Market Perspectives
Portfolio Positioning
Performance Review
Lessons Learned in 2008 and 2009
Maintaining a Long-Term Perspective
Where We Are Finding Opportunities

Since our founding more than 40 years ago in 1969, Davis Advisors' mission as a firm has been to serve our shareholders and to do so with high integrity. Mindful of the enormous responsibility that comes with serving as a steward of others' capital, we are firmly committed to:

• Investment excellence: Davis Advisors conducts rigorous fundamental research with the goal of producing solid long-term investment results for shareholders.

• Sharing wisdom and perspectives about investor behavior: We strive to promote healthy investor behavior, which we firmly believe can positively influence the results that shareholders ultimately realize.

• Open and honest communications: We seek to communicate with our shareholders in a manner that we would desire if our roles were reversed.

As a sign of our commitment to all those who have entrusted capital to us, the Davis family, Davis Advisors, employees, and directors have more than $2 billion of their own money invested side by side with fellow shareholders in the various mutual funds our firm manages.1

1 As of December 31, 2009.



Market Perspectives2

Last winter in the midst of the turmoil in the financial markets, we recommended long-term investors think about conditions as dynamic, not static. Specifically we noted that "we are now in a bear market and economic recession, but it would be a mistake to assume this state of affairs will last forever. Based on our experience, we believe that the economy and financial system...are extraordinarily resilient, that the credit crunch will eventually subside, that businesses can and do adapt to changing realities given time, and that the long-term outlook for businesses—and therefore equities—remains favorable."3

Source: National Bureau of Economic Research using data from the Labor Department, January 1967 through November 2009. Past performance is not a guarantee of future results.

While certain aspects of the market environment remain uncertain, important signs of stabilization began to appear on numerous fronts in 2009. Notably, the pace of deterioration seemed to moderate, particularly with respect to the residential housing market. Credit markets, meanwhile, have thawed considerably over the past year as evidenced by robust debt issuance. Equity markets, while still below their level of two years ago, have risen from their lows. Among other positive news, valuations for many high-quality businesses remain in a range that we consider reasonable relative to their intrinsic worth. (From a risk/reward standpoint this is significant, as low valuations are generally a requirement for higher future returns.) In addition, policymakers around the world are seeking to aid the process of recovery by maintaining relatively accommodative monetary policies, and businesses almost universally are cutting costs and/or consolidating to support profits and margins.

The recent period of dislocation is neither the first nor the last that we will see. In our more than 40 year history as a firm, Davis Advisors has navigated through numerous bear markets and recessions, each of which had aspects that at the time were worse than anyone could have imagined. What our experience has taught us is that crises are inevitable and painful, but ultimately surmountable. None to date has permanently derailed the market's ability to compound over the long term. In fact, for the better part of the last century the U.S. economy has grown over every decade and the market in the long run has managed to produce double-digit returns despite setbacks such as prolonged bear markets; wars; recessions; an oil crisis; a hostage crisis; periods of double-digit interest rates, inflation and unemployment; political scandals; stock market crashes; the 9/11 attacks; and much more.

Source: Yahoo Finance. Graph represents the S&P 500® Index from January 1, 1970 through December 31, 2009. Past performance is not a guarantee of future results.

2 This report includes candid statements and observations regarding investment strategies, individual securities, 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. Past performance is not a guarantee of future results. 3 Source: Selected American Shares Winter 2009 Review, December 31, 2008, page 3.



Portfolio Positioning4

Market conditions may vary from period to period, yet the core tenets of the Davis investment discipline and approach remain the same. We start with the premise that stocks represent fractional ownership in real businesses. We seek to purchase durable businesses at value prices and hold them for the long term. We believe that owning shares of well-managed businesses with attractive reinvestment rates, purchased at reasonable valuations and held for years to allow the power of compounding to work, is a reliable method for building capital over long investment horizons.

