Results and Reflections
The Year 2008
Mistakes
Looking Ahead
Concluding Thoughts

Results and Reflections

The table below summarizes the results of the Davis New York Venture Fund compared with the S&P 500® Index against which my co-manager Ken Charles Feinberg, our colleagues and I judge ourselves. Our objective is to outperform this Index after fees over the long term as we have done in every rolling 10 year period since our inception in 1969.1 While we achieved this objective over the last 10 year period, we do not consider the Fund's absolute return of 1.2% per year much to celebrate despite its advantage over the 1.4% per year decline of the S&P 500® Index.2 As for results over shorter time periods, we will not mince words. They are poor on both an absolute and relative basis.

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 Class A shares as of the most recent prospectus was 0.85%. 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 quoted. For most recent month-end performance, click here or call 800-279-0279.

In the pages that follow, we will provide more perspective to put these results in context but we will not try to excuse them. You have a right to expect more from us. The first part of the report will be a review of the past year, covering the market and economy in general and our Portfolio in particular. As always, this review will include an accounting of our biggest mistakes. The second part will be forward-looking and explain why an environment characterized by fear and uncertainty creates enormous opportunity for long-term investors. By outlining this opportunity, our goal is to provide data that will help investors stay the course at a time when many feel like giving up. This feeling is understandable considering that investors have suffered through the second worst decade for stocks on record—a record that includes the Crash of 1929 as well as the Great Depression. In fact, even if the market produces satisfactory returns for 2009 (and it is certainly not off to a good start), it is highly likely that the 10 year period ending this coming December will prove to be the worst decade ever, as it will no longer include the 21% return of 1999. Given that the market has lost 3.6% per year for the last nine years versus the 1.7% annual loss suffered between 1928—1938, currently the worst decade on record, this is not a bold prediction.

So why should such data give investors confidence? The answer is that low prices may increase future returns.3 Because investors are buyers, they should welcome the opportunity to buy the same businesses at lower prices, as doing so raises their returns. Consider a business that generates $100,000 of income. In good times, such a business might be priced at more than $2 million, leaving the buyer with only a 5% return on investment. But if the price falls by half, the return doubles to 10%. This same math applies at the level of the stock market, which is after all simply a collection of businesses, the majority of which will be earning more money 10 years from now than they do today. The data shows that it has always been profitable to invest in the stock market after a decade of poor returns.3 Specifically, there previously have been ten rolling 10 year periods since 1928 when the S&P 500® Index (and before that the Dow Jones Industrial Average) returned less than 5% per year. In every case, the 10 years that followed produced satisfactory returns averaging approximately 13% per year and ranging from a low of 7% per year to a high of 18% per year.3 While we cannot know for sure what the next decade holds, it is highly likely to be far better than what we have suffered through in the last 10 years as we are starting at much more attractive valuations.We are hopeful that our shareholders who have endured these hard times will be there with us for the rebound.

1 Class A shares, not including a sales charge. Returns are from 2/17/69--12/31/08. Returns would be lower in some periods if a sales charge were included. See endnotes for a description of our rolling 10 year performance and a definition of the S&P 500® Index. Past performance is not a guarantee of future results. 2 Class A shares, not including a sales charge. Past performance is not a guarantee of future results. 3 There is no guarantee that low priced securities will appreciate. Equity markets are volatile and an investor may lose money. Past performance is not a guarantee of future results.

The Year 2008 4

While capital market downturns are nothing new, the dislocation and panic that swept through the markets in 2008 were unique in scale, severity and pace. The vast majority of major financial institutions collapsed, were taken over, raised dilutive capital, and/or required some sort of government intervention. The combined market capitalization of the top 25 financial institutions in the United States (excluding Berkshire Hathaway, which we do not consider a pure financial institution) fell 75% during the last two years from $2 trillion to less than $500 billion (as of January 22, 2009). The loss to shareholders has been even greater than these numbers indicate as most of these companies now have meaningfully more shares outstanding, including warrants held by the U.S. government.

