Primecap Odyssey Funds' 2020 Annual Letter to Shareholders

Discussion of markets and holdings

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Sydnee Gatewood
Dec 18, 2020
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Dear Fellow Shareholders,

For the fiscal year ended October 31, 2020, the PRIMECAP Odyssey Stock Fund, PRIMECAP Odyssey Growth Fund, and PRIMECAP Odyssey Aggressive Growth Fund produced total returns of -1.48%, +6.83%, and +16.52%, respectively. The unmanaged S&P 500 Index pro-duced a total return of +9.71% during the period. Sector allocation generally benefited results relative to the S&P 500, while the impact from stock selection varied widely by fund.

The fiscal year started uneventfully enough, back when yield curves and trade wars dominated investor concerns. But thereafter the COVID-19 pandemic sowed a degree of disruption unmatched in the modern era. As the pandemic worsened, the United States endured a "Great Pause" in March and April when various restrictions, designed to mitigate the pandemic's toll, severely constrained economic activity. The subsequent economic collapse established several record-setting declines, among them the fastest bear market descent (the S&P 500 Index ulti-mately lost 34% of its value in just 22 trading sessions), the most job losses (more than 20 million, easily outpacing the Great Depression's 12 million mark), and the steepest GDP drop on record (-31.4% in Q2). Similar scenes, differing only in timing and magnitude, unfolded around the world, fracturing the once-integrated global economy.

The federal government, in tandem with foreign authorities, unleashed a torrent of stimulus and support in response, including open-ended assurances from the Federal Reserve to maintain low interest rates and staggering amounts of deficit spending. But reopening proved fraught with diffi-culty, and the initial economic recovery stalled somewhat at levels well below pre-pandemic highs.

The equity indices bounced aggressively starting in late March, ahead of the economy's turn. The S&P 500 then surpassed its previous high-water mark in fewer than six months, a record-short bear market dip. It ultimately peaked in early September, up 60% from its late March low, before easing into the fiscal year-end. But this impressive index-level performance masked substantial dispersion within, reflecting the pandemic's uniquely disruptive influence. Some technology-oriented businesses, seemingly ready-made for stay-at-home isolation, thrived; many other companies struggled just to survive. Emblematic of this theme, growth stocks dramatically out-performed value stocks during the period (+28% Russell 3000 Growth Index versus -8% Russell 3000 Value Index). And by sector, information technology (+34%), consumer discretionary (+25%), and communication services (+16%), which together house the so-called Big Tech stocks, fared best, while energy (-46%) and financials (-15%) followed crude oil prices and inter-est rates lower.

Last year we largely missed the market's "flight to quality," wherein both higher-caliber cyclical stocks and bond-proxy defensive stocks outperformed simultaneously. And this year we found our-selves in a similar situation: insufficiently exposed to a select tranche of massive, premium-priced market leaders. The 'Big 4' of Apple, Microsoft, Amazon, and Alphabet/Google surged by more than 50% on average, generating more than 500 basis points of underperformance relative to the S&P 500 in each Fund.

Relatedly, the Funds' wide variance in performance is also partially explained by this stark growth-value performance gap. The Stock Fund has a fairly balanced exposure to value and growth stocks; the other Funds, as their names imply, are more commonly tethered to higher-growth companies. But "growth" stocks are, by definition, typically just high-multiple stocks, whose relatively inflated price-to-earnings and/or price-to-book valuations earn them the growth moniker. We try to approach such lofty valuations with clear-eyed caution, even in our growth-oriented funds. We do eagerly underwrite growth where we see mispriced long-term opportunities see our substantial biotechnology holdings, for instance but we are hesitant to pile into the second half of popular well-worn narratives. This year's rare circumstances, however, gave those latter stories added life.

Each of the Funds held an overweight position in the health care, industrials, and consumer discre-tionary sectors, and an underweight position in the energy, real estate, consumer staples, commu-nication services, materials, and utilities sectors. The Stock Fund maintained a modest underweight in information technology and an overweight in financials; the Aggressive Growth Fund featured the opposite weightings; and the Growth Fund held underweight positions in both sectors.

A more detailed discussion of the results of each PRIMECAP Odyssey Fund follows.

PRIMECAP Odyssey Stock Fund

For the fiscal year ended October 31, 2020, the Stock Fund's total return of -1.48% trailed the S&P 500's total return of +9.71%. Relative to the S&P 500, unfavorable stock selection drove the underperformance, while sector allocation was roughly neutral.

