Dodge & Cox Stock Fund letter to shareholders for the fourth quarter 2014.
To our shareholders
The Dodge & Cox Stock Fund had a total return of 10.4% for the year ending December 31, 2014, compared to a return of 13.7% for the S&P 500 Index. At year end, the Fund had net assets of $60.3 billion with a cash position of 1.2%.
Dodge & Cox Stock Fund: Market commentary
U.S. equity markets were strong during 2014: the S&P 500 closed on December 31 near its record high. Utilities and Health Care were the best performing sectors in the S&P 500, while Energy was the weakest, and the only sector to post a negative return. Global oil prices dropped approximately 50% due to lower-than-expected demand growth and modestly higher-than-expected supply growth. The U.S. dollar strengthened against most major currencies, allowing American companies and consumers to pay lower prices for imported foreign goods. However, in aggregate, the stronger currency dampens profitability of U.S. multinational corporations and makes U.S. exports less competitive.
After declining in the first quarter, U.S. economic activity rebounded and continued to expand at a moderate pace through December. U.S. labor market conditions improved: job gains were solid and the unemployment rate declined. While the recovery in the housing sector remained modest, household wealth and spending rose, and consumer sentiment reached a seven-year high. Corporate profitability was robust, and businesses increased investment in fixed assets. The U.S. Federal Reserve announced the end of its historic asset-purchase program, but retained an accommodative stance and signaled its intention to take a slow approach toward raising interest rates in 2015. Despite concerns about global economic growth, our long-term outlook for equities continues to be positive.
Dodge & Cox Stock Fund: Investment strategy
Our disciplined investment process combines in-depth, bottom-up research and rigorous debate of ideas among our experienced investment professionals; the Fund benefits from the collective judgment of our team. We evaluate potential investments based on a three- to five-year investment horizon and have a strict price discipline. While individual company research is the primary factor in determining the Fund’s portfolio composition, we can identify themes that cut across many industries. Innovation is a pervasive theme in the Fund and is factored into our analysis. We highlight examples of our current investment theses within the Information Technology and Energy sectors below.(a)
Dodge & Cox Stock Fund: Information Technology
In the Information Technology sector, investors can have limited visibility of future earnings because growth is often driven by innovation and disruption; companies are required to make significant investments in research & development (R&D) with uncertain outcomes. In addition, companies face intense competition, have short product cycles, and must combat product obsolescence. As a result, we typically look for companies with reasonable valuations that incorporate modest expectations, industry leadership (e.g., brand, distribution, market share), sustained R&D efforts, a strong intellectual property portfolio, and financial stability. We believe that these characteristics can help offset the inherent uncertainty of changes in technology.
On December 31, 23.7% of the Fund was invested in the Information Technology sector compared to 19.7% of the S&P 500.(b) Information Technology is not a homogeneous sector: the Fund holds 16 technology companies with differing business models and diversified revenue streams and geographic exposures. We evaluate each investment opportunity on a standalone basis and weigh a company’s valuation against its risks and opportunities to ascertain whether it is an attractive investment opportunity. Technology holdings ranged from Hewlett-Packard at 0.7 times sales to Google at 5.5 times sales.
Dodge & Cox Stock Fund: Hewlett-Packard
Hewlett-Packard, a long-term holding in the Fund, is an example of how our patience, persistence, and ability to build conviction in the face of uncertainty have benefited recent performance (up 101% in 2013 and up 46% in 2014, and the largest contributor to Fund results in both years). We believe that Hewlett-Packard remains an attractive investment opportunity with strong business prospects given its large valuation discount to the overall market. As the world’s largest enterprise technology company, Hewlett-Packard has a strong, well- recognized brand and serves more than one billion end users in more than 170 countries. The company generates high, recurring free cash flow. Over our three- to five-year investment horizon, Hewlett-Packard is positioned to benefit from growth opportunities in the cloud, security, and converged network infrastructure markets. Furthermore, we believe that the competent management of the company’s operating businesses is underappreciated by the market. Current risks to the business include the possibility of expensive acquisitions, macroeconomic weakness, and competitive threats in PCs, services, and enterprise server/storage/networking. While these risks are significant, we believe that the valuation reflects an overly pessimistic outlook.
