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Kip 25

The Dodge & Cox Mystique

Stock picking by consensus and an unstinting focus on value are big reasons for this venerable firm's success.

In its 76-year history, Dodge Cox has launched precisely four mutual funds. The firm doesn't advertise and has no marketing department. Yet investors are so taken with its funds that it has had to shut half of its tiny lineup to new customers to stanch the flood of money.

Obviously, results attract customers, and Dodge Cox's results have been marvelous. DC Stock, the biggest fund, with assets of $57 billion, has clipped Standard Poor's 500-stock index seven straight years (including the first eight months of 2006). Over the past 15 years, its annual return of 15% tops the SP 500 by an average of four percentage points per year. DC Income, which invests mostly in high-quality, medium-term taxable bonds, has outpaced its average peer in 16 of the past 17 years. Balanced, the oldest fund, dating to 1931, has been in the top 20% of similar funds in each of the past six years. And International has surpassed its average rival in each of its five years of existence. (International and Income are the only funds that are open to new customers.)

What's behind the success of Dodge Cox? Its funds are helped by remarkably low fees. Staff turnover is almost nonexistent -- another plus. And the firm's unrelenting focus on buying undervalued stocks and bonds is legendary. But what sets the firm apart from most mutual fund shops is its method of picking stocks and bonds: Before a security is added to one of the funds, it must be vetted by one of three committees.

To peer behind the curtain, we chatted in San Francisco with the firm's president, John Gunn, a 34-year veteran who is the firm's chief executive and chief investment officer, and Diana Strandberg, who joined in 1988 and who, like Gunn, is on the committees that oversee the three stock funds.


KIPLINGER'S: What's the key to your success? Is it those fuddy-duddy investment-policy committees?

GUNN: We started as a firm to manage an individual's entire wealth. We try to preserve and enhance the client's wealth over a four- to five-year time horizon. And the first principle that comes out of that is a sort of investors' Hippocratic oath: Do no harm. As for stock picking specifically, we ask ourselves, Do we want to become a part owner of a company looking out four or five years?

But don't other fund companies follow the same principles?

GUNN: We look at the longer-term earnings prospects, but we also focus on valuation. The two are joined at the hip. Let's go back to 2000. The megacap stocks -- those with market capitalizations of roughly $100 billion or more -- were about 33% of the SP 500 and we basically had zero in those stocks. From a valuation perspective, about 25% of the market sold at roughly 15 times sales and 85 times trailing earnings, and we had nothing in those stocks. Another 37% or 38% of the market sold at 3.5 times sales and 30 times earnings, and we had about 9% of assets in the lower-value part of those stocks. So, in the middle of the biggest, wildest speculation ever, almost all of our holdings were in the remaining third or so of the market -- mostly in "old economy" stocks selling at about 80% of revenues, and one-third in financial stocks selling at about 13 times earnings.


You're certainly not closet indexers.

GUNN: We also don't have a momentum bone in our body. We believe that previous share-price activity has nothing to do with future price activity.

Do you assemble your portfolios stock by stock? Or do you make calls on the big picture?

GUNN: We look at long-term forces that we think are pushing the global economy in a certain direction at a certain speed. We believe that the two biggest forces -- things that have been going on for many years now -- are rapid technological innovation, especially in communications, and growth of the developing world. The end of the Cold War has allowed more and more of the world's population to participate in free-market economies, to see how the other half lives, to produce and consume more.


Do you have a limit on the price-earnings ratio you are willing to pay?

GUNN: There is no fixed rule. But we are skeptical of companies with high market-capitalization-to-sales ratios.

Do you pay more attention to market-cap-to-sales ratios than you do to P/Es?

GUNN: The P/E is essentially the price-to-sales ratio divided by the net profit margin [profits divided by sales]. A stock can have a low P/E with high net margins and high price-to-sales ratios. So, we try to look behind the P/E to understand it better. For example, Microsoft, which is selling at about 18 times earnings, is starting to show up in a lot of value portfolios. It's a wonderful company, but we don't own it. Microsoft sells at about six times sales because it has 30%-plus net margins. But what we're increasingly learning is that you don't necessarily have to buy Microsoft products. You can get a lot of them from Google. And then you've got Linux and all sorts of other stuff. So, to me, the 30% net margins at Microsoft are a great big cake in the rain.


So focusing on price is the main reason for your success?