The Stock Fund's beneficial underweight positions in several weak sectors, particularly energy (1% of average assets versus 3% for the index), served to roughly offset its substantial overweight exposure (18% versus 8%) to the underperforming industrials sector (-1% benchmark return). Relative to its Odyssey Fund peers, the Stock Fund has larger industrials (18% of average assets) and financials (13% of average assets) ownership, while its health care (25% of average assets) and information technology (24%) ownership is less pronounced. All four differentiated exposures proved unhelpful during the period, with the Fund's financials overweight position creating the largest incremental headwind.

Stock selection was broadly unfavorable. Within information technology, no exposure to bell-wether Apple (

AAPL, Financial) (+77%) created a substantial hurdle; counterintuitively, so did ownership of Microsoft (MSFT, Financial) (+43%), where the Fund's sizable position represented just half of its index weighting. Elsewhere in the sector, strength in Qualcomm (QCOM, Financial) (+58%) and Ericsson (ERIC, Financial) (+30%) was unable to offset declines in Hewlett Packard Enterprise (HPE, Financial) (-45%) and NetApp (NTAP, Financial) (-18%).

Within industrials, airline weakness led to steep underperformance, as United (

UAL, Financial) (-63%), American (AAL, Financial) (-62%), Delta (DAL, Financial) (-43%), and Southwest (LUV, Financial) (-29%) all plummeted amid the travel freeze; Airbus (XPAR:AIR) (-49%) also suffered as collateral damage. This widespread pain more than offset a robust recovery year for FedEx (FDX) (+73%), which continues to benefit from the rise of e-commerce. Within consumer discretionary, a large and differentiated Sony (SNE) (+38%) position was unable to offset weakness in Carnival (CCL) (-67%), a ground-zero pandemic stock, and the Fund's limited ownership of heavyweight Amazon (AMZN) (+ 54%). And lastly, in financials, several bank holdings (Wells Fargo (WFC) -57%, Bank of America (BAC) -22%, and JPMorgan Chase (JPM) -19%) felt the earnings pressure of record-low interest rates, with Wells Fargo also struggling to overcome twin reputational and regulatory headwinds.

The top 10 holdings, which collectively represented 29.2% of the portfolio at the period end, are listed below:

PRIMECAP Odyssey Stock Fund

Ending % of

Top 10 Holdings as of 10/31/20

Total Portfolio*

AstraZeneca Plc ADR

4.1

Eli Lilly & Co.

3.8

Microsoft Corporation

2.8

Siemens AG

2.8

FedEx Corporation

2.8

AECOM

2.7

Sony Corporation ADR

2.7

JP Morgan Chase & Co.

2.5

Telefonaktiebolaget LM Ericsson ADR

2.5

Whirlpool Corporation

2.5

Total % of Portfolio

29.2

*The percentage is calculated by using the ending market value of the security divided by the ending market value of the total investments of the fund.

PRIMECAP Odyssey Growth Fund

For the fiscal year ended October 31, 2020, the Growth Fund returned +6.83%, behind both the S&P 500's +9.71% total return and the Russell 1000 Growth Index's total return of +29.22%. Favorable sector allocation was unable to fully offset poor stock selection relative to the S&P 500.

Sector allocation was somewhat better than that of the Stock Fund given the Growth Fund's lesser exposure to industrials (13% of average assets) and financials (8%). The Growth Fund has slightly greater exposure to energy (2%), which dampened that sector tailwind, but it benefited similarly from negligible holdings in several underperforming defensive sectors (consumer staples, real estate, and utilities).

The Growth Fund suffered from unfavorable stock selection in information technology and industrials, which together more than offset strength in the Fund's health care portfolio. As with the Stock Fund, Apple and the airlines were the primary sins of omission and commission, respectively. Elsewhere in information technology, Splunk (+65%) and Adobe (+60%) roughly offset the Fund's greater underweight position in Microsoft (+43%).

Selection in health care was broadly positive, with the Fund's portfolio (+18%) outperforming the sector's benchmark return (+10%). Two large holdings, BeiGene (+114%) and Seagen (+55%), led the way, more than offsetting weakness in Biogen (-16%). Finally, consumer discretionary featured several standout performances, which together even managed to overcome the sector headwinds deriving from too much cruise line ownership and too little Amazon ownership. Tesla (+516%) soared on stronger fundamentals and the allure of its seemingly limitless potential, while Alibaba (+72%) and iRobot (+66%) surged higher as well.