By definition, owning shares of companies for years or even decades means that some, perhaps all, of our investments will traverse rough patches along the way, whether they are specific to a company, an industry or the broader market. We know in advance that we are going to own businesses in periods of rising interest rates, falling interest rates, inflation, disinflation, a weak dollar, a strong dollar, and so forth. Therefore, when we think about purchasing shares of a company, we have to weigh carefully up front whether we think the business can withstand inevitable shocks in addition to considering the likelihood the business can grow earnings power (and therefore intrinsic worth) over full cycles. Then, company by company, we set out to build a durable, all-weather portfolio of businesses that can compound over the long term.

Our Portfolio holds three primary categories of investments:

• Market leaders with strong balance sheets

• "Out-of-the-spotlight" businesses

• Headline risk or contrarian investments

Market leaders with strong balance sheets— In many cases these are global companies with universally known brands, earnings that are well diversified from the standpoint of product line and geography, and fortress balance sheets. At this time more than 75% of the Portfolio is invested in companies with market capitalizations in excess of $10 billion and combined revenues totaling more than $2.1 trillion.5 These businesses span a broad range of global industries from financial services to retailing to consumer products to technology. They provide a core foundation of stability within the Portfolio and offer in our view a high probability of long-term sustainable returns through capital appreciation and dividends.

A representative market leader in the Portfolio is Berkshire Hathaway, a conglomerate with a market capitalization well over $100 billion and interests in insurance, reinsurance, utilities, manufacturing, retailing, and a host of other business lines. Under the steady leadership of Warren Buffett and team the company has grown book value at more than 20% per year on average over the past four and a half decades, more than double the return of the S&P 500® Index over the same period. Given its size, the company's prospective returns will almost certainly be lower than its historical record, but we believe Berkshire Hathaway is well positioned through its operating businesses as well as its investment portfolio to increase earnings power considerably over the next five to 10 years and is exemplary in its capital allocation discipline. Moreover, the company trades at a meaningful discount to intrinsic worth by our estimates. Among recent developments, Berkshire Hathaway entered into an agreement in the fourth quarter of 2009 to acquire the roughly 77% of Burlington Northern Santa Fe (BNSF) it did not already own for approximately $34 billion plus the assumption of $10 billion of outstanding BNSF debt. In addition, the company has made numerous opportunistic purchases in its investment portfolio over the past 18 to 24 months, selectively capitalizing on market dislocations.

Costco Wholesale, a membership-based retailer with more than 500 locations predominantly in North America, is another market leader in the Portfolio. Costco opened its first few warehouses in 1983, generating $101 million in sales (with a net start-up loss of $3.3 million) in its first year of operations and ending the year with 244,000 members. In fiscal year 2008, Costco generated sales in excess of $71 billion and net income of more than $1 billion. It has more than 20 million individual members and more than 5 million business members whose annual fees collectively amount to approximately $1.5 billion. The company is the fifth largest retailer in the United States and the eighth largest retailer in the world. Costco's key competitive advantages are threefold: First, the company is the low cost operator in an enormous market. Second, the company generates much of its earnings through membership fees, earning supplemental revenues and income that other traditional retailers do not have. And third, Costco's value proposition for members is virtually unique, with markups capped for the most part at 15%. By providing excellent value to members and growing store count, the number of fee-paying members per store and average sales per store, Costco has been able to build its franchise value from $7.5 million in start-up capital to a market value in excess of $26 billion today, generating very solid returns for long-term shareholders along the way.

Procter & Gamble (P&G) is a global consumer products leader whose products touch the lives of an estimated three billion people each day. It possesses one of the most impressive brand portfolios of any global consumer products company with 23 brands generating annual sales of $1 billion or more and another 20 brands generating annual sales of at least $500 million. The vast majority of these brands are household names and category leaders such as Pampers, Gillette, Tide, Crest, and Duracell among others. Such brands tend to engender strong customer loyalty, which in turn increases P&G's clout with merchants relative to less well-positioned competitors. This pricing advantage is plowed back into marketing and research and development (R&D), reinforcing the strength of P&G's brands and supporting further brand innovation. In addition, Procter & Gamble is a truly global franchise that can benefit from the tailwind of a growing global middle class. Today about 55% of the company's sales are derived outside the United States and we expect foreign earnings to provide a disproportionate share of the company's growth for years, possibly decades, to come.

