To Our Shareholders
The Dodge & Cox Stock Fund had a total return of –15.0% for the six months ended June 30, 2020, compared to a return of –3.1% for the S&P 500 Index.
Market Commentary
During the first half of 2020, the spread of the coronavirus (COVID-19) evolved into a global pandemic that disrupted major economies, increased financial market volatility, and abruptly ended the longest bull run in U.S. stock market history. Volatility spiked in the first quarter, and every sector of the S&P 500 declined. On March 16th, the U.S. stock market experienced its steepest one-day decline since the October 1987 stock market crash. While lower short-term interest rates and the massive U.S. government stimulus package provided some relief to businesses and households, the U.S. economy slipped into a recession.
In the second quarter, however, the U.S. equity market recovered from its March lows: the S&P 500 appreciated 20.5% and every sector posted positive returns. The U.S. government’s fiscal and monetary stimulus, optimism regarding potential health care solutions, and some recovery in corporate earnings have all helped bolster investor confidence. Value stocksa continued their longer-term trend of lagging the overall market, with the Russell 1000 Value Index up 14.3%. In fact, over the last decade U.S. growth stocks have outperformed value stocks by an astounding cumulative 221 percentage points.b During this challenging period for value investors, the Fund has underperformed the broad-based S&P 500, but outperformed the Russell 1000 Value by 33 percentage points.c The valuation differential between value- and growth-oriented stocks has widened, and we believe there are ample opportunities for value-oriented investors like Dodge & Cox.
Amid the fall and rise of the market during the first six months of 2020, almost 70% of the S&P 500 is now comprised of businesses largely immune to the economic impact of the pandemic (we describe them as “COVID defensives”).d The vast majority of these companies are in the Information Technology, Consumer Staples, Utilities, and Health Care sectors. The other 30% of the S&P 500, which has been hit hard by the economic consequences of the pandemic (we call them “COVID cyclicals”), are mostly in the Financials, Energy, Industrials, Materials, Consumer Discretionary (ex-internet retail), and Real Estate sectors.
COVID defensives have substantially outperformed the COVID cyclicals. In the first half of 2020, Information Technology was the bestperforming sector of the S&P 500, and Energy and Financials were the worst. This helps explain the resilience of the S&P 500 during a period of economic disruption. In contrast, COVID defensives account for approximately half of the Russell 1000 Value and only 37% of the Fund’s net assets.
Investment Strategy
As markets melted down during the first quarter of the year, our global industry and fixed income analysts worked closely together to stress test the Funds’ holdings, especially COVID-cyclical stocks in the Energy and Financials sectors. Such collaboration is a hallmark of our investment process and is especially important during periods of market stress, as it was during the 2008-09 global financial crisis and the last oil price downturn in 2015-16.
In Energy, for example, our team has analyzed each holding’s sources and uses of cash across a variety of oil price scenarios. We have focused on sources of liquidity, including further reductions in capital expenditures, dividend cuts, asset sales, and debt and equity issuance. We continue to have frequent discussions with management teams at many energy companies, as well as independent board members, service providers, and industry experts in order to gauge current operating conditions and downside risks.
We believe the Fund’s energy holdings have sufficient capital and liquidity to survive the current headwinds over our long-term investment horizon, although some holdings may face larger challenges than others. Current energy valuations—trading at 90-year lows—are depressed and provide an attractive starting point. We continue to find compelling long-term opportunities in selected upstream and oilfield services companies with solid assets, management teams that have deployed capital prudently through the cycle, and low-to-reasonable valuations. As a result, our U.S. Equity Investment Committee selectively added to the Fund’s energy holdings during the depths of the downturn in the first quarter and has maintained an overweight position in Energy: 9.3% of the Fund versus 2.8% of the S&P 500.
As a Value-Oriented Manager, We Are Finding Attractive Opportunities
In these volatile markets, our global industry analysts have been diligently reevaluating existing holdings and looking for new opportunities. We continue to have frequent discussions with management teams and industry experts to assess current operating conditions and evaluate downside risks. These discussions and our team’s analyses contributed to the U.S. Equity Investment Committee’s decisions to shift the portfolio based on COVID-impacted fundamentals and changed valuations.
During the first half of 2020, we trimmed and sold positions in higher valuation areas of the portfolio that had performed strongly through the turmoil; these were mostly COVID-defensive stocks. Major trims included Roche (XSWX:ROG, Financial), Bristol-Myers (BMY, Financial), and Sanofi (SNY, Financial) in Health Care, and Charter Communications (CHTR, Financial) and Microsoft (MSFT, Financial) in Technology, Media, and Telecommunication (TMT). We redeployed those funds into COVID-cyclical companies whose stock prices have declined substantially in the crisis, particularly in the Financials and Energy sectors, as well as inexpensive companies within TMT. We recently added significantly to State Street (STT, Financial) and MetLife (MET, Financial) in Financials, Occidental Petroleum (OXY, Financial) in Energy, and HP Inc. (HPQ, Financial) and Dell (DELL, Financial) in Information Technology.
