Davis Real Estate Fund
Update from Portfolio Managers Andrew A. Davis and Chandler Spears
Annual Review 2021

Investment Results
Davis Real Estate Fund’s Class A shares provided a total return on net asset value for the year-to-date period ended December 31, 2020 of −8.23%. Over the same time period, the Wilshire U.S. Real Estate Securities Index returned −7.95%. Over the most recent one-, five- and 10-year periods, a $10,000 investment in Davis Real Estate Fund would have returned $9,177, $13,055 and $21,363, respectively.

The average annual total returns for Davis Real Estate Fund’s Class A shares for periods ending December 31, 2020, including a maximum 4.75% sales charge, are: 1 year, −12.59%; 5 years, 4.45%; and 10 years, 7.36%. 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 0.97%. 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. This is not a recommendation to buy, sell or hold any specific security. There is no guarantee that the Fund performance will be positive as equity markets are volatile and an investor may lose money.

Investment Overview

As we reflect on 2020, it occurs to us that for much of the year, real estate securities lived the life of Estragon in Samuel Beckett’s Waiting for Godot. After receiving a thumping from the COVID-19 pandemic in early spring, real estate securities were left bereft of fans and spent much of the year waiting for news of a vaccine or therapeutics.

Broader narratives on the pandemic’s effect on commercial real estate shifted among the knowable, the questionable and the truly uncertain, making for a tumultuous wait. And even though the close of the year has been met with enthusiasm over two very effective vaccines, we believe there will be lasting changes to the demand for commercial space. More importantly, this year, which is the third massive exogenous shock to challenge public real estate securities during the current Fund management’s tenure, will remind investors that such stocks are an indispensable part of a properly diversified portfolio. (We count the 9/11 terrorist attack and the Great Financial Crisis as the other two massive shocks.)

We do not wish to imply that 2020 was bad for all real estate, because a few sectors performed quite well, especially industrial and data centers. Most sectors, however, experienced significant price declines, especially in the early days of the pandemic. On balance, Davis Real Estate Fund slightly underperformed its index. However, we suspect all Fund shareholders, including us, find it difficult to stomach absolute declines.

In a departure from past practice, we are going to spend more time discussing how the Fund has responded to a profoundly disruptive year and less time talking about the vicissitudes of Fund performance throughout the year. The most instructive way to do that is through the lens of those changes to the commercial real estate landscape that we believe will prove most durable. What we think you will ultimately appreciate is that the litany of unchecked and single-dimensional headlines you have read over the past half year do nothing to fully explain what sort of real estate will survive the pandemic and then thrive as we return to normal.

During the most severe price declines of late spring, we centered on three attributes that we considered most important to weather and potentially profit from pandemic-induced shocks. First, the pandemic is a credit issue. Second, geography will matter more than ever, but leadership might change. Lastly, we are social beasts, and experiences enrich our lives. While the Fund has not made wholesale changes, we have trimmed and added in ways that respond to these factors.

The Pandemic is a Credit Issue

Balance sheet strength is the backbone of the Davis Investment Discipline. No matter how good a business is, how insightful its management or how ravenous the demand for its products, it will ultimately fail if the balance sheet isn’t strong enough to weather the bad times. And the bad times always come, unfortunately more often than you think. It is shocking how quickly the pandemic laid bare susceptibilities in so many different types of businesses. The pain engulfed tenants and real estate owners alike as commerce ground to a halt earlier in the year.

That pain was most acute in the retail and leisure sectors. Fitness centers, movie theaters, full service restaurants and hotels, among others, were sent scrambling for financial lifelines. The immediate response from many of those businesses was to stop paying rent on real estate they leased to conduct their businesses. The repercussion for retail real estate owners was likewise immediate. Rent collections dropped meaningfully for most retail property owners in our investment universe. Thankfully, some of that has corrected itself with partial reopening in most areas of the country, but operations for many still remain break-even at best, a situation likely to persist into next summer.

