PRIMECAP Odyssey Funds Letter to Shareholders, Discusses Health Care, IT
For the fiscal year ended October 31, 2011, the PRIMECAP Odyssey Stock Fund, PRIMECAP Odyssey Growth Fund, and PRIMECAP Odyssey Aggressive Growth Fund produced total returns of +7.05%, +5.13%, and +8.50%, respectively. By comparison, the unmanaged Standard & Poor’s 500 Index (S&P 500) produced a total return of +8.09% for the period.
The PRIMECAP Odyssey Growth Fund and the PRIMECAP Odyssey Aggressive Growth Fund will each distribute capital gains in December 2011, primarily related to several stocks held in the funds which were purchased at substantial premiums by acquiring companies during the fiscal year. As long-term investors, we hold most of our positions for years, not months. However, acquisitions and other corporate actions will, from time to time, generate realized capital gains that result in distributions. Despite these distributions, we want to assure the Funds’ shareholders that we are always mindful of the tax consequences of our investment decisions.
Led by energy, materials, and industrial stocks, the S&P 500 gained more than 15% in the first half of the fiscal year. However, by mid-year, confidence in the economic recovery began to falter, and concerns regarding the European sovereign debt crisis and its potential ramifications for the global financial system weighed on financial markets. In response, the S&P 500 declined each month from May through September, more than reversing the gains achieved in the first half of the fiscal year, but finished with positive gains due to a strong rally in October.
The U.S. economy’s recovery from the recession has slowed, as evidenced by moderating growth in GDP and declining consumer confidence. Unemployment remains stubbornly high, and the housing market has failed to show any meaningful improvement. The ongoing debt crisis in Europe has increased volatility in equity markets as investors fear potential contagion to the global financial system. Despite these unsettling developments, industrial production continues to grow and corporations are generating profit margins and returns on capital well above historical averages.
The PRIMECAP Odyssey Funds remain focused on investing in companies that, in our judgment, offer better growth prospects than are currently anticipated by the market. This process often leads us to invest more heavily in some sectors of the market than others. We continue to be overweight in the health care and information technology sectors and underweight in the financials, consumer staples, and energy sectors in each of the three PRIMECAP Odyssey Funds.
During the past fiscal year, a large commitment to the health care sector helped relative returns in the PRIMECAP Odyssey Stock Fund and the PRIMECAP Odyssey Aggressive Growth Fund. In the PRIMECAP Odyssey Growth Fund, stock selection in the health care sector led to more mixed results. We built considerable positions in pharmaceutical, biotechnology, and medical device companies based on our view that these companies are in the process of developing innovative new drugs and other products that represent real advances in the treatments for diseases such as diabetes, cancer, and neurological disorders. As data regarding the efficacy and safety of these new products emerged, several stocks in the portfolios experienced dramatic price changes which significantly impacted the funds’ results, both favorably and unfavorably.
Each of the PRIMECAP Odyssey Funds benefited from its minimal position in the financials sector, which was the only sector in the S&P 500 with negative returns for the fiscal year. An underweight position in the energy sector and poor stock selection in the industrials sector hurt the funds’ results.
A more detailed discussion of the results for each of the PRIMECAP Odyssey Funds follows.
PRIMECAP Odyssey Stock Fund
From November 1, 2010 to October 31, 2011, the Stock Fund returned +7.05%, which trailed the S&P 500’s total return of +8.09%. On a relative basis, our underweight position and poor stock selection in the energy sector and poor stock selection in the industrials sector hurt the fund’s returns. This was partially offset by our underweight position in the financials sector and our overweight position and positive stock selection in the health care sector.
Research in Motion (RIMM) (-64.5%), Southwest Airlines (LUV) (-37.8%), and Whirlpool (WHR) (-31.3%) were among the biggest decliners. Research in Motion suffered from concerns over its loss of market share in U.S. smartphones and delays in the development of its next generation operating system. However, we believe there is significant value in the stock at current levels, given the recurring nature of its service revenues and its strong position in rapidly growing markets in Latin America and Asia. Southwest Airlines, along with other airlines, faced higher fuel costs. Yet Southwest has continued to expand its market share while maintaining its position as the leading low cost airline. Whirlpool experienced lower demand for its appliances due to the continued weakness in the housing market, resulting in a decline in earnings.
On the positive side, several of the fund’s largest holdings in the health care sector helped the fund’s relative returns including Biogen Idec (+85.6%), GlaxoSmithKline (+19.4%), and Roche Holding AG (+18.7%). Biogen Idec reported favorable results from studies of its new oral drug to treat multiple sclerosis, while Roche received regulatory approval for drugs to treat melanoma and lung cancer.
Other top contributors included Range Resources (BIIB) (+84.7%), Electronic Arts (EA) (+47.5%), KLA-Tencor (KLAC) (+35.4%), and Marsh & McLennan (MMC) (+26.3%).
PRIMECAP Odyssey Growth Fund
From November 1, 2010 to October 31, 2011, the Growth Fund’s total return was +5.13%, which trailed the S&P 500’s total return of +8.09% and the Russell 1000 Growth Index’s total return of +9.92%. The fund’s disappointing relative returns were driven mainly by poor stock selection in the industrials sector, including two airlines, AMR (-66.7%) and Southwest Airlines (-37.8%).
The fund’s considerable holdings in the health care sector had mixed results. Several health care stocks were among the largest detractors from the fund’s returns, including Dendreon (DNDN) (-70.0%), Nektar Therapeutics (NKTR) (-62.8%), and Accuray (ARAY) (-39.2%). Dendreon declined after the company lowered sales expectations for Provenge, its treatment for prostate cancer. Despite positive clinical results for Provenge, sales have been disappointing due to the complexity of the treatment regimen.
