Summer 2010 Commentary


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 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 June 30, 2010



Market Perspectives

In the first half of 2010 the U.S. stock market 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. While returns for the first six months of 2010 and in fact for the past decade have been disappointing, history gives us reason to be sanguine about the future. We have just traversed one of the lowest returning 10 year periods in market history. Although past performance is not a guarantee of future results, decades of subpar market returns have historically been a precursor to long periods of relatively robust returns, as the chart below illustrates, and we believe a repeat of this pattern is possible for the coming decade.

Specifically, the chart below isolates the 11 decades since 1928 when the market has produced subpar returns of less than 5% over 10 years (gold bars). In every case, over the following 10 year period the market has historically generated relatively attractive returns (green bars).2 These periods of recovery averaged 13% per annum (ranging from a low of 7% per annum to a high of 18% per annum), which is above the average long-term return for equities of roughly 10% and well above the past decade’s return.

Source: Thomson Financial, Lipper and Bloomberg. Graph represents the S&P 500® Index from 1958 through 2009. The period 1928 through 1958 is represented by the Dow Jones Industrial Average. Investments cannot be  made directly in an index. Past performance is not a guarantee of future results.

Looking at the present situation, the market has declined from its starting level a decade ago, yet the core earnings power of many world-class franchises has increased substantially. That combination of lower prices with rising underlying earnings has led valuations for a large number of quality businesses to contract dramatically, meaning that many of our favorite businesses are now trading at bargain prices. Low valuations set the stage for higher prospective returns and give us reason to believe that the decade ahead may well be more rewarding for quality-oriented equity investors than the last.3

2 Past market performance is not a guarantee of future results. 3 There is no guarantee that in the future the market will be better than it has been in the past.

Portfolio Positioning4

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 financial services to consumer products 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.

Ameriprise Financial, a leading provider of financial planning, asset management and insurance services to middle class Americans, is an example of a market leader with a strong balance sheet. Its network of nearly 12,000 advisors is geared toward helping individuals and families protect their assets through the purchase of affordable insurance products as well as assisting them with retirement planning. Ameriprise has also become a major force in the asset management industry, having grown both organically and through acquisitions. Today the company ranks as the eighth largest U.S. mutual fund manager with more than $520 billion of assets under management. Meanwhile, the business trades for less than 12 times earnings and offers close to a 2% dividend yield.

We believe market leaders 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—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.

Current examples of out-of-the-spotlight holdings in the Portfolio include Express Scripts, a leading pharmacy benefit manager, and Progressive Corp., an exceptionally well-managed auto insurance provider. Out-of-the-spotlight holdings can also include hard asset-related businesses such as Occidental Petroleum, an oil exploration and production company that has outperformed the vast majority of its energy-related peers in terms of historical returns on invested capital. The company stands to benefit in our view from disciplined growth of production as well as from the emergence of a global middle class whose energy consumption is likely to grow over time.

Headline risk or contrarian investments5—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. As an example, uncertainty associated with health care reform in the United States has created opportunity in recent months. In the last few quarters we increased our Portfolio allocation to select, high quality pharmaceutical businesses at what we believe were depressed valuations offering dividend yields in excess of 3% to 4% at the time of purchase.

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 Holdings discussed in this commentary are selected according to objective, non-performance-based criteria. They are chosen each quarter according to a consistent methodology based on their weight in the Davis Advisors Large Cap Value model portfolio as well as recent purchases and recent 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. 5 While we research companies subject to such contingencies, we cannot be correct every time, and a company’s stock may never recover.

Performance Review

For the year-to-date period ending June 30, 2010 the S&P 500® Index returned –6.65%. The Davis Large Cap Value Composite underperformed the broader market by a slight margin during that brief time period.6 Longer term the Davis Large Cap Value Composite has outperformed the Index over the trailing 1, 5, 7, 10, 15, 20, 25, 30, 35, and 40 year periods as well as since its inception in 1969.6

Annualized Total Returns as of June 30, 2010	1 Year	3 Years	5 Years	7 Years	10 Years	15 Years	20 Years	25 Years	30 Years	35 Years	40 Years
with a 3% maximum wrap fee	12.56%	-12.44%	-2.93%	1.54%	-1.29%	5.50%	7.35%	9.02%	10.65%	11.14%	10.52%

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. Investments cannot be made directly in an index. Please ask your financial advisor to contact Davis Advisors.

