The Fund seeks long-term growth of principal and income. A secondary objective is to achieve a reasonable current income.
The Fund invests primarily in a broadly diversified portfolio of common stocks. In selecting investments, the Fund invests in companies that, in Dodge & Cox’s opinion, appear to be temporarily undervalued by the stock market but have a favorable outlook for long-term growth. The Fund focuses on the underlying financial condition and prospects of individual companies, including future earnings, cash flow and dividends. Various other factors, including financial strength, economic condition, competitive advantage, quality of the business franchise and the reputation, experience and competence of a company's management are weighed against valuation in selecting individual securities.
Decades of investing have taught us that the perception of an investment’s worth fluctuates much more widely than its underlying fundamentals. We are skeptical that short-term market trends can be predicted with consistency, so we look further out in our analysis, focusing on the key fundamental factors that will determine investment value over the long-term. As our view diverges from the consensus, we find investment opportunities.
We continually focus on the long-term by asking ourselves the hypothetical question: based on what we know now, how would we invest an “all-cash” portfolio today assuming we could not trade for the next three to five years? This framework forces us to reevaluate our portfolio holdings within an ever-changing market environment, and to reaffirm our rationale for each investment’s long-term value.
Strict Price Discipline
From the earliest days, Dodge & Cox’s investment approach has stressed evaluation of risk relative to opportunity. A strict price discipline — steering clear of popular choices that come at a price premium we would rather not pay — is critical to achieving our investment objectives. Low valuation investments, for example, typically reflect low investor expectations that may serve as a buffer against the risk of significant price decline; these low expectations may also create greater potential for capital appreciation should investor pessimism turn out to be unwarranted or short-lived. At all times, our ongoing search for superior relative value is guided by a rigorous research process that seeks to differentiate the short-term concerns that may be temporarily depressing an investment from the intractable, long-term problems that could doom it.
Period: Q1 2013
Portfolio date: 31 Mar 2013
No. of stocks: 73
Portfolio value: $44,106,297,000
|Stock||% of portfolio||Shares||Recent activity||Reported Price*|
|hist||HPQ - Hewlett-Packard||3.76||69,610,995||$23.84|
|hist||WFC - Wells Fargo||3.68||43,934,841||$36.99|
|hist||COF - Capital One Financial||3.63||29,167,211||Reduce 0.14%||$54.95|
|hist||CMCSA - Comcast Corp.||3.62||38,010,197||Reduce 8.96%||$42.01|
|hist||SNY - Sanofi Aventis||3.23||27,853,029||Reduce 0.54%||$51.08|
|hist||TWX - Time Warner Inc.||3.21||24,592,732||Reduce 0.57%||$57.62|
|hist||NVS - Novartis AG||3.06||18,974,700||$71.24|
|hist||MRK - Merck & Co.||3.02||30,095,800||Reduce 0.33%||$44.23|
|hist||S - Sprint Nextel Corp.||2.98||211,790,639||Add 15.72%||$6.21|
|hist||MSFT - Microsoft Corp.||2.92||44,945,500||Add 15.41%||$28.61|
|hist||GE - General Electric||2.89||55,066,775||Reduce 0.72%||$23.12|
|hist||PFE - Pfizer Inc.||2.76||42,220,364||$28.86|
|hist||GSK - GlaxoSmithKline PLC||2.72||25,621,200||Reduce 0.19%||$46.91|
|hist||RHHVF - Roche Holdings AG||2.46||18,491,600||$58.60|
|hist||GS - Goldman Sachs Group||2.35||7,042,600||$147.15|
