Market Perspectives
Building an All-Weather Portfolio
Performance Review
Investing for the Long Term as Realists
Long-Term Themes



Market Perspectives

Davis Advisors has managed money on behalf of clients since 1969. As long-term investors we have navigated many different market and economic environments, both good and bad. We have witnessed periods of favorable conditions such as low interest rates and low inflation combined with expanding corporate profits. On the other hand, we have seen more trying times as well. In the first quarter of 2008, for instance, the S&P 500® Index finished down 9.45%.1 This decline took place against a backdrop of negative headlines related to a faltering U.S. housing market, a softening economy, rising gasoline and food prices, and dramatic events on Wall Street culminating in the distressed sale of Bear Stearns to JPMorgan Chase.

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.


While we acknowledge the weighty concerns of the moment, we must remember that well-managed, durable businesses and the U.S. financial system as a whole have proven extraordinarily resilient over the long run. In the nearly four decades of our firm's history, there have been prolonged bear markets; wars; recessions; an oil crisis; a hostage crisis; periods of double-digit interest rates, inflation and unemployment; political scandals; stock market crashes; the September 11th attacks; and much more. Despite those setbacks, the stock market has managed to compound at double-digit rates of return and the Davis New York Venture Fund has been even more successful, outperforming the S&P 500® Index over every 10 year rolling period since 1969.2 That span of time includes environments resembling today's in some respects as well as circumstances that were arguably far worse.

A key to our long-term success in the investing business has been a determination to look beyond many of the important but unknowable factors that are commonly featured in day-to-day news headlines and to focus instead on what is important and knowable. That brings us squarely back to the fundamentals of the businesses we own in the Portfolio, their managements, the durability of their earnings power and competitive strengths, and our assessment of their current valuations. By isolating these key drivers of business results, we can make rational long-term investment decisions despite short-term uncertainties.

1 Past performance is not a guarantee of future results. 2 Class A shares, not including a sales charge. 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.




Building an All-Weather Portfolio3

The Davis investment discipline consists of identifying durable businesses through bottom-up research, purchasing them at value prices and holding them for the long term. 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). Then company by company we set out to build an all-weather Portfolio of businesses that can compound over long cycles. Our Portfolio consists of three primary categories of investments:

• Global leaders with strong balance sheets—These companies constitute the majority of our holdings and serve as the anchor to windward in the Portfolio. They provide a foundation of stability and in our view offer a high probability of long-term sustainable returns through capital appreciation and dividends. Costco Wholesale, a warehouse style retailer, is an example of this first category of investments. Costco operates in more than 500 locations primarily in North America with a smaller but growing presence in Europe and Asia. It offers shoppers an enticing value proposition: For a modest annual fee, Costco members can enjoy rock-bottom prices on quality brands. The strength of this value proposition is evident in the franchise's success. Today, Costco's membership base surpasses 52 million card-carrying members whose annual memberships add up to $1.5 billion in revenue, and nearly 90% of these members renew each year. Members tend to spend heavily on the bargains they find within Costco stores, pushing average sales per store beyond $130 million—about three times more than Costco's nearest competitors. The company's CEO, Jim Sinegal, is first-rate and maintains a hands-on approach, visiting every U.S. location twice a year and cutting the ceremonial ribbon on each new store opening. Regarding the business's sustainable competitive advantages, Costco is hands down the low-cost provider in the retail industry with operating margins of only 2.6%, a key strength given the ever-present threat of price wars. Finally, when times are tough the durability of a business matters all the more. It is noteworthy that Costco self-funds its growth, operating with no net debt on its balance sheet and generating ample free cash flow. Other examples of global market leaders in the Fund include Berkshire Hathaway, Procter & Gamble, General Electric, and Microsoft.
  
  
• "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, headquartered in other countries or operate in a mundane nonconsumer oriented industry. Aggregates companies fall into this category, as do off-site document storage, protective packaging and reinsurance companies. Given the right leadership and attractive reinvestment rates, these low-profile holdings often provide the opportunity for the "double play" of expanding multiples on expanding earnings, which can turn a company with a decent earnings growth rate into a stellar return vehicle. Current examples of out-of-the-spotlight holdings in the Portfolio include: Ameriprise Financial (formerly American Express Financial Advisors), which offers a broad array of financial services to middle class investors; EOG Resources, Inc., an oil and gas exploration and production company with an unparalleled discipline of earning high returns on capital; and Progressive Corp., an automobile insurer that sells policies both through a network of agents as well as directly to customers via its phone centers and the Internet.

