Overview
Market Perspectives
Performance Summary
Portfolio Review
Mistakes and Lessons Learned
Long-Term Themes




Overview

Selected Special Shares is a team-managed, opportunistic portfolio that applies the signature Davis investment discipline—purchasing durable businesses at value prices and holding them for the long term—to a portfolio of small, mid and large size companies.1 As a sign of our commitment to and conviction in this approach, the Davis family, 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.2

Selected Special Shares is diversified by company size, industry and the types of businesses that it holds. Currently, the Portfolio is invested predominantly in large and mid size companies. At year-end, the Fund's top five sectors, which include multiple industries, were consumer discretionary, financials, information technology, health care, and industrials, respectively. These allocations reflect where we find value at the individual company level rather than a macro view of any sort. What our individual holdings ultimately have in common is that each was selected using the same fundamentals-based research methodology and represents an appropriate balance of favorable business, management and valuation attributes in the view of our investment management team.

The Fund's investments fall primarily into three categories:3

■ Global leaders with strong balance sheets—We try to anchor the Portfolio with businesses in which we have a high degree of conviction that they will be able to weather the inevitable but unpredictable storms. Typical characteristics of this first category of holdings include a fortress balance sheet, diversified earnings (both by product and by geography) and durable competitive advantages. Current examples include companies like Microsoft, Johnson & Johnson, Disney, and WPP Group. These global franchises generate enormous free cash flow, usually in good and bad times alike. Their stock prices may fluctuate as will their earnings in the short run, but over the course of years these have proven to be highly shock-resistant business models that command great value once the market has had time to adjust to business realities.

■ "Out-of-the-spotlight" businesses—These are often boring, mundane businesses like Costco Wholesale (a membership-based retailer), Iron Mountain (a leader in off-site document storage), IDEXX Labs (a widely used provider of lab products and services to veterinary, food and water testing markets worldwide), Sigma-Aldrich (a specialty chemical distributor), and Sealed Air (the maker of Bubble Wrap and other protective packaging products). Their role in the Portfolio is to serve as quiet compounding machines offering durable cash flows, typically high recurring revenues and the possibility for a "double play" of expanding valuations on expanding earnings as the companies become more recognized over time.

■Headline risk investments 5—Around the edges of the Portfolio we selectively make contrarian investments. We call these headline risk investments because they often involve companies that are perceived as controversial and are frequently in the headlines. As a general rule, the closer a company is to the epicenter of a crisis and the deeper the pessimism, the greater the likelihood of encountering what we mean by a headline risk situation.

We always try to keep an open mind to companies tainted by pessimism, not because we like pessimism but because we like the prices it produces. With our own money invested side by side with shareholders, we are motivated first and foremost to find businesses that represent favorable economic risk/reward trade-offs based on our own research and analysis. Sometimes that leads us to companies that others have openly shunned.

Ambac is an example of a headline risk investment currently in the Portfolio. Ambac specializes in insurance designed to protect bondholders from the risk of default. Historically, the company's business model involved "lending" the company's triple-A credit rating to bonds issued by state and local governments, utilities and corporations that, without a bond insurer's backing, would have to offer higher interest rates to attract investors and, in many cases, would carry lower credit ratings. Over the past decade, Ambac's business became more complex as the company began insuring other types of debt such as mortgage-backed securities. During the last year, the downturn in the U.S. residential real estate market has cast a pall over businesses related to housing, starting with those directly exposed to residential housing such as homebuilders, and then spreading to indirect participants such as banks, other mortgage lenders and bond insurers.

In times of fear and market disruption strange things can happen. For instance, during the Enron saga earlier in this decade shares of Williams Companies fell from a high of $49 to less than $1, only to trade at $32 today. Similarly, another energy company, AES, fell to as low as 92 cents, only to recover to $19 today. With Ambac, the history of how the company will fare in a tougher credit environment has yet to be written. However, based on a wide range of loss assumptions, we believe the company's business is worth significantly more than its current stock price implies, which is why we continue to hold shares in Ambac as of this writing.

Headline risk investments may represent a relatively small percentage of the Portfolio, but they often account for 95% of our conversations with shareholders because they naturally invite the question, "Don't you read the papers?" We cannot promise success in every case, but we can state with conviction that our decisions involving headline risk situations are driven by what we feel are favorable economic risk/reward trade-offs. In their aggregate, contrarian investments have played an important and integral part in our long-term success as investors since Davis Advisors was founded in 1969.

1 Selected Special Shares may be subject to increased volatility as smaller companies' share prices tend to fluctuate more often as they tend to have more limited product lines, markets and financial resources, and their securities may trade less frequently and in more limited volume than those of larger companies. 2 As of December 31, 2007. 3 The information provided in this report does not provide information reasonably sufficient upon which to base an investment decision and should not be considered a recommendation to purchase or sell any particular security. Past performance is not a guarantee of future results. 5 While we research companies subject to such contingencies, we cannot be correct every time, and the company's stock may never recover.




