The Dodge & Cox Stock Fund had a total return of –29.2% for the first quarter of 2020, compared to -19.6% for the S&P 500 Index.
In the first quarter of 2020, the coronavirus (COVID-19) evolved into a global pandemic that disrupted major economies, increased financial market volatility, and abruptly ended the longest stock market bull run in U.S. history. Volatility spiked, and on March 16th the U.S. stock market experienced its steepest one-day fall since the October 1987 stock market crash. While every sector of the S&P 500 posted double-digit declines for the first quarter, Information Technology and the more defensive areas of the market (e.g., Health Care, Consumer Staples) fared better. Energy was the worst-performing sector, as oil prices plummeted 66% due to the combination of an unprecedented fall in demand and an increase in supply when OPEC and Russia failed to agree to production cuts. Financials also declined significantly amid concerns about a pending U.S. recession and declining interest rates. The Fund finished the quarter with disappointing absolute and relative returns due to its overweight positions and underperformance in Energy and Financials, which overshadowed the Fund’s strong relative results within Health Care.
The recent enactment of a massive U.S. government stimulus package, combined with the Federal Reserve’s lowering of short-term interest rates, should provide some relief to businesses and households. Nevertheless, containment measures designed to slow the spread of the virus leave the United States economy heading for a recession. While this is a difficult period, companies are adjusting and the global scientific community is aggressively working on COVID-19 treatments and vaccines. In contrast to the 2008-2009 global financial crisis when problems in the banking system impacted the broader economy, banks entered this crisis in much stronger financial shape, making them well positioned to help serve as part of the solution to the economic impact of the pandemic.
Over the past decade, U.S. value stocks2 have underperformed U.S. growth stocks by the widest margin on record, resulting in a significant valuation disparity. In recent weeks, this valuation differential has widened to an exceptional level: the Russell 1000 Value Index now trades at 15.3 times trailing earnings, a 40% discount to the 25.6 times trailing earnings for the Russell 1000 Growth Index.3 When the valuation spread has been this extreme in the past, value strategies have subsequently performed well. We believe value investors with a focus on deep, fundamental research and a long-term perspective face extraordinary opportunities in these markets, and we are actively taking advantage of them.
Our global industry analysts remain hard at work stress testing existing holdings, conducting additional due diligence, and looking for new opportunities. They are working closely with our fixed income credit analysts to assess balance sheet strength, as well as funding and other liquidity options, against upcoming obligations. This collaboration enables us to better evaluate risk against reward and retest our investment theses. The U.S. Equity Investment Committee, with an average tenure of 24 years at Dodge & Cox, is meeting frequently to review portfolio holdings and overall positioning, drawing on the expertise of our analysts to assess the risks and opportunities of individual companies.
During the quarter, we trimmed selected Pharmaceuticals, Media, and Software holdings that had outperformed such as Roche (XSWX:ROG, Financial),4 Charter Communications (CHTR, Financial), and Microsoft (MSFT, Financial). As value-oriented investors, we added to several holdings—especially in the Financials, Energy, and Information Technology sectors—to take advantage of price dislocations, including Bank of America (BAC, Financial), Booking Holdings (BKNG, Financial), Charles Schwab (SCHW, Financial), Cisco (CSCO, Financial), Hess (HES, Financial), Schlumberger (SLB, Financial), and State Street (STT, Financial).
For example, Booking Holdings (BKNG, Financial)—one of the largest marketplaces for accommodation bookings in the world—is negatively exposed to travel restrictions due to COVID-19, but we believe it is well positioned to weather this downturn. Booking is in a very strong financial position, with close to no net debt, access to additional liquidity, and a very low fixed cost structure. Unlike other companies within the travel industry (e.g., cruise ships, hotels), Booking does not own or lease operating assets but rather serves as an online marketplace and thus has a more flexible operating model. Over half of its operating expenses are variable (primarily marketing expenses), which the company can scale back with the drop in volume.
Given Booking does not own any hotel assets, it has extremely limited exposure to failure of the third-party hotel operators who list on the company’s platforms. In a recovery period, Booking may benefit significantly as hotels seek to rapidly fill vacant rooms and thus provide Booking with a large percentage of their inventory as has happened in past industry cycles. Moreover, over 20% of the company’s 2019 volumes came from alternative accommodations such as home vacation rentals, which positions the company well for future industry growth beyond traditional hotel accommodations.
We have strong conviction in our active, value-oriented investment approach and remain optimistic about the outlook for the Fund’s diversified portfolio. Our firm’s independence and financial strength enable us to stay focused on the long term. Our thoughts are with all the individuals and families of those who have suffered from COVID-19 and also with the dedicated healthcare workers and first responders battling on the front lines. We wish you and your families all the best during these challenging times.
First Quarter Performance Review
The Fund underperformed the S&P 500 by 9.6 percentage points during the quarter.
Key Detractors from Relative Results
- Energy was the weakest sector of the portfolio (down 66%) and the Index (down 50%) by a substantial margin due to both oil supply and demand shocks during the quarter. The portfolio’s average overweight position (9% versus 4%) and weaker returns within the sector hurt results. Occidental Petroleum (OXY), Apache (APA), and Baker Hughes (BKR) were the biggest detractors.
- The portfolio’s average overweight position (25% versus 12%) and relative returns in the Financials sector hurt results (down 39% versus down 32% for the S&P 500 sector). Interest rates declined to record lows during the quarter, which hurt bank stocks. Capital One Financial (COF) and Wells Fargo (WFC) performed particularly poorly.
- Stock selection in the Information Technology sector detracted (Fund holdings down 22% versus down 12% for the S&P 500 sector).
Key Contributors to Relative Results
- The portfolio’s average overweight position (23% versus 14%) and modest outperformance in the Health Care sector helped. Top contributors included Roche, Gilead Sciences (GILD), and Novartis (NVS).
- Sprint was an exceptional performer after its merger with T-Mobile US (TMUS) was approved.
- Charter Communications also had a positive impact.
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 Value stocks are the lower valuation portion of the equity market, and growth stocks are the higher valuation portion.
3 Unless otherwise specified, all weightings and characteristics are as of March 31, 2020.
4 The use of specific examples does not imply that they are more or less attractive investments than the portfolio’s other holdings.
S&P 500® is a trademark of S&P Global Inc. Russell 1000 is a trademark of the London Stock Exchange Group plc. For more information about these indices, visit dodgeandcox.com.
Returns represent past performance and do not guarantee future results. Investment return and share price will fluctuate with market conditions, and investors may have a gain or loss when shares are sold. Fund performance changes over time and currently may be significantly lower than stated above. Performance is updated and published monthly. Visit the Fund’s website at dodgeandcox.com or call 800-621-3979 for current month-end performance figures.