|hist||SLB - Schlumberger Ltd.||2.31||13,581,845||Reduce 0.15%||$74.89|
|hist||FDX - FedEx Corp.||2.30||10,320,099||Reduce 0.19%||$98.20|
|hist||BK - Bank of New York||2.20||34,644,224||$27.99|
|hist||NWSA - News Corp.||2.20||31,836,426||Reduce 12.19%||$30.52|
|hist||SCHW - Charles Schwab||2.13||53,202,700||$17.69|
|hist||SYMC - Symantec Corp.||2.11||37,751,300||Add 11.85%||$24.68|
|hist||BAC - Bank of America Corp.||2.10||76,113,300||$12.18|
|hist||TWC - Time Warner Cable Inc.||2.05||9,407,310||Add 13.24%||$96.06|
|hist||BHI - Baker Hughes||1.50||14,220,450||$46.41|
|hist||GOOG - Google Inc.||1.43||791,700||Add 46.15%||$794.03|
|hist||CVX - Chevron Corp.||1.41||5,244,280||Add 52.26%||$118.82|
|hist||WMT - Wal-Mart Stores||1.35||7,958,650||$74.83|
|hist||ADBE - Adobe Systems||1.33||13,491,841||$43.51|
|hist||TEL - TE Connectivity||1.32||13,853,975||$41.93|
|hist||XRX - Xerox Corp.||1.28||65,746,682||$8.60|
|hist||DOW - Dow Chemical||1.25||17,300,289||$31.84|
|hist||OXY - Occidental Petroleum||1.22||6,856,970||Reduce 22.81%||$78.37|
|hist||NTAP - NetApp Inc.||1.14||14,732,000||Add 2.79%||$34.16|
|hist||SNPS - Synopsys Inc.||1.03||12,694,669||$35.88|
|hist||BSX - Boston Scientific||1.01||56,840,400||$7.81|
|hist||CSC - Computer Sciences Corp.||1.00||8,982,762||$49.23|
|hist||CE - Celanese Corp.||0.93||9,280,071||$44.05|
|hist||AEG - Aegon NV||0.87||63,685,517||$6.01|
|hist||VOD - Vodafone Group PLC||0.86||13,363,300||$28.41|
|hist||MET - MetLife Inc.||0.82||9,461,600||$38.02|
|hist||BBT - BB&T Corp.||0.82||11,454,144||$31.39|
|hist||EBAY - eBay Inc.||0.79||6,442,309||Reduce 40.80%||$54.22|
|hist||BMC - BMC Software||0.78||7,402,540||$46.33|
|hist||JPM - JPMorgan Chase & Co.||0.73||6,766,200||Add 17.34%||$47.46|
|hist||STI - SunTrust Banks||0.71||10,942,233||$28.81|
|hist||LINTA - Liberty Media Interactive||0.71||14,690,075||$21.38|
|hist||PHG - Koninklijke Philips Electronics NV||0.65||9,769,121||Reduce 2.79%||$29.55|
|hist||HBC - HSBC Holdings plc||0.64||5,310,329||$53.34|
|hist||VMC - Vulcan Materials||0.64||5,428,787||Reduce 10.20%||$51.70|
|hist||NOK - Nokia Corp.||0.64||86,286,400||Add 40.79%||$3.28|
|hist||GLW - Corning Inc.||0.63||20,903,400||Add 14.09%||$13.33|
|hist||DISH - Dish Network Corp.||0.61||7,123,253||$37.90|
|hist||MXIM - Maxim Integrated Prod||0.60||8,112,911||Reduce 20.75%||$32.65|
|hist||MHP - McGraw-Hill||0.59||4,968,325||Add 21.26%||$52.08|
|hist||MDT - Medtronic Inc.||0.59||5,571,500||$46.96|
|hist||UL - Unilever PLC||0.53||5,573,600||Reduce 0.89%||$42.24|
|hist||GNW - Genworth Financial Inc.||0.50||21,875,157||$10.00|
|hist||MOLXA - Molex Inc. CL A||0.49||8,924,930||$24.12|
|hist||CI - CIGNA Corp.||0.47||3,295,384||Buy||$62.37|
|hist||KMX - CarMax Inc.||0.47||4,960,350||$41.70|
|hist||DOX - Amdocs Ltd.||0.47||5,713,100||$36.25|
|hist||PC - Panasonic Corp.||0.43||25,925,097||$7.33|
|hist||AOL - AOL Inc.||0.41||4,697,054||$38.49|
|hist||CPWR - Compuware Corp.||0.40||14,249,712||Reduce 2.06%||$12.50|
|hist||CDNS - Cadence Design Systems||0.38||11,971,800||$13.93|
|hist||TYC - Tyco International||0.37||5,090,275||$32.00|
|hist||JCP - Penney (J.C.)||0.37||10,933,700||$15.11|
|hist||DELL - Dell Inc.||0.32||9,761,227||Reduce 30.70%||$14.33|
|hist||ADT - ADT Corp.||0.28||2,545,137||$48.94|
|hist||NVR - NVR Inc.||0.22||88,200||$1080.11|
|hist||MOLX - Molex Inc.||0.16||2,364,500||$29.28|
|hist||UFS - Domtar Corp.||0.12||672,149||$77.62|
|hist||PBI - Pitney-Bowes||0.04||1,286,630||$14.86|
* Reported Price is the price of the security on the portfolio date. This value is significant in that it indicates the portfolio manager's confidence in the stock at that price and suggests at least some level of undervaluation and/or margin of safety.
