Davis Appreciation and Income Fund
Christopher Davis, Peter J. Sackmann, CFA
and Creston A. King III, CFA
Annual Review 2021

Market Perspectives
The market’s resiliency through a year of both heightened economic and political uncertainty has been remarkable. Investors should be selective and employ active management to navigate the current environment.

The year 2020 was defined by the global pandemic, whose effects remain very much still with us and which will remain a challenge in all likelihood well into 2021. While the attention of the world has been appropriately devoted to the various stresses caused by COVID-19, what is remarkable is the market’s incredible resiliency through a year of both heightened economic and political uncertainty.

Early in the year, at the onset of the pandemic, the S&P 500 Index fell more than 30% in less than three months. The mood was somber and categorically bearish. By the end of 2020, however, the S&P 500 Index managed to finish up 18.40% for the year, rebounding 70.17% off its low on March 23. To put the 18.40% calendar year return in context, it bests the long-term average return for stocks of 10% by a wide margin, notwithstanding an unprecedented and formidable set of conditions.

There is no alternative in such times but to make every attempt to combat the problem and ultimately to move forward. To that end, trillions of stimulus dollars have been applied with coordination from the U.S. Treasury and the Federal Reserve. At the same time, a race to find vaccines for the virus was ignited worldwide in short order, with treatments and vaccines now in the early stages of distribution—an astounding feat.

We seek to be realists. We understand that the healing process for businesses and the economy will take some time and would go further to point out that certain industries are in a better position to restart than others in the near term. Some areas of the market may even become secularly disadvantaged. But overall, we see plenty of well-priced opportunities today that meet our definition of successful businesses that should by their nature be compounding machines over the long term. Our strong advice is to navigate these market waters using active management with an emphasis on bottom-up stock selection.

The average annual total returns for Davis Appreciation and Income Fund’s Class A shares for periods ending December 31, 2020, including a maximum 4.75% sales charge, are: 1 year, −0.23%; 5 years, 7.01%; and 10 years, 5.51%. 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 1.00%. 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 recently experienced significant negative short-term performance due to market volatility associated with the COVID-19 pandemic.

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. All fund performance discussions within this piece refer to Class A shares without a sales charge and are as of 12/31/20 unless otherwise noted. This is not a recommendation to buy, sell or hold any specific security. Past performance is not a guarantee of future results. Total returns are not annualized for periods of less than one year.

Portfolio Review
Davis Appreciation and Income Fund generated a positive result for 2020, despite the impact of the virus. The Fund is positioned in what Davis Advisors considers strong, durable companies that can compound shareholder capital over the long term.

Davis Appreciation and Income Fund generated a positive return of 4.75% for the year 2020, a modest result in nominal terms, but reasonable in our view, given the impact of the virus. We are invested across a wide range of businesses and industries as distinct from one another as financial services, technology, industrials, healthcare and consumer-oriented businesses. Some have become legitimately identified as beneficiaries of COVID (e.g., online businesses in particular). Others are stalwarts in areas such as semiconductors and software, which have contributed meaningfully to full-year returns overall. Lastly, we have a number of contrarian laggards in the portfolio, predominantly in the financial and industrial sectors. Overall, and however stock prices vacillated in 2020, we view our businesses and overall positioning as attractive (a) relative to their full-cycle potential looking ahead and (b) from the standpoint of durability and staying power. Building in a degree of offense and defense in our investment case for each business is one way we seek to balance risk and reward, both at the company and portfolio levels, in what we believe is a sensible manner.

The portfolio’s positioning today reflects in large part the areas of greatest interest to us within the broader market. Key themes represented in the portfolio are:

  • Durable, high-grade financials—leading U.S. and foreign banks, best-in-class insurers and diversified holding companies with significant financials exposure
  • Semiconductor-related businesses serving large, increasingly numerous and fast-expanding end markets such as Artificial Intelligence (AI), cloud computing, e-commerce, electric vehicles and 5G, among other areas of emerging growth
  • Dominant giants engaged directly in e-commerce, social media, online search and advertising or software
  • Select industrials with scale advantages and sticky customers
  • Select healthcare companies

The largest allocation within the portfolio consists of high-grade financial leaders both in our home market and in select international markets. Our holdings within the financial sector are diversified by business type and geography and include major U.S. banks such as JPMorgan Chase, Bank of America, Bank of New York Mellon, Wells Fargo and U.S. Bancorp.1 Internationally we hold companies in major wealth centers like DNB Asa in Norway, Danske Bank in Denmark and DBS Group Holdings in Singapore.

