The Dodge & Cox Stock Fund had a total return of –1.8% for the first quarter of 2018, compared to –0.8% for the S&P 500 Index.
After consistently strong performance in 2017, U.S. equity markets were volatile during the first quarter of 2018. The S&P 500 surged in January and reached an all-time high amid positive market sentiment regarding the U.S. tax reform legislation that was enacted in December—the largest change of the tax code in more than 30 years. However, market exuberance was buffeted by significant turnover in the Trump administration and concerns about the Trump tariff initiative escalating global trade tensions. The S&P 500 finished down 0.8% for the quarter, after nine consecutive quarters of positive returns.
Market volatility can create buying opportunities for patient, long-term, value-oriented investors like Dodge & Cox. For example, we selectively added to Johnson Controls International, a global diversified technology and multi-industrial leader serving customers in more than 150 countries. We believe its share price was excessively penalized in reaction to news of impending tariffs. While the company uses steel, aluminum, and copper in its products—such as cooling systems—the financial impact of the tariffs should be minimal because the majority of Johnson Controls’ manufacturing is done regionally (not for export), with steel and aluminum sourced from those markets. In our opinion, Johnson Controls is an attractive holding due to its strong franchise, attractive earnings growth profile, and modest valuation relative to peers.
We are also finding various long-term investment opportunities in the Pharmaceuticals industry. Many of these companies have stable businesses with strong balance sheets and attractive growth potential resulting from new drug discoveries and expansion into emerging markets. During the quarter, the Fund’s largest addition within the industry was Roche, a Swiss-domiciled company with strengths in oncology and diagnostics. Roche’s drugs face increasing competition from biosimilars,2 but we believe its low valuation of 13 times forward earnings does not reflect potential upside from its extensive pipeline of promising compounds as well as its industry-leading research and development budget.
The U.S. economy remains on a steady growth path, as indicated by data released during the first quarter: the labor market continued to strengthen and economic activity rose at a moderate rate. Robust corporate earnings growth and sustained profit growth have spurred stock market returns. However, U.S. equity valuations continue to be near 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 March 31, the Fund’s portfolio of 64 companies traded at 14 times forward estimated earnings, compared to 17 times for the S&P 500.
Our fundamental, active, value-oriented investment approach requires conviction and patience. Since short-term market movements are impossible to predict, and markets could continue to be volatile, we encourage shareholders to remain focused on the long term. Thank you for your continued confidence in Dodge & Cox.
First Quarter Performance Review
The Fund underperformed the S&P 500 by 1.0 percentage point during the quarter.
Key Detractors From Relative Results
Holdings in the Consumer Discretionary sector (down 2% compared to up 3% for the S&P 500 sector) hindered results. Media companies DISH Network (down 21%), Comcast (down 14%), and Charter Communications (down 7%) were weak.
Information Technology (up 4% for the S&P 500 sector) was the strongest area of the Index; the Fund’s lower average weighting in the sector (18% versus 25%) hindered relative performance. Micro Focus (down 58%) lagged significantly following the announcement of the CEO’s unexpected departure and negative business trends.
Cigna (down 17%) also detracted from results, partly due to its bid for Express Scripts (down 7%).
Key Contributors to Relative Results
The Fund’s underweight position in the Consumer Staples sector (down 7% for the S&P 500) and lack of holdings in the Real Estate and Utilities sectors (down 5% and down 3% for the S&P 500 sectors, respectively) helped relative results.
Holdings in the Energy sector (flat compared to down 6% for the S&P 500 sector) had a positive relative impact. Anadarko Petroleum (up 13%) was strong.
Additional contributors included Hewlett Packard Enterprise (up 23%), Booking Holdings (up 20%), GlaxoSmithKline (up 12%), and Twenty-First Century Fox (up 7%).
- The Fund’s total returns include the reinvestment of dividend and capital gain distributions, but have not been adjusted for any income taxes payable by shareholders on these distributions or on Fund share redemptions. Index returns include dividends but, unlike Fund returns, do not reflect fees or expenses. The S&P 500 Index is a market capitalization-weighted index of 500 large capitalization stocks commonly used to represent the U.S. equity market.
2. A biosimilar drug is an almost identical copy of an original drug that is manufactured by a different company.