To Our Shareholders
The Dodge & Cox Stock Fund had a total return of 24.8% for the year ended December 31, 2019, compared to a return of 31.5% for the S&P 500 Index.
Market Commentary
The U.S. equity market’s performance in 2019 was exceptional: the S&P 500 registered its strongest annual return since 2013 and reached an all-time high. Every sector of the S&P 500 posted positive, double-digit returns. Information Technology surged 50% and was the best-performing sector, while Energy (up 12%) was the worst-performing sector.
Since 1926, the relative performance of growth and value stocksa 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. Over the last ten years, the Russell 1000 Value Index has underperformed the Russell 1000 Growth Index by an average of 3.4 percentage pointsb per year. As a result, the valuation differential between the value and growth segments of the market 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.c
Investment Strategy
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, as described below, is trading at an 80% premium to the group of companies that is harmed by low interest rates (or performs better in a rising interest rate environment). This valuation premium is almost three standard deviations above the historical valuation differential observed over the past 24 years.
Historically, these two groups have traded in roughly the same valuation range. After 2010, however, the valuations of these two groups 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. The Fund holds no utilities or real estate companies and has only one consumer staples holding (Molson Coors,d 0.8% of the Fund) because we believe many companies have inflated valuations in these sectors.
Conversely, companies that benefit from rising interest rates—Financials, Energy, and some Industrials—are almost all categorized as value stocks, and they are now selling at extraordinary discounts relative to the market. As a value-oriented manager, the Fund remains overweight Financials (25.8% of the portfolio versus 13.0% of the S&P 500) and Energy (9.9% of the portfolio versus 4.3%).
We continue to identify attractive investment opportunities and have leaned into challenged areas of the market, such as Energy and Industrials. At the same time, we also reevaluated the portfolio’s strong performers and significantly trimmed back several of those large positions, including Charter Communications, Comcast, JPMorgan Chase, and Microsoft. During 2019, we added more to Energy than any other sector and trimmed the most from Communication Services, particularly in the Media industry.
Finding Value in Energy
Energy companies have suffered from years of lower oil prices, which have 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, energy companies currently trade at low multiples relative to their history and to the broader market.
We believe the valuations of the Fund’s energy holdings provide an attractive starting point and more than compensate for these risks. During 2019, we increased the Fund’s exposure to Occidental Petroleum, Concho Resources, Schlumberger, and Halliburton as valuations became more attractive. We also recently initiated a position in Hess, an independent oil and gas exploration and production company.
Hess: Hess (HES, Financial) is investing its strong cash flows from existing assets into a new project with significant production potential in Guyana. The company owns 30% of a partnership with Exxon Mobil in the Stabroek block in the country, and this oil discovery is already one of the largest in recent decades. Much of the Stabroek block remains unexplored and Hess has interests in additional blocks in Guyana and Suriname. Incremental discoveries on these blocks could provide additional upside. In addition, the Guyana resource has some of the lowest development costs outside of OPEC.e Higher incremental returns from this investment should result in attractive free cash flow growth over the next several years.
The Hess management team has expressed a desire to return free cash flow to shareholders, but we acknowledge there is a risk of suboptimal capital allocation. While the Guyana resource will require significant capital over the next several years and Hess is reliant on solid execution from Exxon, we believe these risks are manageable and decided to start a position in Hess. Trading at nine times cash flow, Hess was a 0.7% position in the Fund at year end.
Communication Services: Overweight Media & Entertainment
Within Communication Services, Media & Entertainment is another overweight position in the Fund: 11.9% compared to 8.2% for the S&P 500. The majority of the Fund’s exposure relates to cable and satellite companies (Comcast, Charter Communications, and DISH Network). Comcast and Charter have strong potential to continue generating positive free cash flow and sustaining growth in broadband and business services. In addition, DISH has various options for the unrealized value in its wireless spectrum holdings. The other holdings are content-related media companies (Alphabet/Google, Fox Corp., and News Corp.) that offer scarcity value of premium content and growth in digital distribution outlets, advertising, and international markets.
