Spring 2010 Commentary


Portfolio Positioning
Performance Review
Long-Term Perspectives
Where We Are Finding Opportunities

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 clients.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 December 31, 2009.

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. At this time more than 75% of the Portfolio is invested in companies with market capitalizations in excess of $10 billion and combined revenues exceeding $1 trillion.3

These businesses span a broad range of global industries including technology, health care and consumer-related businesses, among others. They provide a core foundation of stability within the Portfolio and offer in our view a high probability of long-term sustainable returns through capital appreciation and dividends.

A representative market leader and a relatively new addition to the Portfolio is Coca-Cola (Coke), the world's most valuable brand according to the marketing research organization Interbrand. As the largest global beverage company with more than twice the annual sales of its nearest competitor, Coke has an enviable and expanding portfolio of still and carbonated products that generates consistent growth. Tracing the company's progress in recent years, in 1997 the company owned five brands that each generated $1 billion or more in annual sales. Today the company has 13 billion-dollar brands and expects to have 30 by 2020. A large portion of this growth will likely be generated in developing and emerging economies where Coke is investing heavily. Already some 75% of current revenues are derived from international markets and Coke expects this growth to continue as more and more of the world's population joins the middle class.

Another market leader in the Portfolio is Google, a company that dominates the business of online search. In a sense, Google is a new media company whose business model is exceptionally well positioned to capitalize on the transition from traditional print and television media to Internet-based content and advertising. Google's Internet search platform targets ads based on specific search parameters and displays these ads together with the search results. We believe this targeted advertising model is truly revolutionary and Google may have barely scratched the surface of its potential. Only founded in 1998, the company has a first mover advantage, commanding as much as a 70% market share worldwide. Significantly, Google's capital expenditures exceed $2 billion annually, reflecting the high barriers to entry in the online search business. We believe growth will occur both organically through an ever-increasing pool of worldwide Internet users as well as through Google's substantial investments in nascent technologies such as mobile (cell phone) search and cloud (Internet-based) computing.

We believe market leaders such as Coca-Cola and Google that possess strong brands, proven management, fortress balance sheets, and scale advantages are well positioned to create significant value for long-term shareholders.

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 steady compounding machines.

A current example of an out-of-the-spotlight holding in the Portfolio is Sigma-Aldrich, one of the largest distributors of specialty chemicals worldwide. Its products include ultra pure and sometimes custom-made organic and inorganic substances that are used by pharmaceutical companies, biotechnology companies, universities, and government research labs for activities such as identifying and analyzing genes. Sigma-Aldrich's global distribution network gives the company a unique position in the industry as it can deliver chemicals to labs virtually anywhere in the world within 24 hours. In addition to enjoying the operating leverage associated with scale, Sigma-Aldrich generates ample free cash flow and has a solid balance sheet.

Another representative out-of-the-spotlight holding in the Portfolio is Iron Mountain, a leader in off-site document and data storage that serves nearly 95% of Fortune 1000 companies. Founded almost 60 years ago, Iron Mountain today operates more than 1,000 data record vaults in 39 countries across five continents. As technology has progressed, Iron Mountain has added digital data storage to its array of services and today offers its clients integrated paper and electronic records management options. The company benefits from a highly recurring revenue base--an indication not only of the value Iron Mountain offers customers but also a by-product of the high costs involved in changing off-site storage providers. In addition, Iron Mountain's global scale is a distinct advantage relative to smaller, more locally based competitors, particularly in serving larger corporations. What Iron Mountain might lack in public recognition we believe the company makes up for in durability, profitable growth potential and competitive position.

Headline risk or contrarian investments4—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 can be an effective and repeatable way to capitalize on herd mentality in the market.

As an example, while financial businesses often have unique and distinct business models, during much of the economic slowdown virtually all have been indiscriminately tainted by headline risk. Markel, a specialty provider of nonstandard property and casualty (P&C) and life insurance products, is a contrarian investment in the Portfolio. It underwrites policies in noncompetitive niche markets, including P&C coverage for museums, day care centers and commercial parking garages as well as certain specialty life insurance policies such as coverage for public officials. The company's key competitive advantage in our view is its deep expertise in non-standard lines of coverage that are difficult for others to underwrite effectively. In addition, Markel has an excellent record of generating high returns on its investment portfolio, which has enhanced the company's profitability over time. Our long-term approach of owning businesses through cycles requires patience. However, looking out over a span of years (not just months or quarters) we believe the economic rewards of owning a quality business like Markel can be substantial and well worth the wait.

