Dodge & Cox First Quarter Shareholder Letter
The Dodge & Cox Stock Fund had a total return of 6.7% for the first quarter of 2010, compared to a total return of 5.4% for the Standard & Poor's 500 Index (S&P 500). Please refer to page three for longer-term performance results. At quarter end, the Fund had net assets of $42.7 billion with a cash position of 1.6%.
Our investment approach remains focused on the long-term fundamental outlook and current valuation for each company in the Fund's diversified portfolio. The Fund's portfolio turnover has been correspondingly low (less than 20% during the past year) and reflects our view that we are in effect a part owner of each company on your behalf.
The global analysts on our research team make considerable effort to understand both the opportunities and risks for a company in relation to its valuation. We evaluate the key external and internal factors (for example, competitive position and financial strength) that will contribute to a range of potential sales, earnings, and cash flow outcomes over the next three to five years for each company. Regulatory change provides an example of one of the external variables that requires our attention over time. Health Care and Financials are two sectors where regulatory reform may dramatically change future profitability.
HEALTH CARE REFORM LAW PASSED
While the general terms of the U.S. health care reform law are known, the law will require significant interpretation as it is implemented over the next several years. One clear result of the law is that the U.S. government will be more involved in paying for health care. We have written about the reform efforts before, and have factored the major provisions of the law into our analysis of the 20.6% of the Fund invested in Health Care companies at quarter end. The Fund has exposure to Health Care via investments in pharmaceuticals (15.0%), medical supplies and devices (3.0%), and health service companies (2.6%).
We estimate that provisions in the law will reduce earnings at pharmaceutical companies over the next several years. Longer term, the benefit of greater volumes should help offset the costs of the law for pharmaceutical companies, as the legislation should ultimately increase the population covered by insurance. In addition, we believe that companies will respond to this earnings pressure by cutting costs, offering new products, and expanding into overseas markets.
Pharmaceutical stocks' valuations are low due to legitimate concerns about patent expiry and past pipeline disappointments, as well as regulatory reforms. Two of the largest pharmaceutical companies globally, Novartis1 and Merck, are among the ten largest holdings in the Fund. With price-to-earnings (P/E) multiples of 10 to 11 times forward earnings and dividend yields approximating 4%, they illustrate the low expectations for pharmaceutical companies. We believe that these companies, as well as the Fund's other pharmaceutical holdings, can increase earnings by reducing expenses, even with little or no sales growth. There is also the prospect that sales growth improves as these companies make significant investments in research and development. Finally, rapid growth in the emerging markets is becoming an increasingly important driver of future returns. Given our assessment of the risks and opportunities, we find the valuations in the pharmaceutical industry compelling.
In other areas of health care, valuations are also low, but prospects are mixed. In the medical device industry, Fund holdings such as Boston Scientific and Medtronic will face a modest excise tax. However, in the managed care industry, the new law will constrain both profitability and flexibility.
FINANCIAL SERVICES REFORM DEBATE CONTINUES
In the aftermath of the 2008–2009 financial crisis, regulatory reform in U.S. and global financial services seems likely. Efforts by Congress have been underway for nearly a year and we are closely monitoring developments to understand their potential impact on the future growth and profitability of financial companies, especially banks. Among the most significant proposals being discussed, companies may be required to hold more capital, particularly when engaged in riskier lending activities, and to contribute to a bank failure fund. However, we believe that valuations remain attractive for selected franchises such as Wells Fargo, Capital One Financial, and Bank of New York Mellon.
Looking forward several years, we anticipate that the current cycle of higher-than-normal credit losses and unusually low short-term interest rates could begin to moderate. Lower credit losses would benefit Fund holdings such as lenders Wells Fargo and Capital One. Higher short-term rates could benefit money market providers, including holdings Charles Schwab and Bank of New York Mellon, which are currently waiving a portion of their management fees. At quarter end, 14.8% of the Fund was invested in Financials, slightly less than the S&P 500 weighting.
Equity returns can be volatile, as demonstrated by the dramatic swings in market performance over the past couple years. For those with short-term cash needs, investing in the Fund or other equity investments may not be prudent. The role of equities in your portfolio is to seek a real return over the long term to counteract the purchasing power erosion caused by inflation. In the face of inevitable market volatility and the occasional market panic, maintaining this long-term perspective is essential.
For each security in the Fund, we are seeking to invest when our outlook for potential earnings and business franchise value are not reflected in the current valuation. Given the still reasonable level of valuations today and the long-term prospects for economic growth in the U.S. and around the world, the potential for equity returns is attractive.
Thank you for the continued confidence you have placed in our firm. As always, we welcome your comments and questions. For the Board of Trustees, John A. Gunn, Chairman Kenneth E. Olivier, President May 6,
2010 FIRST QUARTER PERFORMANCE REVIEW
The Fund outperformed the S&P 500 by 1.3 percentage points during the quarter.
Key Contributors to Relative Results
Relative returns from holdings in the Consumer Discretionary sector (up 15% versus up 10% for the S&P 500 sector), combined with a higher average weighting in the sector (18% versus 10%), contributed to results. Liberty Interactive (LINTA) (up 41%), Sony (SNE) (up 32%), and Time Warner Cable (TWC) (up 30%) helped.
▪ Relative returns from holdings in the Information Technology sector (up 4% versus up 2% for the S&P 500 sector) had a positive effect. Xerox (XRX) (up 16%), eBay (EBAY) (up 15%), and Citrix Systems (CTXS) (up 14%) were strong performers.
▪ Additional contributors included General Electric (GE) (up 21%), Wells Fargo (WFC) (up 16%), Baker Hughes (BHI) (up 16%), and FedEx (FDX) (up 12%).
Key Detractors from Relative Results
▪ Weak returns from holdings in the Health Care sector (flat versus up 3% for the S&P 500 sector), in combination with a higher average weighting (22% versus 13% for the S&P 500 sector), detracted from performance. Boston Scientific (BSX) (down 20%), GlaxoSmithKline (GSK) (down 7%), and Pfizer (PFE) (down 5%) were notably weak.
▪ Additional detractors included Cemex (CX) (down 14%), Motorola (MMI) (down 10%), HSBC (HBC) (down 10%), and Computer Sciences Corp. (CSC) (down 5%).
We use these examples to illustrate our investment process, not to imply that we think these are more attractive than the Fund's other holdings.