Q:  Could you give us a brief history of the company and the fund? A : Davis Advisors is an independent investment management firm offering services to individuals and institutional clients worldwide. Davis Appreciation & Income Fund was started in 1992 to provide investors with a fund that generates longer term returns with lower than market volatility. Q:  What is the investment objective of the fund? A : The fund seeks to build wealth for our investors by purchasing well-managed, durable businesses that are trading below our estimate of their value and holding them for the long term. Our goal is to capture most of the market’s upside while participating in less of its downside over the long-term. We try to do this by investing in blends of convertible bonds, equity, preferred stock, and straight debt of these target companies. Q:  What are the key steps in your investment process? A : The world is filled with great companies but not all of them will be great investments.. The key factor distinguishing the two is valuation. We try to think like owners of the businesses in which we consider investing. We spend a lot of time analyzing what we call owner earnings – these are cash flows to owners after accounting for required reinvestment in the business -- and where these earnings are likely to trend and what we are willing to pay for them. Our ideas come from many different places. We are voracious readers. We uncover many investment candidates by reading a wide range of sources including SEC filings, trade journals, and other periodicals. We discover some as we research current portfolio holdings. Others we find by reviewing the results of valuation oriented screens. No matter the source, the idea is vetted thoroughly through fundamental research before we invest. We think the best way to quickly learn about a business is to read regulatory filings like Forms 10K, 10Q and proxy statements. This is pretty dry reading, but it provides important insights into historical financial performance, key business relationships, important risk factors, how management is compensated and the quality of corporate governance. Reading and thinking about these public filings provides background for a conversation with the company’s management. When possible we try to visit management teams in person as we find face to face meetings far more valuable than telephonic ones. We also find that developing a personal relationship improves our ability to get access to management when we have more questions later. As prospective owners of a business, we are most interested in the long term prospects for the growth of owner earnings. We try to understand the key drivers of growth and the sources of advantage that may give the business a competitive edge. Once we decide we would like to own a business, we perform a valuation analysis to determine if it can be purchased at a fair price. Finally, we review the company’s capital stack and purchase the combination of securities we believe will enable us to participate in the growth of the business while moderating some of the risk. Q:  When you do your fundamental research, are there any particular details that you look for? A : Reinvestment in a growing business can fairly quickly change the character of the business. Because of this, when we look at an interesting company we examine the track record of the management team seeking to determine if they have been reinvesting the capital intelligently. Understanding management’s goals and objectives helps us to better appreciate what the business is likely to look like several years into the future. Q:  How do you estimate a company’s fair value? A : We base our valuation work on a concept we call owner earnings. We adjust GAAP earnings to come to a measure of the cash flow a business could distribute to its owners over time. We apply some judgment to determine an appropriate discount rate for our projected owner earnings stream and calculate a fair value. When we build our forecasts we give attention to key drivers of value, such as revenue growth rates and margin trends, for example, and how these drivers interact with one another. This level of granularity helps us think in terms of ranges of possible outcomes, something we prefer to point estimates of value. We are big believers in the margin of safety concept because, despite our best efforts to understand the business and estimate the earnings, things can and do go wrong. Q:  Why do stocks get undervalued? A : In the course of years of research and experience we have identified several reasons why the market undervalues a stock. Sometimes selling related to an industry crisis may create opportunity if the market does not distinguish between companies that might fail and those that might actually survive and become stronger. Changes in management can significantly alter the growth prospects of a business. Positive change or secular recovery after a prolonged downturn is often slow to gain market recognition. Changes in analyst recommendations cause short-term volatility in stock prices. And, finally, reasonable investors can view the same corporate strategies differently. That’s what makes a market. Q:  How do you construct your portfolio? A : Once we have found an appropriately valued, attractive company, we determine what securities the company has issued that we could buy. We try to purchase a combination we feel will appropriately balance upside reward potential against downside risk. Some securities, convertible bonds for instance, become more stock-like as the value of the underlying stock increases. If the risk/reward balance of a portfolio position changes materially because of price changes or perhaps due to a change in our fundamental outlook, we will rebalance the position. The basic idea is to try to create a portfolio of positions that have the potential to increase more in value with upside moves in the stock than they would be expected to fall with an equivalent downside move. Q:  Do you