Transcript:
Charles Pohl: Diana, over the past few years equity market valuations have increased substantially, although we continue to believe that they are reasonable. And while our approach has not changed, our expectation for future returns is more tempered today.
Diana Strandberg: That’s right, Charles. The P/E for the S&P 500 is now 17.5 times forward earnings, which is somewhat above long-term averages, and for the MSCI EAFE the P/E is 15 times forward earnings, which is slightly below long-term averages. Within the market, equity valuation disparities, the gap between the most expensive and least expensive stocks, has narrowed considerably and is now below long-term averages.
Charles Pohl: In the first half of 2015, most equity markets around the world appreciated in local currency terms. However, the strong U.S. dollar provided a headwind in terms of dollar returns. The U.S. dollar was particularly strong against the euro and fortunately, both the Global Stock Fund and International Stock Fund had partial hedges against this depreciation in the value of the euro, and that helped the returns for both of those funds. We also note that the level of interest rates is especially low in the United States and many of the developed countries relative to historical levels. And we’ve examined the sensitivity of the funds relative to their benchmarks to a rise in interest rates and we find that both funds would benefit relative to their benchmarks from an increase in interest rates. Particularly interesting along this line is that the U.S. Federal Reserve has made statements that this fall they may begin increasing short-term interest rates.
Diana Strandberg: That’s true. There seem to be three big-picture issues on investors’ minds. You mentioned very low level of interest rates and when they might normalize, affecting equity markets worldwide. As well, the Greek sovereign debt crisis and the Chinese economic picture and recent stock market gyrations. We do see higher valuations around the world but we are continuing to find attractive long-term opportunities at reasonable valuations using our same approach of thorough, bottom-up research with a long time horizon and a strict price discipline.
Charles Pohl: Against this backdrop, the Stock Fund was up approximately 1% in the first half of 2015, which roughly matched the return of the S&P 500.
Diana Strandberg: Financials were a notable contributor. I would point out Charles Schwab, which was up 9% in the first six months of 2015, following its 17% rise in 2014. And our holdings and overweight position in the Health Care sector were also big contributors to performance. Sanofi (SNY, Financial) stands out, up 11% in the first six months, though it was a notable detractor in 2014.
Charles Pohl: And Sanofi is a great example of a subject that we’ve talked about in prior videos, which is the value of patience and persistence, an underperformer last year, significant detractor from returns, and then a big help to the returns in the first half of this year. On the other hand, you know, Hewlett-Packard (HPQ, Financial), which was a great contributor for returns for the past two years, was one of the biggest detractors in the first half of 2015.
Diana Strandberg: Turning to the International Stock Fund, it lagged its benchmark, the MSCI EAFE, by 1.6 percentage points for the first six months. Information Technology was a big detractor. You mentioned Hewlett-Packard. I might also note Samsung, the Korean consumer electronics company, and Baidu, the Chinese internet company, as detractors.
Charles Pohl: And the emerging markets Financials were a significant detractor as well from performance in the first half.
Diana Strandberg: A bright spot in the portfolio is the International Stock Fund’s overweight position and individual holdings in the Media industry. Naspers (JPE:NPN, Financial), the largest holding in the fund, was up 20% in the first six months and Groupo Televisa up 14%.
Charles Pohl: And against this backdrop, the Global Stock Fund slightly lagged its benchmark for the first six months.
Diana Strandberg: As bottom-up investors, we’re always weighing what we’re buying, the company fundamentals, against what we’re paying, its valuation. In today’s market, where valuations are more reasonable and the spread between valuations is fairly narrow, we see more investment opportunity in companies with excellent fundamentals at reasonable valuations. So in other words, we’re weighing fundamentals more heavily in our investment assessment.
Charles Pohl: Diana, one example of a company with stronger fundamentals that’s in the portfolio is Express Scripts (ESRX, Financial), and Express Scripts is the largest pharmacy benefit manager in the United States with revenues of over $100 billion and a market share of 30%.
Diana Strandberg: And it’s accomplished its mission of helping to reduce health care and pharmacy costs for its customers by using its buying power to increase usage of generics where there are multiple equivalent treatments available. And as a result, generic penetration is very high today. A challenge for the company going forward is in the area of specialty drugs. There typically aren’t equivalent treatments available for complex and serious diseases like cancer, Hepatitis C, and multiple sclerosis.
Charles Pohl: And the specialty area is only about 2% of prescriptions in the United States but it’s about 25% of all spending. And that’s because the average specialty pharmaceutical has a price approximately ten times that of the average pharmaceuticals. And so herein lies the great opportunity for Express Scripts to try to manage those costs down. So if they’re able to achieve that, it could be quite a good outcome for Express Scripts in terms of its ability to grow its own profitability.
Diana Strandberg: So we have a company where we believe there are very attractive fundamentals and a reasonable valuation of 15.5 times forward earnings. As a result, we added to Express Scripts in the Stock Fund and the Global Stock Fund in the first half. As of June 30th it was a 2.4% position in the Stock Fund and a 2.1% position in the Global Stock Fund.
Charles Pohl: And while we are finding more opportunities for companies with strong fundamentals in the portfolio, we continue to find a few pockets of opportunity in the deep value space.
Diana Strandberg: Petrobras (PZE, Financial) would be a good example of a company where we’re weighing valuation much more heavily in our assessment of investment opportunity. It’s the leading producer of oil and gas in Brazil and the valuation is compelling. It trades at 40% of net asset value, which is quite low relative to its history, and half the level of its global peers. Investors are skeptical of the company’s prospects in light of the many challenges it currently faces.
Charles Pohl: And it does face some pretty big challenges, not the least of which is the extensive corruption probe that the company has been undergoing, and this has resulted in the replacement of the entire senior management team, which is going to take a little adjustment for the company. Also, there’s been a sharp decline in the oil price since the end of last year, which has put pressure on their cash flow and their ability to fund future development. But in spite of all of these things, the valuation is exceptionally low.
Diana Strandberg: There are some reasons for long term optimism. Petrobras actually increased its production in the first half of 2015 compared to the first six months of 2014. Their leading position in the pre-salt fields of the Santos Basin, one of the largest oil discoveries in the past 30 years, should help them continue to increase production in the years to come. These fields are vast and low cost, and the new management team has already been hard at work. They’ve implemented some improved corporate governance at the company, they display a lot more capital allocation discipline. For example, they’ve cut cap spending almost 40% and are focusing on their profitable exploration and production projects, and they’ve more than tripled their announced asset divestment program, which should bring in cash to help them strengthen the balance sheet.
Charles Pohl: So following a visit to Brazil to meet with the management team, we returned and we added to our positions in both the International Stock Fund and the Global Stock Fund. And so to summarize, while equity valuations are higher than they’ve been for the past few years, we continue to think that they are reasonable, although our expectations for future returns are somewhat more tempered. Corporations continue to have strong cash flow and strong balance sheets and we continue to find companies that we think have interesting prospects on a three- to five-year basis. While the markets may experience some short-term volatility due to some of the macro considerations that we discussed earlier, we believe that investors should remain focused on the long term. Thanks, Diana.
Diana Strandberg: It was a pleasure, Charles.
Charles Pohl: And thanks to all of you for joining us.
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Dodge & Cox Funds SEC Standardized Average Annual Total Returns as of June 30, 2015: Stock Fund: 1-Year 4.55%; 5-Year 17.80%; 10-Year 7.20%; Global Stock Fund: 1-Year 0.54%; 5-Year 14.42%; Since inception May 1, 2008 through June 30, 2015: 5.04%; International Stock Fund: 1-Year -3.64%; 5-Year 11.24%; 10-Year 6.96%.
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