GUNN: It's not just that. Another factor is that we add about one or two new people a year coming out of business school and, basically, nobody ever leaves, so the cumulative intellectual capital keeps growing here. Essentially, we have three portfolios -- a domestic stock portfolio, an international stock portfolio and a fixed-income portfolio -- and everybody knows what's in these portfolios. Including the research assistants, we've got 43 people -- 86 eyes -- looking at the stock portfolios. That's an amazing advantage. We also benefit enormously from our low fees.

Does the committee approach really add that much to the process?

STRANDBERG: The committee's job is not to come up with the idea. In our model, an individual advocates, and you bring a group together to make the decision on something that is being advocated. The person advocating a stock puts his or her recommendation in a written report -- here's what I recommend, at x price, for these reasons, and here are the main concerns, with all the supporting analysis and financials. So you bring all these eyeballs into the room to look at an idea and vet it. You want to have lots of different camera angles. Moreover, this system allows you to build staying power. Persistence is the single most important factor behind our long-term returns. The persistence to be able to stay the course, to hang on to the stocks that go down and to stay out of chasing the stuff that goes up. We can see when a stock is going down. The key is, would you buy more of it? Has it become a better value? That conviction is key.

Do you need to have everyone on one of the committees enthusiastic about a stock before you buy?

GUNN: We don't wait for that. In order to get into a portfolio, we need a couple of people to be enthusiastic and everyone else can be sort of neutral. It is an unwritten law because we don't otherwise formally vote.

Does Stock have any big sector bets?

GUNN: The biggest overweight in Dodge Cox Stock is not a traditional sector. I'm referring to technology companies that trade at 1.2 times sales or below. Those companies represent 1.5% of the SP 500, and they're about 16% of the fund.

Such companies as?

GUNN: Hewlett-Packard, Sun Microsystems, Sony, Matsushita, Xerox and Hitachi.

You just mentioned three Japanese companies. They're in the domestic fund?

GUNN: Absolutely. But let's look at Hewlett-Packard. We did most of our buying of HP when Carly Fiorina was CEO and the stock was in the high teens [it traded in mid September at $36]. The company was selling at two-thirds of sales, and it had a really huge beating heart. It has a global footprint and dominance in the consumables business, such as printer cartridges. And as the developing world grows, those countries will need more computing power. A company like HP should be a big beneficiary. We still think the stock is very interesting. It now sells at a little more than one times sales, but we think the company has excellent prospects.

In what other ways are you taking advantage of the growing wealth of developing nations?

STRANDBERG: We own Femsa [Fomento Econoacute;mico Mexicano], a beer brewer and one of the world's largest Coca-Cola bottlers. We also own companies, such as Nestleacute; and Nokia, that have very strong businesses in the developing world.

Your turnover is extraordinarily low. What does it take to get you to sell a stock?

STRANDBERG: Everything is driven by valuation in relation to our three- to five-year outlook for earnings and cash flow. So, if the price appreciates to the extent that only good news is priced in -- everything needs to work out well to support the current price -- we would probably be trimming or selling. This is a good thing -- selling because the stock went up. Remember, we believe that past price movements have nothing to do with future price movements. Whether the share price went from $10 to $20 or from $30 to $20 is irrelevant. The question is whether the stock, at $20, is likely to be a good investment based on our expectations for earnings and cash flow looking out three to five years. If so, we're adding to our position; if not, we're trimming. Now to fuzz things up a bit, sometimes we trim because the valuation, while appealing, is no longer interesting in relation to alternatives.

GUNN: As the valuation range has narrowed from that extraordinary situation in 2000 -- when we had 97% of our portfolio in roughly one-third of the market -- we have been upgrading our holdings. Some of our holdings then were in companies that weren't all that wonderful. For instance, we were in Whirlpool. It was run by competent people, but it's in a sort of slug-it-out, low-profit-margin business without a hell of a lot of growth. We are now able to buy dominant companies with strong growth prospects at attractive valuations -- for example, Citigroup -- that we couldn't get near five years ago.

Dodge Cox International appears to be holding several U.S. companies. What's the rationale?

STRANDBERG: Our prospectus allows us to hold up to 20% of assets in U.S. companies, and we have 5% of our fund in such companies.

What are the U.S. companies in International?

STRANDBERG: In two of the cases, News Corp. and Schlumberger, it's just a matter of technicalities. The third stock is Avon Products. Lily Beischer, our analyst, wrote up the company. When an analyst writes up a report, it is distributed to the entire investment team, even though one committee or the other will meet to formally review it. So we're all reading this report and saying, Holy smoke. Not only do we think the stock has an attractive valuation, but two-thirds of Avon's sales are outside the U.S. and about half its sales and earnings are in emerging markets. Hello!