Primecap Odyssey Funds' 2022 Annual Shareholder Letter

Dear Fellow Shareholders,

For the fiscal year ended October 31, 2022, the PRIMECAP Odyssey Stock Fund, PRIMECAP Odyssey Growth Fund, and PRIMECAP Odyssey Aggressive Growth Fund produced total returns of -11.33%, -17.61%, and -28.21%, respectively. The unmanaged S&P 500^® Index produced a total return of -14.61% during the period. Sector allocation benefited results relative to the S&P 500^®, while the impact from stock selection varied widely by Fund.

The fiscal year marked an abrupt degradation in market conditions. The year began with a dis-ruptive bout of COVID-19, courtesy of the contagious omicron variant that peaked in mid-January. But in this case the prognosis was mostly good news, and thereafter Covid’s inordinate societal influence largely faded.

Geopolitical hostility and widespread inflation, however, supplanted COVID-19 as fresh sources of market anxiety. Russia’s invasion-turned-quagmire in Ukraine devastated the region and posed substantial risks to Europe and the world. Meanwhile, at home, stimulus-driven excess demand continued to overwhelm structurally-impaired supply chains and an inadequate labor pool; in other words, too much money chased too few goods (and services). Inflation thus broadened and worsened during the period, notching 40-year highs, as price spikes in goods and commodities hemorrhaged into stickier categories, like wages and services.

The Federal Reserve (the “Fed,”) chagrined by its earlier complacency in the face of ramping inflation, executed a dramatic hawkish pivot, punctuated by an ongoing series of aggressive rate hikes. The real economy stalled somewhat; despite solid nominal economic growth and a tight labor market, real gross domestic product declined during the first half of 2022. Yet the Fed resolved to further reduce economic activity, raising the prospects of a hard landing.

Equities unsurprisingly faltered amid this tumult, plummeting more than 25 percent from their January peak to their October lows before staging a late rally. Elevated inflation and rising interest rates weighed especially on high-valuation growth stocks; the communication services (-41%), consumer discretionary (-29%), and information technology (-20%) sectors lagged the market. Energy (+65%) fared best, a repeat of last fiscal year’s accolade, boosted by yet higher oil prices. Defensive sectors also generally outperformed, including consumer staples (+5%), utilities (+3%), and health care (+1%).

The Funds again endured a mixed relative report card, with only the Stock Fund eclipsing the benchmark. This divergent performance persisted from April’s half-year results, and it echoed last year’s rank ordering, as well. For two consecutive years, value stocks have outpaced growth stocks, with the gap widening substantially this fiscal year. Indeed, consistent with our semiannual commentary, the Growth and Aggressive Growth Funds outperformed size-specific, growth-centric indices for the full year despite trailing the broader market.

The Funds’ sector positioning continues to evolve, with information technology now a very modest underweight position in the Aggressive Growth Fund, a new development; the Stock and

Growth Funds had already expressed an underweight view. Otherwise, each of the Funds held an overweight position in the health care and industrials sectors, and an underweight position in the energy, real estate, consumer staples, communication services, materials, and utilities sectors. The Growth Fund was also underweight the financials and consumer discretionary sectors; of these, the Stock Fund was overweight financials while the Aggressive Growth Fund was overweight consumer discretionary.

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

PRIMECAP Odyssey Stock Fund

For the fiscal year ended October 31, 2022, the Stock Fund’s total return of -11.33% exceeded the S&P 500^®’s total return of -14.61%. Relative to the S&P 500^®, sector allocation and stock selection both provided tailwinds to Fund performance.

All three Odyssey Funds benefited from favorable sector allocation, albeit to different degrees. The Stock Fund was the best-positioned Fund, owing chiefly to its more limited exposure to communication services (3% of average Stock Fund assets versus 9% for the index), the worst-performing sector, and a more substantial industrials overweight position (18% versus 8%). As with the other Funds, the Stock Fund also benefited from a large overweight position in health care (24% versus 14%) and a modest cash position (4%). Partially offsetting these exposures were underweight positions in the three best-performing sectors, energy (2% versus 4%), consumer staples (1% versus 6%), and utilities (0% versus 3%).

The Stock Fund also generated favorable stock selection results, in contrast to the Growth and Aggressive Growth Funds. Health care was a primary differentiator, as the Stock Fund’s greater concentration in large-capitalization biopharmaceuticals fared better than its peer Funds’ outsized ownership of smaller-capitalization biotechnology stocks. Eli Lilly (

Stock selection elsewhere was more mixed. All three Funds largely avoided Meta (

PRIMECAP Odyssey Growth Fund

For the fiscal year ended October 31, 2022, the Growth Fund returned -17.61%, trailing the S&P 500^®’s -14.61% total return but exceeding the Russell 1000 Growth Index’s total return of -24.60%. Unfavorable stock selection more than offset favorable sector allocation relative to the S&P 500^®.

