To Our Shareholders
The Dodge & Cox Stock Fund had a total return of 31.7% for the year ended December 31, 2021, compared to a return of 28.7% for the S&P 500 Index and 25.2% for the Russell 1000 Value Index.
Market Commentary
In 2021, the broad-based U.S. equity market posted exceptionally strong results: the S&P 500 was up 29%. However, it was a tale of two halves for the performance of value and growth stocks.a
During the first half of the year, U.S. value stocks appreciated significantly and outperformed growth stocks, reflecting investors’ expectations for a sustained economic recovery. 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 previously lagged (e.g., Energy, Financials, Industrials) outperformed.
In the second half of 2021, however, value stocks underperformed as COVID-19 variants disrupted the economic rebound in the United States. While absolute returns were positive, investors expressed concerns about rising prices and wages, fading fiscal stimulus, and looming monetary tightening by the Federal Reserve. Strong consumer balance sheets and easy access to credit have supported consumer demand, but supply chain bottlenecks and labor market frictions have constrained output and propelled prices higher. Inflation is now at levels last seen in the 1980s, and the Fed has accelerated its plans to raise interest rates in 2022.
Investment Strategy
In 2021, the Fund’s absolute and relative performance was strong. While the U.S. equity market is fully valued in our opinion, the Fund’s portfolio trades at a meaningful discount to both the broad-based and value indices (13.3 times forward earnings compared to 22.1 times for the S&P 500 and 16.9 times for the Russell 1000 Value).b With the Russell 1000 Growth Index trading at 31.6 times forward earnings, the valuation gap between U.S. value and growth stocks is exceptional, and widened further during the fourth quarter.
As a result of our bottom-up, disciplined decision-making process, the Fund is overweight low-valuation stocks, which we believe are attractive given the currently wide valuation disparities. The portfolio is composed mostly of companies with strong franchises that should benefit from long-term economic growth in our view. In addition, the Fund remains underweight higher-valuation growth stocks, which we believe are more at risk due to lofty expectations for future performance. The portfolio continues to look very different from its benchmarks and maintains high active share: 84% versus both the S&P 500 and Russell 1000 Value.c
During 2021, we made gradual portfolio adjustments based on relative valuation changes. Many of the Fund’s holdings in the Financials and Energy sectors performed strongly, and we sold JPMorgan Chase and trimmed American Express, APA, Bank of America, Capital One, and Baker Hughes.d Despite these trims, the Fund remains meaningfully overweight Financials and Energy. On December 31, these two sectors comprised 31.5% of the Fund, compared to 13.4% of the S&P 500 and 25.8% of the Russell 1000 Value. The Fund’s Financials holdings are inexpensive, well capitalized, and could return meaningful amounts of capital to shareholders in 2022. Higher interest rates could further propel earnings growth. In Energy, oil prices rose 51% in 2021 as demand continued to rebound from pandemic-induced lows and exceeded supply throughout the year. Many energy companies have improved capital allocation by restraining spending on traditional oil and gas projects and returning more capital to shareholders. At current commodity prices, the Fund’s energy holdings trade at attractive valuations and generate substantial free cash flow, which can be used for increased returns to shareholders.
While we reduced our exposure to Financials and Energy throughout the year, we added substantially to the Fund’s holdings in the Health Care and Communication Services sectors. We selectively increased the Fund’s exposure to businesses with attractive valuations and durable franchises.
Health Care
Our largest additions to the portfolio in 2021 were in Health Care. Pharmaceuticals broadly underperformed, along with other more defensive sectors of the market. In addition, stock prices were negatively impacted by concerns about potential U.S. drug pricing legislation and lower current and future growth expectations from lower diagnoses and treatment rates for non-COVID-19 conditions.
Based on our value-oriented approach and analysis of the fundamentals, we added to the Fund’s positions in Gilead Sciences, GlaxoSmithKline, Incyte, Novartis, Roche Holding, and Sanofi, among others. These companies have leading franchises, low relative valuations, and innovation-driven opportunities. In addition, we also initiated two new positions in the sector: Elanco Animal Health and Regeneron Pharmaceuticals. In Biotechnology, we added most to Gilead Sciences, and the largest new position in the sector was Elanco Animal Health.