Sector % analysis
Articles & Commentaries
The S&P 500 reached an all-time high during the first quarter of 2013, surpassing its previous peak from 2007. All sectors of the S&P 500 generated positive returns while the Health Care, Consumer Staples, and Utilities sectors (generally considered more “defensive”) had the highest returns. Strong equity returns were influenced by positive U.S. economic news as well as solid corporate profitability. The U.S. economy gained momentum, with increased hiring by private sector firms, strong retail sales, lower unemployment, rising home prices, and continued monetary stimulus by the Federal Reserve. Corporate profits for the fourth quarter beat expectations, and U.S. companies returned record amounts of cash to shareholders via share repurchases and dividends. Amid these positive indicators there were some areas of concern: consumers and corporations were faced with higher taxes and gas prices; the negative effects of sequestration cuts by the U.S. government received a lot of attention; and the banking crisis in Cyprus and inconclusive elections in Italy contributed to continued uncertainty in Europe.
In spite of these economic and political challenges, the long-term outlook for equities remains attractive. Even including the strong stock market rally during the first quarter, valuations are reasonable at 14.0 times forward earnings for the S&P 500, and 12.1 times forward earnings for the Fund’s portfolio. Recognizing that markets could be volatile over the short term, we encourage shareholders to share our long-term investment horizon.
The broad equity market was flat for the fourth quarter, as optimism over the modestly growing U.S. economy was tempered by concerns over the slowing global economy, uncertainty around the outcome of U.S. political negotiations related to the so-called “fiscal cliff,” and mixed third quarter earnings results. Economic statistics revealed a modestly improving economy: existing home sales and consumer confidence reached multi-year highs and the labor market expanded. In addition, low interest rates supported the housing market. However, questions remain about the impact of political negotiations and a global economic slowdown on corporate earnings. Recessionary conditions in Europe and a growth slowdown in China and other emerging economies are of particular concern to multinational companies.
Although companies remain cautious in the near term in light of ongoing uncertainties, we believe the longer-term outlook for corporate earnings is positive. Many companies have improved operationally over the past several years, and technological innovations continue. Corporate profits are poised to grow when economic conditions improve globally. This, combined with reasonable valuation levels, provides the potential foundation for attractive equity returns. We believe the Fund’s holdings are well positioned to benefit from the long-term global growth opportunity. Our strategy is unchanged: we construct a diversified portfolio of investments in companies with strong franchises, long-term growth prospects, and attractive valuations. In 2012, this strategy resulted in strong absolute and relative returns for the Fund.
Name as many of the leading U.S. fund companies as you can off the top of your head. Vanguard, Fidelity, American Funds, PIMCO, T. Rowe Price … did Dodge & Cox spring to mind? Perhaps not; Dodge & Cox is not a household name and has never tried to be. But the company is the 13th-largest mutual fund provider in the U.S., with $120 billion in assets as of the end of September.
U.S. equity markets rebounded strongly in the third quarter of 2012 as investors responded positively to the stimulus announcements by the European Central Bank and the Federal Reserve. Nevertheless, the market environment continues to be volatile due to macroeconomic concerns. Investors remain cautious as uncertainty lingers in the United States around the outcome of the upcoming presidential election and the pending “fiscal cliff,” which may trigger government spending cuts and tax increases. In addition, continuing Eurozone challenges, Middle East tensions, and a slowing Chinese economy are factors dampening investor enthusiasm.
