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Bram de Haas
Bram de Haas
Articles (434)  | Author's Website |

Dodge & Cox Is Well Positioned for When Value Has Its Resurgence

A review of the firm's latest quarterly letter

January 16, 2020 | About:

Dodge & Cox is a value manager with a history going back to 1930, when it was incepted in the midst of the worst crisis on the financial record.

The firm is steeped in the value tradition and looks for relative value, it goes against the grain but also puts a strong emphasis on diversification. It tends to be a very long-term owner of companies. Because the firm emphasizes a team-based approach, there isn't really the star power that is usually required to keep small- to mid-size asset managers running. But Dodge & Cox has a quiet reputation and the firm managed to fade most of the 1999 bubble. Located in San Francisco, it was likely the singular exception. It must have been extraordinarily difficult. I went through the latest quarterly letter and wanted to share a couple of the firm's most interesting observations:

"Since 1926, the relative performance of growth and value stocks has seesawed, but value strategies have nearly always outperformed growth over intervals of a decade or more. In fact, there have only been three times when value has underperformed over a ten-year period in the United States: the Great Depression (1929-1939/40), the Internet Bubble (1989-1999), and most recently."

With every 10-year period, the managers mean from 1926 to 1936, but also 1927 to 1937. There is obviously a ton of overlap, but the fact there are only three such periods going back to 1929 shows how difficult it is to invest in growth and catch up with Warren Buffett (Trades, Portfolio). 

The portfolio managers continued:

"The Russell 1000 Value Index has underperformed the Russell 1000 Growth Index by an average of 3.4 percentage points per year over the last 10 years. As a result, the valuation differential between value and growth stocks remains wide by historical standards: the Russell 1000 Value trades at 16.0 times forward earnings compared to a lofty 23.9 times for the Russell 1000 Growth."

Value is not especially cheap by historical standards as you have probably guessed from the forward earnings multiple. But growth is quite dear.

The firm then commented on low interest rates:

"While the value-versus-growth dynamic captures much of what has driven wide valuation disparities, interest rates tell an even more powerful story. In the United States, the group of companies that benefits from low interest rates is trading at an 80% premium to the group of companies that is harmed by low interest rates (performs better in a rising interest rate environment). And that spread is almost three standard deviations wide on a 24-year span of time."

Around 99.7% of data tend to lie within three standard deviations, meaning this is a very rare occurrence. Clearly the market is communicating these low-interest rates are here to stay. Get used to it. Or... the market is wrong. The firm continued:

"Historically, these two groups of stocks have traded roughly in the same valuation range. Post 2010, however, the two groups’ valuations diverged as investors sought 'bond substitutes'—mainly in the Utilities, Real Estate, and Consumer Staples sectors—with higher dividend yields in a lower interest rate environment."

I've shown the GuruFocus data chart with this division many times in the last several months. If you missed it, you can find the data here.

It also discussed its sector positioning:

"The Fund holds no utilities or real estate companies and has only one consumer staples holding because we believe company valuations in these sectors are inflated. Conversely, companies that benefit from rising rates—Financials, Energy, and some Industrials—are almost all categorized as value stocks and are now selling at extraordinary discounts relative to the market. As a value-oriented investor, we continue to identify investment opportunities, and the portfolio remains overweight Financials (25.8% of the portfolio versus 13.0% of the S&P 500) and Energy (9.9% versus 4.3%)."

These are the cheapest industries within the S&P 500, and by a wide margin. The skew toward financials is observable in almost every value investing portfolio. Although not all of them have energy because it is a tough industry that is dependent on the price of oil. Some value investors don't like that dynamic, but Dodge & Cox embraced the sector:

"During 2019, we leaned further into Energy as valuations became more attractive. Energy companies have suffered from lower and more volatile oil prices, which reduced cash flows at many companies and made it more difficult to invest in new projects. There are also long-term concerns about oil and gas demand as the threat of climate change necessitates a transition to less carbon-intensive alternatives. However, we believe the valuations of the Fund’s energy holdings provide an attractive starting point and more than compensate for these risks. For example, we recently initiated a position in Hess, an independent oil and gas exploration and production company, that is investing its strong cash flows from existing assets into a new project with significant economic potential in Guyana.5 The Guyana oil discovery is one of the largest in recent decades. Higher incremental returns from this investment should result in attractive free cash flow growth over the next several years."

At Dodge & Cox, the managers didn't hesitate, but started buying oil patch assets. I'm afraid these are going to be another lonely few years for them in San Francisco. Hess (HES) is a difficult company to understand and definitely one where they may have an edge in the analysis. Undervaluation isn't easily determined through screeners. Cash flow needs to grow for it to be ultimately rewarding.

Not all of the firm's positions are as hard to understand. I've pulled GuruFocus data with its largest positions, which include Wells Fargo (NYSE:WFC), Johnson Controls International (NYSE:JCI), Occidental Petroleum (NYSE:OXY), Capital One (NYSE:COF) and Comcast (CMSCA).

The firm finished out its letter with the following:

"Overall, we remain optimistic about the long-term outlook for the Fund, which trades at a meaningful discount to the overall market: 13.5 times forward earnings compared to 18.9 times for the S&P 500. Patience, persistence, and a long-term investment horizon are essential to long-term investment success. We encourage our shareholders to take a similar view."

Going by its differentiated and high-active share (meaning they really differentiate from the index), I'm fairly confident the Dodge & Cox name will outlast the current value malaise and will still be around when names like Elon Musk and Adam Neumann are long forgotten.

Disclosure: No positions.

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About the author:

Bram de Haas
Bram de Haas is managing editor of The Special Situations Report and Founder of Starshot Capital B.V.

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