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(Re)Opened for Business

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In last year’s annual letter to their shareholders, the managers of Dodge & Cox Stock’s $54.6 billion stock fund wrote that outperforming the S&P 500 in the current market would be a “real challenge.”

Sure, the Stock Fund (DODGX) underperformed the S&P in 2007, but one bad year can’t harm a product that commands this much respect. Indeed, investors in the fund are more likely to consider its 20-year positive track record, its close watch on expenses, the solid reputation of its managers–widely acknowledged to be among the best value investors in the market by their peers and independent advisors–and its tried-and-true investment approach of analyzing company fundamentals in relationship to stock valuations over a three- to five-year horizon, than the returns for one year.

There’s little doubt that the popularity of the Dodge & Cox stock fund, which after being closed to new investors since 2004 reopened in February, is as strong as ever. Despite the challenges they might present, current market conditions will not deter the fund’s management team, particularly chairman and CEO John A. Gunn; chief investment officer Charles F. Pohl, and director of research C. Bryan Cameron, from doing what they have always done.

Part of what the nine-member Investment Policy Committee team (see sidebar) has always done is to act a bit like a close-knit but slightly unruly family where disagreements are tolerated, if not encouraged, before the ranks close and a consensus is reached on the equities that will find a (usually long-term) home in the Stock portfolio. To be sure, the team believes that the current market volatility has shaken out many interesting and potentially lucrative investment opportunities from the value tree. But finding the right ones takes both time and discipline, and if investors choose to believe in the Dodge & Cox way, then they must have patience and a long-term view toward investing.

We spoke by telephone in late April 2008 with Gunn, Pohl, and Cameron.

You recently reopened the stock fund. Why now?

Gunn: After continually outperforming for about seven and a quarter years, we began underperforming at the end of 2007, and we saw a lot of money going out of the portfolio. There was a certain class of people that were discouraged by our short-term results, but at the same time, we knew there were a lot of other people–financial advisors and the like–who really wanted to utilize our fund. So looking at the situation over all, we decided it was best to open up the portfolio so that we could balance the contrarians (those who wanted to buy us even when we were down) with those who felt discouraged and were taking their money out. Since we’ve reopened the fund, things have basically stabilized, and the money coming in is now balancing the money going out. We believe there is capacity to accommodate reasonable growth into the foreseeable future.

Why do you think people want to come into the stock fund at this time, when the markets are in such turmoil?

Pohl: Well, we have an excellent track record and reputation as long-term equity managers and advisors, more so than retail investors, and like to focus on long-term results. In 2004 when we closed the fund, we decided not to let advisors add new clients, but we found out that was difficult for them, and many wanted us to change our policy. The basic story of the firm is intact despite our recent underperformance and it’s the same story people have bought into for years, which is why we don’t have to do any hand-holding for new investors coming in. Now, because of the volatility, we are getting a lot more questions than we used to, but people are also coming to us because they view this as a chance to come into the market at a time when it’s offering a lot more opportunities than it did a year ago.

What exactly are those opportunities and how will you be taking advantage of them?

Pohl: The entire market has seen a lot of volatility so you can expect just about any industrial sector to be seriously depressed. Given our philosophy, we are looking at the opportunities in just about every sector; we might not necessarily be buying, but we are definitely looking at everything that has been beaten up and assessing the potential of companies for favorable long-term growth. To give one example: In the first quarter, there was a lot of turmoil in the financial sector. This has created many opportunities and the financial sector has been the biggest area of focus for us over the last couple of months.

How do you go about picking stocks?

Pohl & Cameron: We are strictly bottom-up, fundamental analysis kind of folks. We’re out there reading the SEC documents and all other public documents; we subscribe to a lot of trade journals; we spend a lot of time not only visiting company management, but also their competitors, and we hire consultants to advise us on technological and legal aspects of companies. Overall, we are trying to develop a deep understanding of a company’s prospects on a long-term value basis. We focus on the underlying financial condition and prospects of individual companies, including future earnings, cash flow, and dividends, because we want to get a fundamental understanding of what a company is doing with its money. We also look at financial strength, economic condition, competitive advantage, quality of the business franchise, and the reputation, experience, and competence of a company’s management. [Those are all] weighed against valuation in selecting individual securities.


How long do you typically hold onto a stock?

Gunn: We say that we invest on a three-to-five year basis, but on average, we generally hold a company for about seven years. That said, we could own something for six months or even 20 years, but we are always looking for a long-term approach as we want to get the long-term value of companies.

What does the fund look like right now in terms of holdings?

Pohl: We are basically overweight in three areas: Technology, media, and healthcare. On the technology front, we’re in a wide array of stocks that have a low market-cap to sales ratio, which means they have fairly low margins or revenue growth. But all the same, we still believe that we are in an interesting time with companies like Hewlett-Packard, Sony, and Motorola, and we look at them on a four-to-five year time horizon because we think their prospects are excellent. Media companies like Comcast, Time Warner, and Newscorp represent about 12% of our portfolio and we have a growing position in pharmaceuticals and healthcare service companies. We think they are at historically low valuations in terms of market cap over the next 20 years.

What new areas are you looking at?

Gunn: Through this turmoil, we have been adding into the financial sector, so we are perhaps slightly overweight that sector now. We do believe, though, that over the next five to 10 years, global growth will be led by developing economies. The current economic estimate for developing-world growth is 7%, compared to only 1% to 2% for the developed world, so we are seeing a lot of opportunities in developing economies. Other things being equal, therefore, whether [stocks] are in our domestic portfolio or our international portfolio, we are seeking to be exposed to the growth in the developing world. Dodge and Cox is launching a new global fund, only our fifth mutual fund since 1932, where we can emphasize both U.S. and foreign stocks. Many times we look at companies like HP and Motorola, or AIG (which has a great deal of exposure to the Asian insurance market), companies that have a lot of positions overseas, and we want to take advantage of that, so we are proceeding quite rapidly with what’s happening in the developing world.

What would you say is the one trait that sets you apart from your peers?

Pohl: A key characteristic is that we have a lot of staying power. We have done our homework, we have done our analysis, and even in markets like this, we are likely to buy more because we don’t get scared out of our positions easily. We really are “stay the course” players. We saw that in 1998 and 1999, when we underperformed at the tail end of the tech bubble, but by the end of 1999, we had sold out of our tech holdings. So we are extremely disciplined investors and we are always focused on creating lasting value through a disciplined investment approach.

Savita Iyer-Ahrestani is a seasoned financial writer and regularly contributes to Investment Advisor from her home in the Netherlands. She can be reached at [email protected].


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