To Our Shareholders
The Dodge & Cox Stock Fund had a total return of 26.1% for the six months ended June 30, 2021, compared to a return of 15.3% for the S&P 500 Index and 17.1% for the Russell 1000 Value Index (R1000V).
Market Commentary
The U.S. equity market continued to appreciate during the first half of 2021, extending the gains that began in March 2020 (when the World Health Organization declared COVID-19 a pandemic) and reaching an all-time high in June of this year. The successful rollout of COVID-19 vaccines, unprecedented fiscal and monetary stimulus, healthy consumer balance sheets, and tightening labor markets created optimism about U.S. economic growth and helped propel stock market returns. Cyclical sectors of the market that lagged in early 2020 (e.g., Energy, Financials, Industrials) have recently outperformed significantly. Since the end of 2020, interest rates and commodity prices have risen, boosting the Financials and Energy sectors. Stock prices now reflect the market’s expectations for a sustained, strong economic recovery. Since Pfizer and BioNTech’s November 2020 announcement that they had successfully developed a COVID-19 vaccine, the Fund has outperformed the S&P 500 by a substantial 22 percentage points, the R1000V by 15 percentage points, and the Russell 1000 Growth Index by 26 percentage points.a
While value stocks have outperformed growth stocks by 12 percentage points since November, they continue to trade at a large discount to growth stocks.b The Russell 1000 Growth trades at a lofty 31.5 times forward earnings compared to 17.9 times for the Russell 1000 Value, a historically wide valuation disparity.c Many growth stocks are high-valuation technology companies with extreme valuations that reflect high expectations. We believe a number of these companies face significant challenges, including mounting competitive, technological, and regulatory threats. In addition, their valuations have benefited from lower interest rates and their perceived durability amid COVID-19, both of which could change going forward.
Investment Strategy
The Fund’s composition is very different from the overall market, and its portfolio trades at a meaningful discount to both the broad-based market and value universe: 13.9 times forward earnings compared to 22.3 times for the S&P 500 and 17.9 times for the R1000V. Stocks that benefit from rising interest rates are currently trading at particularly low relative valuations, and this is an area of emphasis for the Fund. Even if interest rates do not rise, the Fund still stands to benefit from valuation spreads returning to more historically normal levels.
The Fund also remains highly geared to an economic recovery, and we believe this recovery could be very different from previous ones. The U.S. government has provided extraordinary fiscal stimulus for the economy—more than was put forward in the New Deal, Marshall Plan, and global financial crisis combined as a percentage of gross domestic product (GDP). Moreover, in contrast to the 2008-09 global financial crisis, the U.S. banking system is profitable and well capitalized, consumers are ready to spend, and both home prices and job openings are at record levels. Usually it takes years for job openings to return to historic levels after a recession. Combining all of these factors, we believe the U.S. economy is primed to grow. While concerns about COVID-19 variants could influence the trajectory of the recovery, we believe this is a manageable risk over our three- to five-year investment horizon.
Our disciplined, value-oriented approach—grounded in our extensive research, long-term investment horizon, and organizational independence—has led us to invest in out-of-favor companies with strong fundamentals during periods of uncertainty. During the first nine months of 2020, we shifted over 10% of the portfolio into more depressed cyclical sectors, including Energy, Financials, and Information Technology Hardware. We largely funded those additions with trims from more defensive sectors, including Media, Pharmaceuticals, and Biotechnology.
Since November, however, we’ve taken largely reciprocal actions. We have trimmed more cyclical stocks as relative tradeoffs and value have recovered, and we have added to more defensive sectors based on company-specific opportunities. As the Fund’s holdings in the Energy and Financials sectors outperformed, we sold JPMorgan Chase and trimmed APA, Baker Hughes, Bank of America, Capital One Financial, Halliburton, and Truist Financial based on their increased valuations.d Despite these trims, the Fund remains overweight Financials (25.7% compared to 11.3% of the S&P 500 and 20.8% of the R1000V). Many financial services companies have low relative valuations that stand to benefit from accelerating economic growth and higher interest rates. Meanwhile, the Fund’s Energy holdings (8.4% compared to 2.9% of the S&P 500 and 5.1% of the R1000V) trade at attractive valuations, have generated high free cash flow relative to the market, are focused on returning capital to shareholders, and should benefit from recovering demand for oil as economies reopen.
We recently added significantly to the Fund’s holdings in Health Care based on low relative valuations, attractive business models, and several company-specific opportunities. In the first half of 2021, our largest increases included Sanofi and Incyte within the Pharmaceuticals and Biotechnology industries, respectively.
Sanofi
Based in France, Sanofi (SNY, Financial) is a global pharmaceuticals company with leading positions in rare diseases, vaccines, over-the-counter consumer health products, and emerging markets. Over the past decade, the company was beset by a variety of operational issues and low research and development (R&D) productivity, which led Sanofi’s Board of Directors to change its CEO in 2015 and again in 2019.
The current management team—including CEO Paul Hudson who joined from European competitor Novartis and CFO Jean-Baptiste Chasseloup de Chatillon from the auto industry—has made significant changes. The company has shifted R&D funding away from the highly competitive primary care drug market and towards the more lucrative specialty pharma market. Sanofi also launched an aggressive cost-cutting program to raise profit margins closer to peer levels. Recent results are encouraging, with the company achieving 7% earnings per share (EPS) growth in both 2019 and 2020.
Going forward, this pace of earnings growth could continue or even accelerate due to a potent combination of rising revenue and cost cutting. Over the next few years, we believe Dupixent—a blockbuster anti-inflammatory drug with multiple use cases—can also drive substantial growth. Longer term, we are encouraged by an expanding late-stage drug development pipeline with a number of compounds showing signs of initial clinical success. These positive changes do not yet seem to be appreciated by many investors, as evidenced by the company’s below average valuation of 13.4 times forward earnings. On June 30, Sanofi was a 2.8% position in the Fund.
Incyte
Incyte (INCY, Financial) is a U.S.-based biopharmaceutical company that discovers, develops, and commercializes proprietary therapeutics, largely focused on oncology. Since the Fund invested in the company over two years ago, Incyte has improved its R&D pipeline and launched three new products, which could collectively generate $1 billion in sales annually. We believe Incyte offers an attractive investment opportunity. The company’s reasonable valuation is supported by its main drug, Jakafi, which represents 83% of total revenues. And management continues to reinvest profits from the legacy product portfolio into the R&D pipeline. The team seeks to extend the Jakafi franchise beyond its patent expiry in 2027, and discover the next big drug to transform the company. Finally, Incyte could be an attractive acquisition candidate, given its growth prospects over the next decade, strong Jakafi franchise, and productive R&D organization. In addition, the company’s strong corporate governance and representation of long-term investors on the board align its interests with those of other long-term shareholders like the Fund. On June 30, Incyte was a 0.8% position in the Fund.
In Closing
We believe the current wide valuation disparities between value and growth stocks could close significantly in the coming years. More rapid economic growth and higher interest rates could propel value stocks to continue to outperform. Meanwhile, growth stocks may not benefit as much as value stocks from reopening economies, and they are more vulnerable to rising rates. While we are encouraged by recent performance results, we are aware that market cycles can be quite long. Value has been out of favor for over a decade and could take some time to recover, supported by still-wide valuation spreads. While the exact timing is unclear, we expect interest rates to be higher in the coming years, and the Fund is positioned to potentially benefit, largely through its holdings in Financials. We believe patience, persistence, and a long-term investment horizon are essential to investment success. We encourage our shareholders to take a similar 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
July 30, 2021
