TO OUR SHAREHOLDERS
The Dodge & Cox Stock Fund had a total return of –7.1% for the year ended December 31, 2018, compared to a return of –4.4% for the S&P 500 Index.
MARKET COMMENTARY
In 2018, global equity markets were volatile and posted significant losses. Although returns were negative, the United States outperformed most other equity markets—the S&P 500 was down 4% compared to a decline of nearly 14% for the MSCI EAFE Index.a 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) outperformed value stocks (the lower valuation portion) by 13 percentage points, continuing a longer-term trend.b From 2014 through September 30, 2018, growth outperformed value by 39 percentage points,c fueled by growth-oriented companies in sectors and industries associated with technology—most notably the “FAANG” stocks (Facebook, Amazon, Apple, Netflix, Google). 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.
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, including the escalating trade conflict between the United States and China. Brexit-related uncertainty and Italy’s political turmoil also weighed on multinational companies. There was a significant correction in the fourth quarter, especially among technology stocks. Companies in more value-oriented sectors, including Health Care and Utilities, outperformed. Overall, the S&P 500 declined 14% during the quarter.
INVESTMENT STRATEGY
Market volatility can create buying opportunities for patient, long-term, value-oriented investors like Dodge & Cox. 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. We view this approach as a more reliable factor in determining long-term investment merit.
In 2018, we made gradual portfolio adjustments based on relative valuation changes. For example, as valuations increased, we trimmed selected Information Technology and Health Care holdings that had performed strongly. The Fund’s largest sale was Merck, a leading pharmaceutical company held in the Fund since 2009. While the company has a strong management team, we decided to sell Merck given its higher valuation and our concerns about Merck’s dependence on its blockbuster cancer drug Keytruda for future sales growth. In addition, we believe the company is entering a period of heavy, sustained investment as it manages through a product cycle, which could pressure profit margins.
Nevertheless, the Fund remained overweight the Health Care sector (22.8% compared to 15.5% for the S&P 500).d We are enthusiastic about the Fund’s Pharmaceuticals holdings because valuations are attractive and new drug approvals demonstrate improving research productivity. Moreover, the substantial cash flows at these companies are not sensitive to economic swings and their healthy dividends provide a solid, stable source of return. We believe Health Care is a more attractive, defensive alternative to Consumer Staples, where valuations are higher but growth prospects are lower.
Additionally, as a result of individual security selection, we increased the Fund’s Energy exposure from 7.8% to 8.5% during 2018—a significant add given the S&P 500 Energy sector was down 18%. We also increased the portfolio’s exposure to select Industrials companies as valuations declined. For example, we initiated a position in United Technologiese (highlighted below) and added to the Fund’s existing holdings in FedEx and Johnson Controls International.
Energy
During the fourth quarter, Brent crude oil prices dropped 35%, weighing heavily on the outlook for energy-related companies, and 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 slower supply growth and increasing demand point to higher prices over our investment horizon. Weighing valuation against individual company fundamentals, we recently added to the Fund’s positions in Occidental Petroleum and Halliburton, among others.
Occidental Petroleum
A multinational oil and gas company, Occidental Petroleum (OXY, Financial)’s stock price declined 24% in the fourth quarter along with the broader Energy sector, due to concerns about the macro environment and oil supply. While the company faces political risks in Oman and the United Arab Emirates, we believe investors overreacted in the short term, given Occidental’s solid long-term underlying business fundamentals. Occidental is considered a partner of choice for many companies and countries due to its technological capabilities, experience managing reservoirs, and global reach. The company has an attractive growth profile and low-cost assets in the Permian Basin and the Middle East. Given low operating costs and modest maintenance capital expenditures, these businesses are profitable across a broad range of oil prices. Occidental’s proven management team has created a strong corporate culture with a focus on returns, steady growth, and consistent dividends. In addition, the company has a strong balance sheet, an attractive valuation at 14 times forward earnings, and a 5% dividend yield. On December 31, Occidental comprised 1.6% of the Fund.
Halliburton
Halliburton (HAL, Financial) is the second-largest diversified oil services company after Schlumberger. Of the “big four” diversified oil services companies, Halliburton has the largest and strongest position in the North American market, primarily due to its leading pressure pumping (hydraulic fracturing) business. In 2018, investors became concerned that insufficient pipeline capacity to transport oil out of the Permian Basin may negatively impact North American pressure pumping activity. Infrastructure in the Permian has failed to keep pace with production growth, causing Permian-produced barrels to trade at a steep discount and exploration and production companies to scale back activity until new capacity comes online. As a result, oil services companies with large exposure to North America, like Halliburton, sold off in the first half of 2018. These concerns depressed Halliburton’s valuation and presented an attractive long-term buying opportunity, given the company’s strong franchise.
Although North American services activity has rebounded meaningfully since early 2016, our analysis suggests further investment will be needed for North America to maintain and grow oil production. With competitive advantages due to its scale and superior execution, we expect Halliburton to grow operating profits in North America over the next three to five years. Halliburton’s international business is much better positioned than in previous cycles. Over the past several years, the company invested in key product lines, expanded its international presence, and built deeper relationships with national oil companies. These investments are paying off—Halliburton has outpaced Schlumberger, the leading international service company, on international growth in most quarters since 2015. We believe Halliburton can continue gaining share as international markets recover. In addition, management has renewed its focus on returning capital to shareholders. Thus, we initiated a position in Halliburton during the third quarter and added further in December as oil prices fell. At year end, Halliburton accounted for 0.7% of the Fund’s net assets.
United Technologies
United Technologies (UTX, Financial) is a multi-industry conglomerate comprised of world-class franchises in elevators/escalators (Otis), jet engines and aerospace supply (Pratt and Whitney), HVACf (Carrier), fire/security, and refrigeration. United Technologies’ aerospace margins have been under pressure as Boeing and Airbus moved into the aftermarket, squeezing their supply base. Despite this risk, we believe the company is an attractive long-term investment opportunity at 14 times forward earnings. United Technologies has premier global franchises with attractive long-term growth potential and a high degree of visibility based on its substantial backlog (over seven years) of aerospace contracts. United Technologies recently acquired Rockwell Collins, making the combined company the largest global aerospace supplier. The launch of its new jet engine platform should drive earnings growth in the years ahead. Meanwhile, United Technologies has announced plans to split into three companies, which could create substantial shareholder value; we estimate each of its world-class franchises trades 15 to 20% below “pure-play” peers. United Technologies was a 1.4% position on December 31.
IN CLOSING
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 also 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. As always, we welcome your comments and questions.
For the Board of Trustees,
Charles F. Pohl, Dana M. Emery,
Chairman President
January 31, 2019
