Overview
Performance
Important Contributors to Fund Performance
Outlook for Financial Stocks

Overview

The Davis Financial Fund's Class A shares provided a total return on net asset value of -5.31% for the one year period ended December 31, 2007 while the S&P 500® Index returned 5.49%.1 Since inception on May 1, 1991, the Fund has delivered an average annual total return of 15.17% versus a return of 10.64% for the S&P 500® Index.1

According to Morningstar, "Davis Financial's strong 2007 is showing up its skeptics. . . this Analyst Pick boasts strong long-term returns thanks to its team's sound judgment—this year's avoidance of banks with opaque balance sheets is only the latest example. Reasonable expenses add to the Fund's appeal."2

The performance presented represents past performance and is not a guarantee of future results. Total return assumes reinvestment of dividends and capital gain distributions. Investment return and principal value will vary so that, when redeemed, an investor's shares may be worth more or less than their original cost. The total annual operating expense ratio for Davis Financial Fund Class A shares as of the most recent prospectus was 0.98%. The total annual operating expense ratio may vary in future years. Returns and expenses for other classes of shares will vary. Current performance may be higher or lower than the performance data quoted. For most recent month-end performance, click here or call 800-279-0279.

1 Class A Shares, without a sales charge. Past performance is not a guarantee of future results. 2 Morningstar Mutual Funds, November 9, 2007.

Performance

As Portfolio Managers and investors in our Fund, Charles and I believe our performance should be evaluated in two ways, both measured over a holding period of five years or greater. First, how has our Fund performed versus the S&P 500® Index? Second, how does the Fund compare with its peer group of financial sector funds? We would also encourage shareholders to compare the returns they achieve on an after-tax basis, which capture the turnover in a fund's holdings. The SEC requires all funds to disclose this information in their prospectuses. The Fund's after-tax returns for the latest one, five and 10 year periods are shown in the second table below. We are especially proud that the Fund's after-tax return on distributions for the past 10 years has averaged 6.50%, or 94% of the reported pre-tax return.3 The Fund delivered an average annual total return on net asset value of 13.26% for the five year period and 7.46% for the 10 year period ended December 31, 2007.4 Over the same time periods, the S&P 500® Index returned 12.82% and 5.91% respectively.

Past performance is not a guarantee of future results. See the endnotes for important after tax disclosure.
3 Class A Shares, with a sales charge. 4 Past performance is not a guarantee of future results. An investor may lose money.

Charles and I try to do our best to protect the capital that you have entrusted to us and minimize losses to your investment.4 Since January 2000, just before the S&P 500® Index's March 2000 peak, we have been successful in this effort as the Davis Financial Fund has achieved a positive cumulative return on net asset value of 81.31% versus 14.09% for the S&P 500® Index.4

During 2007 the overall stock market as measured by the S&P 500® Index returned 5.5%. Financial stocks generally performed far worse than the overall market, with particular weakness among sub-prime lenders, U.S. regional banks, several investment banks, and other financial companies caught up in the deteriorating mortgage market. The financial component of the S&P 500® Index declined more than 18%.

Currently we see several negative and few positive trends affecting the various financial sectors in which the Fund invests.

For months now the financial media have focused on the fallout from the sub-prime mortgage market. The major question is what will be the near- to medium-term impact on the U.S. financial system, the overall U.S. economy and the health and confidence of American consumers, who account for approximately 70% of the economy.

The fallout from sub-prime mortgages has spread to other areas of the fixed income market and the overall economy. The contagion has been swift and troubling as many credit and fixed income markets have seized up. Trading has ground to a halt and liquidity evaporated in several markets, raising serious concerns about when liquidity will improve in some of these huge credit markets. Banks must be willing to make new loans and refinance existing loans for the economy to remain healthy and grow.

In my opinion the managements of many banks and investment banks are largely to blame for the huge risks they took in numerous areas: originating or buying huge amounts of subprime loans and collateralized debt obligations (CDOs) that included some sub-prime loans; sponsoring structured investment vehicles (SIVs) or off-balance-sheet funding through third parties involving highly leveraged loans that were agreed to at great terms for the private equity firms but now cannot be sold to investors at the interest rates previously expected and must be marked down in value; and underwriting mortgages and home equity loans sometimes without any income verification, sometimes at a 95% or higher loan-to-value ratio and worse, often based on rosy appraisal values. The list could go on and on.

Furthermore, when these risk-taking CEOs are fired they often walk away with exit packages worth tens of millions of dollars while shareholders have seen tens of billions of market value wiped out. It is hard to understand how this asymmetrical risk/reward relationship can be good for America and its citizens.

