Dodge & Cox Q4 letter to investors
TO OUR SHAREHOLDERS
The Dodge & Cox Stock Fund had a total return of 19.6% for the six months ending December 31, 2013, compared to a return of 16.3% for the S&P 500 Index. For 2013, the Fund had a total return of 40.6%, compared to 32.4% for the S&P 500 Index. At year end, th e Fund had net assets of $54.8 billion with a cash position of 1.7%.
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U.S. equity markets were exceptionally strong in 2013, rising to an all-time high on December 31. The S&P 500 (up 32%) had its best annual gain since 1997, with every sector of the market generating positive returns. Substantially higher valuations reflected both earnings growth and higher investor confidence in light of an improving economy. Recent economic statistics show that the economy is growing at a moderate pace, the job market is improving, and consumer wealth is continuing to increase as home prices and other assets trend higher. As a first step toward normalizing U.S. monetary policy, the U.S. Federal Reserve (the Fed) announced its intent to reduce its quantitative easing program in 2014. This action reflects the Fed’s assessment that the economy is continuing to make progress, but has further to go to reach “normal” conditions. Despite concerns about U.S. trade and budget deficits, we remain optimistic about the long-term p rospects for corporate earnings growth.
While U.S. equity market valuations have increased, we believe valuations are still reasonable: the S&P 500 traded at 17 times forward earnings at year end, compared to its 10-year historical average of 16 times. (a) It is important to note the Fund is not designed to replicate the overall market. Rather, it is an actively managed, diversified portfolio of equity securities. The Fund’s portfolio of 71 holdings—valued at 14 times forward earnings—is trading at a meaningful discount to the S&P 500. Utilizing our bottom-up research process, we believe we have selected holdings with attractive long-term prospects. We employ a consistent and disciplined approach that focuses on intensive fundamental research, a three- to five-year investment horizon, a nd strict price discipline. Through meetings with management, competitors, customers, and suppliers, our global industry analysts build a n in-depth understanding of individual companies. Investment risks and opportunities are evaluated on a company-by-company basis. We apply our time-tested process to determine whether a company’s long-term fundamentals are appropriately incorporated into its stock price. As a result of our individual security selection, the Fund is overweight key areas of the market we believe are particularly compelling, including Health Care (18.9% of the Fund compared to 13.0% for the S&P 500) and Financials (22.5% of the Fund compared to 16.2% for the S&P 500).
Four of the eight new holdings purchased in the Fund during 2013 were in the Health Care sector (Cigna (CI), Express Scripts, Forest Laboratories, and UnitedHealth Group (b) ).Health care services was a particular area of opportunity, as concerns over the implementation of the Affordable Care Act (ACA) lowered valuations and attracted our attention to several leading companies. One such example is UnitedHealth, a diversified health care services company providing managed care, pharmacy benefit management, and other specialty products and services. The company faces significant ACA-related headwinds in its Medicare (reimbursement concerns) and commercial (e.g., loss of individual membership, changes of underwriting rules) segments. Nevertheless, we believe these challenges could be offset by Medicaid expansion and rapid growth in Optum, its diversified health care delivery and IT services division. We initiated a position in the company based on UnitedHealth’s valuation in relation to its market leadership, innovative culture, and diversity of products, customers, and geographies. UnitedHealth (0.9% position) was the Fund’s largest new purchase within the Health Care sector during 2013.
In the Financials sector, the Fund has significant investments (13.9% of Fund assets) in companies with a U.S. consumer banking focus (e.g., checking accounts, savings accounts, credit cards, home and personal loans). Capital One (COF), Wells Fargo (WFC), and Bank of America (BAC) are among the Fund’s largest positions within this category. While each company has diversified lines of business and derives its profitability from numerous customers, U.S. consumer banking has emerged as a dominant theme as a result of our bottom-up research process. For each investment opportunity, we consider the balance between company fundamentals (what we are buying) and valuation (what we are paying). The higher the valuation, the stronger the company fundamentals must be for us to invest. Although U.S. consumer banks are trading broadly in-line with their historical discount to the market, we believe that the quality of bank earnings today is superior to the quality of earnings ten years ago. After several years of intense regulatory scrutiny, most banks now have higher capital, better liquidity, fewer competitors, and the ability to improve profitability. In our opinion, banks could enter a period of loan growth, expanding margins, and positive operating leverage, while maintaining charge-offs below historical levels. Lastly, cyclical factors could work in their favor. For example, higher short-term rates and a steeper yield curve could increase the value of banks with low-cost deposits. Capital One (the Fund’s largest position at 4.0%) is a consumer finance firm with credit card, auto lending, and banking businesses. The company has a strong franchise, attractive growth opportunities, and a disciplined management team with a solid track record and long-term focus. Capital One has grown market share while achieving high return on equity through its data analytics, which have led to sophisticated marketing and strong underwriting. Its acquisitions of ING Direct (ING) and HSBC’s credit card portfolio appear to be strategically sound. While regulatory reform could force changes in business practices that could adversely affect the industry, we believe Capital One— trading at 11 times forward earnings—is an attractive long-term investment opportunity.
I N C L O S I N G
After an exceptionally strong year, our market outlook is more tempered than at the beginning of 2013. In our opinion, the Fund’s portfolio, valued at a discount to the S&P 500, remains well positioned to benefit from long-term global growth opportunities over our three- to five-year investment horizon. Acknowledging that market timing is difficult, and that stock prices can be volatile over the short term, we encourage our fellow shareholders to remain focused on the long term.
Thank you for your continued confidence in our firm. As always, we welcome your comments and questions.
For the Board of Trustees,
Kenneth E. Olivier, Chairman and President
Charles F. Pohl, Senior Vice President
January 30, 2014