlined, actually was a fertile time for stockpickers. That was after the Nifty Fifty market of the early 1970s, when no price was too high to pay for supposed world beaters, supposedly to be held forever. Among those favored stocks was what Davis ruefully referred to as "X-rocks," now known has Xerox Holdings, which trades for $8 and change, down from over $70 back then (and $167 at its peak in 1999).

Also among the former elite were Digital Equipment and Burroughs in tech; J.C. Penney, Sears Roebuck, and S.S. Kresge (later Kmart) in retail; and Eastman Kodak and Polaroid in photography.

Davis sees parallels to that era more than to the dot-com bust at the turn of this century. In the late 1990s, stocks other than the top 10 large-capitalization favorites did well.

Investors now face what he calls two almost contradictory themes. First is the transition from the "almost magical thinking" that budget deficits don't matter, and from the free money that existed after the 2008-09 financial crisis. At the same time, unbelievably rosy growth assumptions persist in the face of economic fragility and pending disruption, as the world grapples with continued deglobalization and higher costs of both capital and labor.

In that environment, Davis sees a U-shaped distribution of companies. On the left axis reside cheap but fragile firms, which are likely to struggle, and on the right, high-growth but overvalued names. In between he sees a narrow range of reasonably priced companies that should be able to grow and show resiliency over time. But selectivity is key, he emphasizes.

That contrasts with the world-beating but pricey megacap tech champions, which were hit this past week after they reported good earnings but failed to top analysts' forecasts. As a result, the tech-heavy Nasdaq Composite lost 2.76% Thursday, its worst one-day loss in about two months.

Davis also sees dangers in putative safe havens such as some consumer staples. Examples include Anheuser-Busch InBev, which has faltered as the result of changing consumer preferences and the pressures from its leveraged balance sheet. Another is Estée Lauder, which he cited before the stock's latest tumble this past week after the cosmetics giant slashed its dividend and suspended its guidance amid its continued struggles in China.

Instead, Davis has continued to emphasize selected financial stocks, many of which remain cheap due to persistent overhangs from worries about credit losses, notably from commercial real estate, and last year's collapses of the likes of Silicon Valley Bank and First Republic, along with regulatory concerns.

That leads him to his longtime favorite pick, Capital One Financial, the big credit-card issuer, which Davis insists trades at a "shockingly low valuation" owing to widespread concerns about stretched consumer credit issues. Even so, the stock is up more than 30% so far in 2024.

Capital One's proposed merger with Discover Financial Services has drawn opposition from regulators and some in Congress. Davis said he would love to see the deal go through and contends it wouldn't be anti-consumer, since the combination would provide competition to the "duopoly" of Visa and Mastercard.

Other longtime financial favorites include Wells Fargo, which continues to operate under an asset cap, owing to its long-running problems that date to a fake-account scandal. The stock is up 32% year to date.

Bank of New York Mellon is in a different category altogether, he adds, calling it more of a "processor" with more than of $50 trillion assets under custody. It is up nearly 45% year to date.

In healthcare, another favored sector, Davis is sticking with Humana, down 44% this year. He is confident management will turn around the company's reputational problems.

And he is drawn to spinoffs, which tend to be undervalued, in part because of forced selling by investors in the former parents, and by the spun-off companies' desire to start trading cheaply to allow for bigger future gains. Among the spinoffs he likes are Solventum, the healthcare company spun off from 3M, and Viatris, the spinoff of Pfizer's Upjohn unit that was combined with Mylan.

Finally, Davis isn't averse to technology, and is drawn to Applied Materials, which gets a much lower valuation since it trades on its latest book-to-bill ratio. The big chip equipment maker has deep connections to its customer base with what he says is the best management outside of the "tech darlings" and Texas Instruments.

AMAT is an example of his favorite type of company, with "lumpy" earnings over the short term but resiliency over the long term. That has penalized the performance of the flagship Davis New York Venture fund, even with Meta Platforms (up 64% year to date) as its No. 1 holding. The fund has returned a total 39.93% over 12 months, versus 41.46% for the SPDR S&P 500 exchange-traded fund, according to Morningstar data as of Oct. 30.

During our chat, Davis emphasized building generational wealth over short-term gains. That old saw about past performance not being predictive of future returns may be more apt than ever.

Write to Randall W. Forsyth at randall.forsyth@barrons.com

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November 01, 2024 12:44 ET (16:44 GMT)

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