The amount of direct investments, pledges and guarantees announced by the federal government now approaches $5 trillion. To put this sum in perspective, previously the most expensive financial debacle in U.S. history, the savings and loan (S&L) crisis, cost the government about $185 billion in today's dollars, about 1/27th as much. The long-term consequences of the government's ownership interest in private businesses are unlikely to be positive and the extension of such vast amounts of credit must almost certainly lead to higher inflation.

Turning to the economy, as is often the case, the capital markets have been leading indicators. What began as a financial crisis tied to falling real estate prices is swiftly becoming a broad-based economic crisis. Consumer and corporate spending are in a free fall. Auto sales, for example, fell a staggering 35% in the fourth quarter alone. Unemployment is increasing sharply as are virtually all other negative indicators. As these metrics deteriorate, however, it is worth remembering that the front side of a recession is always the scariest. To understand why, consider this simple example. Suppose a distributor who normally sells 10 widgets per month sells only eight in a given month. When it is time to reorder, the distributor needs to order only six widgets as there are two left in inventory from the previous month. Thus, a 20% decline in sales leads to a 40% decline in orders. This inventory effect is a painful magnifier that things are slowing but is not permanent and will reverse when sales stabilize.

Another unsettling aspect of 2008 was that many fundamental tenets of sound investing did not help. For example, it is generally (and rightly) believed that diversification among different asset classes should reduce the volatility of an investor's returns, as often one type of investment goes up while others are going down. However, this did not hold true in 2008. As one exasperated institutional investor put it, "All correlations have gone to one." In other words, virtually every asset class except government bonds performed badly: domestic stocks, foreign stocks, commodities, hedge funds, private equity, corporate bonds, real estate, and so on. Only 6% of the stocks in the S&P 500® Index were up last year, the lowest percentage on record.5

In addition, many so-called value investors (a category in which we are generally included) have fared poorly at a time when they would have been expected to do far better than the average. The reason for this expectation is that value investors tend to focus their investments in companies whose businesses are not considered highly speculative in nature and whose valuations relative to current earnings and shareholders' equity are comparatively low. As a result, their stock prices tend to hold up better in times of trouble compared to more speculative companies whose prospects are less secure. For example, in the bear market that began in March 2000 and continued through 2002, when the stock market fell almost 50%, many value investors outperformed dramatically as speculative tech and telecom companies collapsed, while companies in mundane sectors such as raw materials, utilities, retail, and banking held up relatively well.

In the last couple of years, though, many of these well-regarded managers, including us, have underperformed. Some portion of this underperformance can be attributed to the managers' mistaken appraisals and declines in the value of the underlying businesses they owned. We had our share of such mistakes, which we will discuss later in this report. However, another portion of this underperformance is simply attributable to the unpredictability and vagaries of short-term results. It is the nature of markets that value and price can diverge for long periods of time. In euphoric times, such as during the Internet bubble, the stock prices of many companies exceed their value. In times of panic and dislocation, the value of many companies exceeds their prices. In such periods, poor reported results may indicate deferred returns rather than permanent losses. For example, a company purchased at $10 per share that has an intrinsic value of $20 is a good investment even if its price falls to $5 for some period of time. While this seems obvious at the level of an individual company, it is also true for whole portfolios. For example, the vast majority of top-performing managers over a long period of time will still experience multiyear stretches of poor performance. Specifically, as the accompanying chart shows, 97% of all of the managers whose results over the last 10 years placed them in the top performance quartile still underperformed for at least a three year stretch during that decade of excellent relative results. More important, in almost half of these cases (44% to be precise), the three year stretches were bad enough to place them in the bottom decile relative to their peers.

Source: Davis Advisors. 163 managers from eVestment Alliance's large cap universe whose 10 year average annualized performance ranked in the top quartile from January 1, 1999-December 31, 2008. Past performance is no guarantee of future results.



Such periods can be doubly costly for clients. After all, as portfolio managers, we can focus on the value of the underlying businesses, but clients can only see the prices. As a result, clients often lose confidence and get out after they have already suffered through the period of bad performance but before benefiting from the recovery. In these inevitable periods of underperformance, it is often helpful to remember that poor results may not reflect a flawed investment discipline but rather the fact that prices and values can irrationally diverge for relatively long periods of time.