Clearly not every bank has been run so poorly with such disregard for the risks taken but far too many have been. No matter what excuses banks offer for these big losses, mismanagement and exceedingly poor risk controls are really to blame. One of my favorite quotes from Warren Buffett concisely sums up the current environment: "You only find out who is swimming naked when the tide goes out." Fortunately these large banks and investment banks have been able to tap foreign investors for more than $60 billion to repair their balance sheets and their capital ratios at least for now.

The losses in many of these problem areas are huge and rising. The fear is that many banks will continue to rein in lending and hunker down to protect their capital, resulting in a severe, long-lasting credit crunch that would be enormously damaging to the U.S. economy. These huge credit and fixed income markets need to reopen so that companies can securitize their existing loans to raise cash for new loans and keep the system going. Liquidity is crucial for financial firms and without this liquidity more firms may fail or be forced to merge with larger, more liquid banks at unattractive terms for owners. Countrywide's decision to sell itself to Bank of America for $6 per share is a great example as Countrywide's stock sold for $45 a share in February 2007.

Outstanding sub-prime mortgages total approximately $1.3 trillion, or about 12% of the approximately $10.5 trillion U.S. mortgage market. Sub-prime delinquencies and losses are rising and will almost certainly get worse as hundreds of billions of dollars in adjustable rate mortgages issued at artificially low teaser rates over the past few years are now resetting at significantly higher interest rates. This reset will increase monthly mortgage payments for many homeowners, almost certainly triggering a wave of increasing defaults and foreclosures and definitely reducing consumers' confidence and their propensity to spend. So these higher mortgage payments will be a headwind to economic growth going forward. Despite actions by the federal government to freeze many of these resetting loans in an attempt to reduce foreclosures, there are still some tough times ahead.

The Fed is now very straightforward about its intention to lower the federal funds rate and the discount rate in an effort to stimulate the economy and stabilize home prices. Despite rising inflation in the United States, the economy needs to be stimulated if we are to avoid a downturn. The government would also like to pass some fiscal stimulus for the middle class, although in an important election year it may be difficult for Congress and the President to reach an agreement. Any stimulus package would also be modest in size compared to the decline occurring in housing values.

To sum up, U.S. consumers have reined in spending as falling home prices (their most important asset), a declining stock market, higher energy and gasoline costs, and rising unemployment have taken a toll on their confidence and discretionary spending. Not surprisingly, as the housing bubble has been pricked, home values are now falling the most in areas where they rose the most over the past five years, often driven by enormous speculation. Consumer spending has also fallen the most in these often large states, and credit losses are rising fast as well. Furthermore, the current credit crunch has reduced the ease with which many consumers can borrow at favorable terms and this will further reduce consumer spending.

On the positive side, America continues to be an adaptable and dynamic economic powerhouse with a GDP approaching $14 trillion or almost 25% of global GDP. One critical economic indicator to monitor closely is job creation and over the past three years more than five million new jobs have been created. While unemployment is now rising and recently hit 5%, this is still a very favorable level. Significantly there are approximately 146 million Americans working today and almost 70% of Americans own their homes. Also U.S. household net worth is now approximately $58 trillion, up from $25 trillion approximately 11 years ago. These are just a few of many enormously important factors supporting the long-term robustness of the American economy.

While no one knows precisely how the American economy will respond to these stresses, we will do our best to stay focused on the dynamic changes that may be occurring.

Important Contributors to Fund Performance5

On the positive side, the biggest contributors to performance during 2007 were the State Bank of India, China Life, Transatlantic Holdings, Loews, and Bank of New York Mellon.

On the negative side, our performance was hurt by our positions in First Marblehead and Moody's. First Marblehead stock soared 152% during 2006 only to plummet 71% during 2007. Investors worried about the large concentration of First Marblehead's student loan business in two big banks as well as the difficulty of tapping the securitization markets for funding due to the credit crunch. As disappointing as 2007 was for First Marblehead, shareholders received at least some good news in late December when Goldman Sachs agreed to buy up to 19.99% of the company and arrange for $1 billion in new funding to allow the company to continue to grow its business. First Marblehead shares rose over 60% that day alone but it was still an awful year for shareholders.

Moody's shares fell 48% during 2007 as earnings will likely decline for at least the next several quarters. Volume from an important and previously fast-growing part of the company's revenues—structured products—has declined dramatically. However, over the long term we still expect Moody's to deliver solid value for shareholders.

We sold several companies during the year including Wachovia, Altria, Tyco, Tyco Electronics, Covidien, and the vast majority of our position in Commerce Bancorp, which has agreed to be acquired by the extremely well-run Canadian bank Toronto-Dominion.

