Dear Fellow Shareholders,
For the fiscal year ended October 31, 2017, the PRIMECAP Odyssey Stock Fund, PRIMECAP Odyssey Growth Fund, and PRIMECAP Odyssey Aggressive Growth Fund produced total returns of +28.51%, +32.12%, and +32.59%, respectively, in each case exceeding the +23.63% total return of the unmanaged S&P 500 Index.
The Odyssey Funds outperformed the S&P 500 in part due to favorable sector allocations, largely related to underweight positions in consumer staples, energy, telecommunication services, real estate, and utilities stocks. Overweight positions in information technology stocks further bene-fited the Odyssey Funds as the sector led the market during this period, returning +39%. Finan-cials stocks were the other stand-out performers during the past fiscal year, returning +37%. While each of the funds remained underweighted in financials stocks last year, the Stock Fund’s 13% average weighting in financials was only slightly below the 14% index weighting, and finan-cials added to the Stock Fund’s relative return last year due to favorable stock selection.
Favorable stock selection contributed to each fund’s relative outperformance. The benefit was greater in the Aggressive Growth and Growth Funds than it was in the Stock Fund. The Aggressive Growth and Growth Funds’ health care portfolios returned +36% and +30%, respectively, well ahead of the +23% S&P 500 health care sector return. The funds’ semi-conductor and related equipment holdings added to relative results in information technology, especially in the Aggressive Growth Fund (+110%) and Growth Fund (+74%). The Stock Fund benefited from strong selection in industrials. In consumer discretionary, cruise line stocks out-performed, adding to relative results in each fund.
Each of the PRIMECAP Odyssey Funds continues to be overweight in the health care, information technology, and industrials sectors, and underweight in the financials, energy, con-sumer staples, materials, utilities, and real estate sectors.
A more detailed discussion of the results of each PRIMECAP Odyssey Fund follows.
PRIMECAP Odyssey Stock Fund
For the fiscal year ended October 31, 2017, the Stock Fund’s total return of +28.51% exceeded the S&P 500’s total return of +23.63%.
Sector allocations and stock selections each contributed to the fund’s relative outperformance. Underweight positions in consumer staples, energy, telecommunication services, real estate, and utilities added to relative results. JPMorgan Chase, the fund’s largest holding, returned +49%. At the end of the fiscal year, 7% of the Stock Fund’s assets were invested in money center banks, including JPMorgan Chase, Wells Fargo, Citigroup, and Bank of America. We believe the U.S. banking system is far better capitalized than it was prior to the last financial crisis as the money center banks have rebuilt their capital bases over the last several years. We find our bank holdings to be attractively valued in light of their strengthened capital positions, an improving industry regulatory backdrop, and higher expected interest rates.
Favorable selection in industrials added to the Stock Fund’s relative results. The Stock Fund’s 18% average weighting in industrials stocks exceeded those of the other Odyssey Funds due to its larger investments in companies outside of the airline industry. Two of the fund’s machinery holdings, Caterpillar (+68%) and Deere (+54%), contributed meaningfully to the fund’s out-performance in industrials, as did Airbus (+76%) and FedEx (+31%).
The Stock Fund’s information technology portfolio returned +43%, exceeding the +39% index return. In addition to its semiconductor and related equipment holdings, including NVIDIA (+192%), Applied Materials (+96%), and KLA-Tencor (+49%), one of the fund’s “value tech” holdings, HP Inc. (+53%), contributed to the fund’s outperformance in information technology. These positives were partially offset by Qualcomm (-23%), Hewlett Packard Enterprise (+8%), and the fund’s zero weighting in Apple (+52%). We continue to believe in a “hybrid cloud” future in which enterprises will utilize a mix of computing resources deployed on their own prem-ises as well as in third-party “cloud” data centers, and we therefore find our “value tech” holdings, which trade at far below-average valuation multiples due to fears that the public cloud will render their business models obsolete, to be attractive.
Health care detracted modestly from the Stock Fund’s relative performance during the fiscal year. Within health care, the Stock Fund was most heavily weighted in pharmaceuticals stocks, which comprised 10% of average assets. During the past fiscal year, the fund’s pharmaceuticals holdings returned +13%, detracting from relative results. We are especially enthusiastic about our pharma-ceuticals holdings, which currently trade at a discount to the S&P 500. We believe favorable demographics and rising living standards in emerging market countries should result in above-average growth for health care products and services over the long term. In the near term, the Food and Drug Administration appears to be pursuing a more constructive agenda with respect to the pace of new drug approvals, albeit with a greater degree of focus on low-cost biologics.
