Market Perspectives
Portfolio Positioning
Performance Review

Since our founding more than 40 years ago in 1969, Davis Advisors' mission as a firm has been to serve our shareholders and to do so with high integrity. Mindful of the enormous responsibility that comes with serving as a steward of others' capital, we are firmly committed to:

• Investment excellence: Davis Advisors conducts rigorous fundamental research with the goal of producing solid long-term investment results for shareholders.

• Sharing wisdom and perspectives about investor behavior: We strive to promote healthy investor behavior, which we firmly believe can positively influence the results that shareholders ultimately realize.

• Open and honest communications: We seek to communicate with our shareholders in a manner that we would desire if our roles were reversed.

As a sign of our commitment to all those who have entrusted capital to us, the Davis family, Davis Advisors, employees, and directors have more than $2 billion of their own money invested side by side with fellow shareholders in the various mutual funds our firm manages.1

This report includes candid statements and observations regarding investment strategies, individual securities, and economic and market conditions; however, there is no guarantee that these statements, opinions or forecasts will prove to be correct. Equity markets are volatile and an investor may lose money. Past performance is not a guarantee of future results.
1 As of June 30, 2010.




Market Perspectives

In the first half of 2010 global equity markets remained in a broad trading range, appreciating in the first quarter before giving up ground in the second quarter to finish the year-to-date period in negative territory. All major sectors declined to one degree or another during the first six months of the year. The recent market downturn reflects a litany of concerns including relatively high unemployment in a number of major economies worldwide, prolonged weakness in certain residential and commercial real estate markets, relatively weak economic growth in the United States, uncertainty within the eurozone, and the impact of the Gulf of Mexico oil spill, among other factors.

While today’s news headlines may give investors pause, it is important to consider the extent to which those concerns are already reflected in security prices. Today, many high quality, well-established businesses are trading at very reasonable price/earnings multiples, some at the most reasonable valuations we have seen in decades. While we know that stock market declines often weigh on investors’ emotions, an unemotional approach to investing suggests to the contrary that the long-term opportunity to own high-quality businesses is compelling.

Portfolio Positioning2

Market conditions may vary from period to period, yet the core tenets of the Davis investment discipline and approach remain the same. We start with the premise that stocks represent fractional ownership in real businesses. We seek to purchase durable businesses at value prices and hold them for the long term. We believe that owning shares of well-managed businesses with attractive reinvestment rates, purchased at reasonable valuations and held for years to allow the power of compounding to work, is a reliable method for building capital over long investment horizons.

By definition, owning shares of companies for years or even decades means that some, perhaps all, of our investments will traverse rough patches along the way, whether they are specific to a company, an industry or the broader market. We know in advance that we are going to own businesses in periods of rising interest rates, falling interest rates, inflation, disinflation, a weak dollar, a strong dollar, and so forth. Therefore, when we think about purchasing shares of a company, we have to weigh carefully up front whether we think the business can withstand inevitable shocks in addition to considering the likelihood the business can grow earnings power (and therefore intrinsic worth) over full cycles. Then, company by company, we set out to build a durable, all-weather portfolio of businesses that can compound over the long term.

Our Portfolio holds three primary categories of investments:

• Market leaders with strong balance sheets
• "Out-of-the-spotlight" businesses
• Headline risk or contrarian investments

Market leaders with strong balance sheets— In many cases these are global companies with universally known brands, earnings that are well diversified from the standpoint of product line and geography, and fortress balance sheets. These businesses span a broad range of global industries from consumer products to financial services to technology to retailing, among others. They provide a core foundation of stability within the Portfolio and offer in our view the possibility of long-term sustainable returns through capital appreciation and dividends.

Lindt & Spruengli, a Swiss manufacturer of premium chocolate, is a representative market leader in our Portfolio. The chocolate market is very segmented with mass producers at the low end and Lindt and a few others serving the high end premium market. Premium chocolates have higher cocoa and cocoa butter content, which produces a smoother, richer taste. This business enjoys a competitive advantage as premium chocolate is difficult to make, keeping larger mainstream chocolate producers at bay. Importantly, the strength of Lindt’s business model was proven over the past year as the company continued to build market share in spite of a challenging economic environment. From a financial standpoint, Lindt has a solid balance sheet with a net cash position which enhances its flexibility.

With its large, strong, and durable global franchise, Swiss-based Nestlé is another excellent example of a market leader. Its brands, mostly serving the global food and beverage market segments, include Gerber baby food products, Poland Spring water and Purina pet food, among others. Nestlé’s sales show broad geographic diversification with revenues spread almost evenly among the United States, Europe and emerging economies. The company has a long history of disciplined capital allocation and regularly returns cash to shareholders through share buybacks and annual dividends.

