Primecap Management‘s annual shareholder letter for the year ended December 2014.
Dear Fellow Shareholders,
For the fiscal year ended October 31, 2014, the PRIMECAP Odyssey Stock Fund, PRIMECAP Odyssey Growth Fund, and PRIMECAP Odyssey Aggressive Growth Fund produced total returns of +16.45%, +15.82%, and +17.71%, respectively. The PRIMECAP Odyssey Aggressive Growth Fund exceeded the +17.27% total return of the unmanaged S&P 500 Index, while the PRIMECAP Odyssey Stock Fund and the PRIMECAP Odyssey Growth Fund lagged the S&P 500 over the period.
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Each of the PRIMECAP Odyssey Funds will distribute capital gains in December 2014. The sizeable gains in the PRIMECAP Aggressive Growth Fund, and to a lesser extent, the PRIMECAP Growth Fund, are due primarily to the acquisition of companies held in the funds at a premium to our cost basis. In addition, each of the funds has realized capital gains from the sale of stocks. We remain mindful of the tax consequences of our investment decisions. As long-term investors, we typically hold stocks for years, not months, which helps minimize capital gain distributions. The U.S. economy continued to improve during the fiscal year. After declining by 2.1% during the first calendar quarter, driven in part by unusually cold weather, real GDP grew by 4.6% in the second calendar quarter and 3.5% in the third calendar quarter. The unemployment rate declined to 5.9% at the end of September, the lowest level since July 2008. The improving U.S. economy stood in contrast to those of many other countries, and the U.S. Dollar appreciated against most foreign currencies.
Primecap Management: Oil price declines
Crude oil prices declined precipitously towards the end of the fiscal year. According to the U.S. Energy Information Agency, domestic oil production in August reached its highest level since July 1986. Lower oil prices should benefit transportation companies, for which fuels derived from oil are a significant cost, as well as U.S. consumers, through lower gasoline prices.
The Federal Reserve continued to tighten U.S. monetary policy by concluding its monthly bond purchases in October, though the central bank is expected to maintain very low short-term interest rates for a considerable time. Long-term interest rates, which had risen in calendar 2013, decreased during 2014 with the 10-year Treasury Bond yielding 2.31% on October 31, 2014, down from 2.97% on December 31, 2013.
The S&P 500 continued to appreciate and ended the fiscal year at an all-time high. Small capitalization stocks, as measured by the Russell 2000 Index, significantly underperformed large capitalization stocks during the fiscal year. The energy sector was the worst-performing sector in the S&P 500 over the period, driven by declining oil prices.
Each of the PRIMECAP Odyssey Funds continues to be overweight in the health care and information technology sectors, and underweight in the financials, energy, consumer staples, utilities, and telecommunication services sectors. A more detailed discussion of the results of each PRIMECAP Odyssey Fund follows. 2
PRIMECAP Odyssey Stock Fund From November 1, 2013 to October 31, 2014, the Stock Fund’s total return of +16.45% trailed the S&P 500’s total return of +17.27%.
Unfavorable stock selection, particularly in the health care, energy, and materials sectors, detracted from the fund’s relative results. This was partially offset by strong stock selection in the industrials sector. Sector allocation, including an overweight position in health care, the bestperforming sector over the period, and an underweight position in energy, the worst-performing sector over the period, had a positive impact on the fund’s relative results. The largest detractors from the fund’s results were Ascena Retail Group (-37%), Transocean (RIG)(-33%), and SchweitzerMauduit (-28%). These negatives were partially offset by favorable stock selection in the industrials sector, notably Southwest Airlines (+102%) and Curtiss-Wright (+40%).
PRIMECAP Odyssey Growth Fund From November 1, 2013 to October 31, 2014, the Growth Fund’s total return was +15.82%, below the S&P 500’s total return of +17.27% and the Russell 1000 Growth Index’s total return of +17.11%.
