Overview

The Davis Financial Fund’s Class A shares declined 9.02% for the one year period ended December 31, 2011 while the S&P 500^® Index rose 2.11%. Since inception on May 1, 1991, the Fund has delivered an average annual total return of 10.88% versus a return of 8.15% for the S&P 500^® Index.¹

According to a 2011 Morningstar Report, “Davis Financial Fund’s unique edge within a bedeviled sector comes from plain-vanilla principles.… Having joined the fund in 1997, Kenneth Feinberg is the sector’s longest-serving manager, consistently executing a strategy that has kept volatility well beneath peers.… Moreover, Feinberg, a Warren Buffett aficionado, requires that all holdings meet criteria used by the great investor himself.

For example, Feinberg requires that holdings have strong returns on invested capital as well as managers who operate as owners, so their interests are aligned with shareholders’. A buy-and-hold investor, Feinberg demands these quality firms also trade at a deep discount to his cash flow-based valuation, so his holdings tend to be lesser known stocks… or misunderstood ones.… Feinberg has been good at spotting diamonds in the rough… no other fund in the category executes the Buffett approach to financials as well as this one.” ²

As Portfolio Managers and investors in the Fund, Charles and I believe our performance should be evaluated in two ways, both measured over a holding period of five years or greater. First, how has the Fund performed versus the S&P 500^®Index?

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 0.91%. 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. The Fund received a favorable class action settlement from a company that it no longer owns. This settlement had a material impact on the investment performance of the Fund in 2009. This was a one-time event that is unlikely to be repeated.

Second, how does the Fund compare with its peer group of financial sector funds? The Fund delivered an average annual total return on net asset value of –5.32% for the five year period and 1.95% for the 10 year period ended December 31, 2011. Over these same time periods, the S&P 500^® Index returned –0.25% and 2.92% respectively, and the financial component of the S&P 500^® Index returned –16.87% and –4.54% respectively.³ We are particularly gratified the Fund’s track record ranked it number one among financial funds for the three year period and number two for the 20 year period ended December 31, 2011, according to Lipper.⁴

The Davis Financial Fund differs from many other sector funds in that we prefer to be long-term shareholders of attractively priced, well-run companies. This is reflected in the Fund’s low turnover over the years. In 2011 our turnover was 12% compared with average turnover above 158% for our peers.⁵Low turnover helps the Fund’s shareholders compound wealth on a tax-deferred basis.

We encourage shareholders to compare the returns they achieve on an after-tax basis, which capture the turnover in a fund’s holdings. The SEC requires all funds to disclose this information in their prospectuses. The Fund’s after-tax returns for the latest one, five and 10 year periods are shown in the chart below.

We try to do our best to protect the capital you have entrusted to us. Since January 1, 2000, we have been successful in this effort as the Davis Financial Fund has achieved a positive cumulative return on net asset value of 45.72% versus 6.80% for the S&P 500^® Index.⁶

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. See endnotes for additional disclosure.

Davis Financial Fund is categorized by Lipper as a Financial Services Fund. The rankings show where the Fund would place within an all Financial Services universe. Total returns rankings are based on total return performance without accounting for a sales charge. The maximum sales charge for Class A shares is 4.75%. Class Y shares do not have a sales charge. Past performance is not a guarantee of future results. For the periods ending December 31, 2011, Class A share rankings are: 1 year, 20 of 77 funds; 3 year, 2 of 68 funds; 5 year, 11 of 63 funds; 10 year, 9 of 43 funds; and 20 year, 2 of 7 funds. For the periods ending December 31, 2011, Class Y share rankings are: 1 year, 19 of 77 funds; 3 year, 1 of 68 funds; 5 year, 9 of 63 funds; and 10 year, 8 of 43 funds. Inception of Class Y shares was 3/10/97.

Market Perspectives

During 2011, investors had to balance the negative macroeconomic ramifications of a troubled Europe and the likelihood of an imminent recession, the difficulty of structuring a long-term financial bailout of Greece, conflicting information about the long-term health of key economies around the world, weak U.S. housing prices, and structurally high unemployment in the United States with the positives of a modestly improving U.S. economy and continuing low interest rates throughout most of the world. Meaningfully weighing on share prices during the past 24 months have been concerns that the Greek sovereign debt crisis would undermine other financially weakened European countries, including Spain, Portugal, Ireland, and Italy and perhaps even lead to an eventual breakup of the European Union. If such a breakup occurs, the financial markets and many global economies would almost certainly suffer, and the fallout from such a massive disrupting force could be quite significant. For the time being at least, European governments, led by Germany and to some extent France, have bound together in successful efforts to support the European Union by arranging meaningful bond financings in Greece and Portugal, thus preventing fiscal uncertainties from spreading to other countries. However, the situation remains quite fluid and there is no guarantee these issues will not develop into a full-fledged financial crisis in Europe.

