TO OUR SHAREHOLDERS
The Dodge & Cox Stock Fund had a total return of 21.3% for the year ended December 31, 2016, compared to a return of 12.0% for the S&P 500 Index.
AN EXTRAORDINARY YEAR
The Fund’s strong absolute and relative performance in 2016 was achieved with largely the same portfolio that produced weak results in 2015. Many of the biggest contributors in 2016 were the largest detractors in 2015. The past year’s performance also improved the Fund’s longer-term relative results. The Fund’s annualized total return for the past five years was 17.0% versus 14.7% for the S&P 500.
We would like to express sincere appreciation to our fellow shareholders for your patience and confidence in Dodge & Cox. These results serve as a reminder 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 essential to invest in companies that are out of favor. Stock prices can move dramatically in response to the headlines of the day, but it often takes time for a company’s results to improve and for positive change to be recognized by other investors. Accordingly, maintaining a long-term investment horizon and staying the course when markets move against us are essential for our investment team, as well as for our fellow shareholders. We would be the first to acknowledge this is not easy to do, but our persistence to stick with our convictions in the face of market volatility was rewarded during this past year.
For the past 20 years, the Fund’s average annualized total return was 10.0% versus 7.7% for the S&P 500. This period encompassed large swings in Fund performance, market prices, and equity valuations, including the technology stock bubble and crash as well as the 2008-09 global financial crisis and subsequent recovery. More recently, investor concerns have been around global economic growth, lower commodity prices, and the U.S. presidential election. Uncertainty is a constant, but it can create compelling opportunities for patient, long-term, value-oriented, active investors. Our recent insight paper, “Understanding the Case for Active Management,” is summarized at the end of this letter and is available in its entirety on our website.
MARKET COMMENTARY
In 2016, global equity markets were volatile amid macroeconomic and geopolitical concerns. The U.S. equity market was one of the stronger developed markets and appreciated significantly: the S&P 500 reached an all-time high in mid-December and was up 12% for the year.
During 2015, value stocks underperformed growth stocks in the United States by one of the widest margins since the global financial crisis. This trend reversed in 2016, as U.S. value stocks outperformed growth stocks by ten percentage points,a benefiting many of the Fund’s value-oriented holdings. Recently, the more economically sensitive sectors of the market that are likely to benefit from an improving economy and higher interest rates (e.g., Energy, Financials) have accounted for a larger portion of the value category than stocks in the more defensive, stable sectors (e.g., Consumer Staples, Real Estate, Telecommunication Services, Utilities).
Equity returns for these two broad groups—more economically sensitive and more defensive sectors—have been highly correlated with interest rate movements in recent years. As interest rates declined to historically low levels and investors searched for yield in the equity market, defensive stocks with “bond-like” characteristics outperformed more cyclical stocks. In the first half of 2016, the best-performing sectors of the S&P 500 were Telecommunication Services and Utilities, while Financials and Information Technology were the worst performers. Conversely, as U.S. Treasury yields rose during the second half of 2016, especially after the U.S. presidential election, economically sensitive holdings outperformed considerably: Financials and Information Technology were the strongest sectors of the market, while Real Estate and Utilities were the weakest.
INVESTMENT STRATEGY
The Fund’s performance in 2016 mirrored this shift described above between the cyclical and defensive sectors: first half 2016 performance for the Fund was up 1% (versus up 4% for the S&P 500) and second half performance was up 20% (versus up 8%). As a result of individual security selection, the portfolio is tilted toward more economically sensitive companies: Financials comprised 29% of the portfolio, Information Technology accounted for 18%, and Energy was 9%.b We believe the Fund is well positioned based on our opinion that longer-term global economic growth will be better than many expect and interest rates will continue to rise. There is also a significant valuation gap between the Fund’s holdings and sectors where the Fund has little or no exposure.
Our strong price discipline is an essential characteristic of our investment strategy. We constantly weigh valuation against fundamentals and seek to invest in companies where the initial valuation reflects concerns about future earnings and cash flow prospects, while our analysis reveals the possibility of more positive developments. As long-term investors, our challenge is to assess short-term concerns while investing with an eye toward future prospects. When we see long-term value, we often add to positions as valuations decline and other investors become more pessimistic. Two examples include recent activity in the Financials and Health Care sectors, which are discussed below.
