Low Turnover Creates High Marks for Dodge & Cox Stock

Laura Lallos: Hi, I'm Laura Lallos, a fund analyst here at Morningstar. I cover Dodge & Cox, a fund company that's earned a number of Gold ratings in our Analyst Rating system. We are pleased to have with us here today Charles Pohl and Diana Strandberg, to talk about the strategy that Dodge & Cox has used to such success for many years.

Maybe we could start by just talking about your primary approach to picking stocks. What are you looking for in general?

Charles Pohl: Our process is a combination of valuation and fundamentals. And we have a team of analysts. Their coverage is split up by industry, and they spend a lot of time looking at individual companies and trying to really understand a few key things about them. The strength of the business franchise; the quality of the management, in particular, the interest that the management has in building long-term shareholder value; and the potential for growth in future earnings and cash flow.

And then we take those fundamentals, and we weigh that against the valuations that we see in the marketplace. We are very attracted to low valuations. We are value buyers. We like to buy things that are cheap, but we want to buy things with good fundamentals at unreasonably low prices.

Lallos: What are some of the risks of this process? I imagine one of them would be buying too soon or needing to have patience.

Diana Strandberg: We do have to have a lot of patience and persistence, as a long-term investor, and our outlook is typically three to five years, as we are evaluating the merits of a particular investment. When you look at our turnover, our holding periods are typically more on the order of seven to 10 years. But patience and persistence are a hallmark of what we bring to the table.

Particularly, when you are buying companies that are inexpensive, there are usually reasons that other investors are concerned and that those concerns have depressed the valuation. And so, we have to dig in and do research so that we understand the fundamentals, what's priced in, and what might not be priced in. We want to bring that into a group decision-making process. That's where we bring some judgment and experience into the room. That helps us build conviction and where we have conviction, then we have the ability to remain persistent if the thesis remains intact.

The way that we try to mitigate about being too early is, we nudge positions, so that we are not trying to pick the absolute bottom or the absolute top. We will start typically with let's say a 50-basis-point position and then we'll have a series of analyst reviews with policy committee discussion, as we are building the position typically in 30- to 50-basis-point moves.

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Lallos: What is different about your strategy than other strategies out there that we would call value strategies?

Pohl: I think that one of the obvious ones is one that Diana just touched on, which is that the turnover of our portfolio is significantly below-average for other funds. I'd say another thing that's different about our whole firm is the enormous level of focus that we have. We have over $150 billion in the mutual funds, about $230 billion total that we manage. We have the five mutual funds.

And if you go down a list of mutual fund managers, in the top 25 fund managers, which is a category that we fall into, no one else has anything close to five funds. Most of them have dozens, and some will have well over a 100, even in the hundreds of funds. And so their attention is not focused on a few number of funds or trying to do a few things really well. And I think that's a huge advantage of our approach and a very differentiated one.

And then we have a group decision-making process, as well. Each of our funds is managed by a committee. And I've often thought of it in terms of--I've used this example before--if you were in a school and doing your math homework, do you think you'd be better off just doing it yourself or having seven other people that you have very high regard for, in terms of their ability to do math, check your homework for you?

In which situation are you likely to make less mistakes, and I think we can all recognize that you're less likely to make the mistakes if you have some colleagues who are well-informed and willing to help you out with your decision-making. And so, we think that that's a real strength of our process as well, and it's differentiated from those kinds of firms where you have a star portfolio manager or maybe two people running a fund.

Lallos: One thing that we've commented on is that, you also have low turnover among your investment team.

Pohl: Yes. And another key thing about our organization, which differentiates us from a lot of others, is that we are entirely owned by active employees. Van Duyn Dodge, when the firm was founded in 1930, wrote into the bylaws that the shares can only be owned by active employees of the firm. And so, we believe this brings a great deal of alignment between the members of the investment team, who are the owners of the management company, and the shareholders of the funds because we are only in this business of managing money and in a very focused way.

And so, the only way for us to be successful in with our own business and our own careers is for these funds to be successful and for our clients to have good outcomes. But also, owning shares in the funds, binds the employees together, and it enables us to act as a team. And we talked about the strengths of doing that. But it also acts as a device to retain people because to the extent that we're successful, then the employee shareholders benefit from that. And that's an attractive proposition for them to stay with us. And so we've had very, very low turnover among the investment personnel over the years.

Lallos: Even with so many great minds on the job, sometimes things aren't going to work out, or this type of strategy is going to go through rough patches. Can you talk about when people might expect a strategy like yours to be out of favor, as happened during the financial crisis?

Pohl: If we really knew, we wouldn't make those mistakes. This is a tough business, and it's a risky business. And if you look at our returns, we've had years, even a few years in a row at times, where we've underperformed. The long-term record, though, has been strong for a very, very long period of time.

And we hope that we attract shareholders who share our long-term perspective, and we think that if they do and they stick with it, the way that we stick with our strategy, that they will be rewarded over a long period of time. But if there were a way to avoid the underperforming years or avoid the volatility, we'd be doing it. But it's not clear to me, how.

Lallos: And one holding that we often talk, about as perhaps emblematic of what you're doing is Hewlett-Packard, which is an example of a name, as you have said, that you added to persistently in the face perhaps of criticism at times, that paid off well last year. Any other names that, you consider, emblematic of your strategy?

Pohl: Well certainly, last year we had a very good year in terms of performance for the funds, and three of the names that really helped drive that were Hewlett-Packard, Nokia, and Sprint, all of which began as very poor investments and underperformed a lot. But we doubled-down on our research effort, developed the conviction that these were good long-term investments, despite the fact that they had performed poorly initially, and bought more of them. And our shareholders were richly rewarded last year.

And on the international side, Hewlett and Nokia were both in that portfolio. We did not have Sprint, but we did have Panasonic, which was a similar kind of situation. And it's very important that we do our own research and that we are very knowledgeable about these things because as you know, that was a very difficult period for us with those names. There were a lot of questions that we got about it, a lot of pressure to pull the thorn out of your paw, sell it, and pretend that you never owned it or something.

But that's not always the right answer. You've got to look at them objectively on a long-term basis and decide which ones stay and which ones that maybe the fundamentals have deteriorated so much that you want to leave. J. C. Penney last year was an example of that, one where it performed poorly, and we decided the fundamentals had eroded to the point where we needed to sell it. We don't always stay with these, but there's a lot of return to be had for the ones that you stick with and then work out.

Strandberg: And it's important to remain objective. One of the things that we should comment on--so we have the team that's worked together over long periods of time, we have this fundamental research, we bring it into a group to bring perspective into the room--is that all employees of the firm are compensated based on how well the firm is doing, meaning how well our clients are doing.

And what that does is, is it encourages our investment team to collaborate extensively. So someone isn't worried if their stock is underperforming, that they need to pull back. They are encouraged to say, "Let's think objectively. Is it just a better opportunity now, or has the thesis changed?" And I need to bring that forward, as well. So it keeps our analysts objective and working collaboratively to think about what's best for the shareholder in the long term.

Lallos: Thank you for discussing your process with us today.

Strandberg: Thank you, Laura.

Pohl: Thanks for having us.