Gilead Sciences
Gilead (GILD, Financial) (1.9% position) is a biopharmaceutical company that develops and commercializes antiviral drugs for HIV, hepatitis B, hepatitis C, and influenza. While Gilead has a stable legacy HIV franchise, the company has struggled to build a pipeline capable of delivering the next set of products to drive its long-term growth. The HIV business will face pressure in the mid-2020s as patents expire. Since becoming Chairman and CEO in March 2019, Dan O’Day has made significant changes to the management team, and the company has invested aggressively to find products capable of generating growth outside of the legacy business. In September 2020, Gilead announced its acquisition of Immunomedics for $21 billion. Immunomedics’ most commercially promising asset is Trodelvy, a differentiated oncology drug that management hopes will become the cornerstone of Gilead’s oncology franchise. At only nine times earnings, Gilead increases the Fund’s exposure to innovation at an attractive price.
Elanco Animal Health
Elanco (ELAN, Financial) is one of the four largest players in the highly attractive Animal Pharmaceuticals industry. As a result of its acquisition of Bayer’s Animal Health division in August 2020, Elanco now has an enhanced portfolio with a balanced global revenue base and a stronger focus on the more profitable Companion Animal business. The company’s scale in its sales and marketing functions is a competitive strength. In addition, we believe Elanco’s research and development (R&D) results will improve, as Elanco’s R&D budget is now comparable with industry leader Zoetis, after languishing at lower levels for many years. On December 31, Elanco was a 0.5% position in the Fund.
Communication Services
In Communication Services, the Fund’s holdings have demonstrated strong cash flow generation, high recurring revenues, and pricing power. In addition, their customers have utility-like demand for broadband services. Comcast and Charter Communications exemplify these attributes, and we added meaningfully to both holdings during the year.
Comcast
Comcast (CMCSA, Financial) is the largest cable operator in the United States, has over 31 million internet subscribers, and is one of the leading U.S. media companies through its subsidiary, NBCUniversal. In the fourth quarter of 2021, Comcast underperformed after it reported a decline in new cable subscriber growth and increased competitive concerns about fiber and fixed wireless broadband. Despite these risks, we believe Comcast remains an attractive investment. Comcast owns a valuable portfolio of media intellectual property within NBCUniversal, and the company’s cable and theme park businesses have stable long-term growth prospects. Comcast continues to execute its streaming strategy, and Peacock—the company’s ad-based video on demand streaming product—continues to grow at a healthy pace. CEO Brian Roberts owns significant equity, and the company is focused on providing value to long-term shareholders through share buybacks and a 2.0% dividend yield. Trading at 14 times forward earnings, Comcast was a 2.5% position in the Fund at year end.
Charter Communications
Charter (CHTR, Financial) (2.1% position) is the second-largest cable operator in the United States and has more than 27 million internet subscribers. Similar to Comcast, Charter also underperformed the market in the fourth quarter. We added to Charter based on its reasonable valuation and ability to generate cash flow, which has provided significant value to shareholders over the years via share repurchases. Over the last five years, Charter has returned over $35 billion of capital to shareholders via share buybacks, and we believe substantial capital return will continue. Cable is a business with significant barriers to entry, healthy free cash flow generation, reasonable long-term growth prospects, and consistent pricing power.
In Closing
We continue to be optimistic about the long-term outlook for the Fund. While value stocks performed well in 2021, value has been out of favor for over a decade and large valuation disparities remain. In the coming years, we believe the portfolio would benefit from higher interest rates and accelerating economic growth. The Fund is diversified and well balanced across a range of sectors and investment themes.
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
February 1, 2022
- Generally, stocks that have lower valuations are considered “value” stocks, while those with higher valuations are considered “growth” stocks.
- Unless otherwise specified, all weightings and characteristics are as of December 31, 2021.
- Active share is a measure of how much an investment portfolio differs from its benchmark index, based on a scale of 0% (complete overlap with the index) to 100% (no overlap). Overlap for each security in the Fund is the lower of either its percentage weight in the Fund or its percentage weight in the index. Active share is calculated as 100% minus the sum of the overlapping security weights.
- The use of specific examples does not imply that they are more or less attractive investments than the portfolio’s other holdings.
