Goals from Hornets strikers Grzegorz Rasiak and Tamas Priskin saw Matt Thornhill's strike rendered useless but Davies blasted his side's lack of character.
Forest remain two points above the drop zone but Barnsley have three games in hand below them.
Davies said: "We came here and the cards were marked before the game for the players.
"We knew the type of football they would play, we knew it would be a relegation dogfight and we knew we would need to show character to come away with anything.
"But they played the surface better and they had more players who competed.
"There is a certain style of play required to come and win at the likes of Watford and we lack that at the minute."
Rasiak and Priskin - the form striker in the Championship - were presented with their goals by some woeful defending which Davies was at a loss to explain.
He said: "Losing five players to injury didn't help us but the goals we let in were awful, awful goals at this level.
"We told them time and again that we couldn't afford to concede an early goal as that would give them a lift and that's what we did.
"There is a softness in this team that needs to be sorted out but that won't be done until next season in my opinion.
"The league table doesn't lie. It's great passing it around but you have to know how to win."
Watford's resurgence under Brendan Rodgers has been impressive since the former Chelsea reserve team manager took charge in November.
The Hornets are now six points clear of the relegation zone and first-team coach Malky Mackay admits that confidence is sky high.
Mackay said: "It's a great confidence builder to get five wins out of six and we can feel the confidence around the place.
"The crowd are enjoying themselves and that spreads around.
"It's just a pity that we haven't done this all season. There are a lot of teams at the bottom who are producing results that have raised a few eyebrows so it's a good job.
"We are aiming to get to the 52-point mark as soon as possible and we know we are not safe yet."
Rodgers can take great credit for the transformation in Priskin's game since he took over and his latest goal proved enough to give Watford their fifth win in the last six games.
A long ball forward was chested down by the Hungarian and a quick one-two with Rasiak sent him clear of the substitute Ian Breckin.
The striker had an age to weigh up his options but had the air of a man in form as he calmly drew Paul Smith out and passed the ball to his left.
Mackay said: "Tamas is maturing. We bought him over as a 19-year-old who couldn't speak a word of English and expectations were high right from the start.
"It takes time to settle into a different way of life and culture but now
he is blossoming.
"He has scored against the top Premier League sides in the cups this season in Tottenham and Chelsea and one v ones he is the best finisher in the league."