To Our Shareholders
The Dodge & Cox Global Stock Fund had a total return of 6.0% for the year ended December 31, 2020, compared to 15.9% for the MSCI World Index.
In 2020, global equity markets were extremely volatile. Global stocks fell sharply in the spring as the coronavirus (COVID-19) pandemic evolved, then rebounded quickly off March lows and performed well during the second and third quarters. After the successful development of effective COVID-19 vaccines, markets rebounded sharply again in November as investors looked forward to the potential for an economic recovery in 2021. The sudden market reversals this year illustrate the importance of having a long-term view and staying the course with one's convictions. Markets can turn quickly, and history shows us that major market moves are episodic and unpredictable. Thus, missing even a few days in the market can make a big difference to overall returns.
The fourth quarter saw a change in fortunes for value stocks,a with the MSCI World Value Index up 16%, outperforming the MSCI World Growth Index, up 13%. The Fund is overweight value sectors such as Energy and Financials, market laggards that later became market leaders during the quarter as global equities surged. Given its value-oriented positioning, the Fund significantly outperformed the MSCI World by 10.1 percentage points and the MSCI World Value by 8.4 percentage points.
While value outperformed growth in the fourth quarter, value stocks still lagged growth significantly for the yearMSCI World Value was down 1% versus up 34% for the MSCI World Growthand underperformed growth stocks by 142 percentage points over the last decade.b The Fund's value-oriented portfolio similarly lagged the market for the year. Since inception, the Fund has outperformed the MSCI World Value by an average annualized return of 1.9% and has underperformed the broad-based MSCI World by 0.8% on average.
We believe we are still in the early innings of a reversal between value and growth performance, and a strong case can be made for investing in value stocks going forward.
First, starting valuations matter, and 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: 13.2 times forward earnings compared to 21.0 times for the MSCI World.c Historically, lower starting valuations have produced more attractive long-term returns.
Second, we are encouraged by the approval of COVID-19 vaccines. The areas of the market impacted by COVID should continue to recover as more of the population becomes vaccinated. There is also the possibility that interest rates increase as the economy recovers, which would further benefit many of the Fund's holdings.
Third, history has indicated it is hard to stay a market leader. Several very large, high-valuation technology companies have had a large influence on 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.
We have strong conviction in our portfolio positioning. The portfolio is composed mainly of companies with strong franchises that benefit from long-term economic growth. About half the portfolio is invested in innovation-driven businesses in areas such as Internet & Direct Marketing Retail, Media, Communication Services, and Health Care. Given wide valuation gaps, the Fund also continues to have notable overweight positions in value parts of the market. Many stocks that were hit hard by the economic consequences of the pandemicnotably in the Financials, Energy, and Industrials sectorswere down significantly for the year, even after the fourth quarter rebound.
We continue to assess relative valuation opportunities, weighing long-term fundamentals against current prices. For example, while we added to Financials and other cyclicals earlier in the year, in the fourth quarter we trimmed Financials modestly on relative performance and added to Health Care. We discuss Financials and Health Care in more detail below.
After a rocky start, declining 32% in the first quarter, the MSCI World Financials sector appreciated in the second, third, and fourth quarters. Financials were especially strong in the fourth quarter, finishing up 24% and enabling the sector to end the year down just 3%. However, Financials had one of the lowest returns in the market for the year, amid concerns of a weak economy, high credit losses, and low interest rates driven by the pandemic. Additionally, regulators and central banks either explicitly or implicitly caused financial services companies to suspend dividends and share buyback programs that were expected to occur in 2020. In contrast to previous downturns, banks are in a much stronger position this time. In large part due to the effects of the 2008-09 financial crisis, banks entered the current crisis with low leverage, restrained risk taking, and well-diversified sources of revenue. Moreover, in anticipation of a sudden, pandemic driven downturn, many banks quickly set aside significant provisions for expected loan losses and remain broadly reserved for higher levels of joblessness than economies are currently experiencing. Finally, governments have provided unprecedented support to the economy to blunt the impact of potential credit losses. Despite this, valuations for Financials are near historic lows compared to the stock market as a whole. The MSCI World Banks industry trades at 12.8 times forward estimated earnings compared to 21.0 times for the broader MSCI World.
During the first part of the year, we added to the Fund's Financials holdings, which traded at exceptionally low valuations in light of the pandemic. With the resolution of the health crisis, we see potential for a return to higher economic activity, unwinding of provisions, and strong levels of capital return. The Federal Reserve, for example, has allowed the large banks to resume dividend payments and share repurchases. The Fund remains overweight Financials: 28.4% of the Fund compared to 12.8% of the MSCI World and 21.5% of the MSCI World Value.
Capital One (COF, Financial) is an example of a stock we added to opportunistically in 2020. A leading financial services company trading at an attractive valuation, Capital One represents exceptional long-term value in our opinion. The bank's most profitable businesscredit cardsfelt 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, an 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 11.0 times forward earnings, Capital One is trading at a substantial discount to the overall market.
As markets plunged earlier in the year and subsequently rebounded, we adjusted the Fund's positioning in the Health Care sector based on its relative attractiveness. The Fund's holdings in Health Care are largely comprised of pharmaceutical companies, whose earnings are generally stable and not sensitive to swings in the economy. Those defensive characteristics provided relative strength in the first quarter as pandemic worries hurt other areas of the marketsuch as Financials, Energy, Industrials, and Materialsmuch more. Companies in those sectors became exceptionally attractive, so we added to them by meaningfully trimming the Fund's Health Care holdings. The Fund's weighting in Health Care declined from 18.4% on March 31 to 14.5% on September 30.
However, while all sectors posted positive returns in the fourth quarter, Health Care underperformed the overall market by 7.2 percentage points. The Fund added back to Health Care, in particular in the Pharmaceuticals industry that now trades at an attractive 14.9 times estimated earnings. While an average valuation relative to history, it is in the bottom decile of its valuation relative to the market. We recognize concerns over drug pricing and uncertainty regarding the new Biden Administration's policies in the United States. However, we believe the Fund's Pharmaceuticals holdings have impressive innovation potential, global customer bases, and highly attractive valuations. In the fourth quarter, the combination of attractive fundamentals and valuations led us to begin to add back to many of the Fund's holdings, including Sanofi and GlaxoSmithKline.
Sanofi (SNY, Financial) is a French pharmaceutical company with particular expertise in rare diseases. In recent years the company has rebuilt its management team, replacing its Chief Executive Officer, Chief Financial Officer, and Head of Research and Development with executives that have a demonstrable track record of success. Moreover, while the company's new drug pipeline shows promise, we believe the stock price only reflects the discounted value of the current portfolio of approved drugs, with little or no value ascribed to the new drug pipeline.
GlaxoSmithKline (GSK, Financial), a UK-based pharmaceutical company, is a leader in the attractive vaccines and consumer health care markets, but its core pharmaceuticals business has struggled. A new management team joined in 2017-18 and has undertaken a turnaround plan, which includes divesting non-core businesses and rebuilding the company's new drug pipeline, particularly around immunology and oncology. The implied value of its pharmaceutical business is low, indicating that investors are giving little credit for better prospects in the future.
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 Industrialsbecame the market leaders. 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
- Value stocks are the lower valuation portion of the equity market, and growth stocks are the higher valuation portion.
- The MSCI World Value Index had a total return of 92.4% from December 31, 2010 through December 31, 2020 compared to 234.2% for the MSCI World Growth Index.
- Unless otherwise specified, all weightings and characteristics are as of December 31, 2020.
- The use of specific examples does not imply that they are more or less attractive investments than the portfolio's other holdings.