Choosing a Dodge & Cox Fund Is Just the Start

It might be tough to have confidence in an actively managed fund whose portfolio in recent years has featured  J.C. Penney ,  Nokia (NOK),  Hewlett-Packard (HPQ), and  Dell . Portfolio managers are supposed to select winners, not amass a collection of troubled companies with sketchy prospects and painful stock performance. One might guess that this was the portfolio of a struggling stock-picker who should find a different career, or perhaps that of an attention-seeking hedge-fund giant, gambling that he can force shakeups in management or strategy and then profit from a quick pop in the stock price.

Neither is the case. Instead, the manager in question is Dodge & Cox, a very successful firm hardly considered one of the investment world's daredevils, and certainly not an attention seeker. Its portfolio managers aren't hoping for rapid turnarounds; they aim to produce solid returns over decades. In spite of owning challenged companies which, in some cases, have been disappointing investments, the long-term performance of Dodge & Cox's stock funds has been strong. But the ride has not been easy--the funds suffered even more than most rivals in the devastating bear market from late 2007 to early 2009 and again in 2011's rough conditions.

Investors can draw three useful lessons from this. They apply not just to this firm, but to other prominent funds as well.

1) Dodge & Cox Is Not Conservative
In some ways this shop can come across as a bastion of staid, cautious investing. Its managers are soft-spoken and avoid controversial statements. Although they own substantial chunks of prominent firms, you won't see them quoted in the media hectoring company managements. They're not much interested in expansion, either: After 80-plus years, the firm's lineup consists of just five funds. The managers--who tend to stay at Dodge & Cox throughout their careers--focus on buying stocks at what they consider cheap prices and then holding them a long time.

But appearances can be deceiving. When it comes to their funds' portfolios, these managers are not conservative. Companies exhibiting strong and steady growth, with few obvious issues or problems, tend to cost more than these managers are willing to pay. So they often buy firms facing distinct and well-chronicled challenges.

Dodge & Cox doesn't scoop up every downtrodden company, of course. They look for those whose troubles are overblown or should ease in a reasonable amount of time, in the managers' opinion, and those that have solid long-term prospects overall. That said, sometimes their choices can leave you scratching your head, asking "What the heck do they see in that one?"

Their boldness doesn't stop there. For years, the firm's foreign-focused fund,  Dodge & Cox International (DODFX), has stashed a much higher percentage of assets in emerging-markets stocks than most peers have. Not every company based in an emerging market is inherently risky, of course, but emerging markets do tend to be more volatile and can fall more sharply when global fears rise. In a similar vein,  Dodge & Cox Balanced (DODBX), which tempers its exposure to the stock market with a fixed-income component, has long devoted a much higher percentage of its assets to equities than balanced-fund investors typically expect.

With all this in mind, it's not surprising that  Dodge & Cox Stock (DODGX), Dodge & Cox International,  Dodge & Cox Global (DODWX), and Dodge & Cox Balanced all lagged well behind their peers in the 2007-09 bear market and in 2011's weakness.

2) A Good Fund Can Overcome Some Serious Misfires
It's tough to own a fund that holds some of the market's most notorious problem children, especially when their shares keep plummeting. But funds that take a value approach tend to own at least a few such companies. Some of these stocks will bounce back with spectacular gains. Others will never recover. But even if several picks stumble badly, there remain 70 or 80 other stocks in a Dodge & Cox portfolio that can offset the damage, and more--if not immediately, then over time.

Moreover, when the managers have the fortitude to add to their stakes at opportune times, some of the seeming duds can eventually become successful investments, or at least put less of a dent in returns than they otherwise would have. For example, Dodge & Cox International bought Hewlett-Packard in early 2011 (Dodge & Cox Stock has owned it since 2001). The stock's price soon dropped, and then tumbled some more. But the managers held on, and they added substantially to their stake in the fourth quarter of 2012, when the stock fell to its lowest level. So the Dodge & Cox funds have benefited greatly from Hewlett-Packard's big 2013 rebound. (The stock has doubled from its late-2012 low.)

Holding on to or even adding to a falling stock doesn't always pay off, as Dodge & Cox itself found out with several financial-sector plays in the 2008 crisis and more recently with J.C. Penney, sold in 2013's second quarter. Nokia surely hasn't been a long-term winner, either. But even with that floundering company, it's worth noting that Dodge & Cox International, which first bought Nokia in 2005, sold big blocks of shares in 2007 after a huge jump in its price, and then bought more at low levels in 2013's second quarter--thus getting an extra kick from the 30%-plus jump in Nokia's share price after the Microsoft deal was announced last week.

Other choices that were contrarian when first made, such as a basketful of big pharmaceutical stocks bought when they were facing severe doubts about their drug pipelines and the effects of potential health-care legislation, have generally provided smoother rides. By buying such winners when they were out of favor, and by reducing the damage caused by the portfolios' struggling companies through trimming high and adding low, Dodge & Cox Stock, Dodge & Cox International, and Dodge & Cox Balanced have managed to post strong long-term returns for just about every trailing period despite the high-profile misfires.

3) Even if You Look Elsewhere, Patience Still Will Be Required
The Dodge & Cox funds are very appealing long-term choices, but only when owned in a reasonable way. With funds that are purposely buying companies facing issues, or loading up in sectors that are deeply out of favor, it's important for shareholders to avoid selling the funds when they sag and thus miss out on the rebounds. Those who do the latter may not enjoy much success with Dodge & Cox funds no matter how well the funds themselves perform over the long haul.

Unfortunately, some shareholders have suffered this fate. The Morningstar Investor Return statistic, which shows the return received by the average shareholder in a fund, reveals that for Dodge & Cox Stock, Dodge & Cox International, and Dodge & Cox Balanced, the typical investor's performance is far below the funds' actual total return. Such gaps are common, but they're unusually wide for these funds.

The bottom line is that shareholders in these funds and certain other value-oriented options must be willing to live with depressing or alarming headlines about specific holdings and brush off the disappointment when a few stocks never bounce back. Investors who don't feel comfortable with that approach can find other good stock funds more suited to their temperament.

However, there's no escaping the necessity of perseverance. No matter what kind of stock fund you own, whether bold or cautious, actively managed or index-tracker, it's critical to stick with or even add to those stakes when times get tough, if the fund still has the qualities that attracted you in the first place. Without such patience and commitment, you risk having your personal returns fall far short of the performance provided by the funds themselves, making it much more difficult to reach your long-term financial goals.