Rounding out the list of financials in the portfolio are Berkshire Hathaway, credit card and charge card leaders Capital One Financial and American Express, and two insurers, namely AIA Group of Hong Kong (the second-largest life insurer in China) and Chubb.

Across the spectrum of financial stocks in the portfolio today, we believe current share prices understate their true long-term earnings power, particularly in a post-COVID world, while overstating the lasting impact of near-term economic conditions. A real inefficiency lies in the stark difference between the market’s pricing-in of worst-case scenarios—essentially a repeat of 2008–2009 when capital across the banking industry was insufficient to absorb the massive losses associated with that crisis—and the reality today as we see it.

This time around, the major U.S. banks entered COVID with roughly twice as much capital as they had entering the 2008–2009 crisis. The earnings power of the market leaders is more substantial and durable than meets the eye. Juggernauts like JPMorgan Chase, Bank of America, U.S. Bancorp, Capital One Financial and the Portfolio’s foreign banks should be able to cover most of their credit costs (based on current run rates) with income. It is very conceivable, in other words, that COVID could end up an income statement phenomenon in the near term, but not an existential threat to the balance sheets, which have been accumulating capital for a decade or more.

As economic conditions improve gradually, we anticipate well-capitalized banks—and more specifically, those that possess market leadership positions, low-cost funding models built on trillions of dollars of core deposits and very substantial operating leverage—should generate far stronger operating results than currently, once the worst has passed. If those businesses can maintain strong financial health, then it is our expectation that dividends will be reinstated and rise over time. Moreover, the tapering of credit loss projections over time should allow certain banks to release reserves back into earnings attributable to shareholders. Any improvement in the yield curve would be very favorable for financial lending institutions, and that scenario is not really priced in today. In other words, there are multiple ways to win, and the upside potential we see in this group, beginning at near-recessionary valuations, makes financials a particularly high-conviction area of the portfolio.

Semiconductor-related holdings currently include Applied Materials, Texas Instruments and Intel. As a group, they performed relatively well in the trailing 12-month period, with the first two generating strong returns, offset partially by Intel, whose shares declined. While each of these businesses is unique, what they share in common is that they serve fast-expanding global end markets ranging from e-commerce and AI to cloud computing, mobile technologies and electric vehicles—a set of market opportunities that dwarf this group’s historical legacy markets in more mature sectors, such as PCs and mobile devices. We are excited by these new, long-tailed areas of future growth for this set of well-resourced, innovative high-technology companies.

E-commerce, online search and advertising, social media and software are another component of the portfolio that have proven, attractive businesses— in a pre-COVID, during-COVID, and post-COVID world. The online portion of the Fund is currently dominated by such market leaders as Amazon.com, Alphabet (the parent company of Google) and Facebook. We are attracted to these names based on the size and rapid expansion of their market opportunities globally, their ability to generate and grow new revenue sources through constant innovation, ample operating leverage as they continue to scale and capable, focused, highly competitive leadership teams. If purchased at sensible prices, these types of businesses in our experience can contribute meaningfully to long-term results.

In the industrial space, we own a select list of well-entrenched market leaders, niche by niche, such as Raytheon Technologies in aerospace and defense and Carrier Global, a global leader in heating, ventilation and air conditioning (HVAC) solutions. These businesses are experiencing a lull. They are out of favor and trading at reasonable multiples of subdued earnings, making this low starting point a potential setup for the double play of recovering multiples on recovering earnings.

Within healthcare, our largest position is Quest Diagnostics, a leader in independent lab testing and diagnostics. Quest offers its lab services at a fraction of the cost of hospital labs, which constitutes a strong cost-savings value proposition to new and existing customers. It is not surprising that by virtue of the value Quest creates, the company is increasingly serving as an outsource partner to hospitals and healthcare networks across the U.S. We believe Quest’s market is very sticky and only getting larger. The cost savings accruing to Quest’s customers should bode well for the long-term success of the business.

