Dodge & Cox equity review for the first half ended June 30, 2016.
Watch the video here.
2016 Dodge & Cox Equity Review Transcript
Charles Pohl: Welcome to the first half 2016 Dodge & Cox Equity Review. Diana, we have found over decades of investing that where you want to be as investors are invested in stocks that have low valuations relative to their long-term fundamentals, and this is a process that’s served us very well over our history and we believe will continue to serve us well going forward. As you know, the timing in this business of when things will turn around is very imprecise but we’ve learned over the years that things can turn on a dime.
Diana Strandberg: As they have for the performance of the Global and International Stock Funds in the first three weeks of July.
Charles Pohl: And investors may be wondering right now, when we’re going to admit that we’re wrong or, you know, change direction in our investing but we continue to have a great deal of confidence in the process that we’ve developed over many, many years and that’s served our investors well over that period of time, the values of patience and persistence. And we’ve seen over time a significant payoff from, you know, sticking to our convictions.
Diana Strandberg: Charles, investors have been seeking safety and stability. They seek companies in the consumer staples and utility sectors, for example, as having almost bond-like consistent cash flows and the prices have been pushed up to such significant premiums relative to their history and relative to the overall market that we don’t see that it’s likely that these will be attractive investments going forward. In contrast, investors seek companies in more cyclical or economically sensitive sectors as risky, and valuations there have been pushed down to attractive levels, and we’re finding a lot of opportunity. Now we’re able to build investment conviction in the face of uncertainty and pessimism because we have thorough knowledge of individual companies and we’re continually challenging our thinking. We are able now to lean in to areas of investor concern, notably Financials, which have underperformed global equity markets and were a significant detractor to our three funds’ equity performance in 2016.
Charles Pohl: Yeah, in fact in the first half of 2016 the Financials really were the biggest detractor to our equity performance. And they speak to a very interesting phenomenon, which in the first half of 2016 the biggest driver of investment performance in a whole lot of different asset categories was the significant fall in interest rates. And that was driven by concerns about Brexit, concerns about the Chinese economy, concerns really about the potential for future growth in the world GDP and in the United States as well. And in the first half interest rates declined to historically low levels. The Wall Street Journal ran an article showing that they were at the lowest level in over 200 years. And so they’re extraordinarily low. It’s not something that we saw coming. It is something that has negatively impacted the banks. However, we think that the valuations of the banks now are at extraordinarily low levels and if we look at the fundamentals, they’ve been improving for quite a few years. We see much stronger capital ratios, much stronger liquidity ratios. Companies have done quite a job in general of refocusing on their core businesses and exiting less profitable businesses, businesses that didn’t earn an adequate return on capital. And so we think that there’s a lot of opportunity in investing right now. You know, if we look at the first half performance, there are also some indicators of the value of patience and persistence, which is an idea that we’ve talked about in past videos. If you look at HP Enterprises, that was one of the significant positive contributors to the funds’ performance in the first half, and yet in the past, HP has been a significant detractors from performance and we’ve talked about, in past videos, how we had confidence that the fundamentals were improving, that the valuation was very low, and eventually that we would see a turnaround in that business and, you know, continued to add to those positions. And, you know, we saw some payoff from that in the first half of 2016. Similarly, in the International and Global Funds in 2015 one of the key detractors was our exposure to a number of emerging markets names. And there, similar to Hewlett-Packard, we revisited our theses on these companies and retested our hypotheses and found that, you know, we thought in most cases that these were sound investments and so we continued to add to them at lower valuations. And they’ve turned out to be very significant positive contributors in the first half of 2016.
Diana Strandberg: No, it’s really true. Many of the individual companies, MTN, Petrobras, Samsung, for example, that we talked about last year, have been outstanding performers in 2016, in fact to the extent that we’ve been actually trimming back a number of our emerging market holdings because of their strong performance and redeploying that capital into other areas of the portfolio, notably European and UK financials. As you mentioned, we have the combination of actually improving ROA and ROE in the face of declining interest rates, more than two times the capital levels, and lower leverage. Now we recognize more needs to be done to improve profitability but the valuations in many cases are at or even below where they were in the global financial crisis. Barclay’s is a great case in point. We have a business with much higher capital levels, with greater liquidity, with, we think, two pillars of strength in their UK retail bank in global credit cards franchises, and a new management team in 2016 that we and other investors think highly of because they have a demonstrable track record of achieving their targets.
Charles Pohl: That’s true and another factor is, is that Barclay’s, like many of the other Financials in the U.S. and in Western Europe, has suffered from a significant drag from legal and regulatory costs that have been imposed on them mostly relating to activities that occurred during or prior to the 2008 financial crisis. And in Barclay’s case, those penalties and fines and judgments have added up to a significant portion of their entire earnings post-financial crisis. But these things are beginning to move into the rearview mirror for Barclay’s and for a number of the other Financials as well.
Diana Strandberg: No, that’s true. BofA would be another case in point there, where we believe that their financial legacy liabilities are largely behind us and where we have a very low valuation for a bank that has significantly improved its capital, liquidity. It’s one of a handful of national franchises with a leading share in deposits. They’ve greatly simplified their business structure and we think will be able to return capital over our investment horizon.
Charles Pohl: Yeah, and Brian Moynihan, the CEO, has done a terrific job there at expense control and