Investment Results

The Davis Real Estate Fund’s Class A shares provided a total return on net asset value of 9.69% for the one year period ended December 31, 2011 while the Wilshire U.S. Real Estate Securities Index^® returned 8.56%.¹

According to a 2011 Morningstar report on the Davis Real Estate Fund, “The fund’s strategy stands out in the real estate category. While many of its peers focus on a firm’s asset value, longtime comanagers Andrew Davis and Chandler Spears concentrate on a business’ ability to generate strong cash flows in various market environments. A company’s management team is also important, as is its valuation.” ²

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 1.08%. 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.

Overview

A recent report by the Chartered Financial Analyst Society of the UK suggests that “financial amnesia” is a key factor in the evolution of the recent global financial crisis and that innovative financial products as well as regulators and financial institutions share the blame. According to the report, both regulators and institutions appear unwilling to learn from the past and institute changes that address root problems. Investors do not need to know the specifics of the report to appreciate that the frequency of financial crises around the globe is alone sufficient to suggest market participants of all forms fail to learn from past mistakes. We agree that many market participants seem to repeat past mistakes with transgressions of increasing ineptitude.

Financial amnesia is the impetus for this year’s report. With conditions in commercial real estate so much improved over the abysmal conditions that existed in 2008, the question is, are we susceptible to financial amnesia? Given the Fund’s relative success this year it would be all too easy to fall victim to this seemingly contagious malady.³ As is our practice, we do not intend to use favorable relative performance in 2011 as an excuse for avoiding vigorous examination of our investment process. Rather we will review lessons we have learned over the past several years with a view to avoiding past mistakes. Interestingly, almost every mistake we have made since 2006 shares two common features: leverage and development. While we have made other unrelated mistakes, their impact has been immaterial in relation to our mistakes related to capital structure and construction. Our review begins a little more than five years ago as the commercial real estate bubble was reaching its zenith.

Capital Structure Always Matters

As 2006 came to a close, elevated share prices had forced the cost of capital in the real estate sector to unsustainably low levels. Valuations of real estate stocks at that time reflected near indifference to the investment risk posed by real estate securities versus the risk assumed by holding U.S. Treasuries.⁴ Real estate companies are surely more risky than the federal government, but if equity risk premiums (our barometer for the risk assumed by equity shareholders) were the only indicator then it would have seemed real estate companies could tax and print money just like the federal government. We have always believed that the cost of capital is an important long-term consideration and, to paraphrase Alan Greenspan, we agree that protracted periods of low risk premiums end in a disruptive manner. Our response in early 2007 was to remain steadfast in that conviction. As we stated in the Davis Real Estate Fund’s 2006 Annual Review, “We hope that our investors take comfort in our unwillingness to blindly lower investment hurdles…”

That stance proved wise as stock prices began to drop during 2007. By the middle of that year real estate security prices had dropped enough that risk premiums returned to levels even a bit above long-term trends. Unfortunately our prescience with regard to equity risk premiums lulled us into overconfidence. We should have paid more attention to the prices of securities higher in the capital stack. Had we done so we would have noticed signs of rising stress in the credit markets. What occurred during late 2008 is a mystery to no one. The credit markets seized up and shares of the Davis Real Estate Fund declined sharply as General Growth Properties, Inc. (GGP), one of the Fund’s largest holdings at the time, spiraled toward bankruptcy. While we did not hold General Growth Properties when it entered bankruptcy, the damage had been done. As we noted in the Fund’s 2008 Annual Review, “[General Growth Properties’ debt burden] is simply incompatible with the current financing environment and the trajectory of property fundamentals.”

Over the next few years the credit markets improved dramatically. Availability of debt capital increased, the cost dropped (courtesy of a generous Federal Reserve) and most problem loans were extended to what was hoped would be a time of better economic fortune. Even General Growth Properties managed to reinvent itself as a going-concern company when it exited bankruptcy and offered new shares of stock to the public in late 2010. In short, lenders postponed making the hard decisions in the commercial real estate sector just as they did in others. By the middle of 2010 we were relieved commercial real estate had survived but, as noted in the Fund’s 2010 Semi-Annual Review, we harbored concern that we had only deferred the pain: “Banks, while willing to lend, are still extending loans that are underperforming… in hopes that an economic recovery will provide the necessary boost to shift the loans to performing status. That might work but there is no avoiding the mountain of debt that comes due in 2011 and 2012.”