employ a methodology for allocation between stocks, convertible bonds and cash? A : We take a balanced view toward investing the portfolio, but do not make top-down allocation decisions among asset classes. The riskiest security issued by a company is typically its common stock. If we are comfortable with the equity risk of a company, then we should be comfortable with the level of risk presented by higher ranking security types. Some managers seek attractive securities to implement a particular asset class view. Our approach is to find attractive securities to balance our view on a particular equity investment. Our asset allocations are a result of the bottom-up approach we use to construct the portfolio. Our skill at underwriting businesses ultimately drives most of our portfolio performance so we are careful in stock selection. Q:  How many names do you normally hold in the portfolio? A : Many times we hold multiple issues in the capital structure of the same company. Because of this the number of securities in the fund may range from 55 to 60 but the number of unique companies might be 25 to 40. Q:  What are some of the companies that you have held in the fund? A : One holding we can talk about is Tyson Foods. The company is the leading protein processor in the United States. We added the position in early 2006 with chicken prices falling and the beef business generating operating losses. We viewed the industry challenges as transient and saw an opportunity. We performed a simple calculation that showed if we valued Tyson’s chicken business at a “normalized” earnings power that we’d get the company’s beef business essentially for free. That beef business was the largest component of the old Iowa Beef company that at its peak was worth nearly $4 billion dollars. Tyson is a closely held company and that presents the risk of self dealing. We reviewed a number of proxy statement disclosed transactions between the company and Tyson family entities to determine the dealings were truly arms length transactions. We have visited Tyson’s headquarters in Springdale several times in order to gain a deeper appreciation of the company. For example, on one trip we saw in-progress construction on an Innovation Center that would enable Tyson to jointly develop new value added products for its customers. We believed that this center would help Tyson win new customers, increase share with existing ones and probably boost segment margins. We should point out that the composition of our Tyson position has varied over time. We began with corporate bonds and common stock. That transitioned to a position that was a stock-heavy mix of convertible bonds and stock. Today the position is dominated by convertible bonds. Another holding of ours is Forest City Enterprises. We like the company because of its unique ability to manage technically complex projects that most companies cannot. The company is highly leveraged, but most of the debt is non-recourse. We owned a blend of stock and convertible bonds designed to provide downside protection. In the credit crisis Forest City’s survival was called into question because of its debt load. The price of its convertible bonds fell to below 50 cents on the dollar, declining more than many stocks. The defensiveness we expected in the convertible security seemed to disappear. Our investment looked like a big mistake. Our initial research had concluded that non-recourse project financing reduced the risk to the firm. And while this remained true, the markets for Forest City’s securities ignored the fact and our position was punished. With real estate markets collapsing, we had to decide what to do: sell the security and take our loss or hold for a rebound. Recognizing that availability of liquidity would determine the company’s fate, we did a detailed liquidity analysis and concluded that the company had sufficient liquidity to continue its projects. Confident in a talented management team, we added some common stock and held our convertible bonds. Our analysis has been confirmed as both the stock and bond have rallied sharply from their 2008 lows. Q:  What do you consider as primary sources of risk and how do you mitigate them? A : Volatility in stocks is neither good nor bad, but it sometimes presents opportunities to rebalance the portfolio. The biggest risk in any fund is losing money. We are price driven and we do have target prices. We are not averse to taking our profits when stocks are ahead of themselves or to cutting our losses if our original thesis turns out to be wrong. Because business risks are the dominant driver of risk across securities, we believe our diligence in underwriting a business is the most important lever we have to control risk. Our emphasis on valuation and margin of safety provides a measure of additional protection. Also, since we blend securities across the capital structure to build positions, the portfolio’s risk profile is more moderate than owning the stocks alone. Finally, we try to size the aggregate exposure to an individual company in a way that reflects the company’s risk. Industry concentration is another major source of risk. One can spend an enormous amount of time and resources in picking the best company in the sector, but when the entire sector is down or out of favor, being the best in the industry provides little protection. Similarly, in sectors with attractive fundamentals it is easier to find several companies one might like to own. While we do not target specific sector weights, we follow a number of reports that help us gauge our industry concentrations. These reports cause us to be aware of industry concentrations and challenge us to justify their existence. Investing is a continual learning process. We push ourselves to review both decisions that worked and those that did not in an effort to uncover potential flaws in our thinking. Many market lessons come at a price; we fail our investors and ourselves if we do not derive a lesson from a price paid.