For investors in financial services stocks, especially those companies based in the United States, the impact of the financial reform legislation signed into law in mid-2010 has created additional uncertainties for business models and capital requirements.

The economic recovery in the United States that began in 2009 has been slow but conditions are generally improving despite the fact Europe is struggling at present. However, the budget imbalances and high debt levels of many countries, particularly in Europe and the United States, represent meaningful long-term headwinds to real economic growth and create the longer term uncertainty, especially for the United States, of owing so many dollars to foreign creditors.

Importantly, as noted in our 2009 and 2010 Annual Reviews, confidence in the global financial system has vastly improved from the depths of the financial crisis that started in March 2008 when Bear Stearns was sold to JPMorgan Chase. Two important drivers of this growing investor confidence have been greater stability in the global financial markets and a meaningful easing of the global credit crisis.

The credit market freeze that began in 2008 has greatly thawed, especially for strongly rated companies. Most investment grade companies continue to be able to access the fixed income markets or use their banking relationships to issue new debt or refinance debt coming due soon. It is critically important that companies can finance their day-to-day cash flow needs to conduct business operations as well as tap the financial markets to avoid any near-term or medium-term liquidity issues. The fear that companies might be unable to refinance their maturing short-term and medium-term debt was one of the biggest causes of the massive declines in stock markets around the world in 2008 and early in 2009. Fortunately almost all companies avoided this devastating outcome.

At the same time, it seems possible the economic news may remain fairly mixed in the near term. The United States has lost 10 million jobs since the severe recession officially began in December 2007. Unemployment remains problematic, with the unemployment rate peaking at 10% in October 2009 and moderating to a still high 8.5% as of year-end 2011. Since unemployment is a lagging indicator, the rate has remained high despite positive real GDP growth during 2011. The official unemployment figures are an imprecise measure of unemployment as they exclude people who have given up actively looking for work as well as those who have settled for part-time jobs but would prefer to be working full-time. Some economists estimate the truer unemployment rate, including underemployment, is closer to 15% to 20%.

The decline in global stock markets during 2008 wiped out $20 to $30 trillion in household wealth worldwide, including $5 trillion in the United States. In addition, the approximately 30% decline in the value of U.S. homes has wiped out another $6 trillion in U.S. household wealth. These record declines in household wealth, combined with rapidly rising unemployment during the global recession, have dramatically reduced consumers’ willingness to spend on big ticket purchases such as cars, homes, furniture, and expensive jewelry. Inflation is also rising in some important categories such as food and energy, further straining the finances of middle class households. Inflation is especially harmful to households in emerging economies where a greater percentage of income must go to food and energy.

For those reasons, we still do not expect a dramatic recovery in consumer spending back to the levels of 2007. Americans are beginning to save at levels not seen in many years. While this higher level of saving does not stimulate the economy as much as spending, it is clearly a long-term positive that Americans are saving more and paying down their high debt levels.

While significant challenges remain, in a world where 10 year U.S. Treasuries yield a remarkably paltry 2.0%, we believe there will be considerable opportunities to make compelling investments in financial stocks.⁷ One positive today is that despite robust recoveries in stock markets around the world, the overwhelming consensus of opinion remains fairly negative to merely neutral. Although certainly somewhat justified, fear has not been so prevalent in many decades. As Warren Buffett advises, “Be fearful when others are greedy. Be greedy when others are fearful.”

Many companies have survived the recent financial storm, gained profitable market share and reached the shore in better competitive positions with earnings and revenues continuing to recover. Our job is to try to find these winners for our shareholders and purchase them at attractive prices. Moreover, while the headlines may remain mixed for a while, the market is a discounting mechanism. Considerable bad news is likely already fully reflected in current share prices. At the same time, given the strong market gains experienced in 2009 and 2010, we expect 2012 could be more of a stock picker’s market, rather than a market where all stocks are lifted by a rising tide.

To sum up, U.S. consumers have reined in spending as falling home prices (their most important asset), flat stock prices since 2007 and rising unemployment have taken a toll on their confidence, balance sheets and discretionary spending. Not surprisingly, as the housing bubble burst, home values fell the most in areas where they had risen the most over the previous five years, often driven by enormous speculation. Consumer spending has also fallen the most in these often large states, and credit losses are rising fast as well. Consumers are now being forced to save and rebuild their balance sheets. In fact, the household savings rate has increased from very low levels over the past few years. While this higher savings rate is far from a bad thing over the long term, it will have a dampening effect on economic growth. Furthermore, the current credit crunch, despite having moderated since late 2008, has still reduced the ease with which many consumers can borrow at favorable terms, and this will further reduce consumer spending.