Today investors might look at the credit markets and sound the all clear. Indeed it is human nature to forget painful events from the past, but succumbing to such financial amnesia entails great risk. Banks’ deferral of hard decisions regarding their commercial real estate loans has worked to a certain extent. Property fundamentals in almost every sector have stabilized and some sectors like apartments have shown considerable growth. Those factors, however, mask a less rosy reality.

Beneath the surface, problems are brewing that could lead to deteriorating conditions in the lending market. Chief among them is the European financial system’s teetering on the brink of failure. The failure of even a part of that system would create collateral damage for the United States. Because we believe there is a meaningful risk that lending conditions could tighten considerably during 2012 and 2013, we have positioned the Fund accordingly. We have reduced exposure to companies with higher than average leverage and increased investments in those businesses with low leverage and well-staggered debt maturities. Further, we are demanding coverage ratios that can withstand lower property cash flows and provide ample cushion should interest rates rise. We still retain small investments in a few companies with higher than average leverage, but only where we believe valuations compensate us for the risk assumed.

Development, Risk and Reward

Real estate companies typically invest in properties in one of two ways, through acquisitions or development. The former usually involves purchasing stabilized assets with a verifiable history of rental income. This approach reduces risk, but often involves a highly competitive bidding process that may result in less than rational bids and open the door to paying too much.⁵ While development requires a significant cash investment a year or two before any cash is returned, we have always considered it to be the better risk-adjusted opportunity. As we stated in the Fund’s 2008 Semi-Annual Review, “When the [development] process is managed correctly, the relative returns can be significant.”

The credit crisis proved that development, no matter how well conceived, can still result in an imbalance between risk and reward. Even when construction is fully funded, an inability to lease can endanger a project’s viability, which is exactly what happened to Forest City Enterprises, Inc. (FCE/A) in 2008.⁶ Our shortcoming heading into the credit crisis was a financial model that lacked flexibility to change leasing duration. In other words, in evaluating the investment potential of Forest City we did not adjust our model quickly enough to account for the length of time it would take to lease all of the company’s developments. Equally problematic was the fact that our model did not assess the risk that delays in leasing pose for construction financing. Most construction loans demand a certain level of leasing by a specified date and if that level is not achieved, the borrower (Forest City in this case) is required to put more of its cash into the project.

Today we know from experience that an inflexible financial model can create significant problems during periods when expectations are changing rapidly. Highly improbable, high cost events happen far too often and we would have to suffer significant financial amnesia to believe otherwise. As a result we have adapted our financial models to be less dependent on exact forecasts. Where we once calculated one estimate of fair value we now calculate a distribution of all possible outcomes, even the most remote. It is reasonable to conclude after a year of good returns that we have come to greater wisdom through our failures (all due credit to author William Saroyan who coined the thought). We took some gains during 2011 and believe we positioned the Fund conservatively for a 2012 that is likely to be turbulent.⁷

Performance Overview

Generally speaking, the Fund was helped most in 2011 by investments in specialty real estate sectors. Investments in data center real estate investment trusts (REITs) such as Digital Realty Trust, Inc. (DLR), CoreSite Realty Corporation (COR) and DuPont Fabros Technology, Inc. (DFT) performed strongly. Lingering concern over supply in several data center markets was trumped by very strong demand and deeply discounted valuations. Digital Realty and CoreSite remain large positions in the Fund, but we reduced the size of DuPont Fabros to capture some gains and reduce the Fund’s exposure to data center development. We expect to realize additional gains should DuPont Fabros lease its remaining developments. Our objective is to keep the Fund’s development exposure at a level commensurate with prevailing risks.

Student housing was another bright spot. American Campus Communities, Inc. (ACC) was the second best performing of all equity REITs with a 37.3% return in 2011.⁸ ACC’s stellar reputation among U.S. universities and colleges led to several new development opportunities and that, combined with strong internal growth, propelled an increase in free cash flow. The fact that American Campus’s valuation is below most conventional apartment REITs was not missed by investors either.

During the year we sold a small portion of our investment in American Campus, reaping significant gains, and reinvested the proceeds in Education Realty Trust, Inc. (EDR). Education Realty is also in the student housing business, but focuses on improving occupancy and growing rents at stabilized properties. American Campus pursues similar opportunities, but concentrates more on development than Education Realty. With our investment in EDR we also strategically reduced the Fund’s exposure to development while maintaining a significant investment in a sector with excellent growth potential.