Google is a market leader that dominates the business of online search. In a sense, Google is a new media company whose business model is exceptionally well positioned to benefit from the ongoing transition from traditional print and television media to Internet-based content and advertising. Google's Internet search platform, which is free for users, incorporates advanced technology to target ads based on specific search parameters and displays these ads together with the search results. Space on the search results page is limited and advertisers compete for this space by "bidding" against each other, creating a marketplace for ads that contributes in aggregate more than $20 billion to Google's top line. We believe this targeted advertising model is truly revolutionary and Google may have barely scratched the surface of its potential. Although founded only in 1998, the company has a first mover advantage, commanding as much as a 70% market share worldwide. It is highly profitable with operating margins exceeding 30% and possesses a fortress balance sheet anchored by more than $20 billion of cash. In addition, it is significant that Google's capital expenditures exceed $2 billion annually, reflecting the high barriers to entry in the online search business. We believe growth will occur both organically through an ever-increasing pool of worldwide Internet users, as well as through Google's substantial investments in nascent technologies such as mobile (cell phone) search and cloud computing (a Web-based application or service that provides access to the various programs computer users need from e-mail to word processing to data analysis through a central source).

We believe market leaders such as Berkshire Hathaway, Costco Wholesale, Procter & Gamble, and Google that possess strong brands, proven management and scale advantages are well positioned to create significant value for long-term shareholders.

Out-of-the-spotlight businesses— After market leaders, the next major category of investments in the Portfolio is out-of-the-spotlight businesses. These are lesser known companies with attractive economics that in our opinion should eventually command higher valuations. Their appeal may take time to gain recognition, often because these businesses are smaller or operate in a mundane non-consumer-oriented industry. Given the right leadership and attractive reinvestment rates, these low-profile holdings can provide the opportunity for the "double play" of expanding multiples on expanding earnings, which can turn a company with a solid earnings growth rate into a stellar investment. As a general rule, out-of-the-spotlight holdings tend to be boring but steady compounding machines.

Out-of-the-spotlight holdings in the Portfolio include Progressive (personal lines auto insurance) and Iron Mountain (off-site document storage) as well as hard asset-related businesses such as Devon Energy and EOG Resources (oil and natural gas exploration and production companies).

Headline risk or contrarian investments6— On a very selective basis we make contrarian investments. These often involve controversial situations where the market is discounting a company's share price to reflect a perception of risk that we think is greater than the probable economic risk to the business's long-term fundamentals. Typically a minor portion of our portfolios in percentage terms, headline risk investments can sometimes be difficult for clients to understand because they beg the question, "Don't you read the papers?" But it is precisely because so many other investors automatically sell companies with near-term challenges, however surmountable, that the potential for high returns exists in many such instances. Our job is to ferret out opportunities that represent favorable risk/reward trade-offs and do our best to avoid the value traps. We will not get every investment right. However, overall this distinctly contrarian element of our investment discipline has been an important contributor to our long-term success and can be an effective and repeatable way to capitalize on herd mentality in the market.

Early in 2009 while the credit crunch continued to weigh on corporations around the globe, we had the opportunity to invest at very attractive rates in debt positions of Sealed Air and Harley-Davidson, two companies in which we have been long-term stockholders. Specifically, we invested alongside Berkshire Hathaway in five year notes yielding 12% and 15%, respectively. At the time, we were investing at a moment of maximum pessimism. Now that some of the clouds have lifted both notes trade well above our purchase price. In addition, the uncertainty associated with pending health care reform in the United States has created opportunity. In 2009 we were able to purchase shares of a number of high-quality businesses in the health care field, including Merck (which merged with Schering-Plough in November 2009) and Pfizer at what we believe were highly attractive valuations.

Overall, the investments we have made in the three categories described above combine to form a total Portfolio that we believe is well diversified and has a high probability of producing satisfactory compound returns over full market cycles.7

4 Individual 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 Portfolio will vary based on weighting and timing of purchase. This is not a recommendation to buy or sell any specific security. Past performance is not a guarantee of future results. 5 Source: Davis Advisors and Wilshire Atlas. 6 While we research companies subject to such contingencies, we cannot be correct every time, and a company's stock may never recover. 7 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. Equity markets are volatile and an investor may lose money.