Financials
Amid heightened market volatility, we revisited and retested our thinking on many of the Fund’s holdings during 2015 and the first half of 2016. As valuations became more attractive, we concluded market conditions had created long-term investment opportunities in selected economically sensitive companies, especially in Financials. Despite low interest rates and global economic challenges, we saw opportunities because many of the portfolio’s Financials holdings traded at relatively inexpensive valuations (at levels not seen since the 2008 global financial crisis) although they had benefited from loan growth and improved credit quality since the crisis. We added to various companies, including American Express, Bank of America, Goldman Sachs, and MetLife.c
During the second half of 2016, Financials was the best-performing sector of the S&P 500 (up 22%), in large part due to rising interest rates. We trimmed several of the Fund’s holdings in response to higher share prices, but maintain a significant overweight position in the sector (29% versus 15% for the S&P 500). Profits are improving and strong capital positions allow the banks to return significant capital to shareholders via share buybacks and dividends, making them a compelling alternative to other dividend-paying stocks, in our view. As rates increase, profitability within the sector should improve further. The sector also stands to benefit from potential easing of financial regulation by the Trump administration (e.g., The Dodd-Frank Wall Street Reform and Consumer Protection Act could be repealed or modified).
While we trimmed Financials on a net basis during the fourth quarter, we opportunistically added to Wells Fargo (up only 5% for 2016), which detracted from relative performance and was weak among bank stocks due to regulatory infractions and fines. We were disappointed to learn about the bank’s sales practices that resulted in improper account openings, but are convinced Wells Fargo is actively addressing the issues. After a comprehensive review, we believe Wells Fargo’s superior franchise, deep management team, track record of generating higher returns than other banks, and attractive valuation at 1.6 times book value make it an attractive long-term investment opportunity. On December 31, Wells Fargo was a 3.9% position in the Fund.
Health Care
Health Care was the worst performing sector (down 2%) of the S&P 500 in 2016 amid legal, regulatory, and pricing concerns, especially in the Pharmaceuticals industry. Pharmacy benefit managers have exerted increased pricing pressure on drug manufacturers, aided by industry consolidation and higher market shares. This trend could impact long-term profitability for pharmaceutical companies. Additional risks include biosimilar and generic competition, as well as reduced drug reimbursement from government buyers and private payors.
Conversely, research and development (R&D) productivity has increased for many of the Fund’s pharmaceutical holdings. Overall industry R&D pipelines have become larger, and new drug approvals are on the upswing. These companies stand to benefit from long-term growth in emerging markets; consumers and governments have demonstrated a tendency to spend more on health care as consumer purchasing power increases. Furthermore, the Fund’s pharmaceutical holdings have reasonable valuations, strong balance sheets, high free cash flow, and cost-cutting opportunities that help mitigate risk.
After evaluating the risks versus the opportunities, the Fund remains overweight Pharmaceuticals (11% compared to 5% for the S&P 500). We added tactically to several holdings (e.g., AstraZeneca, Sanofi) as valuations became more attractive during the second half of 2016. In addition, we recently initiated new positions in Alnylam Pharmaceuticals and Bristol-Myers Squibb.
Bristol-Myers Squibb
Once a diversified pharmaceutical company facing significant patent expirations (a “cliff”), Bristol-Myers (BMY, Financial) has transitioned into a focused biopharmaceutical company that is positioned to grow. Many of its competitors responded to their patent cliffs by expanding into other non-drug areas; Bristol-Myers shed its interests in those assets unrelated to the drug business (e.g., medical supply, nutritionals), focused on specialty drugs, and concentrated on only those therapeutic areas that it believed could be profitable over the long term. Its medicines help millions of people fight against such diseases as cancer, cardiovascular disease, hepatitis, HIV/ AIDS, and rheumatoid arthritis.
In 2016, one of Bristol-Myers’ lead immuno-oncology trials (CheckMate-026) failed and its stock price declined significantly. We think this is a short-term setback, and believe the company’s immuno-oncology business is particularly attractive with its strong pipeline of other drugs, significant growth potential, and reasonable valuation at 20 times forward earnings. After weighing the risks versus the long-term opportunities, we initiated a position in Bristol-Myers, which accounted for 1.3% of the Fund on December 31.
IN CLOSING
While U.S. equity 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 environment offer significant opportunities for active management. We believe that being patient, persistent, and having a long-term investment horizon are essential for investment success. While we do not know what the future holds, we will continue to apply the bottom-up, value-oriented investment approach that has served the Fund well for decades.
We want to express gratitude to the Fund’s shareholders for taking the long view and having confidence in Dodge & Cox. Our strategy requires patience and persistence, and we appreciate yours.
As always, we welcome your comments and questions.
For the Board of Trustees,
Charles F. Pohl, Dana M. Emery,
Chairman President
January 31, 2017
