Investment Commentary
In 2018, global equity markets were volatile and posted steep annual losses. The United States was one of the better-performing equity markets—the S&P 500 was down 4% compared to down nearly 14% for the MSCI EAFE Index.2 Over the course of the year, the S&P 500 experienced two divergent periods of performance.
During the first nine months of 2018, U.S. equities posted strong returns: the S&P 500 was up 11% and reached an all-time high in late September. U.S. growth stocks (the higher valuation portion of the equity market) had outperformed value stocks (the lower valuation portion) by 39 percentage points since 2014.3 Growth-oriented companies in sectors and industries associated with technology—most notably the “FAANG” stocks (Facebook, Amazon, Apple, Netflix, Google)—had fueled this long-term trend. Over this period, the Fund performed strongly compared to the U.S. value investment universe; however, the Fund’s value-oriented approach hindered its relative returns versus the broad-based S&P 500, which benefited from its exposure to growth stocks.
Starting in October, volatility spiked as investors became worried about the pace of U.S. interest rate increases, a weakening global economy, and rising geopolitical concerns, notably an escalating trade conflict between the United States and China. Brexit-related uncertainty and Italy’s political turmoil weighed on multinational companies. Fear overcame the markets in the fourth quarter and there was a significant correction, especially among technology stocks. The more economically sensitive stocks that had led the U.S. equity market since 2014 were suddenly out of favor, whereas defensive companies in more value-oriented sectors, including Health Care and Utilities, outperformed. Overall, the S&P 500 declined 14% during the quarter.
Market volatility can create buying opportunities for patient, long-term, value-oriented investors like Dodge & Cox. Thus, during the fourth quarter, we selectively increased the Fund’s Energy exposure amid lower valuations. Brent crude oil prices dropped 35%, weighing heavily on the outlook for growth and profitability for energy-related companies. As a result, Energy was the worst-performing sector (down 24%) within the S&P 500. While the short -term direction of oil prices is difficult to forecast, we believe the long-term fundamentals of supply and demand point to higher prices. As bottom-up investors, we pay close attention to macro factors, but our research process places more emphasis on individual company fundamentals relative to valuation, which we view as a more reliable signal in determining long-term investment merit. Hence, we recently added to the Fund’s position in Occidental Petroleum (a multinational petroleum and natural gas exploration and production company), among other Energy holdings. Occidental’s stock price declined in the fourth quarter with the broader oil universe on macro and oil oversupply concerns, despite its solid underlying business fundamentals. Occidental operates a free-cash-flow generative business with an attractive growth profile and low-cost assets in the Permian basin and the Middle East. In addition, it has a pristine balance sheet, 5% dividend yield, and proven management team. On December 31, Occidental was a 1.6% position in the Fund.
Despite the market turmoil, we remain optimistic about the long-term prospects for the Fund’s investments. The portfolio’s valuation is attractive and trades at a meaningful discount to the overall market: 12.1 times forward earnings compared to 15.4 times for the S&P 500. We believe longer-term global economic growth will be better than many investors expect, and the Fund is well positioned to capitalize on this.
Our fundamental, active, value-oriented investment approach requires conviction and patience. Accordingly, maintaining a long-term investment horizon and staying the course are essential. We thank you for your continued confidence in Dodge & Cox.
Fourth Quarter Performance Review
The Fund paced the S&P 500 during the quarter.
Key Detractors From Relative Results
Steep declines within the Energy sector (Fund holdings down 36% compared to down 24% for the S&P 500 sector) were exacerbated by the Fund’s average overweight position (8% versus 6%). Apache (down 45%), Schlumberger (down 40%), Anadarko Petroleum (down 35%), and Baker Hughes, a GE Company (down 36%) were the main detractors.
Companies within defensive sectors were relatively stronger performers of the S&P 500; the Fund’s underweight position in Consumer Staples (down 5% for the S&P 500 sector) and lack of holdings in the Utilities (up 1%, the only sector that posted a gain) and Real Estate (down 4%) sectors hurt results.
Returns from holdings in the Financials sector (down 15% compared to down 13% for the S&P 500 sector), combined with a higher average weighting (25% versus 13%), detracted. Goldman Sachs (down 25%) and Capital One Financial (down 20%) lagged.
FedEx (down 33%) was also a drag on performance.
Key Contributors to Relative Results
Returns for the Fund’s holdings in the Health Care sector (down 4% compared to down 9% for the S&P 500 sector), combined with a higher average weighting (25% versus 15%), contributed to results. Eli Lilly (up 8%), Roche (up 3%), Novartis (flat), and Express Scripts (down 3% to date of acquisition by Cigna) were relatively strong.
In Information Technology, the Fund’s holdings (down 10%) fared better than the S&P 500 sector (down 17%) . Dell Technologies (up 16%) performed well; also, reversing the trend from recent quarters, not owning certain large technology and internet -related companies within the S&P 500 benefited relative results, as Apple fell 30% and Amazon was down 25%.
Communication Services holdings Twenty-First Century Fox (up 4%) and Comcast (down 3%) also contributed.
2018 Performance Review
The Fund underperformed the S&P 500 by 2.7 percentage points in 2018.
Key Detractors From Relative Results
The Fund's average overweight position (27% versus 14%) and weak returns from holdings in the Financials sector (down 17% compared to down 13% for the S&P 500 sector) hampered results. Goldman Sachs (down 34%), Capital One Financial (down 23%), and Wells Fargo (down 22%) were key detractors.
The Energy sector was the worst-performing segment of the Fund (holdings down 27%) and the S&P 500 (down 18%). The Fund’s higher average weighting in the sector (8% versus 6%) also hurt results. Schlumberger (down 45%), Apache (down 36%), and Baker Hughes, a GE Company (down 30%) were notable.
Within the reconstituted Consumer Discretionary sector (down 7% compared to up 2% for the S&P 500 sector), not owning Amazon (up 28%) was the main drag on relative performance. In contrast, small holdings Mattel (down 35%) and Harley-Davidson (down 31%) lagged.
Other detractors included DISH Network (down 48%), Micro Focus International (down 46%), FedEx (down 35%), and Charter Communications (down 15%).
Key Contributors to Relative Results
In Health Care, the Fund's average overweight position (23% versus 15% for the S&P 500) and holdings (up 9% compared to up 6% for the S&P 500 sector) had a significant, positive impact. Eli Lilly (up 40%), Express Scripts (up 24% to date of acquisition by Cigna), AstraZeneca (up 14%), and GlaxoSmithKline (up 14%) performed well.
The Fund’s significant underweight position (average less than 1% versus 7%) in the Consumer Staples sector, which lagged the overall Index (down 9% for the S&P 500 sector), helped results.
Standout performers included Twenty -First Century Fox (up 41% owing to a bidding war for most of the company) and Dell Technologies (up 39%). Not owning certain large companies in the S&P 500, including General Electric (down 55%) and Facebook (down 26%), also contributed notably.