Overall, the investments we have made in the three categories described above combine to form a total portfolio that we believe is well diversified and offers a high probability of producing satisfactory compound returns over full market cycles.5

2 Holdings discussed in this commentary are selected according to objective, nonperformance-based criteria. They are chosen each quarter according to a consistent methodology based on their weight in the Davis Advisors All-Cap model portfolio as well as recent purchases and sales and are intended only as illustrations of the Davis investment discipline. They are not recommendations to buy, sell or hold any security. Individual account holdings may vary. 3 Source: Davis Advisors and Wilshire Atlas. 4 While we research companies subject to such contingencies, we cannot be correct every time, and a company's stock may never recover. 5 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 trailing 12 month period ending March 31, 2010 the Russell 3000® Index delivered solid returns, finishing the period up 52.44%. During this period the Davis All-Cap Portfolio generated strong performance as well.6 Longer term, the Davis All-Cap strategy has outperformed the Index in nine of the past 11 calendar years and by a wide margin since Davis Advisors began managing All-Cap portfolios in 1999.6 These results are a testament in our view to the effectiveness of the fundamentals-based Davis investment discipline through a variety of market and economic environments. (The Davis All-Cap strategy is a representation of Davis Advisors' overall results using this strategy. Individual account performance may vary.)

Total Returns as of March 31, 2010	1 Year	5 Years	10 Years	Since Inception (1/1/99)
Davis Advisors All-Cap Strategy  net of fees	54.88%	1.25%	3.23%	6.35%
with a 3% maximum wrap fee	51.77%	-1.04%	0.93%	4.00%
Russell 3000® Index	52.44%	2.39%	-0.07%	2.04%

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. Current performance may be higher or lower. Total return updates are available quarterly. Please ask your financial advisor to contact Davis Advisors.

The Portfolio's results in the most recent 12 month period reflect strong performance among many individual holdings, particularly within the information technology, consumer discretionary and health care sectors. (Sector allocations are a by-product of bottom-up stock selection and generally represent a cross section of market leaders, out-of-the-spotlight holdings and headline risk investments. We refer to sector-level performance here merely to provide a general framework for understanding the Portfolio's aggregate performance in the most recent 12 month period.)

Information technology has been one of the best performing areas of the Portfolio and the market over the last 12 months. Our technology holdings predominantly include workhorse category leaders in chips, online search and software, among other business types. We believe these businesses stand a high probability of compounding earnings by generating relatively high returns on capital and enjoy significant competitive barriers to entry.

Consumer discretionary holdings in the Portfolio include such unrelated businesses as media companies, a restaurant company with significant international operations and a manufacturer and distributor of home improvement products. Our particular selection of consumer discretionary holdings reflects the characteristics we look for in any business: (1) proven management, (2) a strong, profitable business model and (3) sustainable competitive advantages. We seek to buy such businesses when they are trading at a discount to our assessment of their true economic worth based on future earnings power.

Our health care holdings consist of a variety of businesses including diagnostic testing laboratories for veterinary and human markets, pharmaceutical manufacturers, a leader in surgical and laboratory instruments and supplies, and a global diversified consumer health care product manufacturer. Given the uncertainty created by health care reform, a number of quality businesses--some of which we have followed for many years--have traded at depressed market valuations, offering us the opportunity to selectively add strong durable companies to our Portfolio at attractive prices. We believe that well-managed businesses in the health care area with strong competitive positions in their unique markets stand to benefit from increasing expenditures on health care products and services as populations around the world age.

Regarding notable portfolio changes over the past year, we added select pharmaceutical and other businesses in the health care area to the Portfolio, initiated a position in Coca-Cola and sold our position in Liberty Media.

To provide our clients with timely information, we have discussed Portfolio results for the trailing 12 month period. However, our investment discipline is based on a much longer term view. We evaluate each investment in the Portfolio based on its potential to create value for our clients over multi-year holding periods. Through bottom-up stock selection and rigorous fundamental research, we aim to construct a total portfolio that we believe is well diversified and has a high probability of producing satisfactory compound returns over full market cycles.