The Stock Fund’s consumer discretionary investments detracted from relative results during the past fiscal year. While Sony (+39%) and the fund’s cruise line holdings, Royal Caribbean Cruises (+64%) and Carnival (+39%), outperformed, these positives were more than offset by L Brands (-38%) and Mattel (-35%).
Favorable selection in industrials added to the Stock Fund’s relative results. The Stock Fund’s 18% average weighting in industrials stocks exceeded those of the other Odyssey Funds due to its larger investments in companies outside of the airline industry. Two of the fund’s machinery holdings, Caterpillar (+68%) and Deere (+54%), contributed meaningfully to the fund’s out-performance in industrials, as did Airbus (+76%) and FedEx (+31%).
The Stock Fund’s information technology portfolio returned +43%, exceeding the +39% index return. In addition to its semiconductor and related equipment holdings, including NVIDIA (+192%), Applied Materials (+96%), and KLA-Tencor (+49%), one of the fund’s “value tech” holdings, HP Inc. (+53%), contributed to the fund’s outperformance in information technology. These positives were partially offset by Qualcomm (-23%), Hewlett Packard Enterprise (+8%), and the fund’s zero weighting in Apple (+52%). We continue to believe in a “hybrid cloud” future in which enterprises will utilize a mix of computing resources deployed on their own prem-ises as well as in third-party “cloud” data centers, and we therefore find our “value tech” holdings, which trade at far below-average valuation multiples due to fears that the public cloud will render their business models obsolete, to be attractive.
Health care detracted modestly from the Stock Fund’s relative performance during the fiscal year. Within health care, the Stock Fund was most heavily weighted in pharmaceuticals stocks, which comprised 10% of average assets. During the past fiscal year, the fund’s pharmaceuticals holdings returned +13%, detracting from relative results. We are especially enthusiastic about our pharma-ceuticals holdings, which currently trade at a discount to the S&P 500. We believe favorable demographics and rising living standards in emerging market countries should result in above-average growth for health care products and services over the long term. In the near term, the Food and Drug Administration appears to be pursuing a more constructive agenda with respect to the pace of new drug approvals, albeit with a greater degree of focus on low-cost biologics.
The Stock Fund’s consumer discretionary investments detracted from relative results during the past fiscal year. While Sony (+39%) and the fund’s cruise line holdings, Royal Caribbean Cruises (+64%) and Carnival (+39%), outperformed, these positives were more than offset by L Brands (-38%) and Mattel (-35%).
Favorable selection in industrials added to the Stock Fund’s relative results. The Stock Fund’s 18% average weighting in industrials stocks exceeded those of the other Odyssey Funds due to its larger investments in companies outside of the airline industry. Two of the fund’s machinery holdings, Caterpillar (+68%) and Deere (+54%), contributed meaningfully to the fund’s out-performance in industrials, as did Airbus (+76%) and FedEx (+31%).
The Stock Fund’s information technology portfolio returned +43%, exceeding the +39% index return. In addition to its semiconductor and related equipment holdings, including NVIDIA (+192%), Applied Materials (+96%), and KLA-Tencor (+49%), one of the fund’s “value tech” holdings, HP Inc. (+53%), contributed to the fund’s outperformance in information technology. These positives were partially offset by Qualcomm (-23%), Hewlett Packard Enterprise (+8%), and the fund’s zero weighting in Apple (+52%). We continue to believe in a “hybrid cloud” future in which enterprises will utilize a mix of computing resources deployed on their own prem-ises as well as in third-party “cloud” data centers, and we therefore find our “value tech” holdings, which trade at far below-average valuation multiples due to fears that the public cloud will render their business models obsolete, to be attractive.
Health care detracted modestly from the Stock Fund’s relative performance during the fiscal year. Within health care, the Stock Fund was most heavily weighted in pharmaceuticals stocks, which comprised 10% of average assets. During the past fiscal year, the fund’s pharmaceuticals holdings returned +13%, detracting from relative results. We are especially enthusiastic about our pharma-ceuticals holdings, which currently trade at a discount to the S&P 500. We believe favorable demographics and rising living standards in emerging market countries should result in above-average growth for health care products and services over the long term. In the near term, the Food and Drug Administration appears to be pursuing a more constructive agenda with respect to the pace of new drug approvals, albeit with a greater degree of focus on low-cost biologics.
The Stock Fund’s consumer discretionary investments detracted from relative results during the past fiscal year. While Sony (+39%) and the fund’s cruise line holdings, Royal Caribbean Cruises (+64%) and Carnival (+39%), outperformed, these positives were more than offset by L Brands (-38%) and Mattel (-35%).