The competitive landscape is rapidly evolving, due to growth in video streaming services (e.g., Netflix, Amazon, Hulu), changes in consumer viewing and listening habits, shifting revenue streams, and industry consolidation. Longer term, uncertainty surrounding potential regulatory incursions (e.g., unbundling, forced wholesale access, price regulation on broadband) and 5G fixed wireless as an alternative to cable broadband also pose risks. However, we believe the Fund’s media and entertainment holdings are trading at reasonable valuations in comparison to these risks and their growth prospects.
In 2019, the Fund’s media holdings outperformed significantly with Charter Communications and Comcast up 70% and 34%, respectively. Based on their solid performance and higher valuations, we trimmed both Comcast and Charter. Nevertheless, they remain in the top-ten holdings of the Fund. In addition, Walt Disney acquired the majority of Twenty-First Century Fox’s assets and the Fund (a large shareholder) primarily received cash as a result of this transaction.
Comcast: We have held Comcast (CMCSA, Financial) —the largest U.S. cable provider with over 31 million subscriber relationships—in the Fund since 2002; over the years, we have actively added to and trimmed from the position based on relative valuation. The company has technologically advanced connectivity services and, despite concerns about video “cord cutting,” has the potential to grow through increased broadband penetration and pricing power in both residential and business services. Outside the United States, Comcast owns pan-European satellite broadcaster Sky, which has 24 million subscribers in seven countries, including the United Kingdom, Italy, and Germany. We believe NBC Universal (owned by Comcast) can increase its operating profit through affiliate fee increases at NBC and continued investment in its Universal theme parks. In addition, owner-operator Chairman and CEO Brian Roberts has created significant shareholder value and leads a deep and strong management team. Comcast was a 3.0% position on December 31.
Charter Communications: As the second-largest U.S. cable operator, Charter Communications (CHTR, Financial) offers internet, video, fixed voice, and mobile data/voice services under the Spectrum brand to 29 million subscribers. Despite the threat of 5G fixed wireless, Charter has continued to add subscribers in its cable broadband business due to its high speed and cost advantage. Fixed data usage has grown steadily over the past decade and has the potential to continue to grow at attractive rates for the foreseeable future. In addition, we believe Charter has significant pricing power because of its superior broadband offerings and large barriers to entry. The company’s high financial leverage is supported by predictable cash flows in combination with its long-lasting infrastructure advantage. Management holds a significant equity stake and is thus strongly incentivized to create value for its shareholders. Charter accounted for 3.3% of the Fund.
In Closing
U.S. equity returns in 2019 were extraordinary and certainly not the norm. History shows market timing can be hazardous to an investor’s portfolio. While the U.S. economy will inevitably experience a downturn at some point in the future, we believe there is wisdom in being fully invested through market cycles and maintaining a long-term investment horizon.
As a result of high starting valuations, we caution investors to temper expectations around future U.S. equity market performance. That said, we remain optimistic about the long-term outlook for the Fund’s portfolio, 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. In addition, the Fund is well diversified across 64 companies with strong fundamentals and a variety of investment themes.
As a value-oriented manager, patience and persistence are also essential to long-term investment success. We encourage our shareholders to take a similar view. Thank you for your continued confidence in our firm. As always, we welcome your comments and questions.
For the Board of Trustees,
Charles F. Pohl, Chairman
Dana M. Emery, President
January 31, 2020
a. Value stocks are the lower valuation portion of the equity market, and growth stocks are the higher valuation portion.
b. The Russell 1000 Growth Index had a total return of 312.3% from December 31, 2009 through December 31, 2019 compared to 204.9% for the Russell 1000 Value.
c. Unless otherwise specified, all weightings and characteristics are as of December 31, 2019.
d. The use of specific examples does not imply that they are more or less attractive investments than the portfolio’s other holdings.
e. The Organization of the Petroleum Exporting Countries (OPEC) is an intergovernmental organization of 13 nations.
