03 Aug 2011 Dodge & Cox - Q2 2011 Commentary ( Portfolio )
The Fund had a higher weighting in the Information Technology sector than the S&P 500 on June 30 (21.5% versus 17.8%). In technology, we seek to invest in attractively valued, well-established franchises with solid fundamentals, high free cash flow, and good long-term growth prospects. We avoid technology companies experiencing rapid growth where the high valuations, in our opinion, already reflect investors’ expectations for continued strong growth. The recent uptick in technology IPOs is evidence of investors’ appetite for high-growth companies. In contrast, Hewlett-Packard(a) and Microsoft are two examples of leading technology franchises held in the Fund for their low valuations and reasonable growth potential going forward.

Hewlett-Packard (H-P) has been a long-time holding of the Fund, with the current position initiated in 2001. H-P’s stock price fell 13.5% in the first half of this year. Much of that price decline can be attributed to investors’ concerns about low revenue growth and whether a new management team can continue the cost discipline initiated under former CEO Mark Hurd. In addition, some of H-P’s businesses are facing increased competitive pressures (e.g., personal computers in the face of growth of tablet computers). However, H-P is a global leader in services and printers, which provide over 60% of its profits. Geographically, more than 60% of the company’s sales come from outside the United States, and we expect emerging markets to drive most of the future growth. We believe that H-P’s leadership in its core businesses of servers, services, and printers will enable the company to continue to grow around the world in the years ahead. H-P’s valuation declined to a low of 0.6 times sales and 7 times estimated forward earnings on June 30, compared to the market at 1.5 times sales and 14 times earnings. We added to H-P in 2011, and it was the largest position in the Fund (4.3%) on June 30.

Microsoft, the world’s largest software company, is a new holding in the Fund; we initiated a position during the first half of the year. Microsoft has more than $65 billion in sales, and major franchises include its flagship Windows and Office products. Microsoft’s balance sheet is well fortified with $50 billion in cash. Expected annual free cash flow is more than $20 billion. In addition, the company has invested to create opportunities for growth beyond its core businesses. Despite these positives, Microsoft’s valuation is at historical lows of less than ten times both forward earnings and free cash flow. This leads us to believe that its valuation reflects investors’ low expectations. While we acknowledge Microsoft’s growth prospects are not as strong as in the past, we are optimistic about its potential to generate cash and invest profitably.

The Financials sector has lagged the overall market during the past three years and was the poorest performing sector in the first half of 2011. The sector has experienced recent turbulence, due to the lingering effects of the credit crisis and regulatory changes such as the Dodd-Frank legislation. However, there are reasons for optimism about the prospects of individual companies. Two substantial holdings, Wells Fargo and Capital One, are highlighted below.

Wells Fargo is the second largest bank by deposits in the United States, and Capital One is a consumer finance firm with credit card, auto lending, and banking businesses. Both are strong franchises with disciplined management teams who have made strategic acquisitions and emphasized growth and profitability. Both firms trade at historically low multiples of price to assets. Acting conservatively, both Wells Fargo and Capital One have been building up reserves, setting the stage for future earnings growth and higher profitability as charge-offs diminish and loan growth improves. Should earnings grow for both companies, we anticipate opportunities for future dividend growth and share repurchases. Both sell at less than ten times estimated forward earnings and we are optimistic about their return potential. Wells Fargo and Capital One were the Fund’s two largest Financials holdings on June 30, at 3.3% and 3.6%, respectively.