18 Oct 2011 Dodge & Cox: Q3 2011 Commentary ( Portfolio )
During the third quarter, markets around the world experienced dramatic volatility and significant declines. Extreme volatility is painful to endure, and we recognize that it is difficult to invest with confidence in light of the Fund’s recent volatility and underperformance. However, the long-term return potential of global equities is quite attractive, and we see numerous opportunities. We encourage shareholders to view the current market environment from the perspective of a long-term, value-oriented investor.

There are many serious concerns weighing on investors, including continuing European sovereign debt challenges, a weak U.S. economy, slowing growth worldwide, persistently high unemployment, and declining consumer confidence. We do not seek to minimize these legitimate concerns. The investor pessimism that develops from these challenging circumstances at the same time, though, creates opportunities to invest in strong companies at depressed prices—as investors flee equities for what they perceive to be less risky investments.

Amid the fear and pessimism depressing share prices and despite the global economy growing well below its potential, corporate balance sheets have actually been strengthening, with significant cash balances and improved debt profiles. In addition, corporate earnings have been strong through the most recent quarter. We see industry leaders with healthy profits and balance sheets that are trading at historically low valuations. At quarter end, global market indices were at low valuations by post-World War II standards: the S&P 500 was trading at 11.3 times estimated forward earnings and had a dividend yield of 2.4%. Even if the pace of earnings growth moderates and proves those estimated earnings slightly too rosy, the resultant valuations would still be very appealing. In investing, your starting point always matters. And starting from these low valuations has the potential to yield strong long-term future returns, particularly for investors with the patience to withstand volatility.

One lingering fear for investors is that we will experience another financial crisis and economic downturn similar to 2008. After considerable analysis, including stress-tests of the Fund’s financial services holdings, we believe they are better prepared to weather the current crisis. In particular, we note that banks as a group are much healthier now, with improved liquidity, more stable sources of funding, stronger capital ratios, higher reserves for loan losses, and better asset quality.

Finally, emerging markets remain an important source of growth for many companies around the world. Consumer purchasing power in the developing world continues to expand, as growing populations with rising incomes will lead to greater personal consumption of pharmaceuticals, technology, consumer goods, and more.

Throughout this difficult period of performance, we have remained confident and consistent in our investment strategy of building portfolios with solid companies whose current market valuations do not adequately reflect their long-term profit opportunities. In addition to this emphasis on valuation, key elements of our enduring approach include bottom-up fundamental analysis of individual companies, a team decision-making process, and a long-term investment horizon to guide us through short- term periods of fear and uncertainty. The firm’s 80 years of experience have taught us that the best investment opportunities often arise from periods of such trepidation. We encourage our fellow shareholders to share our long-term investing perspective.