Commentary from Dodge & Cox Q2 letter which is just out.
The Dodge & Cox Stock Fund had a total return of 17.6% for the six months ended June 30, 2013, compared to 13.8% for the S&P 500 Index. On June 30, the Fund had net assets of $46.4 billion with a cash position of 1.5%.
U.S. equity markets rose to record highs during the first half of 2013, although stock markets retreated and interest rates increased toward the end of the period. Ben Bernanke, the Chairman of the Federal Reserve (the Fed), indicated that the central bank could wind down its bond buying program over the next year if it sees sustained economic improvement. Despite the negative market reaction to this announcement, we believe the long-term outlook for equities is encouraging as the Fed’s possible moderation of stimulus would be in response to further improvement in the economy. Recent economic statistics suggest that employment growth is continuing, housing activity is accelerating, and the U.S. economy is growing modestly.
Higher prices of homes and other assets have increased consumer wealth and confidence in the United States. These factors can stimulate household spending and contribute to production and employment gains. Bond yields have risen from historic lows and should normalize as employment and the economy improve. Businesses across the United States continue to grow earnings and cash flow. We acknowledge that there are global macroeconomic challenges, including slowing growth in China and other emerging markets, unrest in the Middle East, Turkey, and Brazil, and declining fiscal spending in the United States and abroad. Nevertheless, we remain optimistic about the long-term prospects for corporate earnings growth, and for the U.S. and global economies.
We continue to utilize the same investment approach that has served Dodge & Cox clients well for over 80 years. Individual security selection is the most important element of our bottom-up investment process. We seek to identify well-established companies that have attractive long-term earnings and cash flow prospects, which are not reflected in the current valuation. Weighing valuation against the risks and opportunities of each investment, we develop pessimistic and optimistic projections for earnings, cash flows, and growth prospects to derive a range of potential investment returns over the next three to five years. As share prices and company fundamentals change, we revisit and retest our long-term investment outlook, and adjust the portfolio accordingly.
Persistence has been a key element of the Fund’s strong performance. Share prices can fluctuate much more than business fundamentals. Our ability to make investment decisions based on fundamentals stems from our long-term, patient approach, independent research effort, and experience through different economic conditions. There have been situations where holding a company as it became less and less expensive did not work out—Wachovia is one example. However, there have been many other examples where staying the course, or adding to holdings as their prices fell, created significant value over the long term. Persistence matters greatly to long-term results.
Selected holdings in the Technology, Media, and Telecom (37.1%(a) of the Fund compared to 24.4% for the S&P 500) area of the market and the Financials sector (22.6% compared to 16.7% for the S&P 500) particularly illustrate how our persistence has aided recent performance. Sprint(b) and Charles Schwab are two such examples.
Sprint, the third largest cellular carrier in the United States, is a 2.3% position in the Fund. Since the Fund’s initial investment in 2006, the company has faced a difficult competitive environment, lost market share to Verizon Wireless and AT&T (the two largest carriers in the United States), and struggled to assimilate Nextel, which it acquired in 2005. In addition, overall economic weakness and the 2008-2009 equity market decline impacted profitability. As a result of these challenges, Sprint’s share price dropped significantly from the Fund’s initial purchase price. By mid 2012, the broader economy and equity markets had recovered from the lows of 2009, but Sprint continued to struggle.
Throughout this period, we continually reassessed the company’s major risks and challenges, including its competitive position, balance sheet, cash flow, and capital spending needs. We also evaluated the value of the company’s customer base, and its other assets, including its ownership stake in Clearwire. Concluding that the shares had significant potential, we decided to add meaningfully to the Fund’s position during 2012. Importantly, our analysis compared the existing price to what we believed the long-term value could be; the initial purchase price did not cloud our analysis.
Recently, the combination of stabilizing market share and continued progress on infrastructure upgrade projects was partly recognized by investors, and Softbank’s offer to buy a controlling interest in Sprint and improve funding caused the shares to move even higher. During the past 12 months, Sprint (up 115%) was one of the largest contributors to the Fund’s outperformance.
Charles Schwab (SCHW)
In 2010, the Fund initiated a position in Charles Schwab (a leading U.S. brokerage company) due to its durable business franchise, strong market position, growth prospects, and attractive valuation. As a result of the low interest rate environment in the United States, Schwab had waived some of the fees it charged customers on money market funds and its net interest margins substantially compressed. We believed that the company’s revenues and earnings would be significantly higher in a more normal interest rate environment. However, starting in late 2010, the Fed announced additional rounds of quantitative easing and interest rates continued to drop.
Throughout 2011 and 2012, we reaffirmed our investment thesis with the belief that a return to a more normal rate environment could dramatically increase profitability. Through our meetings with management, we were able to assess the company’s investment merits and risks, all in the context of valuation. Schwab’s highly scalable business model, excellent market position, growing customer base, focused corporate culture, and capable management team were attractive to us. In addition, founder and Chairman Charles Schwab’s ownership stake aligned his interests with those of public investors. These factors remain the underpinnings of our current investment thesis.
After considering the regulatory, interest rate, and credit risks inherent in Schwab’s business model, we added to the Fund’s position in Schwab multiple times throughout 2011 and 2012. The company stands to benefit from a rise in short-term interest rates. Accordingly, investors have responded to the Fed’s recent announcement and Schwab’s stock price is up 49% year to date. Schwab is a 2.4% position in the Fund.
The Fund’s investments in Sprint and Charles Schwab are just two examples of our analysis, focus on long-term fundamentals, and persistence. We are encouraged by the Fund’s strong results, and believe the portfolio is well positioned over our investment horizon. The long-term outlook for the U.S. and global economies is encouraging, yet we do not believe a robust macroeconomic environment is necessary for the Fund, and equity markets broadly, to do well over the next three to five years. Current equity valuations are reasonable at 14 times forward estimated earnings for the S&P 500. Acknowledging that markets could continue to be volatile over the short term, we encourage shareholders to remain focused on the long term.
Thank you for your continued confidence in Dodge & Cox. As always, we welcome your comments and questions.
For the Board of Trustees,
Kenneth E. Olivier,