Christopher C. Davis: Inflation on the horizon

Christopher C. Davis is a portfolio manager of the Davis Large Cap Value Portfolios. What is your outlook for the economy in the second half? Where do you see the Dow Jones Industrial Average, S&P 500 and Nasdaq Composite Index finishing the year? Also, what is your outlook on interest rates? While we, like any money manager, would like to know the answers to these questions, the reality is that nobody can consistently predict the ultimate level or even the direction of market indexes and interest rates over very short time horizons. We have a longer-term view that select equities should produce satisfactory returns over the next decade, especially versus cash and bonds, based on our long-range expectation of underlying profit growth on the one hand, and today's relatively reasonable valuations on the other hand. The key to outperforming in the long run, in our experience, is to select durable businesses with favorable compounding characteristics that can be purchased at reasonable valuations and held for the long term. What worries you most about the markets and the economy over the remainder of the year? A formidable challenge facing the U.S. economy, and to some extent the global economy as a whole, is the burden of public- and private-sector debt. While extreme situations like Greece may be the exception and not the rule, we must nonetheless consider the likelihood that current policies throughout most developed economies could lead us down a path of higher interest rates and inflation in the years ahead. To mitigate these risks, we have a strong preference for durable, global market leaders with strong balance sheets. Many of these businesses are both self-funded (with minimal external capital requirements) and have pricing power that allows their earnings to be somewhat inflation-protected. Which areas of the equities market look attractive to you? We believe there is no shortage of attractive investment opportunities in the equity markets today starting at current valuations. A number of themes that are prevalent in our portfolios can be summarized as -follows: Globally dominant businesses. By this we are referring to world-class franchises that are industry leaders with strong pricing power, healthy balance sheets and durable competitive moats. Beneficiaries of crisis. Certain businesses, by virtue either of their particular business model and/or their management's skill, can be natural beneficiaries of crises, making accretive investments or acquisitions at favorable prices and exercising the flexibility to buy back stock. Select financial companies. Financial services is largely a “non-obsoletable” industry in the sense that basic banking, insurance and capital markets services should always be in demand by individuals and businesses. Some of the best-managed financial services companies have a history of delivering superior returns for shareholders over the long run, not just relative to the marginal competition but also relative to the market as a whole, yet can be purchased at very attractive valuations today. Energy, commodities and agriculture. Certain well-managed companies in these sectors are well-positioned in our view to benefit from the inexorable long-term growth of a global middle class. Special situations. These are opportunistic, long-term investments that cut across industries and whose appeal is based on the underlying economics of specific businesses coupled with very favorable valuations. What one investment-related suggestion would you make to financial advisers? The most important piece of advice we can offer is that financial advisers, as well as investment managers, should work to promote healthy investor behavior, which is shorthand for advocating a disciplined, unemotional approach to investing. Investment decisions based on emotions can be very costly, as they all too often lead investors to buy high and to sell low. One way to remove emotions from the equation is to invest systematically, where a regular amount of money is invested on a consistent basis, regardless of the market environment. Such a disciplined, systematic approach not only helps in promoting the counteremotional mindset necessary to build long-term wealth, but it can also help investors capitalize on market volatility.