Sector allocation was slightly less advantageous than that of the Stock Fund given more exposure to communication services (5%) and less to industrials (13%). These incremental headwinds were partially offset by the Growth Fund’s larger health care overweight (30%) and less pronounced energy underweight (3%).

Stock selection was unfavorable overall. Despite several familiar health care outperformers – Eli Lilly, Amgen, and Biogen, plus BioMarin (BMRN) (+9%) – the Growth Fund’s greater biotechnology exposure detracted from results, especially Nektar (NKTR) (-75%) and BeiGene (BGNE) (-53%). Selection within consumer discretionary and information technology was also notably more unfavorable, with large positions in Alibaba (BABA) (-61%) and Splunk (SPLK) (-50%), respectively, weighing heavily on sector-level performance.

PRIMECAP Odyssey Aggressive Growth Fund

For the fiscal year ended October 31, 2022, the Aggressive Growth Fund’s total return of -28.21% trailed the S&P 500^®’s total return of -14.61% but slightly exceeded the Russell Midcap Growth Index’s total return of -28.94%. Unfavorable stock selection was the primary driver of underperformance relative to the S&P 500^®, while sector allocation provided a modest offset.

The Aggressive Growth Fund’s sector allocation benefit was quite limited. The main culprit rela-tive to its Odyssey Fund peers was a reduced position (less than 1% of average assets) in the high-performing energy sector. Likewise, even more so than the Growth Fund, the Fund suffered from greater exposure to communication services (6%) and less exposure to industrials (12%).

Stock selection was more unfavorable than the Growth Fund, albeit for similar reasons. As its name implies, the Fund’s more ‘aggressive’ growth orientation amid an unforgiving landscape for growth stocks proved especially punitive relative to the benchmark. Health care selection was a significant headwind, as the familiar winners (such as Eli Lilly and Biogen) were less consequential while sev-eral key holdings struggled. BioNTech (-50%) retrenched after a two-year Covid-fueled explosion; Pulmonx (LUNG) (-66%) plus larger positions in Nektar and BeiGene also detracted from results. Rhythm Pharmaceuticals (RYTM) (+119%) was a notable offset, as its drug for severe obesity, Imcivree, cleared several milestones. Within information technology and consumer discretionary, growth stocks again dragged on relative results. The collapses in HubSpot (HUBS) (-63%) and MaxLinear (MXL) (-51%), for instance, were representative of widespread weakness in high-multiple software and semiconductor stocks, respectively. And positions in Tesla and its Chinese EV competitor, Xpeng (XPEV) (-86%), contributed to underperformance in the consumer discretionary sector.

Outlook

Following late October’s market rebound, the S&P 500^® Index’s valuation returned to modestly elevated levels (16.7x forward P/E versus 15.5x 20-year average). But interest rates soared during the period, undermining a key rationale for above-average equity multiples; the 4.1% 10-year Treasury yield is now comparable to its longer-term historical norm. Meanwhile, recent earnings reports have generally disappointed, and the stronger dollar has a direct negative impact on near-term earnings given companies’ substantial foreign exposures. Forward earnings expectations are thus likely too high. Additionally, we remain wary of above-average macroeconomic risks, most obviously a Fed intent on reducing aggregate demand. These concerns leave us somewhat cau-tious overall, even after the market’s recalibration.

More broadly, we assess this year’s developments as a potential paradigm shift in the market. Notwithstanding an occasional glitch, the decade-plus since the Great Recession had been remarkably benign: accommodative financial conditions, steady if modest global economic growth, and a relentless equity bull market. A pliant Fed, offering investors quasi-insurance in the form of a “Fed put,” underwrote a “buy the dip” mentality that became ubiquitous.

But the COVID-19 era, both the virus and especially the policy response, ultimately sowed enough dislocation to tip the proverbial apple cart. Ironically, it was Covid’s abrupt fade – its welcome shift to endemic status – that applied the final push. The mass normalization of society, coupled with two years of excessive money supply growth, unleashed the worst inflation in forty years.