We made two important, large investments during the year—Bank of New York Mellon and Merrill Lynch. Bank of New York Mellon is now a top holding at almost 6% of the Fund. Bank of New York and Mellon Financial, in which the Fund owned a small position, merged in mid 2007, creating the largest custody bank in the world. Bank of New York Mellon is a big bank with a market capitalization of $54 billion. However, more than 80% of its revenues come from fees rather than much riskier lending activities. Despite being a bank at a time when most bank stocks are suffering from weakening balance sheets and declining earnings due to missteps in sub-prime mortgages and exposure to CDOs, SIVs and highly leveraged lending as well as deteriorating credit trends, Bank of New York Mellon has only negligible exposure to any of these problem areas according to our analysis.

In addition, the company is a leader in almost all of its business lines. One quarter of its earnings comes from asset servicing such as the custody business. Every time a security is purchased by an institutional investor the certificate must be housed safely in a bank. Bank of New York Mellon is the #1 player globally with $21 trillion in assets under custody, giving it a 15% share of this $140 trillion market. Importantly it provides outstanding customer service and has been profitably gaining market share. Smaller banks have exited the business over the years because they do not have the scale to make the technology investments necessary to remain competitive with the leaders including Bank of New York Mellon, JPMorgan Chase, State Street, and Northern Trust.

One quarter of the bank's profits comes from issuer services such as the corporate trust business. All those bond coupon payments must find their way to the rightful owners of the securities with virtually 100% accuracy and Bank of New York Mellon is well compensated for assuring this happens.

Another quarter of its profits comes from the asset and wealth management business where Bank of NewYork Mellon is one of the largest players in the world, with $1.1 trillion in assets under management. The company has a broad array of capabilities in this area, including equities, fixed income, money markets, and hedge funds, and its long-term investment performance for clients has been quite good.

CEO Bob Kelly leads the management team. Bob was formerly the CFO at First Union and led the successful merger between First Union and Wachovia. Bob is a no-nonsense fellow who is extremely focused on creating superior long-term shareholder value. He holds his people accountable with goals that are benchmarked against appropriate peers and openly displayed so management and shareholders can chart progress. Bob also has a strong dislike for corporate waste and understands the importance of allocating capital in driving long-term values. Furthermore, Bank of New York Mellon generates enormous free cash flow and we expect aggressive share repurchases to begin in early 2008.

To date, the merger between these two big banks has gone almost flawlessly as more than 99% of customer relationships have been retained. Bank of New York Mellon is also on track to generate $700 million in expense savings by 2009 and $250-$400 million of revenue synergies by 2011. We hope the company can exceed these goals.

Importantly, 32% of revenues now comes from overseas but this could rise to 50% of revenues in five years as emerging markets and cross-border investing continues to boom.

Bank of New York Mellon trades at just 14 times what we believe the company can earn in 2008, which is an extremely compelling price to pay for the opportunity to own these high return-on-equity, recurring-revenue businesses led by a very talented and shareholder-oriented management team. While not totally immune to the difficulties being experienced by some financial companies today, we expect Bank of New York Mellon to grow earnings per share for many years to come.

We also initiated a position in Merrill Lynch, which as of December 31, 2007 was approximately 4.4% of the Fund. We feel fortunate to be able to invest in one of the most valuable financial services franchises led by outstanding new CEO and former Goldman Sachs COO John Thain.

5 Past performance is not a guarantee of future results. This is not a recommendation to buy or sell any specific security.

Outlook for Financial Stocks

In our experience, investors have always found and will always find something to worry about. We are concerned about the impact of declining home values and the negative wealth effect on consumer spending, the high debt burden on many consumers, rising credit losses at banks and other lenders, the twin deficits, rising commodity prices, rising inflation, and the fast-growing use of derivatives at large financial institutions whose financial health is important to the U.S. and global economy.

However, we believe carefully selected companies with competitive advantages, strong balance sheets, solid free cash flows and earnings growth potential, and proven outstanding management that are purchased at attractive prices should perform well for investors over time. We remain optimistic about the long-term outlook for financial stocks both within the United States as well as overseas.

I want to congratulate Charles Cavanaugh on his new position as Co-Portfolio Manager of the Davis Financial Fund. His promotion is well deserved. Charles has a tremendous drive to create value for our Fund's shareholders and an intense passion for investing. Most important, Charles has a high level of integrity. He has added value to the Fund's returns as an analyst covering financial companies and I fully expect Charles to add even more value as a portfolio manager.

Thank you for your interest and continued support. ■

For more information, please contact...

DAVIS DISTRIBUTORS, LLC
2949 East Elvira Road, Suite 101
Tucson, AZ 85706
1-800-279-0279