Dodge & Cox Stock Fund 4th-Quarter 2019 Commentary

The Dodge & Cox Stock Fund had a total return of 10.1% for the fourth quarter of 2019, compared to 9.1% for the S&P 500 Index. For 2019, the Fund had a total return of 24.8%, compared to 31.5% for the S&P 500.

Investment Commentary

The U.S. equity market’s performance in 2019 was exceptional: the S&P 500 registered its strongest annual return (up 31%) since 2013 and reached an all-time high. Every sector of the S&P 500 posted positive, double-digit returns. Information Technology surged 50% and was the best-performing sector of the S&P 500, while Energy (up 12%) was the worst-performing sector.

Since 1926, the relative performance of growth and value stocks2 has seesawed, but value strategies have nearly always outperformed growth over intervals of a decade or more. In fact, there have only been three times when value has underperformed over a ten-year period in the United States: the Great Depression (1929-1939/40), the Internet Bubble (1989-1999), and most recently. The Russell 1000 Value Index has underperformed the Russell 1000 Growth Index by an average of 3.4 percentage points3 per year over the last 10 years. As a result, the valuation differential between value and growth stocks remains wide by historical standards: the Russell 1000 Value trades at 16.0 times forward earnings compared to a lofty 23.9 times for the Russell 1000 Growth.4

While the value-versus-growth dynamic captures much of what has driven wide valuation disparities, interest rates tell an even more powerful story. In the United States, the group of companies that benefits from low interest rates is trading at an 80% premium to the group of companies that is harmed by low interest rates (performs better in a rising interest rate environment). And that spread is almost three standard deviations wide on a 24-year span of time.

Historically, these two groups of stocks have traded roughly in the same valuation range. Post 2010, however, the two groups’ valuations diverged as investors sought “bond substitutes”—mainly in the Utilities, Real Estate, and Consumer Staples sectors—with higher dividend yields in a lower interest rate environment. The Fund holds no utilities or real estate companies and has only one consumer staples holding because we believe company valuations in these sectors are inflated.

Conversely, companies that benefit from rising rates—Financials, Energy, and some Industrials—are almost all categorized as value stocks and are now selling at extraordinary discounts relative to the market. As a value-oriented investor, we continue to identify investment opportunities, and the portfolio remains overweight Financials (25.8% of the portfolio versus 13.0% of the S&P 500) and Energy (9.9% versus 4.3%).

During 2019, we leaned further into Energy as valuations became more attractive. Energy companies have suffered from lower and more volatile oil prices, which reduced cash flows at many companies and made it more difficult to invest in new projects. There are also long-term concerns about oil and gas demand as the threat of climate change necessitates a transition to less carbon-intensive alternatives. However, we believe the valuations of the Fund’s energy holdings provide an attractive starting point and more than compensate for these risks. For example, we recently initiated a position in Hess, an independent oil and gas exploration and production company, that is investing its strong cash flows from existing assets into a new project with significant economic potential in Guyana.5 The Guyana oil discovery is one of the largest in recent decades. Higher incremental returns from this investment should result in attractive free cash flow growth over the next several years.

Overall, we remain optimistic about the long-term outlook for the Fund, which trades at a meaningful discount to the overall market: 13.5 times forward earnings compared to 18.9 times for the S&P 500. Patience, persistence, and a long-term investment horizon are essential to long-term investment success. We encourage our shareholders to take a similar view. Thank you for your continued confidence in Dodge & Cox.

Fourth Quarter Performance Review

The Fund outperformed the S&P 500 by 1.0 percentage points during the quarter.

Key Contributors to Relative Results

• The Fund benefited from an overweight position and higher returns in the Health Care sector (holdings up 18% compared to up 14% for the S&P 500 sector). Top contributors were Cigna (CI, Financial), Bristol-Myers Squibb (BMY, Financial), and UnitedHealth Group (UNH, Financial).
• The Financials sector was strong for both the Fund and the Index (up 12% and up 10%, respectively); the Fund’s overweight position (average 26%, roughly double the Index weight) helped. Top contributors were Bank of America (BAC, Financial) and Charles Schwab (SCHW, Financial).
• Results were helped by the Fund’s low exposure to the three weakest sectors of the Index, with no holdings in Real Estate or Utilities and an underweight position in Consumer Staples.
• Charter Communications (CHTR, Financial) and Halliburton (HAL, Financial) were also significant contributors.

Key Detractors from Relative Results

• The most significant detractor was stock selection in Information Technology, one of the strongest sectors of the Index (up 7% compared to up 14% for the S&P 500 sector). Underperformance was due to not owning a few of the large, standout performers that boosted S&P 500 returns (mainly Apple); and, to a lesser extent, weak returns from holdings, including Dell Technologies (DELL, Financial).
• Other detractors included Occidental Petroleum (OXY, Financial), Johnson Controls International (JCI, Financial), Comcast (CMCSA, Financial), and FedEx (FDX), and poor performance by small holdings, Qurate (QRTEA) Retail and Sprint (S).

2019 Performance Review

The Fund underperformed the S&P 500 by 6.7 percentage points in 2019.

Key Detractors from Relative Results

• The return for the S&P 500 was led by Information Technology, which rose 50% in 2019. The Fund’s holdings, while up 27%, trailed significantly. The main driver was not owning a few of the large, exceptional performers that boosted the S&P 500 sector, especially Apple (AAPL). Weak performance from holdings, including HP Inc. (HPQ) and Juniper Networks (JNPR), was also a factor.
• The Fund was overweight (average 10% versus 5%) and underperformed in the Energy sector (up 9% compared to up 12% for the S&P 500 sector), which was the weakest sector of the Index by a considerable margin. Occidental Petroleum and Apache (APA) were the main detractors.
• The Fund’s relative returns in the Consumer Discretionary sector lagged substantially (down 6% versus up 28% for the S&P 500 sector), due to poor performance by Qurate Retail and Gap, Inc. (GPS).
• Other key detractors included FedEx, Bank of New York Mellon (BK), Cigna, and Sanofi (SNY).

Key Contributors to Relative Results

• In the Media industry, the Fund was overweight (average 9% versus 1%) and outperformed (holdings up 45% compared to up 36% for the S&P 500 industry). Charter Communications and Comcast were key positives.
• Other contributors included Anadarko Petroleum (APC), Microchip Technology (MCHP), and Bank of America, and not owning Pfizer (PFE), Berkshire Hathaway (BRK.A)(BRK.B), and Exxon Mobil (XOM).

1. The Fund’s total returns include the reinvestment of dividend and capital gain distributions, but have not been adjusted for any income taxes payable by shareholders on these distributions or on Fund share redemptions. Index returns include dividends but, unlike Fund returns, do not reflect fees or expenses. The S&P 500 Index is a market capitalization-weighted index of 500 large-capitalization stocks commonly used to represent the U.S. equity market.
2. Value stocks are the lower valuation portion of the equity market, and growth stocks are the higher valuation portion.
3. The Russell 1000 Growth Index had a total return of 312.3% from December 31, 2009 through December 31, 2019 compared to 204.9% for the Russell 1000 Value.
4. Unless otherwise specified, all weightings and characteristics are as of December 31, 2019.
5. Hess is a 30% partner with Exxon Mobile in the Stabroek block in Guyana

Returns represent past performance and do not guarantee future results. Investment return and share price will fluctuate with market conditions, and investors may have a gain or loss when shares are sold. Fund performance changes over time and currently may be significantly lower than stated above. Performance is updated and published monthly. Visit the Fund’s website at dodgeandcox.com or call 800-621-3979 for current month-end performance figures.