Wed, 23 Apr 2014
A three- to five-year investment time frame and the discipline to fully understand an issuer's creditworthiness have served Dodge & Cox Income well, says manager Tom Dugan.
Sarah Bush: Hello, my name is Sarah Bush. I'm a Morningstar analyst, and today I'm joined by Tom Dugan. Hi, Tom, thanks for joining us. Tom is an associate director of fixed income with Dodge & Cox and a member of their fixed-income policy committee.
Again, thanks for joining us today.
Tom Dugan: Nice to be here.
Bush: We are glad to have you. First of all, I just wanted to talk to you a little bit broadly about the process at Dodge & Cox Income. Could you talk a little bit about your primary approach to managing fixed-income security selection?
Dugan: I think one way to boil it down is when investing in a fixed-income security and a bond, you are effectively making a loan. And first and foremost you want to assure yourself that this is a loan that can be repaid. So understanding the creditworthiness characteristics of the issuer is paramount in terms of selecting securities.
Within the fixed-income universe is a range of issuers. There are issuers we don't have to worry about that with--the U.S. Treasury for instance. There are other government-guaranteed issuers where that is not much of an issue. But there are credit issuers where that's the fundamental point of distinction, and we spend a lot of time trying to understand companies, their fundamentals, and their ultimate ability to repay that bond's interest and principal. So that's an absolutely key characteristic in terms of security selection.
The other ones I mentioned, those without a lot of credit risk, government-guaranteed ones, typically may have other issues. Government-guaranteed mortgage-backed securities have cash flow timing issues because of the prepayment option that a mortgage borrower has, that portions of the bond could be prepaid next month or 10 years from now. And so assessing the durability of cash flow and the predictability of those payments is the paramount concern for issues like that.
It's a range of things. But again, it all starts with creditworthiness of the issuer, and are we comfortable that they have the wherewithal to repay us.
Bush: Your strategy is a fairly credit-intensive one, and corporates play a big role in the portfolio. What are the risks of that approach and that strategy if things aren't implemented correctly?
Dugan: As I mentioned earlier, figuring out the creditworthiness of the company that you are lending money to, which is what you are doing when you are buying a bond, is of paramount importance, and we spend a significant amount of our time on that. We have a deep and talented team of industry analysts who follow companies across the globe doing that, leading that effort, credit analysts looking at the covenants and the terms of the deal are all part and parcel of this research process.
The most fundamental risk of this is getting it wrong; through this process of identifying creditworthiness, [the risk is] perhaps making a mistake and overestimating the creditworthiness, underestimating the potential industry risks, and underestimating the potential for a credit-changing event. Those are the kind of things that are true risks to the process. What we do to mitigate that risk is, again, spend as much time as we possibly can, understanding the investment and its risks, and then of course diversification.
Typically, one of our credit positions on average is about 1% of the portfolio, with a maximum somewhere between 2% and 3%. We have a broad, currently about 50, group of corporate issuers, so diversification is a key element of risk control in terms of credit.
Bush: Could you give us an example of an investment that you have made recently that kind of illustrates how you do think about credit?
Dugan: I think there is a unique investment that we made in the summer of 2013 that would be interesting. It brings together some of the interesting elements of Dodge & Cox and research at Dodge & Cox. We invested in a company called Naspers in July 2013. Naspers isn't a really well-known company, but they were coming to market with an inaugural U.S.-dollar-denominated debt deal.
Naspers is a South African pay-TV company, a significant publishing business as well, and they're an enormous Internet investment. In fact, they have an Internet portfolio that's valued at approximately $15 billion. So, it's an interesting and somewhat complicated company, with some interesting geographical exposures.
Our approach to understanding Naspers business and doing that whole credit research process, I discussed earlier, was absolutely jumpstarted by the fact that we work from a unified research team. We have in our international-equity fund, owned Naspers for many years. And so we benefited tremendously from that knowledge as we shifted to understand the credit and fully appreciate that prior to the deal.
In some respect, Naspers was a new issuer to the U.S. bond market. There was a premium associated in terms of the extra yield they had to pay because of that lack of familiarity, but they were not a new issuer to Dodge & Cox. We had a tremendous amount of familiarity with them and that enabled us to move quickly and participate in what we think will turn out to be a very attractive deal.
Bush: What makes your process distinct from other managers who maybe on the surface are doing something very similar?
Dugan: I think referring back to the Naspers purchase, the unified research team. I mean, we share our industry analysts. That's a deep, talented team, many of whom have been at Dodge & Cox for several decades. That depth and breadth, I think, is truly unique about Dodge & Cox. It allows us to do credit work that is very differentiated and truly high-quality, and I think that is hard to replicate. I think it's a key advantage and one of the very unique things about us.
Bush: Some investment processes can be arbitraged away over time. What about your process? Will it stand the test of time? What makes it endure?
Dugan: I think its hard work, mostly, and it's really hard to do. You need a deep and very talented team. Those aren't easy commodities to come upon. And so the amount of the work required and time commitment and the quality of the people can't just be conjured out of thin air. I really think it's the effort, the intensity, and the individuals doing it that is effectively the magic. And I don't see that as being something that can be arbitraged away.
A second point is simply, fixed-income markets, because of the diversity of issues, the number of issuers, I think, there is a reasonable claim that can be made that they are somewhat less efficient markets than perhaps equity markets. Just that the enormous amounts of information required can also create durable advantages when you have a good team in place and a very solid process.
Bush: While your process has been effective over the long term, and I know you had a very good 2013, in what environments would you expect it to be out-of-favor? In what environments did it not do so well?
Dugan: I think every environment doesn't have a set portfolio position associated with it. We set up our portfolio positioning with a three- to five-year outlook. We're looking at fundamentals; we're looking at valuations across the fixed-income universe--credit, mortgage-backed securities, general level of interest rates--balancing credit risk, prepayment risk, and interest-rate risk, and seeking to optimize the balance between those three, to maximize total returns and their risk-controlled framework over three to five years.
That three- to five-year time frame is a wonderful discipline that has served us well and our shareholders well over the years, but there can be times when short-term movements run adverse to a long-term outlook. And we endure those periods just like anybody else. What I think has fortified us through periods of underperformance, and there can be times, for instance, short and brief, but oftentimes very volatile periods of credit underperformance. That can be challenging for us. With our deep credit team and skills, we tend to overemphasize credit in our process.
So a short period of credit underperformance can provide a short-term headwind for performance for sure. But again, over the long term, if we can identify the right credits and assure their creditworthiness, the returns work out.
Bush: Thank you, Tom, for joining us today. We really appreciate having you here.
Dugan: Great. It was very nice to be here.
Bush: And for Morningstar, this is Sarah Bush.