The Dodge & Cox Stock Fund had a total return of 10.7% for the fourth quarter of 2016, compared to 3.8% for the S&P 500 Index. For 2016, the Fund had a total return of 21.3%, compared to 12.0% for the S&P 500.
Investment Commentary
2016 has been an extraordinary year. We would like to express sincere appreciation to our fellow shareholders for your patience and confidence in Dodge & Cox. The Fund’s strong performance in 2016, in both absolute and relative terms, was achieved with largely the same portfolio that produced weak results in 2015. In some cases, we leaned even further into areas of investor pessimism as valuations declined. Many of the biggest contributors in 2016 were the largest detractors in 2015. The longer-term results for the Fund have improved significantly with this year’s strong performance rebound.
During 2015, value stocks underperformed growth stocks in the United States by one of the widest margins since the global financial crisis. The trend reversed in 2016 as U.S. value stocks outperformed growth stocks by ten percentage points, 2 benefiting the Fund’s value-oriented portfolio. The more economically sensitive, cyclical sectors of the market (e.g., Energy, Financials) account for a larger portion of the value category than stocks in the more defensive, stable sectors (e.g., Consumer Staples, Telecommunication Services, Utilities). Each group’s equity returns have been highly correlated with interest rate movements. As interest rates declined to historically low levels and investors searched for yield in the equity market, defensive stocks with “bond- like” characteristics outperformed the more cyclical stocks. Conversely, as U.S. Treasury yields rose during the second half of 2016, especially after the U.S. election, economically sensitive holdings outperformed considerably. The Fund’s performance in 2016 mirrored this shift: up 1% in the first half and up 20% in the second half.
Performance results over the past few years reaffirm that a single quarter or year is too short an interval over which to judge the success of our strategy. Our bottom-up, value-oriented, active investment approach requires independent thinking to build the level of conviction required to invest in companies that are out of favor and the persistence to stick with those convictions in the face of market volatility. It often takes time for a company’s operations to improve and to be recognized by the market. Accordingly, maintaining a long-term investment horizon and staying the course are essential for our investment team, as well as for our fellow shareholders.
Looking forward, we believe the Fund is well positioned for global growth and rising U.S. interest rates, which will likely continue to create differentiation within the equity market. While valuations have increased, we remain optimistic about the long-term outlook for the portfolio, which trades at a discount: 14.7 times forward earnings compared to 18.8 times for the S&P 500. The valuation disparities that characterize the current market offer significant opportunities for active management.
Fourth Quarter Performance Review
The Fund outperformed the S&P 500 by 6.9 percentage points during the quarter.
Key Contributors to Relative Results
The Financials sector was the strongest in the S&P 500, outpacing the other ten sectors by a large margin. The Fund’s significant overweight position in Financials (30% versus 14%) and stronger holdings (up 29% compared to up 21% for the S&P 500 sector) contributed significantly to relative results during the quarter. Goldman Sachs (up 49%) and Bank of America (up 42%) performed particularly well.
The Fund’s holdings in the Consumer Discretionary sector (up 9% compared to up 2% for the S&P 500 sector) augmented returns, especially Time Warner, Inc. (up 22%).
The Fund’s average underweight position in the Consumer Staples sector (2% versus 10%) and lack of holdings in the Utilities and Real Estate sectors (both average 3% in the S&P 500), all weak areas of the market, also aided relative performance.
Key Detractors From Relative Results
The Fund’s average overweight position (10%, almost twice that of the S&P 500 sector) and holdings in the Pharmaceuticals industry (down 5% compared to down 3%) detracted from results. AstraZeneca (AZN, Financial) (down 17%), Roche (down 8%), and Novartis (NOV, Financial) (down 8%) lagged.
2016 Performance Review
The Fund outperformed the S&P 500 by 9.3 percentage points in 2016.
Key Contributors to Relative Results
Returns from holdings in the Consumer Discretionary sector (up 26% compared to up 6% for the S&P 500 sector) helped results. Time Warner Inc. (TWC, Financial) (up 52%), which agreed to be acquired by AT&T (T, Financial), was particularly strong. Time Warner Cable (up 13% to date of merger) and Charter Communications (up 24% from date of merger) merged during the year and performed well.
The Fund’s holdings in the Information Technology sector (up 25% compared to up 14% for the S&P 500 sector) aided performance. Hewlett Packard Enterprise (HPE, Financial) (up 54%) and HP Inc. (HPQ, Financial) (up 30%) were key contributors.
The Fund’s significant overweight position (27% versus 13%) in the Financials sector (up 22%, in line with the S&P 500 sector) added to relative results. Notable contributors included Goldman Sachs (GS, Financial) (up 35%) and Bank of America (BAC, Financial) (up 33%).
Following a weak 2015, Sprint (up 133%) was a standout performer.
Key Detractors From Relative Results
The Health Care sector (down 2% for the S&P 500) faced headwinds during the year and lagged the overall market. Selected Fund holdings were weak, including Express Scripts (down 21%), Roche (down 15%), and Novartis (down 13%).
Wells Fargo (up only 5%), a large position in the Fund, detracted from performance and was weak among bank stocks due to regulatory infractions and fines.
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. The Russell 1000 Value Index outperformed the Russell 1000 Growth Index by 10.3 percentage points during 2016. Generally, stocks that have lower valuations are considered “value” stocks, while those with higher valuations are considered “growth” stocks.
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