In October, the company announced plans to separate the business into two companies—Hewlett-Packard Enterprise and HP Inc.—and expects to complete the transaction by October 2015. Hewlett-Packard Enterprise will consist of technology infrastructure, software, and services, with a focus on growth opportunities from cloud, big data, security, and mobility. HP Inc. will consist of the personal computing and printing businesses, which generate strong cash flow; the new company intends to invest in innovative technologies, such as 3-D printing. We believe that the proposed deal could build long-term shareholder value. The announcement comes four years into Hewlett-Packard’s five-year turnaround strategy. Management believes that the separation will provide greater focus, flexibility, and management alignment for each new company. Additionally, we believe the proposed capital structures and capital allocation strategy would be better tailored for each company’s respective growth profile. On December 31, Hewlett-Packard was a 4.1% position in the Fund.
Dodge & Cox Stock Fund: Google
As the most popular internet destination in the world, Google has extremely high search engine market share in both developed and emerging markets: ~70% desktop share and over 90% mobile share globally. The company is well-positioned to benefit from continued growth in its core search business as internet penetration increases (currently at approximately 40% globally), users spend more time online, e-commerce expands, and more advertising revenue is earned online. Google also has meaningful non-search assets in display advertising (e.g., YouTube, DoubleClick), mobile (e.g., Android), and social (e.g., Google+). The company is led by a long-term, product- focused management team with significant economic ownership and a demonstrated focus on shareholders and financial returns. However, Google faces increasing competition, greater regulatory scrutiny around the world, and declining margins due to rising R&D expenses. Despite these issues, we believe that its valuation at 17 times forward estimated earnings(c) is reasonable considering its strong long-term growth prospects and cash generation potential. Recently, we added to the Fund’s position; Google was a 2.3% holding at year end.
Dodge & Cox Stock Fund: Energy
In the Energy sector, technological innovation has improved exploration success and oil recovery, increased efficiency of energy conservation, and reduced the environmental impact of energy extraction. We have identified attractive energy investment opportunities, especially within the Energy Equipment & Services (Oil Services) industry. The Fund is overweight Oil Services compared to the S&P 500 (5.2% versus 1.4%, respectively).
To evaluate each potential energy investment, we consider scenarios using a range of oil and gas prices. Our approach tends to be contrarian: we are often more skeptical as other investors become more optimistic, and our interest increases when other investors become more pessimistic. Given the recent collapse in oil prices and lower stock prices, we have reassessed and retested our investment theses and increased positions selectively in the Energy sector with technology leaders, such as Schlumberger. We continue to assess the impact of lower commodity prices on the entire portfolio.
Schlumberger (SLB), the world’s leading oil services company, is the most technologically-focused company among the integrated oilfield service companies, with double the R&D budget of its closest peer. We believe that its consistent spending on technology (e.g., enhanced recovery techniques, seismic interpretation, directional drilling) has provided the company with a competitive advantage that is sustainable over time. The company’s innovation efforts have enabled the industry to extract oil and gas from deepwater and shale resources that were previously cost-prohibitive or physically challenging to reach. Schlumberger is the dominant international provider in key markets, including the Middle East and Russia. The majority of its revenues come from outside the United States, and its international business has higher margins than its U.S. operations. We believe that Schlumberger is well positioned to continue to benefit from the long- term relationships it has with international oil companies and producing nations. If the price of oil remains low, the company will face a challenging environment. Relative to competitors, its strong franchises and solid balance sheet and cash flow should allow the company to endure an extended downturn. Weighing this risk with Schlumberger’s valuation and opportunities, we believe that the company (a 2.5% position in the Fund) remains an attractive investment opportunity.
Dodge & Cox Stock Fund: In closing
The U.S. equity market remains reasonably valued: the S&P 500 traded at 15.2 times forward estimated earnings at year end, which was in line with its 10-year historical average of 15.4 times. We are optimistic about the long-term prospects for sales and earnings growth and believe that cash returned to shareholders can continue to increase. Balance sheets and cash flows continue to be strong for companies within our investment universe. In our opinion, the Fund’s portfolio is well positioned to benefit from long-term global growth opportunities. Acknowledging that markets can be volatile in the short term, we encourage 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,
Charles F. Pohl,
Dana M. Emery,
January 27, 2015