Among recent changes to the portfolio, we have made modest adjustments at the margin, but have otherwise maintained a fairly consistent positioning:

  • In the second quarter, we eliminated the remainder of our energy positions, which accounted for low single-digit percentage exposures. This decision was driven by a reduced outlook for global demand in oil due to COVID’s impact on transportation in particular. With the commodity price environment very uncertain, we felt it was appropriate to repurpose capital from energy into other areas.
  • In the first half of the year, we added to our holdings in Capital One and Wells Fargo based on the reasons outlined earlier, which served us well in the second half of the year.
  • At different points throughout the year, we pared select holdings, mainly in online and other technology-related areas based on position size and opportunities elsewhere in the portfolio.

Across the portfolio, we are confident in the earnings power, competitive strengths, balance sheets and management teams for each of our 25 equity positions over the coming decade. We have consciously built a portfolio of relatively dominant businesses that are as durable as they are attractive long-term compounding machines, in our estimation.

Last but not least, we hold approximately 23% of the Fund in fixed income securities and cash. For this segment of the portfolio, which serves as an income generator and a ballast, we must be realistic about the environment and available opportunities. We are managing through a period of ultra-low interest rates, and thus our income yield is lower than we might expect over a market cycle. We have consciously avoided reaching for income yield, however, instead favoring a relatively conservative posture based first and foremost on the soundness of underlying credits and the defensibility of the principal.

1Individual securities are discussed in this piece. 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. The return of a security to the fund will vary based on weighting and timing of purchase. This is not a recommendation to buy, sell or hold any specific security. Past performance is not a guarantee of future results.

Conclusion
Investors have opportunities to own world-class businesses at value prices today.

Looking ahead and very big picture, we believe the inherent resiliency of the U.S. economy, an expected rollout of vaccines against the virus in the months ahead, and the continued aid of the government in both fiscal and monetary forms are all supportive of a scenario wherein the situation for businesses and consumers should improve. As we wait, we have the opportunity to own a select list of world-class businesses trading at value prices, in our estimation.

In summary, we are operating on what we believe is a set of reasonable assumptions, most notably that the Fund’s battle-tested businesses have the wherewithal to grind through near-term recessionary conditions and to prosper over the course of years into the future. Meanwhile, the portfolio’s overall valuation is very reasonable by our estimates.

At Davis Advisors, we seek to own durable businesses at attractive prices that can compound shareholder value over the long term. The Davis family, our company, the Davis family foundation and our employees and directors have more than $2 billion invested alongside clients in similarly managed portfolios.2

We are grateful for your confidence and trust, and we look forward to continuing our investment journey together.

2As of 12/31/20. Davis Advisors, the Davis family and Foundation, our employees, and Fund directors have more than $2 billion invested alongside clients in similarly managed accounts and strategies.

This report is authorized for use by existing shareholders. A current Davis Appreciation and Income Fund prospectus must accompany or precede this material if it is distributed to prospective shareholders. You should carefully consider the Fund’s investment objective, risks, charges, and expenses before investing. Read the prospectus carefully before you invest or send money.

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. These comments may also include the expression of opinions that are speculative in nature and should not be relied on as statements of fact.

Davis Advisors is committed to communicating with our investment partners as candidly as possible because we believe our investors benefit from understanding our investment philosophy and approach. Our views and opinions include “forward-looking statements” which may or may not be accurate over the long term. Forward-looking statements can be identified by words like “believe,” “expect,” “anticipate,” or similar expressions. You should not place undue reliance on forward-looking statements, which are current as of the date of this report. We disclaim any obligation to update or alter any forward-looking statements, whether as a result of new information, future events, or otherwise. 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.

