Chris Davis comments on BNY Mellon

One of the largest detractors from last year’s results was our holding in Bank of New York Mellon, which we count as a mistake because we have meaningfully lowered our appraisal of the company’s fair value. However, unlike some of the examples mentioned above, we have no doubt about the bank’s durability or the fact that it will remain profitable. After all, this 233-year-old institution has endured despite panics, depressions, civil war, world wars, and more. More important, we believe that the stock price has declined more than the business value and thus we expect to earn back some of this loss in the years ahead.
The immediate cause of the stock’s decline was earnings’ shortfalls, which in turn were caused by a combination of factors. Some of the factors are likely to be permanent. For example, for many years the company made a considerable profit executing foreign exchange trades on behalf of custody clients in a manner that does not appear to have been clearly disclosed to clients. In addition to harming the bank’s reputation, this practice is now the subject of significant litigation led by several state attorneys general. Beyond the cost of litigation and settlements, it is likely that the foreign exchange profit pool has been significantly and permanently reduced. Other factors, such as today’s record low interest rates and clients’ preference for bonds over stocks, should eventually reverse and add to profits. But some, such as a competitive pricing environment in which steep discounting is the norm, may or may not reverse. This last factor is unexpected as the industry is an oligopoly with the top three institutions accounting for about 50% of a very slow growing market, which typically makes discounting unnecessary. Profits lost by price cuts are unlikely to be regained even by meaningful changes in market share.
In our estimation, this combination of short-term and long-term factors has reduced earnings by some 20%–25%. Because we expect at least a portion of these factors to eventually reverse, we have reduced our estimate of Bank of New York Mellon’s value somewhat less. Bank of New York Mellon’s stock price, however, fell more than 30% indicating a widespread belief that all of these factors represent permanent changes. While we think this pessimism is understandable given the bank’s poor record of execution in recent years, considerable evidence also indicates that the bank’s core businesses remain quite strong. For example, in 2011 the bank increased its assets under custody by 3%, its assets under management 8%, its deposits 37%, its loans 18%, and its capital by 10%.
At today’s price, the company’s shares are valued at less than 10 times depressed profits that incorporate all the negative factors described above. We find this a particularly low valuation given that the company’s business model entails relatively little credit risk, obsolescence risk or balance sheet risk and that it can grow with relatively little incremental capital required. If some of the negative factors such as current interest rate spreads or today’s competitive environment improve, the stock could benefit not just from growing profitability but also from an upward revision of the company’s multiple to better reflect the durability and profitability of the underlying business. Although we recognize our mistake and have lowered our assessment of fair value, the fact that the shares now trade at a low multiple on depressed earnings leaves us optimistic that Bank of New York Mellon will add to our future returns and that we will earn back some of this loss in the years ahead.

The entire letter is posted here
http://davisfunds.com/document/read/DNYPMComm1Q12/