Performance Overview

The Davis Appreciation and Income Fund’s Class A shares delivered a total return on net asset value of –7.45% for the one year period ended December 31, 2011 compared with a return of 2.11% for the S&P 500^® Index.¹ Over the same period, the average mixed-asset target allocation growth fund tracked by Lipper returned –1.24% and the average aggressive allocation fund tracked by Morningstar returned –3.81%.² Because short-term results are less interesting to us than long-term results, we find it more meaningful that over the long term the Fund has generated a somewhat better return than the market with less risk. Since the Fund’s inception on May 1, 1992, its Class A shares have generated an average annual total return on net asset value of 8.01% versus an average annual total return of 7.96% for the S&P 500^® Index.¹  At the same time, since May 1992, the Fund has had an annualized standard deviation (a commonly used statistical proxy for risk) of 14.12 versus 15.12 for the S&P 500^® Index.³

According to a 2011 Morningstar report on the Davis Appreciation and Income Fund, “This aggressive allocation fund takes an atypical approach. While most of its peers invest only in stocks and bonds, this fund’s co-managers, Andrew Davis and Keith Sabol, look across a company’s capital structure. . . . The managers like convertible bonds because they often capture the stock market’s upside while participating less on the downside. The fund’s high-conviction, deep-value strategy also stands out. The managers seek competitively advantaged, well-managed companies trading at a steep discount to their intrinsic values….” ⁴

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 0.93%. 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 monthend performance, click here or call 800-279-0279.

Our Strategy

Our long-standing investment goal is to capture most of the market’s upside performance while participating in less of its downside.⁵ We use the Davis Investment Discipline to identify the businesses we wish to own, and then we seek to achieve our goal by investing in convertible bonds, equity, preferred stock, and straight debt of these target companies. We blend securities from these categories, taking into account valuations and other attributes of the particular securities employed. Because of the favorable return profile of many convertible securities, we like to include them when they are available from particular issuers at acceptable prices. In constructing our Portfolio we consider the risk versus reward trade-off at both the issuer and portfolio levels. At purchase, we size the issuer exposure and equity sensitivity of our positions to match our view of that issuer’s fundamentals and valuation and our return expectations. These blends are adjusted over time on an event-driven basis to reflect changes in our outlook.

The Markets

After a strong first half, equity markets languished in the second half of 2011. For the year, the S&P 500^® Index rose 2.11%, and the Russell 2000^® Index declined 4.18%. The Merrill Lynch All Total Return Alternatives U.S. Convertibles Index fell 5.60%, pushed down by the relatively weak performance of convertible securities relative to their underlying stocks. Stocks underlying the convertibles market performed particularly poorly, with an index measuring the performance of the most liquid of these securities falling 8.55%.⁶ Fixed income assets performed relatively well due to their comparative safety in a highly risk averse investment environment.

The performance of fixed income markets is relevant to the Fund because those markets directly affect the fixed income component of our convertible bonds, our corporate bonds and our straight preferred stock positions. When bonds perform better than stocks, we expect the Fund to benefit compared with the S&P 500^® Index and, conversely, when bonds lag, the Fund suffers by comparison. Our portfolio strategy is a balanced one that combines equity and equity-like securities with securities having fixed income characteristics, so we expect the Fund’s returns should normally lie between fixed income and equity returns. During 2011, the Fund declined 7.45%, a disappointing showing, particularly given a reasonably strong start through June.⁷

Understanding Fund Performance

We began the year expecting that the U.S. economy would slowly begin to recover and that the least appreciated risk in the market was the potential for a surge in inflation driven by the liquidity being pumped in to the economy to stimulate recovery. We thought short-term rates were quite low and likely to move higher, a view we believed was reflected in the pricing of options on the investment grade portion of the convertibles market.

What we failed to appreciate was the degree to which fears of an economic collapse in Europe would affect assets in the United States. Despite the rating agencies’ downgrade of the United States, the dollar was still widely viewed as the safest investment in the world and risk-averse traders drove yields down. At the same time, worries about deteriorating economic conditions in Europe dampened the outlook for many businesses.

Consistent with our view that inflation was a significant risk, we positioned the Portfolio to benefit from owning high quality companies in industries that are historically considered hedges against inflation and thus might help protect our purchasing power.⁸ These companies include Devon Energy Corporation (DVN), an oil and gas exploration and production company; Freeport- McMoRan Copper & Gold Inc. (FCX); United States Steel Corporation (X); and Allegheny Technologies Incorporated (ATI), a specialty metals manufacturer. Anticipating a recession, investors sold these cyclical companies, driving their stock prices down 20% to 40% between June 30th and year-end. Over the same time period, our internal estimate for intermediate-term inflation expectations dropped from 3.25% to 2.65%.

In the midst of this turmoil, we took steps to capitalize on the opportunities the market presented. In February, for example, after the stock of United Rentals, Inc. (URI) had appreciated approximately 36% we sold a portion of our equity-sensitive convertible bond position.⁹ The company’s operating trends remained favorable, but management’s focus on reinvesting in its rental equipment implied that while earnings before interest, taxes, depreciation, and amortization (EBITDA) were likely to grow, free cash flow would not. Like many companies operating in cyclical businesses in 2011, United Rentals’ stock subsequently declined sharply, falling 57% between the date of our sale (February 9th) and the 22nd of August.

