14 Feb 2012 Dodge & Cox - Jan 31 Shareholder Letter ( Portfolio )
The past year was highly volatile for equities. Even though stocks generally finished the year about where they started, the year was marked by macroeconomic uncertainty and fear. Concerns largely centered around the subpar economic recovery in the United States and the sovereign debt crisis in Europe. These issues may not be resolved in the short term, so the current environment of risk aversion may continue. However, the outlook for U.S. corporate profitability is strong: 2011 earnings are estimated to have increased by more than 15% and have already surpassed the prior earnings peak in 2007; balance sheets have improved; and dividends are rising. Though unemployment is still high, the United States added nearly two million private sector jobs.

We are optimistic about the long-term prospects for the Fund’s holdings because starting valuation is the most significant driver of long-term equity returns, and many of the Fund’s holdings are currently at unusually low valuations. The Fund’s price-to-earnings multiple (P/E) was 12 times trailing earnings at year end, with 21 of the Fund’s 73 holdings below 9 times trailing earnings, which is low relative to the S&P 500’s long-term average of 15 times earnings. We are encouraged by the modest expectations in the Fund’s holdings (and the overall market) and remain optimistic about the prospects for improving absolute and relative returns from the Fund.

One example of a security with an unusually low multiple is Hewlett-Packard(a) (H-P). H-P’s P/E declined from over ten times to six times trailing earnings as the shares declined sharply during the year. The price decline may have been fueled by investor concerns about management stability, revenue growth, and a large software acquisition. Given the Fund’s large weighting in the company during the year, this decline made H-P the biggest detractor from the Fund’s returns relative to the S&P 500. We maintain our conviction in H-P, previously discussed in the Fund’s Semi-Annual Letter. As the valuation has fallen, we have added to our position, with H-P remaining the Fund’s largest holding at year end (at 4.1%). The company remains a global leader in its core businesses of servers, services, and printers, now with new CEO Meg Whitman at the helm. In addition, the bulk of H-P’s revenues come from outside the United States, including emerging markets, which we expect to be a significant source of future growth.

Our confidence in the Fund’s future prospects is based on our investment team’s years of experience and continued diligent bottom-up analysis of the various businesses of each company held in the Fund, looking at their valuations as well as comparing investment alternatives to current holdings. Gradual changes in the portfolio result from this process, as evidenced by the Fund’s low turnover rate, which last year was 16%. New holdings were in a variety of sectors including Consumer Staples, Financials, Health Care, and Information Technology. Among the Fund’s largest purchases in 2011 were Microsoft and Roche (a position initiated in the fourth quarter of 2010).

Microsoft is a leading software company. Its Windows and Office suite of products dominate corporate and personal computing. Over the past decade, Microsoft more than doubled revenues and increased earnings per share at a faster rate. Yet today, its valuation of nine times forward estimated earnings and a 3% dividend yield reflects skepticism about its growth prospects. One concern is how Microsoft will respond as personal computers and laptops face increasing competition from tablets and mobile phones.

Microsoft has the resources and drive to compete and innovate in the rapidly changing technology markets. The company is well financed and wields a significant research budget that is, for example, 50% larger than IBM’s ($9 versus $6 billion). Management has invested in various initiatives from SharePoint for corporate networks to Windows Phone for mobile phones that should enable them to compete effectively as the internet and mobile and cloud computing continue to develop. Finally, we believe management’s owner- operator mentality aligns their interests with those of long-term shareholders.

Roche is a multinational pharmaceutical company based in Switzerland, with around 60% of its sales from cancer treatment drugs. Our investment thesis for Roche rests on the efforts by management to improve operations and continue to discover innovative pharmaceuticals for the future. While some of its oncology products face patent expiration over the next five years, generic competitors for these biologically derived pharmaceuticals face a significant hurdle: they must demonstrate biologic equivalence to achieve regulatory and commercial acceptance. The Fund is able to invest in an excellent company at an attractive valuation of less than 12 times forward estimated earnings with a current dividend yield greater than 4%.

Throughout our firm’s history, Dodge & Cox’s long-term, value-oriented, fundamental approach has withstood many periods of uncertainty and delivered strong long-term returns. We acknowledge the current challenges around the world. However, global equity markets are at compelling valuations which adequately reflect present concerns in our opinion. Thus, we are enthusiastic about the prospects for equities in general, and especially the holdings in the Fund, over the long run. Since short-term market movements are impossible to predict, and markets could continue to be volatile, we encourage shareholders to remain focused on the long term.