Notwithstanding macroeconomic uncertainties, we believe valuations are attractive. At quarter end, the S&P 500 traded at 13.7 times estimated forward earnings. The earnings power of many companies still appears underappreciated given ongoing balance sheet deleveraging (particularly within the financial sector), low interest rates, and continued corporate earnings progress. Long-term growth in the developing world, which is creating vast new markets for multinational companies to penetrate, is also a positive. We remain optimistic about the long-term outlook for equities.
After a strong first quarter, the S&P 500 fell 2.8% during the second quarter of 2012. Market returns during the quarter were characterized by an increase in volatility, as macroeconomic concerns continued to weigh heavily on investors. Although first quarter estimated GDP growth was revised down to 1.9%, the modest U.S. economic recovery continued. Unemployment declined to 8.2%, inflation and interest rates remained low, consumer credit expanded, and home prices rose. Corporate earnings continue to grow faster than stock prices, which we believe has created compelling valuations for stocks. On June 30, the S&P 500 traded at 13 times forward earnings.
European uncertainty has contributed to investor anxiety regarding economic and political concerns around the world. The growth previously seen in some emerging markets—such as China, India, and Brazil—has slowed. The decline in oil prices has negatively impacted the health of those emerging markets dependent on oil revenues, such as Russia, though it has been a benefit to the U.S. consumer. Political turmoil in the Middle East also continues to feed uncertainty. Closer to home, fear-based investing has caused a “flight” to perceived safety, and the yields on U.S. Treasuries are at all-time lows.
The S&P 500 had a strong first quarter, as investor optimism increased amid encouraging economic signs. Globally, concerns about the European sovereign debt crisis persist but have been ameliorated by recent policy decisions, including a debt restructuring deal for Greece, the European Central Bank’s Long-Term Refinancing Operation (LTRO), and the launch of the European Sovereign Bond Protection Facility. In the United States, the Federal Reserve announced the results of the most recent bank stress tests in March, with the majority of the largest U.S. banks meeting requirements for adequate capital. Unemployment has fallen slightly in 2012 to date. The Federal Reserve also renewed its commitment to keeping interest rates low, putting housing affordability at an all-time high and potentially supporting an improved housing market in 2012. Finally, the outlook for U.S. earnings continues to be positive, balance sheets remain strong, and dividends are rising.
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.
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.
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.
The U.S. equity market rallied during the quarter. News during the period was dominated by persistent political turmoil in North Africa and the Middle East. Oil prices rose more than 15%, with most of the gains occurring during March as investors absorbed the implications of the Middle East unrest. The earthquake and tsunami in Japan caused both short-term and longer-term stresses on the Japanese economy and global growth. In addition, European sovereign debt concerns persisted.
Within the United States, market gains were driven by both consumer confidence and the economic recovery, with strong job growth in March and a gradually declining unemployment rate. The Federal Reserve continued to keep rates low during the quarter to stimulate the economy. At quarter end, the S&P 500 traded at 14.2 times estimated forward earnings, which reflects rather modest investor expectations. Over our long-term investment horizon, we believe that the Fund is well positioned to benefit from global growth, and we encourage our fellow shareholders to take a similar long-term view when investing.
We believe a long-term perspective on investing is especially important during periods like the first half of 2010. Short-term concerns can often deflect attention from longer-term positive developments. After the events of 2008, it is not surprising that many are searching to identify the next “crisis.” In the United States, for example, high unemployment, rising health care costs, and weakness in real estate are real concerns. Past economic recoveries have struggled with similar issues, yet the economic rebound was sustained (the post-1982 and post-1991 recoveries are two examples). The current environment has significant positives: interest rates are at record lows, inflation remains subdued, home prices are stabilizing, and household net worth is rising. While some
economic indicators may lag, the economic recovery can continue. This optimism, combined with what we believe are attractive current valuations, leads us to the view that the long-term prospects for equity investing are favorable.
After a dramatic rally in the equity markets since March 2009 lows (S&P 500 up 58% and the Fund up 76% from March 9 through September 30), some observers are questioning whether investors have become too optimistic, given the current outlook for the domestic economy. We are reminded of the classic expression: “it’s tough to make predictions, especially about the future.” At Dodge & Cox, rather than attempt to forecast near-term economic or market results, we consider the range of potential outcomes for individual companies’ profits and cash flows during the next three to five years. We use this information in selecting the Fund’s investments and are confident that many attractive investment opportunities remain available over our longer-term time horizon.