Market Perspectives

The year 2007 was a turbulent year for U.S. stocks. To recap the market's ups and downs in 2007, the S&P 500® Index was down 3% through early March, up more than 10% through early October and ultimately ended the year gaining a modest 5.49%. In retrospect, perhaps most noteworthy is not so much the stock market's volatility in 2007 as the simple fact that the S&P 500® Index finished higher despite tens of billions of dollars of write-downs on Wall Street, declines in residential real estate, the meltdown in certain segments of the credit markets, a slide in the U.S. dollar relative to other major currencies, and the price of oil approaching $100 per barrel. Given this backdrop, one could have easily imagined a far worse outcome than a sideways trading range market. As for where developments will lead near term, there is no shortage of speculation and forecasts, but in reality nobody has a crystal ball and the market's direction in any given year is just one of many important but unknowable variables such as interest rates, inflation, the price of oil, and so forth.

One of our keys to long-term success in the investing business has been our willingness to look beyond the important but unknowable factors and focus on specific important and knowable facts about the businesses we own in a portfolio. Through persistent, in-depth research, it is possible to understand the dynamics of specific business attributes like management quality, the operating leverage of certain profit models over others, the durability of certain competitive advantages, and the valuations paid to own shares in a company with a reasonable degree of precision. Only by isolating key drivers of long-term business results and paying careful attention to valuations can we make informed investment decisions despite the informational noise that is ever present in the background.




Performance Summary

Selected Special Shares earned an average annual return of 5.89%6 from June 1, 2001 when the Davis team began managing the Fund through December 31, 2007. This compares with an average annual return of 4.96% for the Russell 3000® Index, the Fund's benchmark, which comprises a cross section of small, mid and large size companies. On a cumulative basis, that translates into a return of 45.85% for the Fund versus 37.59% for the 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. The total annual operating expense ratio for Class S shares as of the most recent prospectus was 1.16%. 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 data quoted. For most recent month-end performance, click here or call 800-243-1575.

4 Davis Advisors began daily management of Selected Special Shares on June 1, 2001. From May 1, 1993 until June 1, 2001, Davis Advisors had a subadvisor that handled daily management of the Fund.

Notwithstanding periods of short-term underperformance, which are inevitable, since we began managing the Fund we have added value over the broader market through a variety of market and economic conditions. We have managed the Fund through both bull and bear markets, periods of higher economic growth as well as economic slowdowns, the 9/11 terrorist attacks, rising interest rates, falling interest rates, and so forth. We believe these long-term results demonstrate the effectiveness of our time-tested investment philosophy as a method for building and preserving capital through various market environments.

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.

6 Class S shares. Past performance is not a guarantee of future results. 7 Returns calculated June 1, 2001 through December 31, 2001.




Portfolio Review

In any year there are Fund holdings that contribute to performance and those that detract from performance. In 2007 notable contributors included:

■ Garmin, a market leader in global positioning system (GPS) devices;
■ Google, the leader in Internet search;
■ Transocean, the world's largest offshore drilling contractor;
■ Microsoft, a globally recognized leader in technology that dominates the market for personal computer operating systems; and
■ Trane, a leading provider of heating, ventilating and air conditioning systems and services.

Notable detractors in the period included:

■ Comcast, the leading provider of cable television services in the United States;
■ WPP Group, a global media research and advertising conglomerate;
■ E*Trade, an online stock brokerage and financial services firm;
■ Harley-Davidson, the market leader in heavyweight motorcycles; and
■ Ambac, a bond insurer.




Mistakes and Lessons Learned

The terms "contributors" and "detractors" as used above indicate only whether the shares of specific companies in the Portfolio realized a positive or a negative return over the reporting period. By contrast, the merits and the thesis behind each of our investments typically have an expected payback over a period of years, not months. In some cases, however, detractors are in fact mistakes from which we learn valuable lessons.

E*Trade is an example of a mistake that detracted from our performance in 2007. Prior to owning shares in the company we had followed E*Trade for some time and its (now ousted) management team had built an impressive record, not only growing E*Trade's large online brokerage business, but also expanding into traditional bank services like checking and money market accounts where the company could offer attractive rates because of its low cost business model (including a limited branch network and low overhead). The businesses in which E*Trade specializes are profitable ones long term and we felt the market underestimated this fact.