Before turning to the reasons that such divergences can create real opportunities, we must also recognize the cases in which falling stock prices reflect substantial declines in the value of the underlying business. In these cases, we were mistaken in our business appraisals.



4 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 a portfolio 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. 5 Source: Davis Advisors. Percentage is from 1/1/2008-12/31/08.

Mistakes

By far our largest mistake over the last five years was our investment in American International Group (AIG), which cumulatively detracted roughly 6% from our returns, almost three times as much as any other mistake. In essence, this mistake resulted from our incorrectly assessing three factors: the financial sophistication of management, the leverage of derivatives and the danger of collateral requirements tied to mark-to-market accounting.

Starting with management, the chief executive officer of a complex financial institution also serves as the de facto chief risk officer. He or she must understand the nature and extent of the risks being taken and must have the courage to forgo profits if the risks, however remote, could prove catastrophic. At AIG, the need for a highly capable CEO was accentuated by the diverse business models and risk profiles of its semiautonomous divisions. Unfortunately, the abrupt ouster of its longtime CEO and the promotion of a far less able successor came at the worst possible time. Although this successor had deep experience in the field of property and casualty insurance, the company's financial operations and risks went far beyond this sector into areas in which new management had virtually no expertise.

The second factor that we—and this new management team—grossly underestimated lay in a relatively small division of AIG called AIG Financial Products. This unit contributed about 5% of total profits, only a small portion of which came from selling a type of highly complex and highly leveraged derivative known as a credit default swap, or CDS. At its heart, a CDS is a type of financial insurance in which a buyer would pay AIG a tiny premium in exchange for coverage against a highly unlikely financial event, such as the default of a triple-A security. In some cases, the premium could be as low as $1 for $1,000 worth of coverage. Unfortunately, many of the triple-A securities that AIG insured were tied to mortgages and presumed that residential real estate prices would never go down substantially. To make matters worse, unlike normal insurance contracts, credit default swaps are marked-to-market, meaning that they are priced not for what the actual losses are today but for what the market estimates the losses will be in the future. This mark-to-market accounting brings us to the third aspect of our mistake.

As the estimated losses on the contracts went up, AIG was required to post cash collateral for the buyers of the swaps. Worse still, the amount of cash collateral was also tied to AIG's own credit rating. As is now apparent, all the factors were in place for a spiral. Because these contracts assumed virtually no losses, small increases in loss estimates led to huge losses. As these losses mounted, rating agencies became concerned and downgraded the company. Thus, AIG was required to post more collateral for both higher estimated losses and its lower credit rating. Adding to these liquidity demands, the company engaged in a massive securities lending program in which it lent out many of its investments. These loans were themselves collateralized with cash. Unfortunately, rather than simply hold this cash in short-term liquid instruments, the company invested much of it in illiquid, often mortgage-related securities. As nervous customers returned borrowed securities and immediately demanded their cash back, AIG was forced to try to sell these illiquid securities at a time when there were no buyers. In just a matter of months, these liquidity demands exceeded AIG's available resources. Facing default, AIG asked for government intervention. In exchange for providing the necessary liquidity and guaranteeing or assuming responsibility for a number of assets and liabilities, the government took equity warrants for approximately 80% of the company.

All of the above analysis begs the question: "Why did we continue to hold the shares even as the situation got worse and worse?" The answer is twofold. First, we remained focused on the fact that the company had close to $100 billion of tangible equity, more than $1 trillion in investments and more than $20 billion of pretax earnings from global insurance, leasing and asset management operations. Furthermore, in contrast to a bank, it is difficult to have a run on an insurance company, as policyholders, unlike depositors, generally cannot suddenly take back their premiums. Thus, we thought the company's powerful diversified earnings, tangible equity and assets would more than cover the losses over time. This thinking ignored three important facts. First, because of the collateral requirements discussed above, the company did not have the luxury of time but needed to come up with the cash immediately. Second, because there had been inadequate disclosure about the massive securities lending operation, the scale and immediacy of the cash requirements were far greater than anyone had imagined. Finally, although the company's financial statements showed a huge amount of liquid assets, most were held in the company's insurance subsidiaries. As regulated entities, these subsidiaries were not permitted to release the assets to the parent company in order for AIG to meet these collateral calls. As a result, even if these mark-to-market losses proved temporary rather than permanent (as they still could), even if the company's net worth remained substantial, or even if the company could have earned enough in the next five years to pay the losses as they came due, it still faced bankruptcy as a result of defaulting on the collateral calls.