6 The Davis Advisors Multi-Cap Equity Composite, net of fees. Inception was January 1, 1999. Past performance is not a guarantee of future results.

Long-Term Perspectives

In our experience, one of the keys to building long-term wealth is to avoid making emotional investment decisions. The way in which emotions can undermine an investor's ability to build long-term wealth was evident in 2009 when cautious investors poured a record $375 billion into bond funds while pulling close to $10 billion out of stocks. As a result, many investors missed the market's 26% return in 2009.7 While such a reaction reflects human nature on the heels of a difficult decade for stocks, successful investors recognize the importance of remaining unemotional when making investment decisions.

Source: Investment Company Institute. Stocks and bonds represent different asset classes subject to different risks and rewards. Future economic events may favor one asset class over another.


Applying an unemotional, objective approach to today's market environment suggests that long-term investors would be well served adding to, or maintaining, their equity allocation over the next decade.8 Why? Because historically disappointing decades for stocks have been followed by periods of attractive returns. This is illustrated in the chart below, which shows the 10 year returns for the market from 1928-2009. Returns of at least 5% are represented by the green bars and returns of less than 5% are represented by the red bars. Here are a few key points:

• From 1928 through 2009, there have been eleven 10 year periods where the market delivered disappointing returns of less than 5%.
  
• In every case, the decade following these disappointing decades produced satisfactory returns. (For instance, the -0.2% average annual return from 1928-1937 was followed by a 9.3% average annual return from 1938-1947.) Past performance is not a guarantee of future results.
  

Source: Thompson Financial, Lipper and Bloomberg. Graph represents the S&P 500® Index from 1958 through 2009. Periods before 1958 are represented by the Dow Jones Industrial Average. Past performance is not a guarantee of future results.


The fact that stocks have suffered through an awful decade is precisely why investors should be excited about their prospects for the next 10 years.8 Historically, it has been profitable to invest in the stock market after a period of poor returns. In our view, the coming decade should be no exception as many high-quality businesses are trading at very reasonable valuations today.8 Taking advantage of these opportunities, however, requires an unemotional, objective investment approach.

7 The market is represented by the S&P 500 Index. In 2009, the Barclays Capital U.S. Long Government/Credit Bond Index returned 1.92%. Stocks and bonds represent different asset classes subject to different risks and rewards. Bonds are considered to have less risk than equities. Future economic events may favor one asset class over another. 8 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.


Where We Are Finding Opportunities

There are always opportunities and risks. In our view the keys to outperforming the market over the next decade, as we have done in the previous four,9 are: (1) to think long term rather than get caught up in short-term cycles, (2) to exercise a highly selective and disciplined approach with respect to business quality and valuation, and (3) to remain focused on in-depth, bottom-up research.

Today we are finding compelling values in many areas of the market that in our view represent attractive avenues for compounding shareholders' capital over the next decade. Most of these opportunities fit within the following long-term themes:

• Globally dominant businesses—These industry leaders are characterized by strong pricing power, diversified earnings, healthy balance sheets, strong competitive moats, and durable business models. Because these businesses produce excess cash, they are not dependent on external funding.

• Beneficiaries of crisis—Certain companies' business model, capital position and management discipline allow them to take advantage of chaos. Given strong free cash flow, these companies are often able to use distressed prices to make investments, acquisitions or significant share buybacks at accretive prices.

• Select financial companies—The financial services industry is not prone to obsolescence. People will always need basic banking services, insurance products, investment management advice, and other such services. Nonetheless, it is necessary to differentiate between strong and weak players in order to invest successfully in this area of the market.

• Energy, commodities and agriculture businesses—Well-managed companies in these areas are positioned to benefit from the inexorable long-term growth of a global middle class, which will result in increasing demand and potentially higher prices for most natural resources.

• Select special situations—These are highly opportunistic companies in diverse industries trading at steep discounts to intrinsic worth that may prove to be exceptional long-term investments in our view.

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. ■

9 The Davis Advisors Large Cap Value Composite (net of fees) has outperformed the S&P 500® Index since the inception of the Composite (4/1/69). Past performance is not a guarantee of future results.