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Holly LaFon
Holly LaFon
Articles (9279)  | Author's Website |

Dodge & Cox 4th Quarter Commentary

Shareholder letter from the firm

February 13, 2018 | About:


The Dodge & Cox Stock Fund had a total return of 18.3% for the year ended December 31, 2017, compared to a return of 21.8% for the S&P 500 Index.


U.S. equity markets continued to climb steadily during the fourth quarter, capping off a year of strong performance and low volatility. The S&P 500 reached an all-time high in mid-December and ended the year up nearly 22%. The period of sustained performance in U.S. equities since March 2009 is the second longest in U.S. history.

During 2017, U.S. growth stocks (the higher valuation portion of the equity market) outperformed value stocks (the lower valuation portion) by 17 percentage points overall.a Companies in sectors and industries associated with technology (e.g., Information Technology, Internet Retail, Media) led the market. The “FAANG” growth stocks—Facebook, Amazon, Apple, Netflix, and Google—were particularly strong, accounting for 20% of the S&P 500’s total return. Within the traditional value sectors, Energy was a laggard despite an 18% increase in oil prices during the year. Dodge & Cox’s approach is value oriented, and the Fund outperformed the U.S. value investment universe by five percentage points.b However, the outperformance of growth stocks had a negative impact on the Fund’s relative results versus the broad-based S&P 500.

Robust corporate earnings growth, sustained economic expansion, and rising interest rates were major factors influencing equity market returns. Anticipation of the new U.S. tax bill signed in December, which significantly reduces statutory corporate tax rates, also contributed. Economic data released during the fourth quarter was solid (e.g., the unemployment rate hit a 17-year low), suggesting the U.S. economy remains on a steady path.


At Dodge & Cox, our strong price discipline is an essential component of our investment strategy. Investment returns hinge on the purchase price: a good company is not always a good investment if the starting valuation is too high. We seek to invest in companies with valuations that do not fully reflect prospects for the company and where our analysis suggests the possibility of more positive developments. We constantly weigh valuation against company fundamentals and re-evaluate our thinking as prices change.

In response to diverging valuations, we made a number of gradual portfolio adjustments during 2017. We trimmed selected Information Technology, Media, and Financials holdings that had performed strongly. The Fund’s largest sale was DXC Technology, the company formed through the merger of Hewlett Packard Enterprise’s services division and Computer Sciences Corporation. As a result of the Fund’s investment in Hewlett Packard Enterprise, the Fund received DXC shares in April 2017, and the stock performed strongly. While the CEO has an impressive track record of shareholder value creation, management’s three -year plan embedded high expectations for margin expansion and earnings growth. We questioned whether these targets, even if achieved, would be sustainable over the long term. These concerns, combined with DXC’s higher valuation, led us to sell the stock (up 36% over the holding period). We redeployed these proceeds, and others, into more attractively valued companies in the Health Care and Energy sectors, where our long-term outlook is more positive than that of many other investors.

Health Care

In the Pharmaceuticals industry, we believe valuations are compelling, reflecting regulatory and pricing concerns. As a result of industry consolidation and higher market shares, pharmacy benefit managers have been able to exert increased pricing pressure on drug manufacturers. This trend could impact long-term profitability for pharmaceutical companies. Despite these challenges, the FDA has recently increased the pace of new drug approvals. Most of the Fund’s pharmaceutical company holdings feature durable franchises with significant barriers to entry and growth potential from new discoveries and expansion into emerging markets.

Based on our evaluation of the risks and opportunities, the portfolio has significant exposure to the Pharmaceuticals and Biotechnology industries (15.0% compared to 7.4% for the S&P 500c ). In 2017, we added tactically to several holdings (including Bristol Myers Squibb) as valuations became more attractive and initiated three new positions: Eli Lilly and GlaxoSmithKline, which are highlighted below, and Gilead Sciences (a biopharmaceutical company focused on treatments and research for HIV/AIDS and hepatitis).d

Eli Lilly

During the second quarter of 2017, we initiated a position in Eli Lilly (NYSE:LLY), a leading drug company focused on branded pharmaceuticals and animal health products. As the only pharmaceutical company with a presence across all major drug classes in the diabetes field, it has an advantage in contracting and marketing products. Until recently, Eli Lilly was losing market share to Novo Nordisk and Sanofi in the key area of diabetes classes, given its smaller emerging markets footprint and lack of a basal insulin therapy. This trend reversed as Eli Lilly launched several new products during the last few years, and the company is now gaining share in most therapeutic areas within diabetes. Eli Lilly’s partnership with Boehringer Ingelheim, where costs and profits are shared 50/50, has been important in rejuvenating its diabetes portfolio.

After weathering two recent patent expirations, Eli Lilly is entering what could be an extended period of growth. The company’s four new drugs should each generate over $1 billion in annual sales. All of these recent product approvals have found commercial success and are driving future sales growth. If revenue grows as we expect, margins should improve significantly and boost earnings growth. The company has consistently had one of the better research and development (R&D) groups in the Pharmaceuticals industry due to its stable organization, thoughtful leadership, and high funding.

Most importantly, the company’s newly appointed CEO leads a competent management team that appears to be well aligned with the interests of long-term shareholders and capable of navigating competitive and regulatory risks. Eli Lilly was a 1.4% position in the portfolio on December 31.