We will end this discussion with an example of the dangers of this sort of collateral posting requirement. Imagine a homeowner has a $400,000 home with a $300,000 mortgage. Now imagine he earns $100,000 per year of which he uses $50,000 for living expenses, leaving $50,000 to service the mortgage. If we add to this example as a given that this person will never move and will never lose his job, it would seem that the mortgage is virtually risk free. But if we change one feature that on its face seems minor, we completely alter the risk profile. Specifically, imagine that the mortgage requires that if the estimated price at which the house could be sold on any given day falls below $300,000, the homeowner must put the shortfall in an escrow account or face eviction. Now, even if the homeowner could service this mortgage forever and even pay it down completely over time with no risk to the bank, he could still be bankrupted by having to mark his house to market and post collateral. It was this type of liquidity risk that, in a matter of months, brought down what has been the most profitable and highly valued insurance company in the world.

The other mistake that deserves mention reached its conclusion in our fourth quarter sale of virtually all our Merrill Lynch at a substantial loss. Although our first purchase was at $48 per share, we added to our investment at lower prices giving us an average cost of $35 for all shares acquired. As has been widely reported, on September 15th Bank of America offered $29 per share to acquire Merrill Lynch. We sold the shares in the weeks following the announcement at prices ranging from $13—$29 per share. We acknowledge that this investment was a mistake, though we remain convinced that Merrill's powerful network of financial advisors combined with decisive management reduced our downside and prevented the sort of catastrophic loss we experienced in AIG and others experienced in firms like Lehman Brothers and Bear Stearns.

As always, the only value of mistakes lies in the lessons learned. Looking back at the crisis of 2008, the lessons can be reduced to a single word: liquidity. In a nutshell, we learned that while the answer to the question, How much long-term debt is appropriate for a given company? varies by industry and business, the answer to, How much short-term debt is appropriate for a given company? should almost always be zero. In 2008, even companies with plenty of earnings and equity relative to their debt found themselves shut out of the credit markets. In the best cases, they were required to fund themselves at very high rates. In the worst, they were forced to sell valuable assets at pawn shop prices, auction off the entire company or face bankruptcy. Companies like Countrywide, Lehman, Bear Stearns, and even Fannie Mae and Freddie Mac (none of which we owned) all were financed with short-term funds or required constant access to new capital. In virtually all these cases, managements put companies at risk by trying to save a few percentage points of interest costs. Such a strategy has accurately been likened to picking up pennies in front of a fast-moving steam roller.

Looking Ahead

This long dissertation on economic turmoil and uncertainty, as well as the recounting of our biggest mistakes, raises the question: Why are we almost fully invested and confident that today's prices should be viewed as an enormous long-term opportunity? Before answering, we should provide one caveat. In making the case for equities today, we are not predicting that the market has reached bottom. Although stocks could be substantially higher six months from now, they could also be 30% lower. We simply do not know—and no one else does either. With this caveat out of the way, we will now turn to the subject of opportunity.

When I first started investing, my grandfather gave me a card on which was written,"You make most of your money in a bear market, you just don't realize it at the time." Although at first blush this saying sounds counterintuitive—after all, in a bear market prices are going down—it makes sense when you recognize that as investors we are buyers and thus should welcome lower prices for the simple reason that lower prices may increase future returns. In bear markets, prices are driven down by fear and forced selling. Sellers are not asking what a business is worth but taking whatever they can get. Such irrational selling allows investors with patience to buy great businesses at distressed prices. These low prices may increase future returns.

