To Our Shareholders
The Dodge & Cox Stock Fund had a total return of 7.2% for the year ended December 31, 2020, compared to a return of 18.4% for the S&P 500 Index and 2.8% for the Russell 1000 Value Index.
Market Commentary
The U.S. equity market was extremely volatile in 2020. In the first quarter, the coronavirus (COVID-19) evolved into a global pandemic, disrupting major economies around the world and abruptly ending the longest stock market bull run in U.S. history. U.S. equities fell sharply, then quickly rebounded off their March lows and performed strongly for the remainder of the year. A combination of depressed valuations, substantial fiscal and monetary stimulus, and a robust recovery in corporate earnings buoyed the U.S. equity market. After the successful development of effective COVID-19 vaccines in the fourth quarter, segments of the market that had previously lagged—such as Energy, Financials, and Industrials— outperformed as the U.S. stock market surged to an all-time high in December. This rapid and dramatic reversal illustrates the importance of having a long-term view and staying the course with one's convictions because markets can turn quickly.
Looking back on 2020, companies have fallen into two groups: businesses largely immune to the economic impact of the pandemic (we describe them as "COVID defensive") and those hit hard by the economic consequences of the pandemic ("COVID cyclical"). Approximately 70%a of the S&P 500 is in COVID-defensive businesses, mainly those in the Information Technology, Health Care, Consumer Staples, and Utilities sectors. Large technology-related companies have surged, especially the FAANGM stocks—Facebook, Amazon, Apple, Netflix, Google (Alphabet), and Microsoft. In contrast, the other 30% of the S&P 500 is comprised of COVID-cyclical companies—largely in the Financials, Energy, Industrials, and Real Estate sectors—that have not fared well. For example, Energy (down 34%) was the worst-performing sector of the S&P 500 in 2020, reflecting an unprecedented decline in demand due to worldwide stay-at-home orders and the global economic slowdown.
Investment Strategy
While the Fund's value-oriented portfolio underperformed the broad-based S&P 500 over the past decade, it outperformed the Russell 1000 Value by 38 percentage points.b Over the same period, U.S. value stocksc underperformed growth stocks by 218 percentage points.d In September 2020, however, the market started to shift in value's favor, but it is too soon to know whether this could be the beginning of a major reversal in market leadership. Increasingly, we believe a strong case can be made for investing in value stocks going forward.
First, the valuation differential between value and growth stocks remains wide by historical standards, which creates ample opportunities for value-oriented investors like Dodge & Cox. The Fund trades at a significant discount to the broad-based market: 13.7 times forward earnings compared to 23.7 times for the S&P 500. Historically, lower starting valuations have produced more attractive long-term returns.
Second, we are encouraged by the approval of effective COVID-19 vaccines. The COVID-cyclical areas of the market should continue to recover as more of the population becomes vaccinated and economic activity accelerates. In addition, as supply and demand move toward a better balance in the oil markets, Energy could outperform. Moreover, U.S. interest rates may increase as the economy recovers fully, which would further benefit many of the Fund's holdings.
Third, history has indicated it is hard to remain a market leader. Several very large, high-valuation technology companies have had a substantial impact on overall market returns. We believe many of them are overvalued and face significant challenges, not only in justifying their valuations but also because of mounting competitive and regulatory threats. In addition, they would be disadvantaged by higher interest rates.
The Fund leans heavily toward COVID-cyclical and value sectors, with notable overweight positions in Financials and Energy. We continue to look for opportunities to optimize in the portfolio based on our long-term outlook for each company and assessment of the valuation and market's expectations. During 2020, we added significantly to various financial services, energy, and low-valuation technology companies.
In Energy, oil prices have started to recover from a low of about $20/barrel in the spring to $49/barrel on December 31. We believe there is an opportunity for further price increases as demand continues to recover and supply is impacted by the low investment in oil exploration and production. While Energy led market returns in the fourth quarter, the valuations are still quite depressed in our opinion. Our views on two other sectors, Financials and Information Technology, are highlighted in more detail below.
Financials
In 2020, Financials was one of the worst-performing sectors of the market amid concerns that a weaker economy would lead to increases in credit losses for U.S. banks and lower interest rates would reduce profit margins. However, we believe the large U.S. banks are in a much stronger position compared to past downturns. During the 2008-09 global financial crisis, U.S. banks were at the epicenter of the downturn because of their heavy exposure to the troubled housing market. In contrast, the COVID-19 pandemic is a health crisis that has led to a sudden decline in economic activity. Most U.S. banks entered the current crisis with low leverage, restrained risk taking, and well-diversified sources of revenue. Moreover, in anticipation of a sharper downturn, many banks have set aside significant provisions for expected loan losses and remain broadly reserved for higher levels of economic distress than the United States is currently experiencing.