• Headline risk or contrarian investments4—Around the edges of the Portfolio we selectively 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 can be an effective and repeatable way to capitalize on herd mentality in the market.
  

A current headline risk investment in the Portfolio is Merrill Lynch, a global investment banking and brokerage franchise. Merrill, like many of its financial peers, is at the moment navigating rough seas in the capital markets, particularly in the area of mortgage-related securities. In the last 12 months alone, Merrill has written down more than $20 billion of assets and replaced its CEO last fall. While Merrill's challenges are real, we believe its new CEO, John Thain, is a proven industry veteran who is taking the right steps to shore up the company's balance sheet and reorient the risk controls (and importantly the incentives) within Merrill's various divisions. Furthermore, we believe Merrill Lynch's present financial condition and unique brand should allow the franchise to raise additional capital if necessary and to benefit over the longer term from powerful tailwinds in global capital markets activities, wealth advisory services and asset management.

Portfolio management is a dynamic process and the way we describe a holding at a given time is specific to the moment. Individual companies may move from one category to another. For example, either headline risk or out-of-the-spotlight companies can over time evolve into global leaders. Global leaders can stumble and move into the headline risk category. An important benefit of having several different categories of investments at all times is that each moves in different cycles and their interplay can be a form of diversification. To use a gardening analogy, in a typical year we expect to plant some new ideas, see the benefits of others that are coming into bloom, harvest some of the more mature holdings, and clear out some of the weeds (ill-fated investments or mistakes). This framework for designing a "perennial" portfolio has the objective and often the benefit of producing a consistent compound return through different types of market environments.5 We feel our approach in this regard is distinct in an industry where a popular belief is that investment managers can optimize their portfolios for next year's market when in fact next year's major developments are simply unknowable. Instead, at Davis we believe we should concentrate on building the best risk-adjusted portfolio we can for all weather conditions.

3 Individual securities are discussed in this piece. The return of a security in a portfolio will vary based on weighting and timing of purchase. 4 While we research companies subject to such contingencies, we cannot be correct every time, and a company's stock may never recover. 5 Past performance is not a guarantee of future results.




Performance Review

At Davis we maintain a long-term perspective and view stocks as ownership interests in real businesses. We invest with an expected holding period of five or more years. Stocks can be volatile in the short term, driven as much by investor psychology as by real fundamentals. Over the long term, in contrast, stocks generally reflect the real profit growth of businesses. To illustrate this distinction Benjamin Graham called the stock market a "voting machine" in the short term—measuring how people feel—but a "weighing machine" in the long term— weighing business values based on the earnings companies can generate. Accordingly, for purposes of evaluating our performance in any period it is worth noting not only how share prices may have changed but also whether they reflect the underlying reality of operating performance at the business level.

For the trailing 12 month period ending March 31, the Portfolio performed more or less in line with the S&P 500® Index, which declined 5.08%.6 Our performance was helped most dramatically by our energy holdings, which consist primarily of exploration and production companies (E&Ps) that own vast reserves of oil and/or natural gas. Shares of our energy investments returned more than 40% on balance, nearly double the S&P 500® Energy sector's 22% return in the period.7 Our strong performance in energy reflects sharply higher oil prices among other factors, which have translated into higher revenues and profits for a number of the energy-related businesses we own. To give a sense for how significantly oil prices have changed in recent years, West Texas Intermediate crude averaged $72.34 per barrel in 2007 versus $31.08 per barrel in 2003 and year-to-date as of this writing the price per barrel has surpassed $115.

Going forward, we are conservative in our valuation estimates as we believe many E&Ps face two headwinds if the price of oil remains elevated. First, the sovereign nations that actually own the vast majority of the world's proven oil reserves charge higher royalty fees the higher the price of oil, which means the economics of high oil prices increasingly accrue to host countries and less to oil companies. For this reason, oil at $70 per barrel can be more profitable for certain E&Ps than oil trading at $100 per barrel. Second, oil is a depletable resource and oil companies must therefore replace reserves on an ongoing basis, either through new finds or by extracting more from existing fields, just to keep their production constant. Finding and development costs for the industry are going up as E&Ps compete for a finite amount of equipment such as rigs as well as technical staff. These higher costs can eat into oil company profit margins. Given these realities, we believe capital allocation discipline in the energy industry will be critical and could mean the difference between shareholders earning a satisfactory compound return going forward and a lackluster result.