The point we are trying to make is that we are a long way from business as usual. Varying degrees of closure will be introduced, withdrawn and reintroduced until effective vaccines are distributed widely enough to achieve some semblance of herd immunity. If any tenant cannot fund operating shortfalls for at least the next year, well, then, that tenant is not likely to survive. That leaves real estate owners as the lenders of last resort and resulting demands on their liquidity just as onerous. Said a bit differently, come next summer when we are likely to have a better handle on what normal demand looks like, it will not matter if your business is bankrupt. That is why we continue to place balance sheet strength and, by extension, our estimate of tenant financial strength at the center of our investment decisions. We believe that the Fund is invested in the strongest businesses with the strongest possible tenants most likely to make it to a time when we are most likely to know what “normal” means.

It is easy to point to Fund favorites in the industrial or self-storage sectors as examples of businesses with exceptional balance sheet strength, but they are not challenged like companies in other sectors.

Instead of putting more investment dollars to work in relative safety where valuations are rich, we began looking for balance sheet strength among companies in maligned sectors, like hotels. Revenue in that sector literally fell to zero, putting all in a position of burning cash to support corporate infrastructure and maintain now-vacant property. All hotel companies we follow are currently burning through available liquidity and will do so until the middle of next year, at the earliest. That means very few investment options will satisfy our demanding balance sheet requirements, but there are a few. Host Hotels (HST) and Sunstone Hotel Investors (SHO) each have very little debt and a liquidity surplus capable of funding cash shortfalls for 25 and 24 months, respectively. Importantly, that is before borrowing one single additional dollar. Their properties are located in some of the best markets in the country and should benefit as leisure travel returns, though we freely admit business travel will take additional time to revert to pre- COVID levels. Yet even underwriting a recovery that takes well into 2022, these two hotel REITs could yield very good risk-adjusted returns.

Geography Matters

Over the past nine months, we have read numerous articles about how one city or region of the country is handling pandemic outbreaks well, where another is not. It was bemusing in one respect. Those waggling their fingers most vociferously at cities with surging infections one week, were the next week on the receiving end of the pointing. The reality is that the pandemic has been fairly evenhanded when it comes to its impact, with only temporal issues differentiating one region from another. However uniform the impact might be, we think there will be some durable outcomes.

For the better part of two decades, there has been a steady migration to urban centers, particularly for the well-educated and well-heeled. Attracted by amenities and culture, people traded suburbia for 24-hour life in the big city. Employers took notice and expanded operations in places like New York, San Francisco and Seattle. Urban-focused office owners profited from growth in demand and the higher rents that followed. In response, investors awarded premium valuations to owners of urban office property. The pandemic has changed that. Work-from-home (WFH) initiatives have worked very well for employers, and even though the valuation pendulum has swung too far in the other direction, the halcyon days are over for urban office.

Care needs to be taken so that this change doesn’t get overplayed. This is not an issue of rent getting paid. Office companies under our coverage have received rent at levels consistent with pre-pandemic periods. An employer that announces it intends to move part of its workforce to the sunny beaches of Florida cannot discharge itself from existing lease obligations. However, we see durability in the way employers will make incremental occupancy decisions. Employers will surely consider a broader array of options to support their workforce. That includes balancing WFH with in-person work, plus a willingness to consider a broader array of locations.

As a result, we have tilted the Fund in favor of those office companies with properties in locations such as Austin, Atlanta and Charlotte. In those areas, living costs and costs of occupancy are lower than in larger major urban areas. They also benefit as drive-to markets are less dependent on mass transportation. Underpinning our investment thesis is that rent growth in these smaller metropolitan locations is likely to get stronger at the same time that urban rents are resetting to lower levels. Cousins Properties (CUZ) is a favorite suburban office holding of ours. It has a long history of successful development and ownership of office properties in cities we think will benefit from a more geographically diverse workforce.

While we favor suburban office businesses at this time, we are not giving up on their urban brethren. We believe demand for urban office will be soft for quite some time and rents are likely to drop, but depressed valuations have a role to play. Further, some urban office companies cater to tenants that might be less inclined to scatter their workforce across the country. Hudson Pacific Properties (HPP) is a perfect example. Its valuation was washed away along with that of other urban office REITs, but unlike many other urban office owners, they cater to a unique tenant base. Their media and tech tenants thrive on collaborative environments. To say they are going to widely disperse their workforce stretches reason, but investors seem unwilling to reward Hudson for its unique market position. We, on the other hand, believe that once the pandemic is behind us, Hudson is likely to be one of the few urban office REITs to see a material acceleration in growth. Part of that is due to a well-leased development pipeline, but also because there is considerable mark-to-market in its existing rent roll that should buffer all but the most dramatic declines in market rents.