Primecap Management: Portfolio holdings
Unfavorable stock selection in the health care, information technology, and energy sectors detracted from the fund’s results, and was only partially offset by favorable stock selection in the industrials sector. Sector allocations, including overweight positions in health care and information technology, and an underweight position in energy, added to the fund’s relative results. While many of the fund’s largest health care holdings, including Amgen (+42%), Eli Lilly (LLY) (+38%), and Biogen Idec (BIIB) (+31%), outperformed during the period, these gains were offset by losses in other health care holdings such as ImmunoGen (-44%) and Seattle Genetics (-5%). In the information technology and energy sectors, Cree (-48%) and Transocean (-33%), respectively, were the most significant detractors. The fund’s airline holdings, including Southwest Airlines (LUV) (+102%), American Airlines Group (+69%), JetBlue Airways (+63%), United Continental (UAL) (+56%), and Delta Air Lines (+54%) accounted for most of the outperformance in the industrials sector.
PRIMECAP Odyssey Aggressive Growth Fund From November 1, 2013 to October 31, 2014, the Aggressive Growth Fund’s total return of +17.71% exceeded the S&P 500’s total return of +17.27% and the Russell Midcap Growth Index’s total return of +14.59%.
Favorable sector allocations, including overweight positions in health care and information technology, and an underweight position in energy, accounted for most of the fund’s outperformance during the period. This was partially offset by unfavorable stock selection, notably in the energy and consumer discretionary sectors. Rex Energy (-64%), Transocean (-33%), and Solazyme (- 27%) were the largest detractors in the energy sector, while Quicksilver (-79%), Ascena (-37%), DreamWorks Animation (-35%), and Shutterfly (-15%) were the largest detractors in the consumer discretionary sector. Strong results in industrials, primarily related to the fund’s airline holdings, partially offset these negatives. Southwest Airlines (+102%), Spirit Airlines (+69%), American Airlines Group (+69%), JetBlue Airways (+63%), United Continental Holdings (+56%), Delta Air Lines (+54%), and Alaska Air Group (+52%) were the largest contributors to the fund’s favorable relative performance in the industrials sector.
Primecap Management: Outlook
Looking ahead, we are less constructive on the outlook for U.S. equities than we have been in recent years, though we continue to believe that many individual stocks are attractively valued, and that stocks represent a more attractive investment than bonds at current prices. As of October 31, 2014, the S&P 500 was trading at approximately 15.5 times 2015 consensus earnings per share of $130, a reasonable valuation by historical standards. S&P 500 earnings per share growth has exceeded revenue per share growth for the past several years as profit margins have expanded, and consensus estimates assume this trend will continue. For 2015, S&P 500 consensus estimates assume 3.7% revenue per share growth and 10.0% earnings per share growth. Corporations may find it increasingly difficult to grow earnings faster than revenues, as corporate profit margins are already near all-time highs.
The funds remain significantly overweight in health care. We believe that favorable global demographic trends and ongoing innovation will create opportunities for health care companies to grow revenues faster than the overall economy for the foreseeable future. Aging populations in developed countries as well as China should lead to greater consumption of health care products and services since elderly people consume significantly more health care resources than the rest of the population. At the same time, rising disposable incomes and household wealth in developing countries should lead to greater consumption of health care products and services by people of all ages. The funds’ investments in biotechnology and pharmaceutical stocks further reflects our belief that the industry’s considerable investment in research and development over the years is driving the development of new and more effective therapies for many diseases, such as cancer, diabetes, and Alzheimer’s. The precipitous decline in the cost of genetic DNA sequencing is allowing researchers to identify unknown diseases and to rapidly develop therapies which improve the standard of care. Increasingly, drugs developed based on a better understanding of the underlying genetic causes of a disease are providing higher cure rates with fewer side effects than conventional treatments.
In conclusion, we remain committed to our investment philosophy, which is to invest in attractively priced individual stocks for the long term. This “bottom-up” approach often results in portfolios that bear little resemblance to market indices; therefore, our results often deviate substantially from such indexes. Furthermore, our long-term investment horizon results in low portfolio turnover, which creates the possibility for extended periods of underperformance when the stocks in our portfolio fall out of favor. We nonetheless believe that this approach can generate superior results for investors over the long term.
PRIMECAP Management Company