America continues to be an adaptable and dynamic economic powerhouse, with a GDP of approximately $15 trillion, or almost 25% of global GDP. While unemployment remains a problem at approximately 8.5%, there are still some 140 million Americans working today and almost 66% of Americans own their homes. Per capita GDP (GDP divided by 309 million, the approximate population of the United States) remains by far the highest in the world at $48,000. This is more than 10 times the per capita GDP of China, for instance. Also, U.S. household net worth, while lower than two years ago, is now approximately $57 trillion, up from $25 trillion some 15 years ago. These are just a few of many enormously important factors supporting the long-term strength of the American economy.

Important Contributors to Fund Performance⁸

On the positive side, the biggest contributors to performance during 2011 were Oaktree Capital Group, American Express, Visa, and Transatlantic Holdings.

On the negative side, our performance during 2011 was hurt by our positions in Bank of New York Mellon, State Bank of India, Wells Fargo, Sino-Forest, and Goldman Sachs.

During 2011 we initiated positions in several non-financial companies where we saw compelling value including CVS Caremark and Bed Bath & Beyond.

We eliminated our positions in several companies that had been excellent long-term holdings for the Fund: Dun & Bradstreet, Moody’s and China Life. We thank the management teams for their hard work in making these companies outstanding investments for shareholders. We also sold our small positions in GAM Holding and Ace Limited.

During 2011, Transatlantic Holdings, our largest position, agreed to merge with Alleghany Corporation in a cash and stock transaction at terms we consider quite favorable for both companies. We have followed Alleghany for many years and are pleased to become partners with this first class, savvy and high integrity management team.

The Fund continues to be highly diversified by financial subsector: property-casualty insurers (led by Transatlantic Holdings, Markel and Progressive) represent 27% of assets; international financial companies (led by State Bank of India and Julius Baer) 13%; U.S.-domiciled banks (led by Wells Fargo, Bank of New York Mellon and Goldman Sachs) 18%; financial conglomerates (Loews and Brookfield Asset Management) 10%; consumer-related financial companies (American Express and Visa) 13%; non-financial holdings (Canadian Natural Resources, CVS Caremark and Bed Bath & Beyond) 7%; and asset management firms (Oaktree, Ameriprise and T. Rowe Price) 12%.⁹

Through our 19% weighting in international holdings we hope to capitalize on the faster long-term growth rates in Brazil, India, China, and the rest of Asia.¹⁰

Outlook for Financial Stocks

We continue to be optimistic about the long-term outlook for financial stocks both within the United States and in select overseas markets. Yet we remain realistic and are conscious of the potential concerns: the impact of the continuing decline in home values and the negative wealth effect on consumer spending; the high debt burden on many consumers and governments; the trade and budget deficits; massive underfunded entitlement programs; renewed government intervention and increasingly tougher regulation of financial companies; potentially rising long-term commodity prices and rising inflation down the road; and the enormous use of derivatives at large financial institutions whose financial health is important to the U.S. and global economy.

We are also concerned about the damaging impact on the U.S. economy if another financial shock occurs. One problem now is businesses are reluctant to borrow given the tepid economic recovery rather than banks being reluctant to lend. However, over time we expect the world’s economies will grow, businesses will borrow to finance their need to keep up with that global growth and banks will indeed lend them money.

We believe carefully selected companies with competitive advantages, strong balance sheets, solid free cash flows, and earnings growth potential, and proven outstanding management that are purchased at attractive prices should perform well for investors over time.

An Important Thank You

One of the challenges managing a mutual fund is that when stocks are down and markets are uncertain, the average mutual fund investor tends to lose confidence and withdraws money from the fund to invest in instruments perceived to be safer. Fund managers are often forced to liquidate positions at depressed prices to meet these redemptions, which can be disruptive to long-term returns. We are happy to report that investors in the Davis Financial Fund must not be “average.” During 2008, investors actually added a net $112 million to the Davis Financial Fund. This occurred at a time when the industry experienced an all-time record level of net redemptions. During 2009, 2010 and 2011, the Fund experienced very manageable net redemptions. Thank you.

The Fund’s ability to buy businesses when others may be forced to sell is a powerful advantage that we work hard to use to create value for all shareholders in the Fund. When the Fund appreciated 46% during 2009 there were more shareholders invested to experience the recovery.¹¹

In closing, I want to acknowledge and thank my colleague Charles Cavanaugh who after deep and prayerful consideration has decided to dedicate his life to education and the Catholic Church. Words cannot express the profound respect, trust and affection that all of us feel for Charles. For more than a decade, he has worked tirelessly to improve our analysis and understanding of financial companies. But even more, he has worked to reinforce our culture. We are unquestionably a better firm for his example and his contribution. Charles currently manages 8% of the Davis Financial Fund, which will now be managed by me in addition to the 92% that I currently manage. We wish him the very best as he starts this new journey in early March.

We greatly appreciate the trust you have placed in us and promise to continue to work hard on your behalf. ■