The Fund recently re-established a position in GlaxoSmithKline (NYSE:GSK), after selling it in 2015. Based in the United Kingdom, the company has leading therapeutic franchises in respiratory care and HIV. In addition to its traditional pharmaceuticals business, the company is diversified through strong and growing businesses in vaccines and over-the-counter consumer health.

In 2015, we sold GlaxoSmithKline based on market headwinds and a higher valuation. The company’s pharmaceuticals business was suffering from pricing pressure on a key respiratory drug, Advair, and the pipeline of new drug launches was weak. The valuation, at 20 times forward earnings, was relatively expensive and did not sufficiently compensate for the risks. Some of those risks, including continued weakness in Advair sales, materialized, and the valuation declined after we sold the position.

In the second half of 2017, however, we built a position in GlaxoSmithKline again based on a more favorable fundamental long-term outlook and a lower valuation (12 times forward earnings). In the respiratory care division, declines in Advair sales should be offset by new drugs, aided by a new inhaler. The HIV segment is growing at healthy rates due to increased adoption of Dolutegravir, a drug that blocks an enzyme needed for HIV to replicate. Combined with continued growth in vaccines and consumer health, the company should achieve modest earnings growth. Meanwhile, the management team has also been revamped. The new CEO is focusing on renewing the pharmaceutical pipeline and has brought in a well-regarded head of R&D to lead that effort. Improvements in the drug pipeline will take time to manifest, but in the meantime, the company continues to generate stable cash flow and has an attractive 6% dividend yield. On December 31, GlaxoSmithKline was a 1.4% position in the Fund.


While Energy was the second-worst performing sector (down 1%) of the S&P 500 during 2017, we continue to believe Energy is an attractive area of the market. Global supply and demand fundamentals are supportive of higher oil prices. Demand growth in the developing world continues to be healthy, and the dearth of investment in new supply over the past few years should lead to a tighter balance. We conduct ongoing research to test our investment thesis and recently met with industry executives and experts in Houston and the Middle East. Our trips reaffirmed that development costs in U.S. shale oil are rising with more activity and that other global sources of new supply are likely needed to satisfy demand. Our research also reinforced the importance of investing in oil producers with assets on the low end of the cost curve and management teams that are investing counter-cyclically.

The Fund remains modestly overweight the Energy sector (7.8% compared to 6.1% for the S&P 500), primarily due to investments in the Energy Equipment & Services (Oil Services) industry and growing exposure to exploration and production (E&P) companies. Oil services companies are particularly appealing due to their strong franchises and ability to expand earnings as producers reinvest in projects to meet growing global demand. Given attractive valuations, we recently added to selected holdings, including Anadarko Petroleum (a leading global E&P company with strong operational capabilities) and Baker Hughes.

Baker Hughes, a GE Company

We have held Baker Hughes in the Fund since 1998, actively adding to and trimming from the position given relative valuation opportunities and changing fundamentals over the years. In July 2017, GE (NYSE:GE) Oil & Gas completed its acquisition of Baker Hughes, forming Baker Hughes GE (BHGE), now the second largest oilfield services company in the world after Schlumberger (also held in the Fund, 1.6% at year end). By combining oilfield services (Baker Hughes) and oilfield equipment (GE Oil & Gas) businesses, BHGE is the only company that serves the upstream, midstream, and downstream segments of the Oil, Gas, and Consumable Fuels industry.

Adjusting for the $17.50 per share cash dividend the Fund received in July, the stock was weak in 2017. While oil service activity levels have started to rebound in North America due to the resurgence of U.S. shale oil, hopes for an international recovery have been delayed. During the second half of 2017, we added to BHGE given its lower valuation, earnings growth potential, diversified business model, and financial strength. Management is targeting a $1.6 billion improvement in EBITDA, driven by 75% cost savings and 25% revenue synergies. BHGE has a long-term opportunity to increase its market share with its improved scale. BHGE’s leadership position in compressors and turbines generates long-term service contracts with attractive recurring revenue, which should reduce downside volatility. In addition, the company has a healthy balance sheet and recently announced a $ 3 billion share buyback. We believe BHGE provides attractive risk-reward diversification to the Fund’s Energy portfolio. The company was a 1.0% position on December 31.


U.S. equity valuations are now at the high end of the historical range. While we have a tempered return outlook for the overall U.S. market, we are optimistic about the long- term prospects for the Fund’s portfolio, which continues to trade at a significant discount to the market. On December 31, the Fund’s portfolio of 66 companies traded at 16 times forward estimated earnings, compared to 20 times for the S&P 500.

As an active, value-oriented manager, we believe the valuation disparities that characterize the current market offer significant opportunities. Our fundamental, bottom-up, price-disciplined investment approach requires conviction and patience. Accordingly, maintaining a long-term investment horizon and staying the course are essential. We thank our fellow shareholders for your continued confidence in Dodge & Cox. As always, we welcome your comments and questions.

For the Board of Trustees,

Charles F. Pohl, Dana M. Emery,

Chairman President

January 30, 2018

a. The Russell 1000 Growth Index had a total return of 30.2% compared to 13.7% for the Russell 1000 Value Index during 2017.

b. The Dodge & Cox Stock Fund had a total return of 18.3% compared to 13.7% for the Russell 1000 Value Index during 2017.

c. Unless otherwise specified, all weightings and characteristics are as of December 31, 2017.

d. The use of specific examples does not imply that they are more or less attractive investments than the Fund’s other holdings.

About the author:

Holly LaFon
I'm a financial journalist with a master of science in journalism from Medill at Northwestern University.

Visit Holly LaFon's Website

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