Dodge & Cox 2Q Letter - Comments Financials, Tech
The Dodge & Cox Stock Fund had a total return of 6.3% for the six months ended June 30, 2011, compared to 6.0% for the S&P 500 Index. On June 30, the Fund had net assets of $43.8 billion with a cash position of 1.0%.
The S&P 500 rose 6% during the first half of the year. Despite this reasonable gain, there were several ongoing concerns weighing upon investors. The U.S. housing market continued its slump, with the Case-Shiller Index reporting that home prices hit a new low in March. Energy prices spiked during the first part of the year due to widespread unrest in the Middle East, but then moderated. European sovereign debt concerns escalated again with the potential default by Greece and the implications for difficulties throughout the European Union. Finally, the effects of the March 11 Japanese earthquake and tsunami continued to impact supply chains around the world. We acknowledge these short-term concerns, yet are encouraged by the robust health of corporate balance sheets and continuing growth in corporate earnings. We find equity valuations to be attractive: on June 30, the Fund was trading at 11 times estimated forward earnings (compared to the S&P 500 trading at 14 times), which is an advantageous starting point for future returns. The Fund is well positioned for long-term investors with the patience to endure short-term volatility.
While we analyze how economic conditions and current events can impact specific industries and companies, macroeconomic forecasts are not the primary consideration in our decision-making process. The Fund's holdings are a result of our bottom-up fundamental research, which evaluates individual companies and their long-term prospects in relation to valuation. Information Technology and Financials are two areas of the Fund that have underperformed the overall market in the first half of 2011. We continue to re-assess the valuations, long-term opportunities, and risks for each company in the portfolio, and the Fund continues to have significant exposure to both sectors. We are invested in well-capitalized business franchises with attractive valuations in both areas, and we believe they have the potential to make positive contributions to the Fund's performance over the next three to five years.
Technology: Durable Franchises
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) (HPQ) and Microsoft (MSFT) 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.
Financials: Low Valuations
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 (COF), 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 (WFC) 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.
While the Fund's relative performance has improved over the past 12 months, the Fund has underperformed the S&P 500 for the three- and five-year periods ending June 30. Much of this underperformance is attributable to steep declines in several of the Fund's Financials holdings during the 2008–09 credit crisis. The Fund's relative performance has fluctuated over shorter time periods and there have been previous periods of underperformance. Our ability to stay the course with our convictions is a key factor behind our strong 10- and 20-year results. Every member of our team is a shareholder of the Dodge & Cox Funds, and we encourage our fellow shareholders to share our long-term perspective when investing. Our optimism about the Fund's potential to outperform is based on our knowledge that the holdings in the Fund have been selected using our bottom-up investment philosophy with emphasis on individual company analysis and price discipline. These elements have served us well over the firm's 80-year history. Thank you for your continued confidence in our firm. As always, we welcome your comments and questions. For the Board of Trustees,