Objective and Risks. Davis Appreciation and Income Fund’s investment objective is total return through a combination of growth and income. There can be no assurance that the Fund will achieve its objective. The Fund is subject to both equity and debt risk. Some important risks of an investment in the Fund are: stock market risk: stock markets have periods of rising prices and periods of falling prices, including sharp declines; common stock risk: an adverse event may have a negative impact on a company and could result in a decline in the price of its common stock; headline risk: the Fund may invest in a company when the company becomes the center of controversy. The company’s stock may never recover or may become worthless; large-capitalization companies risk: companies with $10 billion or more in market capitalization generally experience slower rates of growth in earnings per share than do mid- and small-capitalization companies; manager risk: poor security selection may cause the Fund to underperform relevant benchmarks; preferred stock risk: preferred stock is a form of equity security and is generally ranked behind an issuer’s debt securities in claims for dividends and assets of an issuer in a liquidation or bankruptcy. An adverse event may have a negative impact on a company and could result in a decline in the price of its preferred stock; bonds and other debt securities risk: Bonds and other debt securities generally are subject to credit risk and interest rate risk; interest rate risk: interest rate increases can cause the price of a debt security to decrease; variable current income risk: the income which the Fund pays to investors is not stable; credit risk: the issuer of a fixed income security (potentially even the U.S. Government) may be unable to make timely payments of interest and principal; convertible securities risk: convertible securities are often lower-quality debt securities; changes in debt rating risk: if a rating agency gives a fixed income security a low rating, the value of the security will decline; extension and prepayment risk: the pace at which borrowers prepay affects the yield and the cash flow to holders of securities and the market value of those securities; foreign country risk: foreign companies may be subject to greater risk as foreign economies may not be as strong or diversified. As of 12/31/20, the Fund had approximately 8.9% of net assets invested in foreign companies; depositary receipts risk: depositary receipts may trade at a discount (or premium) to the underlying security and may be less liquid than the underlying securities listed on an exchange; fees and expenses risk: the Fund may not earn enough through income and capital appreciation to offset the operating expenses of the Fund; mid-and small-capitalization companies risk: companies with less than $10 billion in market capitalization typically have more limited product lines, markets and financial resources than larger companies, and may trade less frequently and in more limited volume; and high-yield, high-risk debt securities risk: issuers of these debt securities are unlikely to have a cushion from which to make their payments when their earnings are poor or when the economy in general is in decline. These issuers are likely to have a substantial amount of other debt, which will be senior to the high-yield, high-risk debt securities. An issuer must be current on its senior obligations before it can pay bondholders; See the prospectus for a complete description of the principal risks.

The information provided in this material should not be considered a recommendation to buy, sell or hold any particular security. As of 12/31/20, the top ten holdings, not including cash and equivalents, of Davis Appreciation and Income Fund were: Capital One Financial, 6.43%; Applied Materials, 6.32%; Berkshire Hathaway, 6.20%; Amazon.com, 5.03%; Alphabet, 4.92%; Texas Instruments, 4.14%; U.S. Bancorp, 3.42%; Wells Fargo, 3.21%; DNB, 3.18%; and Intel, 3.07%. The cash and equivalents were 2.77%.

Davis Funds has adopted a Portfolio Holdings Disclosure policy that governs the release of non-public portfolio holding information. This policy is described in the prospectus. Holding percentages are subject to change. Click here or call 800-279-0279 for the most current public portfolio holdings information.

We gather our index data from a combination of reputable sources, including, but not limited to, Thomson Financial, Lipper, Wilshire, and index websites.

The Fund can invest in a variety of derivative investments to pursue its investment objective or for hedging purposes. The Adviser and the Fund have claimed exclusions from the definition of the term “commodity pool operator” under the Commodities Exchange Act and, therefore, are not subject to registration or regulation as a pool operator under the Commodities Exchange Act.

The S&P 500 Index is an unmanaged index of 500 selected common stocks, most of which are listed on the New York Stock Exchange. The index is adjusted for dividends, weighted towards stocks with large market capitalizations and represents approximately two-thirds of the total market value of all domestic common stocks. Investments cannot be made directly in an index.

After 4/30/21, this material must be accompanied by a supplement containing performance data for the most recent quarter end.

Shares of the Davis Funds are not deposits or obligations of any bank, are not guaranteed by any bank, are not insured by the FDIC or any other agency, and involve investment risks, including possible loss of the principal amount invested.

Item #4775 12/20, Davis Distributors, LLC 2949 East Elvira Road, Suite 101, Tucson, AZ 85756, 800-279-0279, davisfunds.com