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Dodge & Cox: Pharma Stocks Showing Value

As incomes rise, emerging-markets consumers can afford more and better medications driving attractive growth in the pharmaceuticals sector, say the managers of Dodge & Cox International Stock.

Esther Pak, assistant site editor, 07/15/2011

The managers of Dodge & Cox International Stock DODFX recently answered our questions on how they avoid value traps as well as their stance on emerging-markets valuations. They also discussed their convictions behind the pharmaceuticals industry and provided an example of a firm that satisfies their stock-picking criteria. Additionally, they explained how they repositioned the portfolio in response to the tragedy in Japan. Finally, they highlighted a few key lessons they learned as well as some of their successes and failures over the past decade since the fund's inception.  

1. The fund aims to home in on companies with low valuations "that more than compensate for the perception of weak fundamentals." Could you provide an example of a specific firm that fits the bill? How do you differentiate between the "perception" of weak fundamentals versus a company that may present a value trap?
Investing is a high-error-rate business. There are going to be times when we are right and when we are wrong in our view of the future prospects of a particular investment. That said, our task is to thoroughly understand a company's long-term fundamentals (for example, its earnings and cash flow prospects) in relation to its valuation so that we can weigh the extent to which the risks are priced in relative to the opportunities.

Valuation discipline is critical because investment returns depend on the initial purchase price. A great company can be a terrible investment if you pay too much. At the same time, a company with a low valuation might not be a good investment; in many cases the market's perception is an accurate gauge of a company's future prospects. We strive to avoid value traps by understanding each company as thoroughly as we can and by making investment decisions as a team to bring experience and perspective to bear.

Thorough company research is a cornerstone of our approach. Our team of 25 global industry analysts gathers a wide range of inputs to develop detailed knowledge about a company's competitive position, management, operations, financials, and governance. Based on this extensive analysis, the research analysts prepare a detailed set of three- to five-year financial forecasts outlining a range of scenarios. We explicitly consider the downside--what can go wrong with the investment if the risks materialize--and what factors might mitigate investment loss. We compare this with the potential upside because, though avoiding potential loss is important, growing long-term wealth is the goal of equity investing.

We believe our team decision-making process improves objectivity and leverages the extensive intellectual capital built over multiple decades of working together. The International Investment Policy Committee, whose members have an average tenure of 21 years at the firm, is the team that is collectively responsible for the success or failure of each decision. Making investment decisions as a team removes the emotion or pressure that any individual might succumb to as share prices move up and down. As new developments emerge and prices change, we continually revisit and retest our thinking so that we can objectively consider the long-term risks and opportunities from the current price. When things work against us, it is critical to remain intellectually honest as we assess whether current conditions have changed our thesis. We will exit a position, even at a lower price, if the fundamentals have deteriorated and the range of returns is no longer attractive. Conversely, we will stay the course or even add to our holding if we believe that the investment still has long-term merit. As our team has worked together for decades and benefited from low employee turnover, we can learn from our investment successes and failures.

Lanxess AG (LXS) is a good example of how we weighed valuation against fundamentals as we assessed what could go wrong and right during our three- to five-year investment horizon. In January 2005, Bayer, a German conglomerate held in the fund, spun off its chemical business known as Lanxess in an effort to focus on its pharmaceutical and agricultural chemicals businesses. At the time of the spin-off, Lanxess was one of the cheapest publicly traded chemical companies in the world because of the many challenges facing the company. These challenges included low end-market growth, very low levels of profitability, the continued shift of its business to Asia from Europe, high levels of debt, and the difficulty of restructuring a company in Germany.

Although Lanxess was perceived as having weak fundamentals, our research revealed that there was more to like about the company than just its low valuation. In more than 40% of its sales, Lanxess was either the market leader or the second-largest competitor in its markets. For example, it is the world's largest producer of synthetic rubber, which is largely used in tires. This leading position particularly appealed to us, as the market is an oligopoly, and high-performance tires help fuel efficiency and driving performance.

Because Lanxess' profit margins trailed those of the industry by a wide gap as a result of the company's high cost structure, management's ability to execute its restructuring plan would be a critical factor in the success of our investment. Management impressed us with their drive, focus on the business, and ambition to improve profitability. They would be rewarded handsomely for increasing the long-term value of the company, which we thought aligned their interests with shareholders'. We decided to hold Lanxess based on its strong market positions, secular growth opportunities, and low valuation.

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