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Dodge & Cox: Health Care Now More Attractive

Dan Culloton

Dan Culloton: Hi, I'm Dan Culloton, associate director of fund analysis at Morningstar, and I'm here with Diana Strandberg and Charles Pohl from Dodge & Cox Funds. They work on both the Dodge & Cox International, Dodge & Cox Global, and Dodge & Cox Stock Fund. Diana and Charles, thank you for being here today.

Diana Strandberg: Thank you.

Charles Pohl: Thank you for having us.

Culloton: As bottom-up global investment managers, you guys have a very broad view of equity markets all over the globe. To focus in on health care, because there's been a lot of news obviously regarding the health-care debate and recent elections, how has the election in Massachusetts and the effect that's had on the health-care debate in Washington affected your view of the health-care stocks you own? Are they still more attractive, less attractive?

Pohl: Well, I think it has to have improved the situation. We spent a lot of time over the last year with our health-care team in Washington, meeting the various folks involved, trying to understand the impact that the various different bills would have had on our health-care holdings.

I think it's fair to characterize the impact of both the Senate and House bills would have been negative on our holdings. But in spite of that anticipation of a negative outcome there, we still thought it was a very attractive area for investment, and overweight that area.

The election in Massachusetts has greatly reduced the likelihood that either of those bills will be passed. So that's got to make the whole investment thesis more attractive, and we're evaluating how much more right now.

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Culloton: What were some of the other fundamental factors that led you to this health-care overweight in the global, international, and stock portfolio?

Pohl: I think the valuations on many of these companies had gotten to very low levels, probably out of concern on the part of many market participants that the health-care reform would do a lot of damage to their profitability.

And we think that many of these businesses are very strong franchises. Historically, they've been able to earn very good return on capital. In the pharmaceutical and the medical device sectors in particular, patent protection is quite strong and really creates good franchise value there.

And with both the aging of the U.S. population, and then on top of that as the emerging markets gain in terms of wealth and income, there's a rapidly expanding demand for better-quality health-care there. And so these companies have the ability to expand their revenues and earnings into those markets as well.

So we see some attractive growth dynamics, strong franchises, and we had quite low valuations here. So that's a very attractive combination to us.

Culloton: In regards to the pharmaceutical stocks, there's been lots of concern over the years, even before health-care reform was on the table, about their ability to develop blockbuster products to replace things that are going off-patent, are being challenged by generic drugs.

Is that already priced into the stocks? Are there things in the pipeline for these companies that can really prove to be revenue and earnings generators for them?

Strandberg: We think that the valuation starting point for many of the world's pharmaceutical companies reflects a great deal of pessimism about what you just pointed out. There's been a lack of successful innovation, really, over the past decade. And then on top of it, some very profitable drugs have come off-patent, creating earnings holes at these companies, and then the specter of what regulation might mean.

Starting from very low valuations, these companies in general are very, very cash-generative businesses. When we look at what technology is allowing pharmaceutical companies to do in terms of increased compounds going through their R&D efforts--what we would call at Dodge and Cox "shots on goal," without a prediction of the outcome--that has been steadily rising.

We also look at the fact that there has been consolidation in the industry, and you now have maybe two handfuls of companies that stand between innovation and the ultimate customer.

And so we think the world's pharmaceutical companies are essential in helping any innovation, whether internal or elsewhere, be able to develop, get approved, marketed, and then into patients' hands. And so that's still a very, very strong franchise.

Charles mentioned the opportunities in the developing world. And I want to step back for a moment, when we think about valuation in relation to the fundamentals.

When our analysts are looking at individual businesses, they're thinking about, over a three- to five-year period, what might the financial model look like if things don't work out, if innovation doesn't take place, if growth is disappointing, if regulation is draconian, and what might that mean from a valuation and, therefore, a potential-return perspective, for us, from today's starting point.

When we go through a thought exercise of really stress-testing some of the negatives and discussing them very intensively, the cash-generating power of these businesses is enough to keep you pretty patient as a shareholder, even if some of these negatives materialize.

We also ask our analysts to think about what are the financial, what does the profit-and-loss, the cash-flow, the balance sheet look like if things really do work out, and then what do we think might be a likely outcome, as a way to frame our discussions around the key drivers.