We also started seven new positions in the Fund. These can be divided into two principal groups: 1) high-quality businesses with valuations we had previously deemed to be too high, and 2) COVID-cyclical companies with stock prices that have declined sharply due to the pandemic.
In the first category, we established positions in Facebook (FB) and Medtronic (MDT). We invest in companies based on our assessment of the value of their franchise and our estimate of the potential growth in future earnings and cash flow. When valuations come down and we are able to buy above-average growth at a discount, we see opportunity. Facebook (a social media conglomerate) has significant growth opportunities and a durable franchise that would be extremely difficult to replicate. The company has compounded revenue growth at more than 40% over the past five years, while still generating significant amounts of free cash flow. However, fears about advertising spending, political controversy, and possible regulatory changes caused its stock to trade at a below-market valuation. We concluded that this was an opportune time to initiate a position in the stock. Similarly, Medtronic is a leading medical device company with opportunities for innovation-led growth. However, concerns about the deferral of elective medical procedures provided a valuation opportunity in the first quarter.
In the COVID-cyclical category, we recently started positions in Lincoln National (LNC), LyondellBasell (LYB), and Williams Companies (WMB) (highlighted below), among others. Lincoln National is a well-managed, well-capitalized life insurance company, and LyondellBasell is a commodity chemical producer with a strong balance sheet. Their share prices plummeted 71% and 63%, respectively, from the beginning of the year through their March lows. While both stocks have since rebounded significantly, we believe they remain attractive long-term opportunities.
Williams Companies
Williams—a leading U.S. midstream energy company—has a diversified portfolio of assets and operates large best-in-class natural gas pipelines, handling approximately 30% of all U.S. natural gas volumes. Demand for natural gas and oil has faced significant macroeconomic and structural headwinds. Following the recent global commodity slump, oversupply has led to substantial oil and natural gas price declines, which has weakened the financial profiles of Williams’ producer customers. One of Williams’ key customers (Chesapeake Energy) declared bankruptcy in June. This was a well-known risk that we had already incorporated into our risk-reward profile for the company, and we believe it is reflected in its current valuation of only six times cash flow.
Partnering with our fixed income credit analysts, our equity analysts assessed the durability of Williams’ core pipeline business, the likelihood of producer shut ins, and the degrees of protection in Williams’ long-term contracts with its clients. We have also conducted extensive due diligence through conversations with Williams’ management team, key customers, midstream peers/competitors, industry experts, and rating agencies.
Going forward, we believe the company has considerable sources of downside risk mitigation: high quality assets, a disciplined, shareholderoriented management and board, a healthy liquidity position with an improving balance sheet, and solid cash flow to support its dividend payments. Williams’ well-positioned pipeline network should also benefit in a stabilization/recovery scenario where natural gas demand normalizes. We believe Williams is an attractive investment opportunity over our three- to five-year investment horizon.
In Closing
While the portfolio remains tilted toward Financials, Health Care, and Energy, the Fund remains broadly diversified with exposure to many different investment themes. We have strong conviction in our value-oriented, active investment approach, and we continue to believe this is an opportune time to invest in value stocks. We remain optimistic about the long-term outlook for the Fund, which trades at a significant discount to the overall market: 13.4 times forward earnings compared to 24.2 times for the S&P 500.
Market movements and valuation changes can occur swiftly and without warning, as evidenced by the strong rebound in Energy and Materials over the past quarter. These were two of the hardest hit areas of the market in the first quarter of 2020, and then they went on to be among the top performers in the second quarter. We have found that patience and persistence are essential to long-term investment success. We encourage our shareholders to take a similar view.
Our thoughts are with all the individuals and the families of those who have suffered from COVID-19, and we also express our gratitude to the dedicated health care workers and first responders battling on the front lines of this pandemic. We wish everyone the best during these challenging times.
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
July 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 390.3% from June 30, 2010 through June 30, 2020 compared to 169.1% for the Russell 1000 Value Index.
c The Dodge & Cox Stock Fund had a total return of 202.5% from June 30, 2010 through June 30, 2020 compared to 169.1% for the Russell 1000 Value Index.
d Unless otherwise specified, all weightings and characteristics are as of June 30, 2020.
e The use of specific examples does not imply that they are more or less attractive investments than the portfolio’s other holdings.
