Dodge & Cox (Trades, Portfolio), a mutual fund that can be found among the investing gurus at GuruFocus, is an institutional investor. And, one with a unique style.
It is a style that has worked. The San Francisco-based firm reports in its year-end message that its flagship Stock Fund had a total return of 21.3% in 2016, well ahead of the 12% posted by the S&P 500 Index.
But getting to that outperformance meant traveling a bumpy road; as the company also noted, “The Fund’s strong absolute and relative performance in 2016 was achieved with largely the same portfolio that produced weak results in 2015. Many of the biggest contributors in 2016 were the largest detractors in 2015.”
A Barron’s article from 2015 says, “Dodge & Cox’s superior performance, small roster of funds and steady inflows are bucking just about every trend in the fund industry today.”
In this article, we will review its argument for active investing, which parallels its own operating principles, and how the company has performed using these principles.
Committed to active management
It seems a never-ending debate, but in recent years public sentiment has often favored passive management of mutual funds and retail investing over active. Passive means mostly a hands-off approach such as indexing; set up a fund according to certain criteria, buy securities based on those criteria and then leave it alone. Perhaps the most well-known advocate of this strategy has been John Bogle, the founder and longtime head of Vanguard Group, a giant mutual fund company with a big roster of low-cost funds.
Dodge & Cox, on the other hand, runs just six funds and is definitely a believer in active management. This approach to investing means believing good managers can generate above-average returns by selling and buying securities relatively actively. In most cases, active management will involve buying and selling based on some preset philosophy or triggers.
In October 2016, the firm wrote and produced a paper titled "Understanding the Case for Active Management." The introduction includes this statement, “...the case against active investing is not as clear cut as its critics suggest. There are, in fact, substantial opportunities for astute managers who take an active approach to outperform passive alternatives. While no active manager can beat all markets all the time, a significant number of active managers have outperformed over longer-term intervals.”
The key here is "longer-term." As many value advocates will attest, judging performance on a quarterly or annual basis misleads investors. Responding to the frequent claim the majority of active managers do not beat the benchmark each year, it says, “…that turns out to be flawed approach to measuring long-term investment performance. Evaluating and comparing results for a calendar year may be convenient but not necessarily meaningful. In fact, 12 months, and particularly the 12 months that start each January, is an interval that generally doesn’t encompass a complete market cycle, nor does it capture the success or failure of active management strategies, which tend to have longer investment horizons.”
To bolster its case, Dodge & Cox analyzed Morningstar data for U.S. large-cap active equity funds; it concludes about one-third of active managers at those funds beat their benchmark over 20-year periods. During that time, of course, the results are very uneven, with underperformance some years and outperformance in others. The paper acknowledges the average annual outperformance is small but still significant because of the power of compounding.
As for the challenge, “who invests for 20 years?” The company responds: many individuals, foundations and pension funds. In particular, it points to pension funds which may begin receiving contributions for a person in their 20s, continue collecting contributions for 40 years, and then paying that person a pension for the next 30 years—in other words, a 70-year span.
It concludes the first section of the paper by noting, “…taking the long view is critical when investing in equities; similarly, measuring active managers over the long term is the best way to discover which ones truly have stock-picking skill.”
Believers in active investing, whether fund managers or retail investors, will welcome this contribution to the active versus passive debate. The paper provides a rationale, based on modest evidence, that active investing can work. It might be interesting, as a follow-up, to determine how much of the outperformance can be attributed to compounding versus stock picking. And, if we do invest for 20 years, at what point between buying and the 20th anniversary do we decide whether or not the fund meets our expectations? Or to put the question another way, if I bought a dog or collection of dogs, how will I know before its too late?
Long term—with conditions
The second half of the paper focuses on that question, which to the authors of the paper means finding the right active manager(s). How does an investor identify which managers will be among the successful minority over the next 20 years?
Dodge & Cox says six "features" stand out in research of successful active managers. Each of these features can be linked statistically to longer-term outperformance, in advance and consistently:
- High "active share": meaning managers who are not afraid of deviating significantly from the benchmark against which they are compared.
- Low fees and expenses: as noted, annual outperformance over the long term will involve small margins, which can only be preserved through minimal expenses.
- Low turnover: first because of trading costs, but also because large transactions can affect the price of the stock being bought or sold.
- Risk avoidance: by focusing on fundamental value, successful active managers can consistently generate higher risk-adjusted returns.
- Focus on a core competency: refers to a "particular strategy or type of portfolio"; when implemented on a firm-wide basis, it allows for the growth of expertise and depth.
- Alignment of interests: portfolio managers should personally invest their own money where they invest client funds.
Five of the six features seem intuitive, obvious to many observers. The high active share feature, though, comes as something of a surprise; could it also suggest active managers who fail to outperform over the long term have not been daring enough? Inquiring minds that consistently challenge the evidence will also want to know if the selection of these six features was (consciously or unconsciously) affected by the firm’s own key values and practices, which are much the same.
Dodge & Cox's performance
In its 87-year history, the company has created just six funds and killed off none. This table from the company’s website summarizes how those funds have done and how they compare with the benchmarks:
On the summary table, it all looks quite placid; but this year-by-year performance table from GuruFocus shows six years of losses and four years of gains, with the gains in the good years eclipsing the losses in the losing years:
The employee-owned company holds relatively few stocks from a limited number of sectors, as shown in this GuruFocus chart:
The company’s performance makes good on the claim made in the paper, that active management can provide better long-term gains, and the path to those long-term gains is a bumpy one. Presumably, a larger universe of stocks would reduce that bumpiness at the expense of long-term gains.
Conclusion
In its paper and 87 years of operations, Dodge & Cox has made a case for active investing, or what it calls "for deviating beyond the benchmarks."
But it is not easy; year-to-year results underline the angst of retail investors and active managers, as notably expressed by fund manager and GuruFocus writer Thomas Macpherson in his article, "Getting What You Need."
Getting back to Dodge & Cox, evidence from operations is more convincing than evidence from the paper. While the paper is an interesting articulation of the active management advantage, it does not provide the academic rigor which would make a robust case. On the other hand, the long-term results from operations have been consistent enough to make us think it is its management's skill, rather than luck or random results, that accounts for the success.
Disclosure: I do not own stock in any of the companies mentioned in this article, nor do I expect to buy any in the next 72 hours.
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