The Composite has also outperformed the S&P 500® Index over every rolling 10 year period since 1969,6 a testament in our view to the effectiveness of the fundamentals-based Davis investment discipline through a variety of market and economic conditions. (The Davis Large Cap Value Composite is a representation of Davis Advisors’ overall results using this strategy. Individual account performance may vary.)

The figures above represent past performance and are not a guarantee of future results. Investment return and principal value will vary so that an investor may lose money. Total return assumes reinvestment of dividends and capital gain distributions. Current performance may be higher or lower than performance quoted. Total return updates are available quarterly. For more current performance, please ask your financial advisor to contact Davis Advisors. Rolling 10 year returns would be lower in some periods if a 3% maximum wrap fee were included. See endnotes for a description of our rolling 10 year performance and a definition of the S&P 500® Index. Investments cannot be made directly in an index.

The Portfolio’s results over the past six months were slightly below the market’s return. On balance, energy, technology, health care, and consumer related holdings were detractors from performance while financials declined only modestly during the period. Against this backdrop of volatility we have selectively added to a number of positions recently and sold our position in Cardinal Health.

Taking a longer view, the Portfolio 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–i.e., 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.

Businesses engaged primarily in some broadly defined facet of financial services currently represent the largest sector weighting in the Portfolio. This broad sector exposure encompasses many highly distinct industries and thus is well diversified by itself. For instance, we currently own: two diversified holding companies with insurance subsidiaries but also interests in utilities, natural gas pipelines and railroads, among other business lines; two banks engaged in traditional lending activities; one bank that does little lending but instead specializes in trust services, custody and processing as well as asset management; a pure-play personal lines auto insurer; a global charge card business; diversified financial services businesses like Ameriprise; and so forth.

Overall, there is no single overarching theme that runs through all of our financial holdings. Each business is somewhat unique. What our specific financial holdings generally have in common is that they meet our strict investment criteria in terms of management quality, business models, competitive advantages, and valuations. 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 that 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.

Select energy, natural resource and materials holdings are the next largest weighting in the Portfolio. Our investments include energy-related businesses that are engaged in the exploration and production of oil and/or natural gas, a leading manufacturer of protective packaging (classified as a materials holding) and a global research and development company specializing in biotech-agricultural products. In this area of the Portfolio we seek first and foremost to invest in businesses with the ability to create substantial shareholder value through disciplined capital allocation. In addition, we believe a number of our holdings, particularly those related to oil, offer us the opportunity to benefit should the price of this global commodity trend higher over time due to increasing demand from fast-growing, populous nations such as China and India.

Consumer staples represent a meaningful portion of the Portfolio as well. Within this broadly defined category we own: a low-cost, membership-based retailer; two global beverage companies with significant growth opportunities in emerging markets; a consumer products powerhouse that boasts more than 20 global brands each of which generates more than $1 billion of sales annually; and a pharmacy benefit manager/retail pharmacy operator, among other businesses. These consumer-related businesses cannot be grouped under a single universal theme. Put simply, these companies 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 rear its ugly head again at some point.

Health care related businesses are the next largest weighting in the Portfolio. Our health care investments encompass a wide range of business types including leading pharmaceutical manufacturers, pharmacy benefit managers and globally diversified medical supply providers. Here, in addition to owning well-managed, durable businesses, we also 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. Meanwhile, as noted earlier, in recent months a number of well-managed health care related businesses have traded at multiples as low as 5 to 12 times earnings with dividend yields in excess of 3% to 4%.

The balance of the Portfolio is broadly diversified among well-managed businesses in the technology, consumer discretionary and industrial 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. ■

6 Davis Advisors’ Large Cap Value Composite, net of fees. Inception was April 1, 1969. Rolling 10 year returns are from the first full calendar year after inception of the Composite (January 1, 1970). 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. 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.