Our decision to stick with stalwart Simon Property Group (SPG) during 2011 proved fortuitous. It is quite difficult for a company Simon’s size to create any meaningful growth through acquisition or development, so most investors, including us, were surprised when Simon’s core growth performed as well as it did. We would have expected poor consumer sentiment to depress retail sales growth and therefore curb demand for space in Simon’s malls. That did not happen. Rather, space in the best U.S. malls, a description that fits almost all of Simon’s portfolio, is still in demand. Occupancy in 2011 held firm and rents on new and renewal leases actually grew. Even though Simon did not achieve the highest total return among the Fund’s holdings, its 33.6% total return combined with a fortress balance sheet and unmatched access to capital made it the Fund’s best risk-adjusted performer.⁹

While strong performers were in the majority this year, the Fund had a few laggards. Long favored Forest City Enterprises began the year strongly and grew to one of our top holdings by April. The company’s progress on deleveraging and development leasing plus the monetization of a few assets, including a land sale in Cleveland to Rock Ohio Caesars LLC and a successful joint venture with Madison International Realty, helped to lift investor sentiment. Despite the progress made and the fact that Forest City Enterprises is still priced at a considerable discount to other real estate companies, we trimmed approximately half our holding in Forest City in April. During the balance of the year Forest City underperformed our benchmark by more than 3,000 basis points as the European financial crisis refocused investor attention on the risk of too much debt.¹⁰ While our remaining position in Forest City detracted from performance, we have learned not to invest too much of the Fund’s assets in a business with higher than average leverage and a larger than average development pipeline. Today Forest City is a smaller holding with what we believe are excellent long-term prospects.

Corporate Office Properties Trust (OFC), which caters to government and defense-related tenants, had another disappointing year. The current logjam within the federal government and the pending sequester of the military’s budget have many questioning whether the company will be able to lease properties in its current development pipeline or even maintain occupancy in its existing property portfolio. We share that concern and trimmed a portion of our holding during August, thus avoiding almost 2,000 basis points of underperformance.¹⁰ Nevertheless, our remaining investment hurt performance. By November the stock’s price appeared to discount even the most dire future, so we repurchased some of the shares we had sold in August. We have long favored Corporate Office Properties’ niche strategy of catering to the federal government’s demand for space, but there is considerable risk that demand may be much reduced over the next several years as the government deals with the consequences of years of overspending. Corporate Office Properties remains in the Fund as a small position with, what we believe is, the potential for considerable long-term gain.

Like Corporate Office Properties, Alexandria Real Estate Equities, Inc. (ARE), the Fund’s top holding, faces the risks associated with potential government spending reductions. To mitigate that risk and capitalize on the company’s deeply discounted valuation, our investment is split between a convertible preferred security and the company’s common stock.¹¹ The convertible preferred limits the impact of a drop in the stock’s price while the equity position ensures we capture most of any stock price increase. Considering our investment in Corporate Office Properties is much reduced from prior years, it is worth asking why we continue to hold Alexandria in such size since it too is subject to the risks of government spending cuts. The answer is that Alexandria caters to the life science sector. Tenants seeking space in its buildings are unlikely to see funding cuts on par with those tenants looking for space in Corporate Office Properties’ buildings. Moreover, Alexandria trades at a significant discount even after assigning a zero value to the company’s land holdings. We believe that the market is overestimating the impact of potential spending reductions and that Alexandria’s value will be vindicated over the next few years.

We begin 2012 with a Portfolio composed of companies with less leverage and fewer development projects than the Portfolio had at the beginning of 2011. Commercial real estate faces a number of potentially high cost events where the probability of occurrence is essentially unknown. Despite that we refuse to take a myopically conservative stance. Instead the Fund holds certain stocks that offer the potential for great returns if certain positive events occur. In essence the Fund is structured as a barbell with most of its assets invested in companies with fortress balance sheets that cater to business areas enjoying relatively strong demand. At the other end are deeply discounted companies with significant appreciation potential, but whose smaller weighting in the Fund is consistent with their higher potential risk. We believe the long-term outlook for real estate securities is encouraging, but over the next few years the global financial system will likely be under stress as it regains its footing. We may not be able to immunize the Fund against every potential shock, but we can go a long way toward avoiding financial amnesia by staying true to lessons learned over the past tumultuous years.¹²

We thank you for putting your trust in us, your fellow investors in the Fund, as we do our best to make the Fund strong, adaptable and profitable for us all. ■