U.S. Financials' valuations are near historic lows compared to the stock market as a whole. Specifically, the S&P 500 Banks industry trades at 13.4 times forward estimated earnings compared to 23.7 times for the broader S&P 500. This sizeable discount does not fully reflect the banks' underlying strength, in our opinion. Looking ahead, we believe large banks are well positioned to benefit from the vaccine rollout and anticipated economic rebound, which should lead to better growth and lower credit costs in 2021. We expect capital returns to increase, as the Federal Reserve has allowed all the large banks to resume paying dividends and buying back their shares, with certain restrictions.
On December 31, the Fund had significant exposure to Financials: 28.4% compared to 10.4% for the S&P 500 and 19.6% for the Russell 1000 Value. Capital One Financial (a 4.3% position) was the Fund's largest holding at year end.
Capital One Financial
Capital One (COF, Financial) is a leading financial services company trading at an attractive valuation and, in our opinion, it represents exceptional long-term value. The bank's most profitable business—credit cards—felt the impact of weaker consumer spending as the pandemic took its toll on the economy. Yet, like many other Financials, it is well positioned to benefit from a healthier economy that we believe should emerge once vaccinations become widespread. The company has a number of strengths: scale in credit cards and auto lending, robust deposits, advanced digital banking platform, and a legacy of heavy investment in technology. Management is focused on the long term, committed to improving the bank's expense efficiency, and has a track record of earning higher risk-adjusted margins than its peers. At 11 times forward earnings, Capital One is trading at a substantial discount to the overall market, and we opportunistically added to the Fund's position in this stock during 2020.
Information Technology
Many of the U.S. growth stocks are expensive technology-related companies. Especially after their strong 2020 performance, Information Technology sector valuations are approaching year 2000-type levels by some measures, and unprofitable technology stocks now account for 32% of total technology stocks, which is close to the March 2000 level of 36%.
Given such stretched valuations, the Fund remains underweight the overall Information Technology sector and is primarily invested in lower-valuation technology stocks. The Fund's technology holdings trade at a significant discount to the overall Information Technology sector on various metrics, including 1.3 times sales (compared to 6.9 times for the S&P 500 sector and 2.1 times for the Russell 1000 Value sector) as well as 13.2 times estimated earnings compared to 29.4 times for the S&P 500 sector and 16.5 times for the Russell 1000 Value sector.
In 2020, we added to the Fund's enterprise hardware holdings, such as Dell (DELL, Financial), Hewlett Packard Enterprise (HPE, Financial), and HP Inc (HPQ, Financial). These companies have strong free cash flow and relatively modest valuations. Since hardware spending is cyclical, these stocks were negatively impacted by the pandemic, but they tend to perform strongly coming out of recessions. In addition, we added to Cognizant Technology Solutions (CTSH, Financial) and started a new position in Fiserv, which increased the Fund's exposure to IT Services.
Fiserv
Fiserv (FISV, Financial) is a diversified provider of financial technology and payment processing services to banks and merchants. Decreased merchant activity during the COVID-19 pandemic, combined with a sooner-than-expected CEO transition and partial sale of KKR's stake in the company, weighed on Fiserv's stock price and created an opportunity for us to start a position during the fourth quarter. Fiserv has a strong business franchise with dominant market positions in several major business lines, including global merchant transaction processing, U.S. issuer processing, and U.S. core banking processing. The company has a shareholder-focused management team and trades at an attractive valuation given its growth prospects. It also offers significant margin expansion potential from revenue synergies and cross-selling opportunities. On December 31, Fiserv was a 0.7% position in the Fund.
In Closing
2020 was a difficult year for value investors. However, the tide started to turn dramatically in the fourth quarter, as the previous laggards— specifically Energy, Financials, and Industrials—became the market leaders that quarter. Going forward, we continue to believe this is an opportune time to invest in value stocks.
We have strong conviction in the Fund's value-oriented portfolio, which is comprised mostly of companies with strong businesses that we believe would benefit from sustained economic growth. We remain optimistic about the outlook for the Fund and confident in our active investment approach. Since changes in valuations and share prices can happen swiftly and without warning, we encourage our shareholders to take a long-term 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 29, 2021
- Unless otherwise specified, all weightings and characteristics are as of December 31, 2020.
- The Dodge & Cox Stock Fund had a total return of 209.4% from December 31, 2010 through December 31, 2020 compared to 171.3% for the Russell 1000 Value Index.
- Value stocks are the lower valuation portion of the equity market, and growth stocks are the higher valuation portion.
- The Russell 1000 Value Index had a total return of 171.3% from December 31, 2010 through December 31, 2020 compared to 389.3% for the Russell 1000 Growth Index.
- The use of specific examples does not imply that they are more or less attractive investments than the portfolio's other holdings.