PRIMECAP Odyssey Aggressive Growth Fund
For the fiscal year ended October 31, 2017, the Aggressive Growth Fund’s total return of +32.59% exceeded both the S&P 500’s total return of +23.63% and the Russell Midcap Growth Index’s total return of +26.25%.
Positive stock selection was the primary factor that drove the Aggressive Growth Fund’s relative outperformance. Sector allocations also added to the fund’s relative results, due primarily to the relative underperformance of its underweighted sectors, including consumer staples, energy, tele-communication services, real estate, and utilities. These positives more than offset the negative impact from the fund’s underweight position in financials.
The Aggressive Growth Fund’s consumer discretionary holdings (16% of average assets) returned +35%, exceeding the +20% index return. Chegg (+133%), a provider of digital education resources, Tesla (+68%), CarMax (+50%), and Sony (+39%) were the biggest contributors to the fund’s outperformance in consumer discretionary. Sony’s leadership in image sensing technologies is creating new revenue opportunities for the company, as evidenced by the increased use of Sony’s components in Apple’s latest iPhone X, which utilizes the company’s 3D image sensors for its signature facial recognition-based authentication feature.
The fund’s health care holdings (29% of average assets) returned +36%. Exact Sciences (+253%), the manufacturer of the Cologuard colorectal cancer diagnostic test, Nektar Therapeutics (+94%), and ABIOMED (+84%) were the largest contributors to the fund’s outperformance in health care. Other positive contributors included Spectrum Pharmaceuticals (+100%), QIAGEN (+39%), and Insulet (+58%). These more than offset declines in Axovant (-57%), OncoMed (-56%), Cerus (-41%), Xencor (-7%), and Alkermes (-3%).
Strong selection in information technology (31% of average assets) was largely due to the Aggressive Growth Fund’s semiconductor and related equipment portfolio, which returned +110%, led by NVIDIA (+192%), Micron (+158%), and Axcelis (+141%). The fund’s information technology holdings returned +46%, ahead of the +39% index return. Other positive contributors included Universal Display (+184%), Alibaba (+82%), Adobe (+63%), Cree (+60%), Blackberry (+55%), and FARO (+54%). These positives were partially offset by Ellie Mae (-15%), comScore (+4%), and the fund’s zero weighting in Apple (+52%).
The Aggressive Growth Fund’s industrials holdings (15% of average assets) returned +12%, below the +25% index return, due primarily to the fund’s investments in airlines (12% of average assets). While the fund’s airline portfolio returned +10%, the returns of its individual airline hold-ings varied widely. Southwest Airlines (+36%), Delta Air Lines (+22%), and American Airlines (+16%) were the best performers, followed by JetBlue Airways (+10%), United Continental Holdings (+4%), Alaska Air Group (-7%), Spirit Airlines (-23%), and Hawaiian Holdings (-26%). Airfares in certain regional markets have recently come under pressure as ultra-low-cost carriers attempted to gain market share from legacy players. We expect that legacy players will respond in a rational manner, and that their competitive positions will be sustained. We therefore remain optimistic about our airline holdings, which trade at among the lowest price-to-earnings multiples in the S&P 500.
The top 10 holdings, which collectively represented 30.5% of the portfolio at the period end, are listed below:
Outlook
Looking forward, we are constructive on the U.S. economic outlook. The current political envi-ronment could lead to deregulation and potentially lower taxes, which would support greater economic growth and corporate profits. As previously mentioned, we believe the U.S. banking system is far better capitalized than it was prior to the last financial crisis, lending further support to the economy. Real GDP growth has picked up recently, exceeding 3% in each of the past two quarters. The unemployment rate reached a new post-recession low of 4.1% in October, and real median household income is at record levels.
Even after a strong, multi-year run, U.S. equities currently trade for approximately 18x forward earnings per share, a reasonable valuation by historical standards. We believe this valuation com-pares favorably to bonds, with the U.S. 10-year Treasury Bond yielding approximately 2.4%. After holding flat at around $119 per share for three consecutive years, S&P 500 operating earn-ings per share are expected to grow 10% in 2017 to $132 per share, with double-digit growth currently forecasted for 2018. Ongoing earnings per share growth could support further S&P 500 stock price appreciation.
As always, we acknowledge that our long-term, bottom-up approach to investing can result in large deviations between the performance of our funds and that of the broader market. We none-theless continue to believe that this approach can generate superior results for our shareholders over the long term.
Sincerely,
PRIMECAP Management (Trades, Portfolio) Company
November 16, 2017
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.