Over the years, my father and grandfather used to tell me about the opportunities they had to buy great growth companies at 10 to 12 times earnings with 3% dividend yields or leading financial companies at five times earnings with 5% dividends and so on. Great records developed from the depths of these bear markets as steady-handed investors purchased stalwart companies with decent dividends at low price/earnings multiples and simply held on, letting compounding and gradually improving confidence take care of the rest.

Imagine, for example, a high-quality company that can grow its earnings on average at 10% per year over a decade. In a bull market, such a company might sell at 20 times earnings and have a negligible dividend yield. As a result, buyers of that company would be lucky to have returns even in line with the earnings growth rate. In fact, should the multiple contract to the long-term market average of 15 times earnings over a decade, the company's 10% growth rate would shrink to a 6.9% return for investors.

However, in a bear market, this math is reversed. Imagine the same company now trading at 10 times earnings and carrying a 3% dividend yield. The buyer of this company now can reasonably expect to make returns in line with the earnings growth rate of 10% plus dividends of 3% for a total return of 13%. While this in itself is a satisfactory return, it can even be enhanced should confidence return and the multiple rise to the long-term average of 15 times earnings. If this happens over a decade, the company's 10% growth rate would expand to an 18% return for investors.

Because a bear market presents the opportunity to benefit from earnings growth, dividend yield and multiple expansion, I had always been a bit jealous of the opportunities that my father and grandfather were given in the terrible bear markets of the last 60 years. Now that our generation has finally been given the same opportunity, I recognize the wisdom of the saying, "Be careful what you wish for." In a time of fear and panic, investments will never seem as straightforward as the example given above.

More important, even if investors can recognize such opportunities with their heads, their stomachs often have other ideas. As legendary manager Peter Lynch observed, "The key organ (for investment success) is your stomach. Everyone has the brainpower, but not everyone has the stomach for it." In today's bear market, investors are racing for the exits. Cash is pouring into "riskless" securities like short-term U.S. Treasuries with virtually no yield. Although such a choice feels good, it is, given the near certainty of inflation, likely to prove very costly. Meanwhile, investments in high grade common stocks, which feel like a terrible choice, are likely to prove very profitable and are almost certain to outperform cash over the next decade.6

Before turning to the Portfolio itself, we would remind you of the old saying that investing is the art of the specific and warn that general discussions tend to oversimplify the rationale behind our investment decisions. Nevertheless, in today's environment, we are looking for opportunities that roughly fall into four categories.

• The first most closely resembles the hypothetical high-quality company discussed above and would include companies such as Procter & Gamble, Johnson & Johnson, Costco, Shering-Plough, and Philip Morris International. These companies are characterized by healthy balance sheets, strong competitive positions and durable business models. They are generally (but not always) global leaders with relatively strong pricing power and the ability to pass through cost increases. Because such businesses produce excess cash, they are self-funding and have no need to regularly replenish capital. This self-sufficiency has led some wags to refer to such companiesas "camels."

• A second, much smaller category is made up of companies whose business model and management mindset put them in a position to take advantage of the chaos in the capital markets. Such opportunistic companies may use distressed prices to make investments or acquisitions or even to buy in their own shares. Although many companies have the balance sheet strength to fall into this category, few have the temperament.
  
  Instead, most companies that were only too happy to buy in shares and do deals when prices were high have reduced or eliminated such activities in response to the current uncertain environment, forgetting that the environment is never certain. While savvy holding companies such as Loews and disciplined share repurchasers such as Dun & Bradstreet and Comcast fall into this opportunistic category, by far the best example is Berkshire Hathaway, which spent much of the last decade building up cash and warning about the dangers of derivatives. It is now routine to read about the enormous investments that Berkshire is making at a time when others seem paralyzed. Of note, we recently joined with Berkshire to invest in senior securities of two companies whose common stock we already own, Sealed Air and Harley-Davidson. These investments were made at yields of 12% and 15%, respectively.

