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 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 Positioning

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 investments4:

• 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 health care to technology to consumer products, 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.

Johnson & Johnson (J&J) is a representative market leader in the Portfolio. Its strong lineup of everyday brands, such as Tylenol, Aveeno and Listerine, make it the world’s largest consumer health care products company. In addition, J&J has a sizeable pharmaceutical operation and owns the largest medical devices business in the world. We believe each of J&J’s business segments will continue to benefit from well-established, long-term demographic trends as well as continuing globalization. From a financial perspective, J&J’s revenue is diversified both by its varied product array as well as its geographic reach. It generates ample annual free cash flow of roughly $14 billion and has a fortress balance sheet with no net debt that has allowed it to maintain a rare AAA credit rating.

We believe market leaders like Johnson & Johnson 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.

Harris Corporation is an example of an out-of-the-spotlight company in the Portfolio. It is a leading designer and manufacturer of communication systems and networks used by the U.S. military, various civilian agencies, local governments, and for certain commercial purposes. Its products, such as handheld radio gear, are used by all branches of the military and public safety organizations ranging from the Massachusetts Bay Transportation Authority to the Miami-Dade Police Department to the Royal Canadian Mounted Police. Because of the potential life or death nature of the communications likely to be transmitted over these systems, they are designed to be state of the art, highly reliable and totally secure. Key to Harris’s competitive advantage is the depth of knowledge of its employee base. Some 7,000 of these employees, nearly half of the company’s workforce, are engineers and scientists.

Another example of an out-of-the-spotlight investment in the Portfolio is Blount International, a company that manufactures power chainsaw and related equipment used by the forestry, yard care and general contractor industries worldwide. Blount’s business is so specialized that it operates in a near duopoly, which constitutes in our view a strong and enduring competitive moat. Because demand for its products is housing-related, Blount’s business is cyclical and recently has been sluggish due to the global economic slowdown. We believe, however, that secular demand for timber–a key driver for Blount–will eventually resume its long-term growth and that Blount is well positioned to benefit from this trend.

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.

An example of a headline risk investment in the Portfolio is Monsanto, a biotech-agricultural company that helps farmers enhance the productivity of their land. As the world’s population grows and modernization increasingly drives rural populations to cities, dwindling numbers of farmers will have to feed ever more people. Monsanto develops seeds for important crops, such as corn and soybeans, which have been genetically modified so that the plants can better withstand herbicides and pests. The company complements its market leading seed business with an herbicide business that features its flagship product, Roundup. Importantly these two seemingly disparate businesses are intertwined as Monsanto seeds are designed to produce plants that are resistant to Roundup, allowing farmers to freely apply herbicide to their fields to help control weeds and enhance yield per acre. Recently, Monsanto’s sales of Roundup have been negatively affected by several factors including competition from cheaper generic herbicides causing volatility in its share price. From a long-term perspective, however, we believe that Monsanto’s R&D efforts remain significantly ahead of its competitors and may provide an array of new seeds offering solutions for other farming needs in years to come.

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.6

4 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 Core 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. 6 While we believe we have a reasonable basis for our appraisals and we have confidence in our opinions, actual results may differ materially from those we anticipate. Equity markets are volatile and an investor may lose money.

Performance Review

For the year-to-date period ending June 30, 2010 the Russell 3000® Index returned –6.05%. Davis All-Cap portfolios underperformed the broader market during this brief time period.7 Longer term, the Davis All-Cap strategy has outperformed the Index in 9 of the past 11 calendar years and by a wide margin since Davis Advisors began managing All-Cap portfolios in 1999.7 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 June 30, 2010	1 Year	3 Years	5 Years	10 Years	Since Inception (1/1/99)
Davis Advisors All-Cap Strategy  net of fees	11.79%	-11.85%	-1.68%	2.11%	5.04%
with a 3% maximum wrap fee	9.26%	-13.93%	-3.93%	-0.18%	2.71%
Russell 3000® Index	15.72%	-9.47%	-0.48%	-0.92%	0.93%

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 over the past six months reflect the volatile conditions that led all major market sectors to decline in the period. Technology, energy, health care, and materials holdings were the largest detractors on balance during the period.

We have selectively added to a number of positions recently on price weakness, initiated a new position in Baxter International (a global health care company whose products include medical devices and biotech-based pharmaceuticals) and sold our position in E*Trade.

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–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 discussed the Portfolio’s two largest sectors by weighting to highlight some of the areas where we are finding long-term opportunities.

Businesses in the technology sector represent the largest portion of the Portfolio. Our holdings broadly include workhorse hardware, software, computer chip, online search, and gaming technology companies. In our view, all are leading companies within their competitive spheres and satisfy our preference for strong management, durable businesses, sustainable competitive advantages, and reasonable valuations. While each business is somewhat unique, many of our holdings in this sector have either a dominant or growing market share, solid balance sheets sometimes with significant cash on hand and, through disciplined capital allocation, are well positioned to grow over the long term.

The next largest weighting in the Portfolio is health care related businesses, which encompass a wide range of business types including leading pharmaceutical companies, providers of laboratory services and supplies, and globally diversified medical device manufacturers. Here, in addition to owning well-managed, durable businesses, we like the long-term demographic tailwind that helps support the industry’s economics. Specifically, we believe that health care spending is likely to rise over the next decade as a percentage of global output as developed countries spend more on medical products and services to meet the needs of aging populations, and as developing countries are increasingly able to afford the luxury of health care. Meanwhile, 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 consumer, energy, financial, 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.8

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. ■

7 Davis Advisors’ Multi-Cap Equity Composite, net of fees. Inception was January 1, 1999. Past performance is not a guarantee of future results. 8 While Davis Advisors attempts to manage risk there is no guarantee that an investor will not lose money. Diversification does not ensure against loss.