Performance Review

For the year ended December 31, 2009 the S&P 500® Index delivered very solid returns finishing the year up 26.46%, and Selected American Shares outperformed the benchmark by a wide margin.8 Longer term the Fund has outperformed the Index over the trailing five, 10 and 15 year periods as well as since Davis Advisors began managing the Fund in 1993,9 a testament in our view to the effectiveness of the fundamentals-based Davis investment discipline through a variety of market and economic conditions.

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 S shares as of the most recent prospectus was 0.92%. 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 returns, click here or call 800-243-1575.

The Portfolio's results in 2009 reflect strong performance among many individual holdings, particularly within the financials, information technology and energy sectors. (Sector allocations are a by-product of bottom-up stock selection and generally represent a cross section of market leaders, out-of-the-spotlight holdings and headline risk investments. We refer to sector-level performance here merely to provide a general framework for understanding the Portfolio's aggregate performance in the most recent calendar year.)

Our financial holdings vary widely by industry and business type and include JPMorgan Chase (money center bank), Wells Fargo & Company (regional bank), Progressive (personal lines auto insurer), and holding companies like Berkshire Hathaway and Loews that have significant interests in utilities and insurance among other businesses. We are interested in owning what we believe are durable, best-in-class financial franchises with expert managements, robust balance sheets and favorable competitive positions. A positive for certain well-managed, well-capitalized financials today is that strong franchises with focused managements are in a position to take market share as weaker competitors are marginalized. Potential negatives include the possibility of future regulation and lower returns on equity due to higher capital requirements (or conversely lower leverage ratios). In general, we have a strong preference for financial institutions with excess capital and liquidity, a history of intelligent capital allocation and CEOs who serve as de facto chief risk officers among their other roles.

Information technology has been one of the best performing areas of the Portfolio and the market as a whole year to date. Our technology holdings predominantly include workhorse category leaders in chips, online search and software such as Texas Instruments, Google and Microsoft among other business types. We believe these businesses stand a high probability of compounding earnings by generating relatively high returns on capital and enjoy significant competitive barriers to entry.

Our energy-related holdings consist predominantly of oil and natural gas exploration and production companies that have historically earned above-average returns on capital versus their peers and that in our view are trading at reasonable normalized valuations. These companies include Canadian Natural Resources, Occidental Petroleum, EOG Resources, and Devon Energy. We believe our energy holdings are capable of creating value for shareholders under a variety of economic and market conditions through the disciplined allocation of capital. They also stand to benefit potentially from the long-term tailwinds of a growing global middle class and a veritable industrial revolution taking place within certain developing economies.

Regarding portfolio changes in the year-to-date period, we added to a number of positions based on valuation including Google, Activision Blizzard, Johnson & Johnson, Disney, Pfizer, Merck, ABB, and Becton, Dickinson. To fund these new purchases we have pared or sold our positions in Cisco Systems and Comcast among others.

To provide our clients with timely information, we have discussed Portfolio results for the trailing 12 month period. However, our investment discipline is based on a much longer term view. We evaluate each investment in the Portfolio based on its potential to create value for our clients over multi-year holding periods. Through bottom-up stock selection and rigorous fundamental research, we aim to construct a total portfolio that we believe is well diversified and has a high probability of producing satisfactory compound returns over full market cycles.

8 Past performance is not a guarantee of future results. 9 Class S shares. Davis Advisors began managing the Fund on May 1, 1993. Past performance is not a guarantee of future results.

Lessons Learned in 2008 and 2009

Reflecting on the past two years, which include the economic crisis of 2008 and the partial recovery of 2009, these are among the key lessons we have learned:

• Periodic crises are inevitable and painful, but they are ultimately surmountable and can create significant opportunities for disciplined long-term investors.

• Liquidity, reasonable limits on leverage, franchise durability, and management quality are critical to companies weathering the inevitable yet unpredictable periods of crisis. Mistakes we made in 2008, most notably our investments in American International Group and Merrill Lynch, underscore the importance of these characteristics.