The top 10 holdings, which collectively represented 26.5% of the portfolio at the period end, are listed below:

PRIMECAP Odyssey Growth Fund

Ending % of

Top 10 Holdings as of 10/31/20

Total Portfolio*

Alibaba Group Holding ADR

3.4

Eli Lilly & Co.

3.0

ABIOMED, Inc.

2.9

Alphabet Inc. Class A & C

2.9

Biogen Inc.

2.6

AECOM

2.4

Seagen, Inc.

2.4

Micron Technology, Inc.

2.4

Morgan Stanley

2.3

BeiGene, Ltd ADR

2.2

Total % of Portfolio

26.5

*The percentage is calculated by using the ending market value of the security divided by the ending market value of the total investments of the fund.

PRIMECAP Odyssey Aggressive Growth Fund

For the fiscal year ended October 31, 2020, the Aggressive Growth Fund's total return of +16.52% led the S&P 500's total return of +9.71% but lagged the Russell Midcap Growth Index's total return of +21.14%. Both sector allocation and stock selection boosted results relative to the S&P 500.

The Aggressive Growth Fund benefited from sector exposures that were nearly all incrementally favorable relative to the Stock and Growth Funds. Most notable among these differences include its overweight positions in the two best-performing sectors, information technology (27% of average assets) and consumer discretionary (14%) and reduced relative exposure to industrials (11%) and financials (6%).

Stock selection was favorable overall, with strength in health care, consumer discretionary, and financials offsetting the familiar weakness in industrials and information technology. The Aggressive Growth Fund featured even greater exposure to travel laggards, including meaningful positions in JetBlue (-38%), Royal Caribbean (-47%), and Norwegian Cruise Lines (-67%), and the least aggregate exposure to the so-called Big 4 technology companies; these served to worsen the related stock-specific headwinds.

And yet favorable selection elsewhere still drove outperformance. Health care was a particular bright spot, as the portfolio's +23% return handily outpaced its benchmark. BioNTech, one of the most promising COVID-19 vaccine developers, rocketed higher (+408%), complementing the bio-technology strength in BeiGene (+114%) and Seagen (+55%). Consumer discretionary benefited from even larger positions in Tesla (+516%) and Sony (+38%), and strength in Chegg (+140%), a pandemic-friendly education technology company, also provided a powerful boost. Within finan-cials, top 10 holding MarketAxess (+47%) was the primary driver of sector outperformance.

The top 10 holdings, which collectively represented 27.5% of the portfolio at the period end, are listed below:

PRIMECAP Odyssey Aggressive Growth Fund

Ending % of

Top 10 Holdings as of 10/31/20

Total Portfolio*

Sony Corporation ADR

3.8

Splunk Inc.

3.4

Seagen, Inc.

3.4

Micron Technology, Inc.

3.0

ABIOMED, Inc.

2.7

Tesla Inc

2.4

MarketAxess Holdings, Inc.

2.4

Biogen Inc.

2.2

Alibaba Group Holding ADR

2.2

BeiGene, Ltd. ADR

2.0

Total % of Portfolio

27.5

*The percentage is calculated by using the ending market value of the security divided by the ending market value of the total investments of the fund.

Outlook

Our view on U.S. equities is decidedly mixed. The post-recession economy has been heavily reli-ant on artificial and unsustainable measures, including a three trillion-dollar federal deficit and the promise of further stimulus ahead. And, as noted, the market's apparent strength, unusually concentrated in larger technology stocks, belies a broader fundamental struggle on metaphorical Main Street, creating an unusually bifurcated stock landscape. That said, Treasury yields hover at historically depressed levels (0.9% 10-year Treasury yield at period-end), providing some support for the S&P 500 Index's elevated valuation (19.6x P/E valuation on 2021 estimated earnings).

We do see more fundamental reasons for optimism in select cases. The groundbreaking BioNTech-Pfizer vaccine may not be an immediate silver bullet, but it speaks loudly to the poten-tial of a robust medical solution. Additional vaccine candidates and antibody therapies are also on the cusp of clinical outcomes. Meanwhile, even after early November's vaccine-fueled market rotation, many stocks continue to languish, left behind in this protracted socially-distanced existence. Our original expectation of a fairly prompt snapback was misplaced, but we still expect the eventual 'new normal' to more closely resemble its 2019 antecedent than the current state of apprehension and isolation. This should divert oxygen from pandemic beneficiaries to a wide swathe of struggling companies. A more fulsome recovery may also spur inflation and interest rates upward, which could finally and forcefully shift sentiment from high-multiple growth stocks to inexpensive value stocks.