• The third category comprises investments made where the headlines are the worst7—specifically in selected financial companies. While we recognize there are many fundamental uncertainties, we believe that some positives are being overlooked in the midst of the turmoil. First, although aspects of the insurance, asset management, and retail, commercial and investment banking businesses are changing, their underlying business models are unlikely to become obsolete. Furthermore, those companies that get through this storm will face far less competition.
  
  In retail and commercial banking, for example, there is an astounding flight to quality. Incredibly, in the fourth quarter alone,Wells Fargo's deposits, which pay extremely low interest, grew at a staggering 31% annualized rate. For investment banks, although leveraged proprietary trading will never be the same (which is a positive), services like mergers and acquisitions advice and equity and debt underwriting will always be in demand. To be clear, we know that there are still many risks in this sector, including the fact that nonperforming assets will continue to rise. While we are selectively adding, we are not "swinging for the fences."

• The final category focuses on what we consider to be the inexorable growth of the middle class in massive economies such as China's. We continue to expect that the Chinese economy will grow faster than average for decades to come, putting strain on China's infrastructure and increasing demand for most natural resources. A number of Portfolio companies are positioned to benefit from these trends including our direct Asian holdings and our investments in energy, commodity and agricultural companies.

6 Equity markets are volatile and an investor may lose money. 7 While we research companies subject to such contingencies, we cannot be correct every time, and a company's stock may never recover.

Concluding Thoughts

In mid-October Warren Buffett wrote an unusual and important editorial for The New York Times. Just as we were coming through one of the worst years and worst decades ever for stock investors, he noted, "The financial world is a mess, both in the United States and abroad. Its problems, moreover, have been leaking into the general economy, and the leaks are now turning into a gusher. In the near term, unemployment will rise, business activity will falter and headlines will be scary. So . . . I've been buying American stocks." He continues, "Over the long term, the stock market news will be good. In the 20th century, the United States endured two world wars and other traumatic and expensive military conflicts; the Depression; a dozen or so recessions and financial panics; oil shocks; a flu epidemic; and the resignation of a disgraced president.Yet the Dow rose from 66 to 11,497."8 To view this article, visit the "Investor Education" section of www.davisfunds.com.

Although such a powerful statistic makes it hard to believe that stock investors could have lost money during a century marked by such an extraordinary gain, Mr. Buffett goes on to caution that "some investors did. The hapless ones bought stocks only when they felt comfort in doing so and then proceeded to sell when the headlines made them queasy." While the dire headlines we read day after day make "queasy" an understatement, they should be welcomed by long-term investors for their role in creating bargain prices. While we cannot predict the direction of the market over the next month or the next year, we do know that it will move higher long before the economy or the headlines are more reassuring.9 If investors wait until things seem better, they will pay much higher prices. In our experience, today's prices reflect some of the most attractive valuations we have seen in decades.

This optimism about the future does not minimize the fact that together we have gone through one of the worst periods in market history. We are disappointed with our short-term results and humbled by our mistakes. But most important, we are grateful for the patience you have shown us during this difficult time. We never forget the trust you have placed in our firm. We wholeheartedly look forward to the years ahead when we should be able to report that today's low prices became tomorrow's high returns.10 Thank you for staying the course with us. ■


8 Buffett, Warren, "Buy American. I Am." The New York Times, October 17, 2008. 9 There is no guarantee that low priced securities will appreciate. Equity markets are volatile and an investor may lose money. 10 There is no guarantee that low priced securities will appreciate. Equity markets are volatile and an investor may lose money.

The Wisdom of Great Investors

Investing for the long term necessarily involves investing through periods of dislocation. Staying the course in such times can be difficult for investors. For this reason we have collected some useful lessons and insights from investors who managed successfully through challenging times in the past in The Wisdom of Great Investors:

• Avoid Self-Destructive Investor Behavior
• Understand That Crises Are Inevitable
• Don't Attempt to Time the Market
• Be Patient
• Don't Let Emotions Guide Your Investment Decisions
• Recognize That Short-Term Underperformance Is Inevitable
• Disregard Short-Term Forecasts and Predictions

For a copy of this brochure please contact your Davis Regional Representative at 800-717-3477. Click here to view the information online.

Return to top

For more information, please contact...

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