Our mistake was ultimately a mistake in judgment regarding the people running the business. E*Trade's senior management had managed the company's balance sheet with sufficient capital for the company to qualify as well capitalized by regulatory standards. However, management should have been even more conservative in that respect in order to handle the kind of financial hurricane that has set upon the global credit markets recently. E*Trade's balance sheet was stressed not so much by its own direct lending activities but because it owned mortgage-backed securities that suddenly declined in value, and the company was ill-prepared to absorb the magnitude of the write-downs it ultimately had to take.

Amid the crisis, Citadel, a large private equity firm, bought E*Trade's mortgage-backed portfolio, purchased 20% of the company's equity and the board of directors replaced E*Trade's management. Based on a new set of circumstances—a strong financial backer with more than enough capital to see E*Trade through a difficult environment and a strong economic interest in helping the business move forward—we decided to hold our remaining position (approximately 0.4% of the Portfolio).

As of this writing, the company has shown progress toward stabilizing, its balance sheet has been repaired and we believe the potential reward from holding shares in the company represents a multiple of the potential downside from this point forward. While tarnished brands take time to mend, the market's memory is short and we believe that given time and newfound stability, E*Trade stands a good chance of reviving its franchise.




Long-Term Themes

Looking ahead, the near term is rife with uncertainty. For instance, when will housing declines reach bottom? When will liquidity improve in the credit markets? When will the dollar strengthen? These are important but unknowable developments. Fortunately, the longer one's investment perspective the easier it becomes to make at least some meaningful predictions. For instance, although we do not know the exact timing, we are very confident that home values in the United States will eventually stabilize, that liquidity will eventually return to the credit markets (as it has following all major shocks to the financial system in the past) and that the U.S. dollar will see days when it strengthens against other currencies instead of weakening. We just do not know when. That stated, in a framework of investing that spans years and decades, we would argue that the more critical task to get right is understanding the businesses one owns and their ability to weather the inevitable cycles and create value for shareholders through a wide variety of conditions.

A number of key themes suggest where we are currently looking for long-term investment opportunities:

■ Global, high-quality multinationals—Investing in large corporations today almost necessarily leads to a universe of global multinationals, some of which are based in the United States while others are headquartered elsewhere.8 These businesses look attractive to us for a number of reasons. Dominant global brands that can raise capital in virtually any environment, withstand the inevitable shocks, access fast-growing local markets in developing nations, and enjoy the stability of geographically diversified earnings should trade at a premium in our view. Instead many are trading at market or below-market multiples and are one of the few groups that has not participated significantly in the market's last five years of returns.

■ Capital spending—The U.S. economy, now 70% driven by the consumer, may be moving into a phase similar to the late 1960s and 1970s where a prolonged capital spending cycle plays a more significant role again. That could mean more profits for infrastructure-related investments both in the United States and abroad—e.g., companies that build jetliners, cranes, highways, locomotives, and port companies.

■ Energy and natural resources—As developing nations add to worldwide incremental demand for commodities like oil and natural resources, we believe that the average price ranges for such resources could remain elevated relative to the decade of the 1990s. Consistent with our energy investments to date, we will be on the lookout for management teams with a strong capital allocation discipline who can generate reasonably attractive profits for shareholders given a stable price environment and generate windfall profits under more bullish scenarios.

■ Demographically favored industries (health care and financial services)—The populations of the United States, Europe and Japan are getting older and we believe that this inexorable trend will direct more nondiscretionary spending, partly from governments and partly from individuals and companies, toward different areas of health care. A rule of thumb in investing is to follow the money and a good deal of money will be flowing into health care equipment, treatments and services. To the extent people are living longer, they will also need to save and invest for retirement, and leading brands in financial services are the logical places where consumers will shop.

In addition, we are always looking for the "quality accidents of the day," or the headline risk situation that becomes a bargain for temporary but surmountable reasons according to our own analysis. We also continually sift through the universe of lesser known, out-of-the-spotlight businesses that others may simply have failed to notice.

Ultimately, whatever happens in 2008 and whatever styles, industries or market capitalizations move in or out of favor, we remain committed to our signature investment discipline of buying durable businesses at value prices and holding them for the long term. We have seen this bottom-up, research-driven approach prove highly effective through a wide variety of market conditions. We believe that keen attention to stock selection combined with a sensible framework for building portfolios (global leaders, out-of-the-spotlight holdings and headline risk investments) is a time-tested and reliable way to compound capital over full market cycles.

Thank you for your support. We at Davis Advisors look forward to continuing our investment journey together. ■


8 Companies operating, incorporated or principally traded in foreign countries may have more fluctuation as foreign economies may not be as strong or diversified, foreign political systems may not be as stable and foreign financial reporting standards may not be as rigorous as they are in the United States.

For more information, please contact...

DAVIS DISTRIBUTORS, LLC
2949 East Elvira Road, Suite 101
Tucson, AZ 85706
1-800-243-1575