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Dodge & Fox's 2nd-Quarter Shareholder Letter

T o our shareholders,

The Dodge & Cox Stock Fund had a total return of 13.1% for the six months ended June 30, 2019, compared to a return of 18.5% for the S&P 500 Index.


After posting strong returns in the first quarter of 2019, the U.S. equity market continued to climb during the second quarter: the S&P 500 reached an all-time high in late June and ended the first half of the year up 19%. Continued U.S. job growth and the Federal Reserve's consideration of lower interest rates propelled U.S. stocks to record levels. Growth stocks outperformed value stocksa as technology- related companies surged during the six-month period: Information Technology (up 27%) and Consumer Discretionary (up 22%) were the best-performing sectors of the S&P 500, while Health Care (up 8%) and Energy (up 13%) lagged the most. These market dynamics extended a longer-term trend.

S T R O N G C O N V I C T I O N I N O U R VA L U E - O R I E N T E D , A C T I V E I N V E S T M E N T A P P R O A C H

Over the last decade, U.S. growth stocks have outperformed value stocks by a cumulative 107 percentage points.b During this challenging period for value investors, the Fund has outperformed the U.S. value investment universe by 27 percentage points.c The valuation differential between value - and growth-oriented stocks remains wide by historical standards. Growth stocks are relatively expensive: the Russell 1000 Growth Index trades at 22.0 times forward earnings compared to 15.0 times for the Russell 1000 Value Index. This valuation gap should narrow as market prices move to more closely reflect our assessment of fundamental value. Historically, many value stocks have tended to outperform when they are particularly inexpensive, as they are today. We have conviction in our value-oriented, active investment approach and continue to believe now is an opportune time to be invested in more reasonably priced equities, selected individually after thorough research.

In addition, U.S. interest rates are extremely low by historical standards, and there is an overwhelming expectation in the market that they will remain "lower for longer." We believe current valuations may already reflect most of these beliefs about rates. The future market "surprise" may be interest rate increases from today's low levels, and we think there is a strong likelihood this will happen over the long term. Any increase in interest rates should create meaningful upside for many value stocks, especially in the Financials sector.

We are optimistic about the long-term outlook for the portfolio, which remains overweight in sectors poised to benefit from a rebound in U.S. value stocks such as Financials, which comprised 25.0% of the Fund compared to 13.1% for the S&P 500, and Energy at 9.6% versus 5.0%. Health Care is also an overweight in the portfolio, and accounted for 20.6% of the Fund versus 14.2% for the S&P 500.d


U.S. financial services companies are trading near historically low valuations relative to the overall market. Banks, for example, are trading at 57% of the S&P 500 forward price -to-earnings multiple, the lowest relative level since the dotcom bubble in 1999. Why are bank stocks so inexpensive? Since September 2018, U.S. Treasury yields have declined by 100 basis points,e as have market expectations for the federal funds rate through 2020. For most banks, lower rates have a negative impact on earnings, but we believe this issue has been fully priced into current valuations.

Despite low valuations, company fundamentals have been resilient. The Fund's bank holdings that were subjected to the Fed's 2019 stress- testing process have received approval to return a weighted average of 11% of their market cap in dividends and buybacks in 2020. This total yield compares favorably with the broad market and notably income-oriented equities, such as in the Real Estate (e.g., Investment Trusts) and Utilities sectors. Banks' capital levels are near historical highs, as are aggregate banking sector profits. In recent years, Banks' earnings growth has outpaced the broad market. We expect banks to offset the effects of lower interest rates through volume growth, cost controls, and share buybacks. Going forward, we are particularly constructive on several national retail banks--Bank of America, JPMorgan Chase, and Wells Fargof--that are increasingly using their scale, advantages in technology, and marketing expertise to drive outsized deposit growth and profitability.


While the short- term direction of oil prices is difficult to forecast, the long-term fundamentals of supply and demand are constructive. We believe demand will continue to grow at roughly 1% per year, or around 1.0 to 1.5 million additional barrels per day. From a supply perspective, U.S. shale oil growth is currently robust, but the rate of growth should taper as U.S. shale producers shift their priority from production growth to generating free cash flow. The rest of the industry will need to reinvest at higher rates to counteract the natural decline from existing fields and to meet new demand growth. It is likely that world oil prices at or above current levels will be needed to incentivize that higher level of investment.

When evaluating energy stocks, we look for companies with assets that are on the low end of the global cost curve, management teams that have deployed capital prudently through the cycle, and low -to-reasonable valuations. We continue to find long- term opportunities in selected upstream and oilfield services companies with these characteristics and recently added to the Fund's energy holdings, including Occidental Petroleum following its agreement to acquire Anadarko Petroleum, which is also held in the Fund.

In June, one of our global industry analysts met with Occidental's management team at their headquarters in Houston, Texas to conduct due diligence on the company's pending acquisition. While there are concerns about integration risk and the high cost of financing, we believe Occidental's risk-reward profile is compelling due to its attractive valuation, strong operational capabilities, and diversified, free-cash-flow generative upstream portfolio that is supplemented by its midstream and chemicals businesses. From our research on Anadarko, we know that Anadarko's asset portfolio has been meaningfully streamlined in recent years and the remaining assets are world class with large reserves and low break-even oil prices. In addition, Occidental aims to achieve $2 billion in cost synergies, and we believe there is a high probability these savings will be realized long term. On June 30, Occidental and Anadarko were 2.3% and 1.2% positions, respectively, in the Fund.