These negative results were mostly offset by strong gains in four health care stocks, which were among were the fund’s top 10 holdings: Biogen Idec (+85.6%), Cepheid (+70.5%), ImmunoGen (+65.2%), and Seattle Genetics (+34.1%). Cepheid (CPHD), a leading manufacturer of molecular diagnostic tools, has experienced strong growth in the sales of its GeneXpert™ system, which helps hospitals detect bacteria responsible for serious infections with greater accuracy, ease of use, and
speed. ImmunoGen and Seattle Genetics are two leading developers of antibody drug conjugates. ImmunoGen released positive data regarding its candidate drug to treat breast cancer while Seattle Genetics received regulatory approval for its drug to treat Hodgkin’s lymphoma. We are excited about the potential of using antibody drug conjugates because they deliver chemotherapy directly to the cancerous cells, providing greater efficacy than conventional treatments with fewer side effects. Other top contributors included Nuance Communications (+68.6%) and Electronic Arts (+47.5%). The fund’s minimal holding in the financials sector contributed positively to relative returns.
The fund’s top 10 holdings, which collectively represented 33.0% of the portfolio at October 31, 2011, are listed below:
PRIMECAP Odyssey Aggressive Growth Fund
From November 1, 2010 to October 31, 2011, the Aggressive Growth Fund’s total return was +8.50%, ahead of the S&P 500’s total return of +8.09% but behind the Russell Midcap Growth Index’s total return of +10.08%. Positive stock selection in the health care sector and the fund’s underweight position in the financials sector helped results. This was offset by poor stock selection in the industrials and consumer discretionary sectors.
Several of the fund’s holdings in the health care sector were major contributors to the fund’s results: OraSure Technologies (+128.3%), Pharmacyclics (+115.2%), Biogen Idec (+85.6%), Cepheid (+70.5%), ImmunoGen (+65.2%), and Seattle Genetics (+34.1%). OraSure Technologies, a manufacturer of oral fluid diagnostic products, made important progress in the clinical development of its rapid blood test for hepatitis C and for its over-the-counter HIV test. Pharmacyclics reported favorable results from novel oral drug candidates for the treatment of cancer and immune-mediated diseases.
Other top contributors included Cabot Oil & Gas (+168.9%), Smart Balance (+84.0%), and Electronic Arts (+47.5%).
Although our selections in the health care sector made a net positive contribution to returns for the fiscal year, certain health care stocks were among the largest detractors from the fund’s results, including Dendreon (-70.0%), Nektar Therapeutics (-62.8%), and Accuray (-39.2%). AMR (-66.7%), Research in Motion (-64.5%), and DreamWorks Animation (-47.5%) were among the other large detractors.
The fund’s top 10 holdings, which collectively represented 33.5% of the portfolio at October 31, 2011, are listed below:
As we enter fiscal 2012, U.S. equities look attractive in our judgment. In the sectors that the PRIMECAP Odyssey Funds have the greatest weightings, notably health care and information technology, we find valuations particularly compelling.
Over the last decade, the greatest returns among U.S. stocks were concentrated in the energy and materials sectors. Driven by rapidly growing demand from China, India, Brazil, and other emerging economies, prices for commodities such as oil, copper, and corn have soared. This led to expanded profit margins and rapid earnings growth at companies in these sectors and resulted in high valuation multiples for their stocks. In our opinion, and contrary to conventional wisdom, this trend is unsustainable. Conversely, the information technology and health care sectors have endured a decade of valuation compression as investors questioned the long-term growth prospects and earnings potential of companies in these sectors. As we have previously discussed, in our view, the fundamental outlook for many holdings in the information technology and health care sectors is promising. Also, we feel the investment case for many of these stocks is further supported by compelling valuations and very strong balance sheets.
Over the history of the PRIMECAP Odyssey Funds, we have tended to find the greatest opportunities in downtrodden stocks and sectors in which others have often perceived the greatest risks. Similarly, we have frequently found the risks to be greatest in stocks and sectors that have been viewed most favorably by the consensus. We believe this approach has been instrumental to the results of the PRIMECAP Odyssey Funds since their inception.
PRIMECAP Management Company
November 15, 2011
Note: On November 29, 2011, AMR Corporation filed for Chapter 11 bankruptcy after failing to negotiate new labor contracts with its employees’ unions.
Past performance is not a guarantee of future results. The funds invest in smaller companies, which involve additional risks such as limited liquidity and greater volatility. All funds may invest in foreign securities, which involves greater volatility and political, economic and currency risks and differences in accounting methods. Mutual fund investing involves risk, and loss of principal is possible. Growth stocks typically are more volatile than value stocks; however, value stocks have a lower expected growth rate in earnings and sales. Please refer to the Schedule of Investments for details of fund holdings. Fund holdings and sector allocations are subject to change at any time and are not recommendations to buy or sell any security.
The S&P 500 Index is a broad based index of 500 stocks, which is widely recognized as representative of the market in general. The Russell 1000 Growth Index is an index that measures the performance of those Russell 1000 companies with higher price-to-book ratios and higher forecasted growth values. The Russell Midcap Growth Index measures the performance of those Russell Midcap companies with higher price-to-book ratios and higher forecasted growth values. You cannot invest directly in an index.
Any tax information provided is merely a summary of our understanding and interpretation of some of the current income tax regulations and is not exhaustive. Investors must consult their tax advisor for advice and information concerning their particular situation. Neither the funds nor their representatives may give tax advice.
Earnings growth is an indicator for measuring a company’s success and can be the driving force behind stock price appreciation.
The information provided herein represents the opinions of PRIMECAP Management Company and is not intended to be a forecast of future events, a guarantee of future results, or investment advice.