25 Feb 2009 Dodge & Cox Funds - Annual Report ( Portfolio )
While the economic landscape has clearly worsened with rising unemployment, declining home values, and continuing uncertainty within the Financials sector, there are a number of factors which build our convictions about the positive prospects for equity returns over the long term.

First, government officials and companies’ management teams have been actively addressing and responding to the economic downturn. Unlike some past recessions or the Great Depression, when policy makers either did nothing or raised barriers, the U.S. and foreign governments have implemented large programs to support the financial system and stimulate the economy, and have largely maintained free-market principles.

In our regular discussions with management teams, we hear how they are also rapidly responding to the downturn. Many companies are reducing costs, improving processes, reconsidering strategies, and looking for growth and market share opportunities as competitors struggle.

The survivors should be better positioned and more profitable when the economy does turn around. Examples of Fund holdings gaining market share and/or aggressively cutting costs include Hewlett-Packard, Comcast, Pfizer, FedEx, Schlumberger, and Wal-Mart.

Second, the U.S. economy has been through difficult periods before - it has survived wars, flu pandemics, inflation, labor unrest, and terrorist attacks. Pessimism during these periods - just like optimism during upturns - can become pervasive. Stock market volatility during this crisis has been at record levels with prices moving as much as 10% in a day - certainly beyond any changes in the underlying fundamentals of the companies these stocks represent.

Third, valuations for companies have obviously come down dramatically, and in our opinion are even more attractive today. As a whole, the stock market is selling at depressed valuations, and select companies are selling at very low multiples to sales and earnings potential. When the global economy stabilizes and recovers, attractive nominal returns could be achieved. Furthermore, companies perceived by investors as being more defensive- generally in the Utilities, Telecommunication Services, and Consumer Staples sectors - now trade at premium valuations, while companies viewed as riskier - generally those in the Consumer Discretionary, Information Technology, Industrials, and Financials sectors - have been discounted. The “flight to safety” strategy could prove successful in the near term. We, however, do not believe it will prove to be successful over the long term.

And finally, the powerful forces behind accelerated global economic growth over the past five years remain in place - namely, technological innovation and the growth in developing countries.