Financial stocks detracted from performance over the trailing 12 month period on balance. Our preference for balance sheet strength, diversified sources of earnings and proven management helped us avoid many of the worst-hit companies in the sector, even though our record was not spotless and we admittedly had some disappointments. Overall, however, we fared much better than the market in financials. The Portfolio's financial holdings declined roughly 19% on balance, versus a decline of 28% for the S&P 500® Financials sector.8 The operating environment, particularly for capital markets players and banks, remains challenging and the news could continue to get worse before it gets better. That said, what matters ultimately is not how bad the news is, but rather what has already been discounted in the price. With a selective eye we believe shrewd investors should find some exceptional long-term investment opportunities amid the current turmoil. As Warren Buffett has famously said, it is better to be "fearful when others are greedy and greedy when others are fearful." Currently, considerable fear and unctainty have been discounted in the share prices of many durable businesses that will likely be worth significantly more a decade from now than they are today, not only in financial services but elsewhere in the market. We will be redeploying capital among businesses where we believe risk/reward trade-offs are favorable, knowing that news headlines may continue to be gloomy for a while. Lest that sound like a negative, the silver lining is that if the news were rosier the prices of the businesses we seek to own would likely be much higher. As things stand, we are already finding solid long-term "compounding machines" that, based on our work, look like bargains.

6 Class A shares, not including a sales charge. Past performance is not a guarantee of future results. 7 Figures are generated using holdings-based attribution analysis based on the Davis New York Venture Fund and S&P 500® Energy and do not take into consideration any impact of fees or expenses. Returns are from 03/31/07 through 03/31/08. The energy holdings contributions to the Fund are dependent on a variety of factors, including weighting and performance of individual companies. These views may not be relied upon as investment advice and are subject to change. Past performance is not a guarantee of future results. Source: Wilshire Atlas and Davis Advisors. 8 Figures are generated using holdings-based attribution analysis based on the Davis New York Venture Fund and S&P 500® Financial and do not take into consideration any impact of fees or expenses. Returns are from 03/31/07 through 03/31/08. The financial holdings contributions to the Fund are dependent on a variety of factors, including weighting and performance of individual companies. These views may not be relied upon as investment advice and are subject to change. Past performance is not a guarantee of future results. Source: Wilshire Atlas and Davis Advisors.




Investing for the Long Term as Realists

Building long-term wealth with a portfolio of businesses is like driving an automobile. If investors focus too narrowly on the stretch of road a few feet ahead, they run the risk of making unnecessary adjustments and oversteering. Only by lifting our eyes to see the road further ahead are we likely to reach our ultimate destination.

In the current environment that means avoiding extreme optimism and pessimism, either of which can result in oversteering. In the first quarter of 2008, 75% of all companies in the S&P 500® Index declined and all of the Index's sectors had negative returns overall.9 The danger in such an environment is that investors will be tempted to sell businesses they own so as not to have to worry anymore. While that might bring psychological relief in the near term, making such adjustments in moments of pessimism can be very costly to long-term performance. The chart below illustrates how costly this behavior can be. The chart is from a Dalbar study, which estimates that over a 20 year period the average stock fund investor dramatically underperformed the average stock fund, effectively due to the timing penalty of buying high (presumably encouraged by years of positive market returns) and selling low (most likely in reaction to market declines).

Source: Quantitative Analysis of Investor Behavior by Dalbar, Inc. (July 2007) and Lipper. Dalbar computed the "average stock fund investor" returns by using industry cash flow reports from the Investment Company Institute. The "average stock fund return" figures represent the average return for all funds listed in Lipper's U.S. Diversified Equity fund classification model. Dalbar also measured the behavior of a "systematic investor" and "asset allocation investor." The annualized return for these investor types was 6.1% and 3.7% respectively over the time frame measured. All Dalbar returns were computed using the S&P 500® Index. Returns assume reinvestment of dividends and capital gain distributions. Past performance is not a guarantee of future results.


As long-term investors we seek to be realists, not optimists or pessimists, so that we set proper expectations and are capable of making rational decisions through inevitable market and economic cycles. One realistic perspective is that 2008's first quarter performance, while negative, represents a single 91 day period that is likely to be irrelevant to the long-term earnings power of most businesses. Another reality is that well-managed, durable businesses with attractive reinvestment rates can serve as powerful compounding machines for capital over long holding periods, and that has not changed as a result of short-term market volatility. Finally, purchasing shares of compounding machines at lower prices should, all other things being equal, improve the risk/reward trade-off for investors—a fact that prompted legendary investor Shelby Cullom Davis to remark, "You make most of your money in a bear market, you just don't realize it at the time."