• Adhering to a reliable, time-tested discipline and keeping a long-term perspective are crucial to compounding wealth over time.10 Investors who maintained a patient, objective and long-term perspective through 2008 and who recognized that periods of dislocation can cause security prices to diverge widely from business values were generally rewarded for their steadfastness in 2009, as the chart below suggests.11
  
  
  

Source: The Wall Street Journal, January 4, 2010. There is no guarantee that these indices or securities, or any other indices or securities, will appreciate in the future.

10 There is no guarantee that an investment will compound over time. 11 Source: The Wall Street Journal, January 4, 2010. There is no guarantee that low-priced securities will appreciate.




Maintaining a Long-Term Perspective

Building long-term wealth with a portfolio of businesses is like driving an automobile in some respects. If investors focus too narrowly on the stretch of road a few feet ahead, they run the risk of making unnecessary adjustments and oversteering. Only by lifting our eyes to see the road further ahead are we likely to reach our ultimate destination. The crisis that unfolded in 2008 and from which we are gradually recovering is a case in point. While 2008 was extraordinary in many respects and the experiences of that year provide some important lessons for the future, investors must not forget that the norm over longer time horizons generally favors growth and positive equity returns.12 In fact, history suggests that the probability of achieving positive returns from equities increases the longer one's investment horizon, which is a strong endorsement for being patient and staying the course.12


The charts below illustrate this point by showing the percentage of time from 1928 through the end of 2009 the Dow Jones Industrial Average produced positive returns over one year and five year holding periods. Extending one's horizon from one to five years increased the historical chances of realizing a positive return in the market from 73% to 92%. In navigating uncertain times, it is useful to remain focused on the long term since stocks have generally rewarded patient investors.12




Source: The performance was obtained from a combination of sources, including, but not limited to, Thomson Financial, Lipper and index websites. Returns are annualized total returns. Past performance is not a guarantee of future results.


12 Past performance is not a guarantee of future results.



Where We Are Finding Opportunities

There are always opportunities and risks. In our view the keys to outperforming the market over the next decade, as we have done since Davis Advisors began managing the Fund in 1993,13 are: (1) to think long term rather than get caught up in short-term cycles, (2) to exercise a highly selective and disciplined approach with respect to business quality and valuation, and (3) to remain focused on in-depth, bottom-up research.

Today we are finding compelling values in many areas of the market that in our view represent attractive avenues for compounding shareholders' capital over the next decade. Most of these opportunities fit within the following long-term themes:

• Globally dominant businesses— These industry leaders are characterized by strong pricing power, diversified earnings, healthy balance sheets, strong competitive moats,and durable business models. Because these businesses produce excess cash, they are not dependent on external funding.

• Beneficiaries of crisis— Certain companies' business models, capital positions and management disciplines allow them to take advantage of chaos. Given strong free cash flow, these companies are often able to use distressed prices to make investments, acquisitions or significant share buybacks at accretive prices.

• Select financial companies— The financial services industry is not prone to obsolescence. People will always need basic banking services, insurance products, investment management advice, and other such services. Nonetheless, it is necessary to differentiate between strong and weak players in order to invest successfully in this area of the market.

• Energy, commodities and agriculture businesses— Well-managed companies in these areas are positioned to benefit from the inexorable long-term growth of a global middle class, which will result in increasing demand and potentially higher prices for most natural resources.

• Select special situations— These are highly opportunistic companies in diverse industries trading at steep discounts to intrinsic worth that may prove to be exceptional long-term investments in our view.

All of us at Davis Advisors thank you for your support. We are grateful and fortunate to have your confidence and will continue to work hard on your behalf. We look forward to continuing our investment journey together. ■

13 Class S shares. Inception was 5/1/93. Past performance is not a guarantee of future results.

Audio Webcast:
Insights from One of the Most Successful
Investment Families in History

Drawing from over 60 years of investing on Wall Street, the Davis family shares insights and wisdom on building wealth and the temperament needed to invest successfully.

To listen the audio webcast, please go to the SelectedFunds.com home page.

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2949 East Elvira Road, Suite 101
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