As noted earlier, an especially unusual feature of today's equity market is its inequity: the sheer rela-tive size of so-called Big Tech. The Big 4 technology stocks Apple, Microsoft, Amazon, and Alphabet/Google comprise more than 20% of the S&P 500 Index. Their combined capitalization (approximately $6T) is roughly equivalent in size to the bottom 350 constituents of the index, or to the Japan Exchange Group, the largest equity market outside the United States. And their com-bined performance strong-armed the S&P 500 to its record highs; indeed, the S&P 500 Equal Weight Index, reflecting broader-based challenges, has lagged its capitalization-weighted peer.

History suggests this concentrated frenzy warrants caution. In the early 1970s, the so-called "Nifty Fifty" similarly captivated investors, dominating that era's bull market as the must-own blue-chip growth companies. In the late 1990s, the Nasdaq 100 Index's meteoric rise was symbolic of that decade's irrational exuberance. In both cases, despite above-market earnings growth thereafter, these high-flying stocks underperformed in the ensuing decade. Valuation ultimately mattered.

But maybe this time is different. In aggregate, valuations for these heavyweights are high but not excessively so; their competitive moats seem to deepen with time, a function of their aggressive reinvestment strategy; and technology's coronation feels less speculative or premature this time around. And yet the Odyssey Funds' exposure to these four companies stood at just 2-5% at period-end, or a fraction of the index, with Microsoft and Google representing the bulk of our ownership. The Fund's underweight position in Apple and Amazon has created a massive multi-year performance headwind. We acknowledge these errors, but we remain wary. These titans have executed near-flawlessly in an environment tailor-made for their ascendance. As we emerge from the pandemic's long shadow, the durability of their dominion will be tested anew. Our bias is to search elsewhere.

Health care also features prominently in both the news and our portfolio. The pandemic reinforces the incalculable value embedded in existing drugs, therapies, and devices, which facili-tate our ongoing fight against disease and death and which have presumably helped pressure COVID-19's infection fatality ratio (IFR) down to roughly 50 basis points. But the pandemic also highlights how much value remains to be created with future breakthroughs, both in the COVID-19 realm and beyond. The health care sector has unsurprisingly fared well, and con-sensus estimates project market-leading revenue (+7%) and earnings (+5%) growth in a calendar year more commonly scarred with steep declines. But this is not chiefly a pandemic-fueled surge, and growth should persist indefinitely. Despite ongoing political concerns following a tense elec-tion, we are optimistic our companies will continue to develop life-saving innovations, and that they will be rewarded by the marketplace.

Finally, much ink has been spilled in past letters defending our outsized airlines ownership. We viewed them as secular growers, operating in a vastly-improved industry structure, and trading of late at less than half of the market's valuation. Whatever the merits, our investment thesis and our performance was dealt a dramatic blow by COVID-19, forcing a structural reset in both our holdings and our thinking. We continue to own these companies, albeit more selectively and with overall lower exposure, ahead of travel's eventual revival.

We still believe that some semblance of normalcy will prevail. Several pandemic-driven structural changes will likely persist, including a more flexible workforce, the fast-forwarding of digital tran-sitions, and certain business travel indefinitely lost to Zoom. But if and when life does normalize, we expect the market's go-forward winners to be drawn heavily from its pool of COVID-19 los-ers. And we believe our Funds are positioned accordingly, focused on stocks whose long-term potential deviate meaningfully from today's dislocated share prices.

Sincerely,

PRIMECAP Management (Trades, Portfolio) Company

November 10, 2020

Past performance is not a guarantee of future results.

The funds invest in smaller companies, which involve additional risks such as limited liquidity and greater volatility. All funds may invest in foreign securities, which involve greater volatility and political, economic and currency risks and differences in accounting methods. Mutual fund investing involves risk, and loss of principal is possible. Growth stocks typically are more volatile than value stocks; however, value stocks have a lower expected growth rate in earnings and sales.

Please refer to the Schedule of Investments for details of fund holdings. Fund holdings and sector allocations are subject to change at any time and are not recommendations to buy or sell any security.

The information provided herein represents the opinions of

PRIMECAP Management (Trades, Portfolio) Company and is not intended to be a forecast of future events, a guarantee of future results, or investment advice.

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I am the editorial director at GuruFocus. I have a BA in journalism and a MA in mass communications from Texas Tech University. I have lived in Texas most of my life, but also have roots in New Mexico and Colorado. Follow me on Twitter! @gurusydneerg