9 Past performance is not a guarantee of future results.




Long-Term Themes

The short term is always filled with important but unanswerable questions. The longer one's perspective the easier it becomes to see the ultimate destination. For instance, although we do not know the exact timing, we are very confident that home values in the United States will eventually stabilize, that liquidity will eventually return to the credit markets (as it has following all major shocks to the financial system in the past) and that the U.S. dollar will see days when it strengthens against other currencies instead of weakening. We just do not know when. That stated, in a framework of investing that spans years and decades, we would argue that the more critical task to get right is understanding the businesses one owns and their ability to weather the inevitable cycles and create value for shareholders through a wide variety of conditions.

The key themes currently guiding our search for long-term investment opportunities include:

• Global, high-quality multinationals—Investing in large corporations today almost necessarily leads to a universe of global multinationals, some of which are based in the United States while others are headquartered elsewhere.10 Many of these businesses look attractive to us for a number of reasons. Dominant global brands that can raise capital in any environment, withstand the inevitable but hard-to-anticipate shocks, access fast-growing local markets in developing nations, and enjoy the stability of geographically diversified earnings should trade at a premium in our view. Instead, many are trading at market or below-market multiples. Companies like Procter & Gamble, News Corp., JPMorgan, and Hewlett-Packard for instance all trade at earnings yields—i.e., the current earnings of a business divided by the amount we would have to pay to own the entire business—well above the yield now offered by 10 year Treasuries (a so-called risk-free alternative in finance). Furthermore, businesses such as these have a high probability, in our opinion, of generating growing "earnings coupons" of cash in contrast to the fixed-coupon alternative of a government bond.
  
  
• Capital spending—The U.S. economy, now 70% driven by the consumer, may be moving into a phase similar to the late 1960s and 1970s where a prolonged capital spending cycle plays a more significant role again. That could mean more profits for infrastructure-related businesses in the United States as well as abroad—e.g., companies that build jetliners, cranes, highways, and locomotives as well as port operators. A recent addition to the Portfolio that we believe is well-positioned to benefit from capital investment and infrastructure spending around the globe is General Electric, a diversified industrial conglomerate known for its first-class management culture.
  
  
• Energy and natural resources—As developing nations add to worldwide incremental demand for commodities like oil and natural resources, we believe that the average price ranges for such resources could likely remain elevated relative to the decade of the 1990s. Consistent with our energy investments to date, which include Devon Energy, EOG Resources and Canadian Natural Resources, we will be on the lookout for disciplined capital allocators who can generate reasonably attractive profits for shareholders given a stable price environment and generate windfall profits under more bullish scenarios.
  
  
• Demographically favored industries (health care and financial services)—The populations of the United States, Europe and Japan are getting older and we believe that this inexorable trend will direct more nondiscretionary spending, partly from governments and partly from individuals and companies, toward different areas of health care. A rule of thumb in investing is to follow the money and a good deal of money will be flowing into health care equipment, treatments and services. Johnson & Johnson, a global leader in consumer health care, pharmaceuticals and medical devices, is a relatively new addition to the Portfolio that is well positioned in our opinion to benefit from this demographic tailwind. To the extent people are living longer, they will also need to save and invest for retirement, and leading brands in financial services are the logical places where consumers will shop. Our recent purchase of Merrill Lynch shares reflects not only our belief that the company's short-term challenges are surmountable but also our favorable long-term outlook for the business.
  

In addition, we are always looking for the "quality accidents of the day," or the headline risk situation that becomes a bargain for temporary but surmountable reasons according to our own analysis. We also continually sift through the universe of lesser known, out-of-the-spotlight businesses that others may simply have failed to notice.

Ultimately, whatever happens in the rest of 2008 and whatever styles, industries or market capitalizations move in or out of favor, we remain committed to our signature investment discipline of buying durable businesses at value prices and holding them for the long term. We have seen this bottom-up, research-driven approach prove highly effective through a wide variety of market conditions.11 We believe that keen attention to stock selection combined with a sensible framework for building portfolios (global leaders, out-of-the-spotlight holdings and headline risk investments) is a time-tested and reliable way to compound capital over full market cycles.

As a sign of our commitment to and conviction in this approach, the Davis family, 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.

All of us at Davis Advisors thank you for your support and look forward to continuing our investment journey together. ■

10 Companies operating, incorporated or principally traded in foreign countries may have more fluctuation as foreign economies may not be as strong or diversified, foreign political systems may not be as stable and foreign financial reporting standards may not be as rigorous as they are in the United States. 11 Past performance is not a guarantee of future results. Equity markets are volatile and an investor may lose money.

For more information, please contact...

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