To Our Shareholders
The Dodge & Cox Global Stock Fund had a total return of 23.8% for the year ended December 31, 2019, compared to a return of 27.7% for the MSCI World Index.
Market Commentary
Global equity markets experienced strong performance in 2019. Improving sentiment surrounding the same macro factors that dragged markets down in 2018—sluggish economic growth, the direction of monetary policy, and trade wars—propelled markets in 2019.
In the United States, the S&P 500 Index reached an all-time high, delivering its strongest annual return since 2013 (up 31%), as every sector posted double-digit returns. Information Technology surged 50% and was the best-performing sector of the S&P 500, while Energy (up 12%) was the worst-performing sector. International equity markets also rebounded sharply in 2019 (MSCI EAFE Index up 22%), more than offsetting the decline in 2018, with every sector of the MSCI EAFE posting positive returns.
Investment Strategy
We believe this is an extremely compelling time to be invested in the value part of the market, given the enormous valuation disparity between value and growth stocks.a History has shown that starting valuation is a major factor in long-term returns, and the current valuation disparity is exceptional: the MSCI World Growth Index now trades at 23.1 times forward earnings, while the MSCI World Value Index trades at 13.4 times.b Investors are paying one of the highest premiums for growth stocks since these indices’ inception in 1997. The current valuation spread is in the 94th percentile and also represents the largest gap since 2000.c
Four sectors encapsulate the current spread between value and growth stocks. On the value end of the spectrum, Financials and Energy are the two largest overweights in the MSCI World Value compared to the overall market. Conversely, Information Technology and Consumer Discretionary are the two largest overweights of the MSCI World Growth compared to the overall market. As a result of our bottom-up approach, the Fund is overweight Financials, Health Care, and Energy and underweight Information Technology, Consumer Discretionary, and Consumer Staples.
Given the wide valuation spread, 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, ICICI Bank, JD.com, and Naspers.d During 2019, we added more to Energy than any other sector and trimmed the most from Communication Services, particularly in the Media industry.
Compelling Valuations in Energy
Energy companies are trading at low valuations relative to their history and to the broader market. On a price to cash flow basis, the MSCI World Energy sector is trading at its lowest valuation over the past 20 years relative to the overall MSCI World. Energy companies have suffered from years of lower oil prices, which have reduced cash flows for many companies and made it more difficult to invest in new projects. But this combination of low valuations, lower investments in future supply, and low expectations for oil prices may have created the conditions for attractive relative returns in the future.
During 2019, the Fund increased its exposure to Occidental Petroleum and Baker Hughes as valuations became more attractive and initiated positions in Encanae and Hess. At year end, Energy was 8.9% of the Fund compared to 4.9% for the MSCI World.
Encana: Encana (ECA, Financial) is one of the largest shale oil producers in North America, with high-quality assets in the Permian Basin, Eagle Ford, and Montney. Through its acquisition of Newfield Exploration, Encana also recently entered the Anadarko basin. The company has developed industry-leading operating and technical capabilities. As one of the most sophisticated and low-cost shale operators in the industry, Encana is able to generate substantial free cash flow across a wide range of oil prices. The company has a strong balance sheet, trades at a high single-digit free cash flow yield, and should be able to grow production at mid-single-digit rates over our investment horizon. Encana’s shares declined substantially after the recent Newfield Exploration acquisition, providing an attractive entry point for us to start a position. This combination of low valuation and reasonable growth is scarce in today’s market. On December 31, Encana was a 1.0% position in the Fund.
Hess: Hess (HES, Financial), an independent oil and gas exploration and production company, is investing its strong cash flows from existing assets into a new project with significant production potential in the country. The company owns 30% of a partnership with Exxon Mobil in the Stabroek block in Guyana, 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 further upside. In addition, the
Guyana resource has some of the lowest development costs outside of OPEC.f The Guyana resource will require significant capital over the next several years, and Hess is reliant on solid execution from Exxon. However, higher incremental returns from this investment should result in attractive free cash flow growth over the next several years. Trading at nine times cash flow, Hess was a 0.9% position in the Fund at year end.
Communication Services: Overweight Media & Entertainment
Within Communication Services, Media & Entertainment is another overweight position in the Fund: 11.4% compared to 5.8% for the MSCI World. Several holdings are in cable and satellite companies (Comcast, Charter Communications, and DISH Network). Comcast and Charter generate strong free cash flows and continue to benefit from growth opportunities in broadband and enterprise services. And DISH has significant wireless spectrum holdings representing unrealized value and potential. Other holdings are content-related media companies such as Alphabet, Baidu, and Grupo Televisa, which offer exposure to 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 models, and industry consolidation. Longer term, the industry will continue to face uncertainty around potential regulatory incursions (e.g., unbundling, wholesale access, broadband price regulation) as well as technological change, most notably 5G and the challenge it could pose to cable broadband. However, we believe the Fund’s media and entertainment holdings are trading at reasonable valuations in light of attractive 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 holdings.
Comcast: We have held Comcast (CMCSA, Financial)—the largest U.S. cable provider with over 31 million subscriber relationships—in the Fund since its inception in 2008. 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 the potential to grow through increased broadband penetration and pricing power in both residential and business services. Video cord cutting has turned out to be a manageable risk in light of the company’s broader opportunity set for growth. 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. And NBC Universal (owned by Comcast) has opportunities to 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 1.8% 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 to 29 million subscribers. Charter has continued to add subscribers in its cable broadband business due to its high speeds and cost advantages. 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. The company’s high financial leverage is supported by significant infrastructure advantages, which translates to high barriers to entry, significant pricing power, and predictable cash flows. Management holds a significant equity stake and is thus strongly incentivized to create value for its shareholders. Charter accounted for 2.4% of the Fund’s assets.
In Closing
As an employee-owned firm with large ownership in our Funds, we have the independence to invest for the long term and find opportunity in unpopular parts of the market.
Given the wide valuation spread between value and growth stocks in the global equity market, we are finding many attractive opportunities today in the value part of the market. History shows that starting valuation is a major factor in long-term returns. We believe the Fund is well positioned, especially if and when this large valuation gap compresses.
At Dodge & Cox, we remain focused on the long term, on our valuation discipline, and on fundamental analysis of prospective investments on a company-by-company basis. That is how we construct what we believe is the best portfolio for our clients. We remain optimistic about the outlook for the Fund, and we 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. Unless otherwise specified, all weightings and characteristics are as of December 31, 2019.
c. The MSCI World Value Index and MSCI World Growth Index were formed in 1997. The 94th percentile was calculated using monthly data from FactSet for 1997-2003 and MSCI for 2003-present.
d. The use of specific examples does not imply that they are more or less attractive investments than the portfolio’s other holdings.
e. Encana changed its name to Ovintiv Inc. on January 24, 2020.
