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What Went Wrong at Dodge & Cox

The venerable value investing shop has made some costly mistakes, but it can recover.

Daniel Culloton, 11/11/2008

Shortly after Dodge & Cox closed its Stock DODGX and Balanced DODBX funds to new investors in 2004, I asked then CEO Harry Hagey if the firm would ever consider reopening them. "Probably when everybody hates us," he replied. I knew friendly markets and adoring investors could quickly turn cruel and fickle, but still found it hard to conceive of the conditions that would turn the venerated firm's fortune on its head. "That would be a pretty hostile environment," I thought. I had no idea.

Can You Feel the Hate
I wouldn't say everybody hates Dodge & Cox now. Judging from my e-mail, though, the firm has ticked off a lot of people. All five of the boutique's funds have gotten slaughtered in 2008, especially its domestic and international equity funds which, this year, loaded up on many of the poster children of the crash of 2008.

I've been getting a steady stream of messages asking, "Have they lost it? Fannie Mae? AIG? Wachovia? What were they thinking? I thought these managers were supposed to be experienced and smart! Couldn't they see this coming? How could you still recommend this fund?"

A lot of investors haven't waited for an answer. Shareholders have streamed out of the fund as fast as they were piling into it a few years ago. For the year through Oct. 27, the firm saw $6.7 billion go out the door of its mutual funds, according to Morningstar estimates. The stock and balance funds have been hit the hardest with more than $2 billion and $3.3 billion in outflows, respectively, so far. Redemptions at Dodge & Cox International DODFX, however, have accelerated in recent months as that fund has foundered.

What Were They Thinking?
I think investors selling these funds are mistaken. But they have a right to be disappointed and even angry. Dodge & Cox has made some colossal blunders. As far back as 2003 the firm cautioned investors that future equity returns were unlikely to be as strong as they had been, but the magnitude of what has transpired makes those warnings seem weak.

And just what happened? How did a firm with such an enviable long-term track record and reputation for sober, in-depth fundamental analysis end up with so many time bombs? Based on recent and past conversations my colleagues and I have had with the firm's managers, as well as the funds' portfolios and shareholder reports, I don't think they lost their minds or chucked their process. Indeed, they seemed cognizant of the financial sector's risks. As recently as 2006 the Stock fund had less money in financials than its benchmark and peers because the managers thought the stocks' valuations unrealistically assumed profits would stay high and credit losses low. Even after boosting its financials stake after the credit crisis broke late in 2007, buying AIG AIG, adding to Wachovia WB, and in the first half of 2008 picking up Fannie Mae FNM, the managers were hardly cheerleaders.PAGEBREAK

In the firm's June 30 semiannual shareholder reports, they acknowledged the companies faced big challenges, but noted they also had raised significant capital. The managers even tried to model what the stocks would be worth in worse case scenarios, such as if AIG had to absorb significant losses from its derivative, credit default swap and mortgage insurance portfolios. The problem was reality turned out much worse than their worse case scenarios--a costly error made by many others, including Legg Mason Value's LMVTX Bill Miller and Selected American's SLADX Chris Davis and Ken Feinberg.

Wachovia is a good example of went wrong. The managers liked the bank's strong retail franchise, solid base of deposits and tight lending standards. They acknowledged the housing crisis and slowing economy could make things difficult for the company, perhaps even forcing it to raise more capital and cut its dividend. But the company's share price reflected an even more dire future than that, the managers said.

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