Quick Take: As an employee-owned investment firm, San Francisco-based Dodge & Cox relies on a cooperative spirit to sharpen its competitive edge. Indeed, the fine long-term performance of its Dodge & Cox Income Fund (DODIX) recently won the management team a 2005 Standard & Poor’s/BusinessWeek Excellence in Fund Management Award.
Dana Emery, manager of the firm’s fixed-income department and an employee since 1983, stresses that piloting the Income Fund is very much a group effort. Emery is one of nine members on the firm’s fixed-income committee, which sets the strategy for the Income Fund and other fixed-income portfolios. In addition, 20 analysts, whose responsibilities are divided by industry, perform equity and credit research, contributing to all of the firm’s activities.
The reliance on collective wisdom has paid off. For the five years ended May 31, 2005, the Income Fund registerd an average annualized return of 8.3%, versus 7.0% for its peers, and 7.2% for the fund’s benchmark. With total assets of $8.46 billion, the fund’s portfolio turnover is 30%, versus an average of 199.7% among domestic taxable fixed income funds. Its expense ratio, at 0.44%, is far below its peer average of 1.05%. And its risk-averse approach is reflected in its standard deviation (a measure of volatility) for the past three years, which is 3.37%, versus 4.25% for its peers.
The fund’s 290 holdings as comprised U.S. corporate bonds, 28.7%; U.S. government securities, 52.4%; U.S. cash, 18.5%; and foreign corporate bonds, 0.4% as of March 31. Its benchmark is the Lehman Brothers U.S. Aggregate Bond Index, a broad investment-grade index with various security types, including Treasuries, agencies, mortgages, a corporate bonds, and asset-backed bonds.
The Full Interview:
S&P: What is your basic investment philosophy on the fixed-income fund?
EMERY: We construct and manage high-quality portfolios that we believe can outperform the market benchmark over longer time periods. We believe that building a high, stable income stream will translate into long-term total return.
We do fundamental research to look at the credit quality as well as the structural features of a bond… the duration and the call features. In the case of mortgages, prepayment risk. In the case of corporate bonds whether or not it’s callable. We look at specific covenants that protect you as a bondholder.
We are definitely bottom-up. Each investment in the portfolio has a role, a thesis. We do all of our work independent of the rating agencies, and look for good long-term investment opportunities. We have low turnover, and try to keep the expense ratio reasonable, because that can eat away at results.
S&P: What are some ways you might find investment opportunities?
EMERY: If a company’s fortunes change, the bond can start trading at a discount. It can be attributable to general market moves or to specific things at that company. We like to dig in when there’s some trouble, because that’s many times your best investment opportunity.
S&P: Has that happened recently with a security that you could mention?
EMERY: [During the] period where WorldCom [now MCI Inc (MCIP)] failed…many bonds became depressed in value and we were able to take advantage of that. We bought AT&T Corp (T) bonds, which went down in sympathy with WorldCom, and have done very well with those. Their coupon steps up with changes in the credit ratings.
AT&T was having issues as well, but we didn’t think they were ever in jeopardy of bankruptcy. We felt that they had a very strong business franchise, generated a great deal of cash flow, had been buying back debt, were trying to improve their balance sheet…and were the low-cost provider of long-distance telephone. We knew their top-line revenue was declining because of the consumer long-distance business, but felt they had a very strong franchise in the business enterprise area.
We started buying AT&T around the time that WorldCom’s troubles were unfolding, in the fall of ’01. We started [with a small position] in the very short bond, and then as the compensation for risk increased, started adding and lengthening. Now AT&T is likely, we think, to be acquired by SBC Communications (SBC) , and in that case the bonds will be upgraded.
S&P: What are your criteria for selecting bonds?
EMERY: We want to have confidence in the timely repayments of principal and interest. We want to properly model the securities [and to understand] the range of returns that we could earn on them, so they will meet the role that we want them to play in the portfolio. We want a high, secure income stream, [and will] take on credit risk when well compensated.
The mortgages that we’re buying are guaranteed by Fannie Mae [ Federal Natl Mtge (FNM)], Freddie Mac [ Federal Home Loan (FRE)], or Ginnie Mae…We’re buying “seasoned mortgages” — mortgages that have been outstanding for a period of time, usually three, four years or more. So we’ve got two protections there.
In the corporate area, we want a strong business franchise, a company that’s improving their balance sheet. We look at their liquidity, their funding, their access to bank lines, their legal structure. [If] you have a parent company [with] a bunch of subsidiaries, where are they issuing the debt…If you’re subordinated to them, they have to pay them off first before cash can get up to the parent.
We review the portfolio every day, because all that matters is what happens going forward.
S&P: What causes you to change allocation among bonds?
EMERY: Relative value. If we can find a higher quality alternative at a reasonable yield, we’ll do that. Overall interest rates are low. [As] the yield premiums on corporate bonds…have narrowed, we’ve gradually reduced our corporate exposure and upgraded our portfolio. For example, in ’02 we were over 40% in corporate bonds, and now we’re about 30%.
S&P: You could either allow the securities to mature or sell them.
EMERY: We could, but a lot of our corporate bonds are longer….So if we want to reduce positions we generally sell them rather than letting them mature. In the case of the…seasoned mortgages, we can let them run off a little bit, and we did that this year.
S&P: Do you buy any debt below investment grade?
EMERY: Yes. As of March 31, 9.8% was below investment grade. Most of those are “fallen angels,” where the bonds were downgraded subsequent to purchase, or “crossover credits,” split-rated bonds that one agency thinks are investment grade, and another agency thinks are below investment grade. So they’re not original-issue high-yield. There’s a big difference, because a lot of [our] companies are more mature and have more asset coverage, good cash-generating ability.
S&P: What is the fund’s duration range? We have it as 3.19 years as of April 29.
EMERY: That’s correct. There’s no minimum duration, so we’ve been gradually reducing our duration as interest rates have come down.
We think it makes sense to be defensive and this helps us, over time, to conserve principal…..We’ve been relatively conservative for a few years. We really shortened up in June of ’03, and then since then we’ve been staying pretty short.
S&P: Can you describe the portfolio maturity structure?
EMERY: We have cash flows all along the term structure, but have more exposure in the very short end. We’ve got about 63% less than three-years duration, which is a lot. But we also have long bonds…[though] less exposure than the index. We have about 9.5% in long bonds — eight years or longer in duration, mostly corporates.
S&P: Are there any types of bonds or sectors you avoid?
EMERY: We haven’t used emerging market debt or nondollar.
S&P: To what do you attribute the fund’s relative strong performance for the past five years, despite a difficult past year?
EMERY: Being long-term-oriented, being very careful security selectors, trying to make good long-term decisions, and focusing on protection of principal. We really believe that…generation [and] reinvestment of income dominate the return numbers.
[With] fixed income, a lot of winning is what you don’t do. We try not to build the portfolio on one particular outcome but on a range of outcomes that could do well over a variety of environments.
S&P: What is your outlook for the bond market overall?
EMERY: We think that returns will be relatively low over the next few years. Over the short run, returns could be very low, even into negative territory. But over the longer run, 3% to 5% seems reasonable to us, which relative to a 3% inflation rate is about break-even to slightly better.
It’s not as great as it’s been historically. But with fixed income, because of the mathematics of it, you have pretty high confidence that you can stay in positive territory over a longer period.
Contact Bob Keane with questions or comments at: .