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 at attempting, once again like Barclay’s, to refocus the company onto its core businesses, profitable core businesses, and exit areas that really don’t make a lot of sense for them longer term.
Diana Strandberg: So bottom line in Financials we have valuations that are as low or lower than during the global financial crisis and vastly improved fundamentals even in face of lower interest rates. So we’ve been selectively adding to Financials across our three equity portfolios. Now Financials aren’t the only story. We have also added to other areas of the portfolio. In the Global and International Stock Funds we added in our European media holdings. We started a new position in Altice, based in the Netherlands. They operate pay TV and telecom services throughout Europe and the U.S. And we increased our holding in JD.com, China’s second largest ecommerce platform. We added AstraZeneca, a new pharma holding, across our three equity portfolios and in the Stock Fund we started three new positions, one in Anadarko, a U.S. based exploration and production company, and Union Pacific, which operates rails in the Western U.S. and importantly, with connections to our big trading partner in Mexico.
Charles Pohl: While many investors are focused on current volatility, we have found that volatility often creates opportunities for us to make investments at attractive prices that have a long-term benefit for our shareholders. If we look back over the decades, we saw this occur in 1987 following the stock market crash in that year, in the late 1980s, early 1990s, real estate, commercial real estate and banking crisis in the United States; in the 1998 Asian financial crisis and the long-term capital blow-up in that year, and more recently in the 2008 financial crisis. And in each of these instances we found opportunities to make investments that had significant long-term payoffs for the shareholders of the Funds, and we’re confident that we can find some opportunities like that today.
Diana Strandberg: Well you and I having weathered those examples during our careers here, know that patience and persistence are the key to achieving your investment goals. You mentioned at the beginning that the best approach is to be in place where you see valuations low enough that they’re not imbedding attractive long-term fundamental because we can never predict the timing but things can turn very quickly.
Charles Pohl: Patience and persistence are values that have served Dodge & Cox very well over a very long span of time, and we hope that they are values that will be embraced by the shareholders in our funds. We want to thank for continuing to be shareholders in our funds and thank you for watching this video.
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