Opportunity in Health Care - The health care sector of the U.S. economy has been getting significant attention lately, due to the well-publicized movement for government reform in some fashion. In our view, the cloud of uncertainty hanging over the sector is giving us the opportunity to invest in solid business franchises in pharmaceuticals, medical devices, and services at their lowest valuations in decades. Our fundamental research and stock selection process continues to be “bottom-up” oriented, focused on the long-term outlook for and valuation of individual companies. We develop a range of potential outcomes, incorporating downside risk and upside potential, for each company’s profits and cash flow. As we assess the possible impact of U.S. health care reform, we believe current stock prices for many leading companies reflect a fairly pessimistic scenario and may not reflect positive developments. For example, technological innovation will continue to drive advancements in medical products and services. We also believe the developing world is likely to be a source of significant long-term incremental growth, as more resources are dedicated to modern health care.
The first half of 2009 illustrates the importance of persistence for long-term investors. The S&P 500 fell 25% from January 1 through the recent market trough on March 9. During this time, the U.S. government and others around the world pledged fiscal and monetary stimulus. Management at many companies took dramatic actions to reduce costs and inventories in response to rapidly shrinking demand. Some companies even increased productivity in this time period. With capital markets stabilizing and the rate of economic decline moderating, investors began to anticipate the nadir and eventual upturn of the economy. We do not know why the shift in investor sentiment began on March 10, but since then the S&P 500 rose by 37% through June 30. Our investment experience and belief in the favorable long-term prospects of the individual companies in our diversified portfolio lead us to be optimistic and persistent in staying fully invested. Looking back over the last six months, it would be difficult to identify the time to invest by observing daily news reports. Even now, the recent signs of potential improvement (such as increased consumer confidence, increasing auto sales, and increasing new home starts) are balanced by countervailing forces (such as increased unemployment, continued decline in housing prices, and increased foreclosures).
We have found in decades of investing that share prices can change much more in the short term than underlying business fundamentals. In a difficult environment, when companies are under pressure and share prices are down, we often see indiscriminate selling of companies perceived as risky. We believe our investment process gives us the tools to make informed decisions: an independent research team with detailed knowledge of the companies the Fund holds, an eye on long-term value across economic cycles, and the patience to hold on to investments that we believe are sound.
Although we are pleased by the recent strong equity market rally, the economic recession has not yet ended and credit markets remain dependent on Federal Reserve Board and U.S. Treasury Department support programs. However, credit and business cycles invariably run their course and capital markets usually anticipate the eventual recovery well in advance of improving conditions. We remain optimistic about the potential for long-term global economic growth, especially in the developing world, in the years ahead.
As we continually survey the investment landscape with an eye toward a meaningful economic rebound over the next few years, our bottom-up research approach has led us to invest in many companies in Health Care, Information Technology, and Media, where the Fund is overweight compared to the S&P 500. These areas represented more than 60% of the Fund’s portfolio as of June 30 and include industry leaders Hewlett-Packard, Sony, Comcast, Time Warner, GlaxoSmithKline, Merck, Amgen, and WellPoint. In addition, the Fund holds a number of midsize competitors such as Citrix Systems, Maxim Integrated Products, Interpublic Group, Liberty Media, and Boston Scientific. In other cases, where our analysis indicates that the risks outweigh the potential returns, the Fund has sold positions. Sales in the second quarter included Citigroup and American International Group (AIG).
We are devoting resources to understanding the possible investment implications of the health care reform initiatives being proposed by President Obama’s administration and Congress. In our opinion, historically low valuations in the Fund’s pharmaceutical and managed-care companies reflect these potential risks. At the same time, we see significant long-term growth opportunities for these companies as technological innovation continues in the developing world and penetration of health care products and services increases over time.
Dodge & Cox’s experienced team of investment professionals is working hard to take advantage of what we believe are attractive opportunities being created during this period of economic stress. Although it is impossible to predict the short-term direction of stock prices, decades of experience have taught us that persistence in the face of significant market dislocations can potentially be rewarding for patient investors with long-term investment horizons. For further review of the Fund’s performance and long-term investment strategy, please visit www.dodgeandcox.com and download the Fund’s Semi-Annual Report, which will be available in August.
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.