Health Care

Within the Health Care sector, attractive valuations reflect uncertainty about potential changes to U.S. health care regulations. As part of ongoing due diligence, our global industry analysts recently met with industry experts, regulators, and policymakers in Washington, D.C. and affirmed our belief that the risk of holistic, dramatic change to U.S. drug pricing due to regulatory or market changes remains low.

There are two primary goals behind U.S. health care reform debate: providing coverage for the majority of the uninsured population and managing the rising costs of providing health care for all. If more uninsured individuals gain coverage, then the Fund's three health care services holdings (CVS Health, Cigna, and UnitedHealth Group) should benefit as they provide managed care services for both individuals and employers. Additionally, our holdings could benefit from the expansion of government programs, such as Medicaid and Medicare, as many of these program's beneficiaries receive their care from the Fund's health care services holdings. While there is uncertainty around how to address the issue of rising cost, our companies are also well positioned to play a critical role in reducing U.S. health care cost trends. Moreover, these three companies have enormous competitive advantages and can leverage their scale to negotiate the best prices, invest extensively in technology and data analytics, and utilize their vast stores of clinical data to deploy innovative, proactive care management strategies. Having merged pharmacy benefit manager (PBM) companies with managed care businesses, they are well positioned to drive down the total cost of care, influence costs and incentives within the system, and deliver on the promise of patient centric care.

In Pharmaceuticals, research and development productivity continues to improve, evidenced by historically high numbers of drug approvals in the last few years. Although PBMs have been able to exert increased pricing pressure on drug manufacturers, we believe this industry has attractive prospects. The Fund continues to have a meaningful overweight position in Pharmaceuticals and Biotechnology: 14.9% compared to 6.8% for the S&P 500. These holdings have durable franchises with significant barriers to entry and long-term growth opportunities from product innovation, burgeoning emerging market demand, and development of new drug categories.

We continue to find compelling opportunities in Health Care and recently added to Cigna and Bristol-Myers Squibb, among other holdings.


Cigna (NYSE:CI) (2.2% position) is one of the largest and most diversified health care services organizations in the United States. In late 2018, Cigna acquired Express Scripts, a leading PBM, and we believe there will be significant cost savings from the transaction over the next several years. The combined company is also generating substantial free cash flow that can be used to reduce debt, repurchase shares, and drive earnings growth. In addition, Cigna has proven to be a leading innovator in the midsize employer based segment where continue to gain share due to their patient centric care model and industry leading cost trend which remains well below industry averages. Cigna is trading at only nine times forward earnings amid heightened competitive and regulatory risks surrounding its employer-sponsored health insurance and PBM segments. Weighing the risks and opportunities, we recently added to Cigna based on our view of its modest valuation in light of its solid business franchise and management's strong execution track record.

Bristol-Myers Squibb

Bristol-Myers Squibb (NYSE:BMY) --a global leader in immuno-oncology (IO) --is acquiring Celgene, a biopharmaceutical company, for $74 billion. The deal is expected to close by early 2020. While we would have preferred that the two companies remain independent, we have conducted extensive due diligence into the prospects for the combined company and continue to believe Bristol-Myers' risk -reward profile is attractive. Hence, we recently added to the Fund's position in Bristol-Myers, which trades at under 11 times forward earnings. Activist investors have applied significant pressure on Bristol-Myers' management team to perform and increase profitability by commercializing Celgene's pipeline, cutting costs, and expanding the IO business. IO drugs target a mammoth oncology market with enormous unmet needs and large patient numbers across many tumor types. The combined company will have nine products with more than $1 billion in annual sales and significant growth potential in the core disease areas of oncology, immunology, and inflammation and cardiovascular disease. On June 30, Bristol-Myers Squibb represented 2.0% of the Fund.


We remain optimistic about the long-term prospects for the Fund's portfolio, which continues to trade at a significant discount to the market. On June 30, the Fund's portfolio of 65 companies traded at 12.9 times forward estimated earnings, compared to 17.3 times for the S&P 500.

A fundamental, active, value-oriented investment approach requires conviction and patience. The rewards of active management are most likely to accrue to those investors who have the discipline to maintain a long-term investment horizon.

Thank you for your continued confidence in our firm. As always, we welcome your comments and questions. For the Board of Trustees,

Charles F. Pohl,


Dana M. Emery,


July 31, 2019

a Value stocks are the lower valuation portion of the equity market, and growth stocks are the higher valuation portion.

b The Russell 1000 Growth Index had a total return of 351.7% compared to 245.0% for the Russell 1000 Value Index from June 30, 2009 through June 30, 2019.

c The Dodge & Cox Stock Fund had a total return of 272.0% from June 30, 2009 through June 30, 2019.

d Unless otherwise specified, all weightings and characteristics are as of June 30, 2019.

e One basis point is equal to 1/100th of 1%.

f The use of specific examples does not imply that they are more or less attractive investments than the portfolio's other holdings.

This article first appeared on GuruFocus.