The hallmarks of the prior paradigm – low interest rates, inflation, and growth – bred a certain type of winner. Big Tech stocks were perhaps the ultimate winners, highlighted by the ascendance of FAANG stocks (Apple, Amazon, Alphabet, Meta, and Netflix) – plus a few select peers. A new paradigm would presumably upend this dynamic, as investors migrate from yesterday’s darlings to fresh leadership. And, as previously mentioned, these stocks indeed struggled this year; Meta, Netflix, Amazon, and Alphabet all badly lagged the market’s decline.

That said, picking the next winners is never straightforward. Despite largely avoiding Big Tech weakness, the Growth and Aggressive Growth Funds still struggled in relative terms due to their own idiosyncratic miscues. The Funds’ unconventional ownership of small-capitalization bio-technology and Chinese technology stocks, for instance, discussed at length in recent letters, has fared poorly of late. The Funds continue to own numerous beaten-down stocks in these industries.

The Funds also own underappreciated successes, however, including Eli Lilly, the Funds’ largest position. Lilly has long been a meaningful Fund position – it was the Stock and Growth Funds’ largest holding at the start of the year, and a Top 10 Aggressive Growth Fund position, as well. Its outsized gains during the period (+44%) catapulted the stock to the top of all three Funds, and it finished the period between 4 and 8 percent of each Fund’s year-end assets, multiples above its benchmark weighting of less than 1 percent.

Like several Fund stock narratives, the Lilly story began nearly two decades ago. The Stock and Growth Funds initiated positions in the 2000s as Lilly was approaching patent cliffs for its so-called “twin towers” of Zyprexa and Cymbalta. The market, foreseeing a collapse in revenue and earnings, assigned Lilly an anemic valuation. But this ignored a key plotline: the company’s earnings were disproportionately depressed by healthy R&D spend, and its promising pipeline had huge potential. Looking through our long-term lens, we identified this latent opportunity, which had been obscured by the market’s obsession with near-term dynamics. It took time, but by the mid-2010s Lilly had returned to robust revenue growth on the back of a stable of new products. Its earnings climbed and its multiple expanded.

But the story was not over. The Funds stayed invested (and the Aggressive Growth Fund joined the bloc) because of our optimism regarding two pipeline drugs that were largely overlooked by Wall Street’s sell-side consensus, each with transformative blockbuster potential: tirzepatide (brand name Mounjaro) for obesity and donanemab for Alzheimer’s. Since then, tirzepatide sur-passed trial expectations, achieving approval in diabetes with additional approval in obesity expected next year. And donanemab, despite skepticism regarding the beta amyloid hypothesis, continues to make regulatory progress. Following in Biogen’s choppy wake, donanemab faces ample investor doubt – but there persists an enormous unmet need for a desperate Alzheimer’s population, and the commercial opportunity is staggering. The stock’s spectacular run has gen-erated a superficially-high valuation (40.0x forward P/E), but earnings could plausibly quadruple in the mid-term as these drugs are absorbed by Lilly’s income statement. We believe that com-bined with a best-in-class management team, these two drugs (and the rest of Lilly’s pipeline) can deliver another decade-long chapter in this remarkable success story.

Meanwhile, in stark juxtaposition, the Funds have no exposure to Apple. Unlike its Big Tech peers, Apple has thus far avoided a major stumble. Its market capitalization is north of two trillion dollars, and it now represents roughly 7 percent of the S&P 500^® – a record-high weighting for any constituent since 1980. The company’s multiple re-rated higher pre-Covid and valuation has sustained at elevated levels (24.3x forward P/E). Apple is a premier brand that has made a habit of revolutionizing the consumer electronics industry. But it undeniably benefited from COVID-19, and its mid-term earnings outlook is uninspiring – in contrast to Lilly’s imminent inflection.

Each of these two Fund “positions” – a massive Lilly overweight and corresponding Apple under-weight – is a material departure from the benchmark. Each position embodies a high-conviction, inherently contrarian belief. Such deviation is emblematic of the Funds’ differentiated investment philosophy and process. And on the eve – or in the midst – of a paradigm change, we prefer the Funds’ distinctive portfolios to the benchmark status quo.

Tomorrow’s longer-term winners are, as always, uncertain. The contours of this potential new paradigm have yet to take shape. Rapidly rising rates tend to break things, and we expect wreck-age if the Fed perseveres. But eventually we believe a less Fed-centric market will arise, one where fundamentals and valuations feature more prominently than last decade’s artificial backstop. We are optimistic our holdings’ long-term fundamentals and attractive valuations will benefit from this evolution.

Sincerely,

November 6, 2022

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 involves 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.

The information provided herein represents the opinions of