With the market declining in August seemingly in expectation of a recession, we reacquired much of the United Rentals’ position we had sold earlier in the year. As a leader in a highly fragmented market, United Rentals enjoys significant opportunity for growth through acquisitions in our view. The company again confirmed this view in mid-December when it made a significant friendly acquisition of RSC Equipment Rental, Inc. (RRR). Both companies have long shared similar operating philosophies, and a larger presence will enable the merged entity to offer even better coverage to national accounts as well as realize operational synergies by reevaluating rental locations and adjusting equipment inventories. These synergies should allow United Rentals to continue to grow its cash flow even in the event of an economic slowdown.

However, not all of the additions we made to existing Fund positions worked so well. We added to our bond positions in U.S. Steel and Allegheny Technologies relatively early in the summer selloff and both of those additions exacerbated our third quarter downside. Ultimately the ATI bonds recovered, but the U.S. Steel purchase contributed to our disappointing performance in 2011.

In what was perhaps the most frustrating sale of the year, between August 5th and August 9th we liquidated our holdings of Avon Products Inc. (AVP). Avon’s stock had seemed inexpensive for several years and we believed the experience that interim CFO Chuck Cramb brought from his long career at Gillette, now part of Procter & Gamble, would drive a renaissance at Avon. For a time operational improvements seemed steady but by late summer signs of difficulties became apparent. Increased spending on advertising floundered; changes in reporting procedures suggested the potential for further deterioration in operating profits; and the company stumbled in Brazil, one of its best markets, suggesting that competition there may be taking its toll on Avon. With the company seemingly adrift and lacking confidence in the management team, we eliminated our position in Avon. On January 31st of this year, we learned Avon had dismissed Mr. Cramb, reinforcing our conviction that our sale in early August 2011 was the right course of action.

No one relishes a bankruptcy filing by a Portfolio company but it can provide valuable lessons. As an example, in 2009, one of the Fund’s holdings, Thornburg Mortgage, filed for bankruptcy protection and we have served on the creditors’ committee since. While the Thornburg bankruptcy was a costly drag on Fund performance, our experience there helped preserve shareholder capital in 2011 when the Fund’s investment in Kodak convertible bonds faltered. When we bought the Kodak bonds in 2009, investors had committed new capital; the company was licensing some of its intellectual property; and Kodak’s printer business, though small, was growing rapidly. These facts made the bond’s 7% coupon seem attractive. By September of 2011, however, rising silver prices had become an increasing drag on Kodak’s film business, general economic malaise further impaired the prospects of its other businesses and a key patent infringement decision was delayed by the retirement of an administrative judge. (A history of previous favorable judgments had helped Kodak secure key licensing agreements that provided a cash flow lifeline to the company.)

Despite indications from Kodak that the seasonally strong second half of the year would be its best cash flow period, that Kodak would generate adequate cash to continue its efforts to revitalize the company and that the sale of a large patent portfolio was pending, the company caught investors off guard by drawing down a credit line. From our experience with the Thornburg bankruptcy, we recognized this as the act of a desperate management team. The credit line draw down strongly suggested the odds of Kodak running out of cash before the patent portfolio could be sold were quite high. Further, we knew prospective buyers of the patent portfolio would worry about possible fraudulent conveyance claims debt holders could make in a bankruptcy proceeding. Even in a best case scenario, the sale of the portfolio would come at a distressed price, and that might not be adequate to guarantee Kodak’s survival. As a result, we immediately sold our position, avoiding a 20 point drop in the bonds over those several days.¹⁰

Looking Ahead

The high correlation between the euro and the U.S. stock market is well reported in the financial press. That the stock market moves in the same direction as the euro is an indication investors continue to worry about how, or even if, the eurozone crisis will be resolved. The number of separate European governments involved adds a layer of complexity that makes the outcome largely unknowable. What we do know is interest rates in the United States are extremely low, with mortgage rates at their lowest levels since the 1950s. While not everyone will be able to refinance, the current wave of refinancing is large enough that brokers and lenders are extending closing dates to accommodate the demand. In many cases homeowners can reduce their payments 15% or more by refinancing. While rising food and energy costs may absorb much of that savings, the extra money will at least provide an offset.

Just as low interest rates are a boon to homeowners and buyers, they are great for companies too. Low rates enable companies to take on additional projects, buy other businesses and buy back shares. All of these activities should buoy the stock market.

On the other hand, low rates can be a serious problem for people living on fixed incomes. Not only are yields on retirement assets low, but risk to principal is higher. As of this writing, the yield on 30 year Treasury bonds is about 2.9%. While that yield could stay low, the concern is what if it does not? If the yield on 30 year Treasuries moves up to just 3.9%, which is where it was in August, holders of these bonds would lose about 14% of their principal.

In fairness, judging by the implied forward yield curve, the market is not anticipating such a move in long-term bond yields anytime soon. (The implied forward yield curve reflects current market expectations for interest rates at various points in the future.) Currently, the projected yield for 30 year Treasury bonds in 2022 is 3.6%.¹¹ This suggests the market is expecting another decade of lethargic economic growth on top of the one we just experienced. That is a dreary outlook. Today the dividend yield on the S&P 500^® Index is higher than the yield to maturity on 10 year Treasury bonds and dividends on S&P 500^® stocks can grow while bond coupons will not. Predicting the future is hard, if not impossible, but the hurdle for stocks to outperform 10 year Treasury bonds does not seem too high.¹²

Market turmoil presents both pitfalls and opportunities. As shareholders in the Fund along with you, we thank you for your support as we continue to work diligently to uncover those investments that will create value for all of us over time. ■