ABB, a Swiss engineering giant that manufactures power generation, transmission and distribution equipment for the electric grid, is yet another market leader in our Portfolio. Given the safety, reliability and technological requirements of its customers, ABB offers products and services on a global basis that can be matched only by a short list of competitors. In our view ABB is well positioned to benefit from the billions of dollars governments and private utilities are investing worldwide to build and update electric grids. For example, in Western economies investments in renewable power generation such as solar and wind create concurrent demand for improved transmission and distribution capabilities as these new sources of energy must be connected to the power grid. In addition, intermittent sources of power such as wind may require upgrades in transmission and distribution equipment to redistribute loads quickly. Meanwhile, in emerging markets like China and India, governments are actively building their electrical infrastructure to provide reliable power to both industrial and rural areas, often investing in state-of-the-art electrical equipment to do so. ABB has both the technical capabilities and financial wherewithal to assume a substantial role as this development continues.

We believe market leaders like Lindt & Spruengli, Nestlé and ABB that possess strong brands, proven management, fortress balance sheets, and scale advantages are well positioned to create significant value for long-term shareholders especially starting from today’s very reasonable valuations.

Out-of-the-spotlight businesses— After market leaders, the next major category of investments in the Portfolio is out-of-the-spotlight businesses. These are lesser known companies with attractive economics that in our opinion should eventually command higher valuations. Their appeal may take time to gain recognition, often because these businesses are smaller or operate in a mundane non-consumer-oriented industry. Given the right leadership and attractive reinvestment rates, these low-profile holdings can provide the opportunity for the “double play” of expanding multiples on expanding earnings, which can turn a company with a solid earnings growth rate into a stellar investment. As a general rule, out-of-the-spotlight holdings tend to be boring but have the potential to compound returns over time.

An example of an out-of-the-spotlight business in the Portfolio is China Merchants Holdings (International), a leading port operator in China with strategically located container and bulk terminals throughout key economic regions of the country. This company has characteristics we prize in our business investments: a product that has no substitute (its ports), high barriers of entry (as it is difficult and costly for a competitor to build a port), pricing power, low normalized maintenance costs, and strong recurring free cash flow. With more than 80% of international trade volume carried by ships, well-managed port operators such as China Merchants Holdings have significant growth potential in our view.

Headline risk or contrarian investments3— On a very selective basis we make contrarian investments. These often involve controversial situations where the market is discounting a company’s share price to reflect a perception of risk that we think is greater than the probable economic risk to the business’s long-term fundamentals. Typically a minor portion of our portfolios in percentage terms, headline risk investments can sometimes be difficult for clients to understand because they beg the question, “Don’t you read the papers?” But it is precisely because so many other investors automatically sell companies with near-term challenges, however surmountable, that the potential for high returns exists in many such instances. Our job is to ferret out opportunities that represent favorable risk/reward trade-offs and do our best to avoid the value traps. We will not get every investment right. However, overall this distinctly contrarian element of our investment discipline has been an important contributor to our long-term success and may be an effective way to capitalize on herd mentality in the market.

A current headline holding in our Portfolio is Sinovac Biotech, a China-based health care business focusing on vaccines. Sinovac manufactures three main vaccines that protect people from Hepatitis A, seasonal flu and H1N1 pandemic flu and has a pipeline of other vaccines under development. As China is still in the early stages of developing its health care system, the percentage of the population receiving vaccinations is low, perhaps as low as 20% for Hepatitis A in some rural areas. The percentage vaccinated for seasonal flu is lower still. Sinovac has earned a reputation for high quality standards, is well capitalized with net cash on its balance sheet and is positioned to increase its share of a growing market.

Overall, the investments we have made in the three categories described above combine to create a Portfolio that we believe is well diversified and can produce satisfactory compound returns over full market cycles.4

2 Individual securities are discussed in this piece. While we believe we have a reasonable basis for our appraisals and we have confidence in our opinions, actual results may differ materially from those we anticipate. The return of a security to the Fund will vary based on weighting and timing of purchase. This is not a recommendation to buy or sell any specific security. Past performance is not a guarantee of future results. 3 While we research companies subject to such contingencies, we cannot be correct every time, and a company’s stock may never recover. 4 While we believe we have a reasonable basis for our appraisals and we have confidence in our opinions, actual results may differ materially from those we anticipate. Equity markets are volatile and an investor may lose money.

Performance Review

For the year-to-date period ending June 30, 2010 the MSCI All Country World® Index ex USA returned –11.06%. The Davis International Fund returned –8.10%, outperforming the broader market during that brief time period.5 Longer term the Davis International Fund has performed competitively since its inception in December 2006.5

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 Fund is subject to a 2% short-term redemption fee for shares held for fewer than 30 days. The total annual operating expense ratio for Class A shares as of the most recent prospectus was 1.51%.6 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.

