Dodge & Cox Sticks with Its Strategy
The past year was a tough one for Dodge & Cox, the venerable San Francisco money manager known for its consistent, bargain-priced approach to picking stocks. Two Dodge & Cox funds -- Stock (symbol DODGX) and International Stock (DODFX) -- were in the bottom 25% of their categories in 2011 through December 12. Barring a miraculous turnaround between now and December 31, this will be the fourth year out of five in which Stock, the firm's flagship, with some $37 billion in assets, has trailed Standard & Poor's 500-stock index. (Both Stock and International Stock, as well as Dodge & Cox Income -- DODIX -- a bond fund, are members of the Kiplinger 25.)
To find out what, if anything, the firm is doing to turn around the funds, Kiplinger's paid a visit to Charles Pohl, Dodge & Cox's co-president and chief investment officer. Pohl, a 28-year Dodge & Cox veteran, sits on the committees that run all of the firm's funds. What follows is an edited transcript of our conversation.
KIPLINGER'S: In light of the way the markets have behaved in the past few years, have you given any thought to changing your approach to investing?
POHL: Our basic investment philosophy has remained unchanged since the time I started working here 28 years ago. We focus on the long term, three to five years. Historically, the average turnover of our stock funds is 15% a year, so that would imply an average holding period of six to seven years for each stock. The average mutual fund turnover rate is about 100%. We've always had a strong valuation discipline. Our process is bottom up and research-intensive. We try to look at things like the quality of the business franchise, the potential for growth in earnings and cash flow over time, the reinvestment opportunities for the firm and the quality of the management -- not only the competence of the management, but also the degree to which it's oriented toward shareholders. Then we weigh those factors against the valuation and arrive at some decision based on how we think things are going to do over a long period of time.
Barring a miraculous surge in what's left of 2011, this will be the fourth year out of five in which your flagship fund, Dodge & Cox Stock, will have trailed the stock market. I'm keenly aware of that.
But is sounds like you're sticking to your guns. One of the great dangers in this business is changing your philosophy at a point when you've had an unfavorable market environment and you're behind your benchmark. When people do that, it usually doesn't end very well.
There have been other periods when we've done poorly. The late '90s were not good. We underperformed in 1996, 1997, 1998 and 1999; 1998 was the worst year relative to the market in our history. We then delivered a string of seven absolutely magnificent years that more than made up for the underperformance. We have a process that has served this firm well for decades, and we still have one of the more enviable records in the industry.
Has the financial crisis in Europe affected the way you run your funds? We try to stay informed about what's going on. But we don't sit here in our investment policy meetings and say we want to have x% of our assets in France. Our experience is that macroeconomic forecasts are not very accurate. We could spend a lot of time working on those kinds of forecasts, but they're not likely to pay off by helping us produce consistent results
Are you finding a lot of bargains today in stocks? Almost all equities are selling at fairly attractive valuations. But the cheapest stocks are things that are exposed to the economy, especially cyclical and financial names.
Dodge & Cox Stock has a fairly hefty stake in financials -- 19% at last report. How confident are you that the companies you own will survive? Great question. One of the things an investor in bank stocks needs to ask is, what are the prospects for future credit losses? In fact, the balance sheets for most companies in this country are in very strong shape. Cash as a percentage of assets is at a record level. Debt to equity is at the lowest level in 20 years. Issuance of commercial paper is way down. And debt to free cash flow is quite low.
Then there's the health of the banks themselves. Equity to assets for the entire U.S. commercial banking system is at the highest level since 1938. There is more liquidity and more capital in the system than there was in 2008 -- by a lot. I can't tell you whether there will be a financial crisis in the U.S, but I can tell you that the banks are in much better shape than they were three years ago.
Why are Wells Fargo [WFC] and Capital One [COF such big positions in the stock fund? Both companies are exceptionally well managed. Both have very strong franchises, particularly in consumer businesses. Capital One is a major player in the credit card business. Wells has a different set of businesses in which it has strong market share. It is one of two banks -- the other is Bank of America -- that has a national footprint in terms of retail branches.
Like many value investors, you've taken a shine to Microsoft [MSFT] Why? You start out with a very low valuation. Plus, the company has continued to grow; it keeps producing more money. The company's top managers have come under criticism, but they have bought back a lot of stock and they're raising dividends. They're behaving in ways you would want them to behave. And the upcoming Windows 8, with its potential to unite the phone, the tablet and the desktop in one operating system, will be very interesting.
I've heard some people say the stock won't move until Microsoft gets rid of CEO Steve Ballmer. I've met an enormous number of management teams. I meet with CEOs or CFOs of large companies every day, and I have for about 30 years. It's hard to know who's really doing a good job and who's not doing a good job, and you find that oftentimes people are criticized for not doing a good job because their company's stock hasn't done well. But that doesn't necessarily mean that they're not doing a good job. Maybe the problem is that you bought the stock at too high a price.
Your biggest holding at last report was Hewlett Packard [HPQ]. You bought more shares after the stock cratered last summer. What's your rationale? One of our disciplines is that we try to look at stocks on a go-forward basis. That means that what has happened to the stock in the past, whether we've owned it or not owned it, is not relevant. Do I wish we hadn't owned HP last summer? Absolutely. But our job now is to look at it at a much lower valuation. The company has generated something on the order of $8 billion a year in free cash flow. It still has strong business franchises, and it appears to be holding market share in its major businesses. We think the underlying businesses are sound. There had been questions about the management, but you now have a new CEO. You look at that combination, and the stock still looks attractive.
So basically the past is history. Yes. You have to look forward. As an investor, that's a very important thing to do.
Stock and International Stock own a number of health care stocks, a group that has performed well over the past year. Will you be reducing your exposure to that sector? Most of the health care stocks we own are in pharmaceuticals. A lot of those companies are still trading at single-digit or low double-digit price-earnings multiples. So even though they've done relatively well this year, they're not very expensive.
We've gone through a long period of drought in terms of introduction of new blockbuster drugs. But a number of interesting products are going through the FDA [Food and Drug Administration] approval process, and we could see some of them hitting the market soon. That would make up for lost sales due to some of the patents that have expired this year and will expire next year.
Also, some of the pharmaceutical companies have fairly extensive exposure to emerging markets, and they're growing quite quickly there. For example, 30% of Sanofi's revenues are in emerging markets.