Experiences Enrich Our Lives

We are all tired of the pandemic. To be clear, we are not making light of the profound impact it is having on anyone or any institution. Rather, as a matter of helping keep the pandemic’s worst at bay, all of us have been thrust into lives almost completely devoid of meaningful human-based experiences. This new reality has given birth not only to uncertainty as to how dense urban areas will recover (discussed above), but also to questions about the future of leisure travel and even the college experience. The latter has proven particularly divisive.

On the one hand, college is very expensive and in some instances encumbers graduates with debt not easily repaid. It doesn’t take an economist to understand that paying more for something than you get in return is a bad trade. As the pandemic escalated this spring, uncertainty over its duration and an equally ambiguous response from universities as to how instruction might be conducted raised an even greater chorus questioning the value of the in-person college experience. Our counter-argument is that college has never been strictly about classroom education. Rather, it is an overall enriching experience, one that we do not believe will be immediately surrendered in response to the pandemic.

American Campus Communities (ACC), the only publicly traded company that owns and develops student housing, was on the receiving end of investor skepticism. Its financial results during the second and third quarter this year were evidence of the challenges faced by colleges sending kids home and cancelling on-campus activities. Making matters worse, ACC has had to issue refunds for certain on-campus properties whose enrollment is run by the universities they serve. Casual interpretation of those results and haphazard extrapolation had some believing ACC’s days were numbered.

We believe that interpretation misses the point. The price parents pay for their children to attend college covers not only instruction, but also all of the other experiences that go along with it. Scores of kids have grown up in households where the objective was to build credentials strong enough to gain acceptance at the college of their choice. We do not believe for a minute that all of those kids are going to exchange “the four best years of their lives” for the practical and austere environment of virtual instruction. As support, consider ACC’s final leasing results for the 2020-2021 academic year. Ninety percent of its portfolio of student housing was leased, with a 1.1% increase in same-store rent growth. If ACC can lease nine of every 10 beds it owns at higher rents during the throes of a pandemic before any news of a vaccine, it is not too much of a stretch to believe that much better results are possible next year. That is where we land. We believe the full educational experience, broadly defined, will continue to be in high demand, particularly at those universities and colleges served by ACC’s properties. While ACC no longer trades at the depressed values it did earlier this year, it is still a very cheap stock and remains one of the Fund’s top overweights.

As we enter 2021, it is fair to say we will continue to focus on owning companies with strong financial wherewithal, superior assets and management teams who think like owners of the business. We will continue to take advantage of deep value where it is prudent to do so, while maintaining an anchor to windward with some of our “forever” investments in sectors propelled by secular trends. At the same time, we will remain flexible. Valuations will surely exhibit dramatic movements as we march steadily toward herd immunity late next year. We are also optimistic that real estate’s performance during this pandemic, though volatile, proves it is not simply staid bricks and mortar. We invest in real businesses that have proven time and again that they can weather the bad times and should be an indispensable part of a well-diversified portfolio. As fellow shareholders in the Fund, we thank you for your trust and support.

This report is authorized for use by existing shareholders. A current Davis Real Estate 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 Real Estate 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. Under normal circumstances the Fund invests at least 80% of its net assets, plus any borrowing for investment purposes, in equity, convertible, and debt securities issued by companies principally engaged in the real estate industry. 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; real estate risk: real estate securities are susceptible to the many risks associated with the direct ownership of real estate, such as declines in property values and increases in property taxes; 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; 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 variable current income risk: the income which the Fund pays to investors is not stable. 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 of Davis Real Estate Fund were: Prologis, 7.1%; Equinix, 5.1%; Public Storage, 5.1%; Rexford Industrial Realty, 4.4%; Terreno Realty, 4.2%; Welltower, 4.2%; Essex Property Trust, 3.8%; Brixmor Property Group, 3.6%; Host Hotels & Resorts, 3.4%; AvalonBay Communities, 3.1%.

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 Wilshire U.S. Real Estate Securities Index is a broad measure of the performance of publicly traded real estate securities, such as Real Estate Investment Trusts (REITs) and Real Estate Operating Companies (REOCs). The index is capitalization-weighted. The beginning date was 1/1/78, and the index is rebalanced monthly and returns are calculated on a buy and hold basis. 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.

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