The Fund’s performance in the year-to-date period reflects declines in most major sectors, particularly materials, financials, health care, and energy. Against this backdrop of volatility we have selectively added to a number of positions recently and sold our holdings in Swedish Match, Lagardère, Nokia, and SAP.

Taking a longer view, the Fund is essentially a group of business models that we have researched and view as attractive vehicles that may compound capital over the long term based on their management quality, business durability and competitive advantages, coupled with relatively attractive valuations. As noted earlier, these businesses generally fall into one of three categories–market leaders with strong balance sheets, out-of-the-spotlight holdings and contrarian investments. They also represent a broad array of industries and business activities, creating a Portfolio that is prudently diversified in our view. Below we have summarized the current positioning of the Portfolio by economic activity to illustrate this diversification in addition to highlighting where we are finding long-term opportunities.

Financials currently represent the largest weighting in the Fund. Broadly defined, financial services consist of vast, fragmented markets and span activities as diverse as traditional lending, asset management, commercial real estate, and insurance, among other areas. Representative holdings that illustrate the immense diversity in this sector include the Hang Lung Group (Hong Kong-based commercial real estate owner and developer), Brookfield Asset Management (Canadian-based global asset manager specializing in commercial real estate and infrastructure), CNinsure (Chinese insurance broker), and Fairfax Financial (Canadian-based insurer).

We have a longstanding interest in financial services for three main reasons: First, due to the sector’s sheer size and fragmented market structure, well-managed operators have the potential to grow earnings for years, even decades, by expanding market share relative to marginal competitors. Second, although the future is always uncertain, we believe the financial services category as a whole is not particularly prone to obsolescence since consumers and businesses generally need basic banking, insurance, investment management, custody, and other such services on an ongoing basis. That fundamental durability can allow investments to compound over many, many years. Last but not least, valuations for the sector tend to be relatively modest, meaning some of the best-managed businesses in the world can frequently be purchased at value prices and held for the long term.

Industrials represent the second largest weighting in the Fund. Industrials encompass a broad array of different industries and business types. Current representative holdings in this sector include Kuehne & Nagel (Swiss-based global logistics provider), China Merchants Holdings (Chinese port operator) and ABB (Swiss-based global manufacturer of power transmission, distribution and automation equipment).

Consumer staples constitute the next largest weighting in the Fund. Here we own global market leaders such as Nestlé, Lindt & Spruengli and Heineken. These consumer-related businesses cannot be grouped under a single universal theme. Rather, the companies we have elected in this category satisfy our preference for strong management, durable businesses, sustainable competitive advantages, and reasonable valuations. One additional feature we like about globally dominant consumer brands is that they generally exhibit strong pricing power, i.e., the ability to pass on higher costs to brand-loyal customers in the form of higher prices. This may prove significant in the long run should inflation appear again at some point.

Health care related businesses are a meaningful portion of the Fund as well. Within this broad category we own Sinopharm Group (Chinese drug distribution company), Essilor (French manufacturer of high-end eyeglass lenses), Roche (Swiss-based biotech company focused on pharmaceuticals and diagnostics), and Sinovac Biotech (leading developer and provider of vaccines in China). Here, in addition to owning well-managed, durable businesses, we like the long-term demographic tailwind that helps support the industry’s economics. Specifically, we believe that health care spending is likely to rise over the next decade as a percentage of global output as developed countries spend more on medical products and services to meet the needs of aging populations, and as developing countries are increasingly able to afford the luxury of health care.

The balance of the Fund is broadly diversified among well-managed businesses predominantly in the materials, technology, consumer discretionary, and energy sectors. Once again, the common thread running through these holdings is that each was selected according to the Davis investment discipline with an emphasis on management quality, business model strength, durable competitive advantages, and appropriate valuations.

The sum total of our investments creates a Portfolio that in our view affords our clients the potential to generate satisfactory compound returns over the course of many years while managing risk through prudent diversification.7

All of us at Davis Advisors thank you for your support. We are grateful and fortunate to have your confidence and will continue to work hard on your behalf. We look forward to continuing our investment journey together. ■

5 Class A shares, not including a sales charge. Davis began managing the Fund on 12/29/06. Past performance is not a guarantee of future results. 6 The Advisor is contractually committed to waive fees and/or reimburse the Fund’s expenses to the extent necessary to cap total annual fund operating expenses for Class A shares at 1.30% until March 1, 2011. After that date there is no assurance that expenses will be capped. 7 While Davis Advisors attempts to manage risk there is no guarantee that an investor will not lose money. Diversification does not ensure against loss.

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DAVIS DISTRIBUTORS, LLC
2949 East Elvira Road, Suite 101
Tucson, AZ 85756
1-800-279-0279