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Dodge & Cox’s Success and Diversifying Your Bond Portfolio

Funds that favor wide moats, fixed-income performance, and an undervalued biotech name.

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Susan Dziubinski:
Hi, I'm Susan Dziubinski from Morningstar.com. At Morningstar, we're fans of wide-moat companies: those companies with durable advantages that should allow them to thrive and keep competitors at bay for a decade or longer. Many money managers like these kinds of companies, too. Here are three highly rated funds focused on wide-moat stocks.

Robby Greengold: Harbor Capital Appreciation is a large-growth fund subadvised by Jennison Associates. The managers in charge are talented, and they have a long-shared history. But what makes this strategy stand out--what makes this investment team really stand out--is the team of dozen or so equity analysts who are deeply knowledgeable about their areas of expertise. The team puts together a portfolio of about 60 stocks that are routinely invested-in companies with competitive advantages. About 50 of those stocks, as of the most recent available portfolio, have been awarded either wide or narrow economic moat ratings by Morningstar's team of equity analysts. What you'll find here are companies that derive economic benefits, competitive advantages from, for example, their network effects. Visa and Mastercard are perfect examples. We like the strategy a lot. We've liked it for a long time, and we currently rate it Silver.

Jack Barry: Silver-rated ClearBridge Appreciation benefits from two experienced managers taking a risk-averse approach to investing in large-cap stocks. Scott Glasser and Michael Kagan have worked together on this strategy for 10 years, but they've been colleagues going back to the 1990s. They're supported here by ClearBridge's well-regarded central analyst team of 13 sector specialists. The strategy seeks to modestly outperform the S&P 500 while displaying significantly less risk. In order to do so, the managers invest in both growth and value stocks, looking for blue-chip companies with either underappreciated earnings potential or sustainable growth stories. To defend against volatility, the managers pay close attention to valuations and invest in companies with economic moats that have predictable cash flows. Altogether, this fund continues to be a solid choice for risk-averse investors.

Dan Culloton: Jensen Quality Growth is a low-muss, low-fuss fund. There's very experienced managers; each of the six team members have more than a decade with the strategy. And the strategy limits them to a very manageable circle of competence. The managers won't even consider any company that hasn't earned returns on equity of 15% or more over 10 consecutive years, which puts it in a very high-quality pond to fish from at the start. And then they dig into those companies to discern which ones are able to sustain those returns over the long term. It's a very high bar to meet. So that's why the fund usually limits itself to fewer than 30 stocks. And despite this concentration, it's been able to be very resilient on the downside, including the fourth quarter of 2018 when it lost around 6 percentage points less than the Russell 1000 Growth Index. That's because this fund tends to gravitate to steady-Eddie growth stocks rather than highfliers that are not priced for perfection. This fund offers a very attractive risk/reward profile.

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Susan Dziubinski: Hi, I'm Susan Dziubinski from Morningstar.com. Should your bond portfolio stay bland and boring? Or does it ever make sense to venture into some of the more specialized or even exotic types of bonds? Joining me to discuss that topic is Morningstar's director of personal finance, Christine Benz.

Christine, thank you for joining us today.

Christine Benz: Susan, it's great to be here.

Dziubinski: Now, before we start talking about some of these more narrowly focused categories, let's take a step back and talk about what are some of the type of bond funds that investors should consider as more of the core of their portfolios?

Benz: I think a core starting point for investors adding fixed-income exposure to their portfolios would be to think about the short- and intermediate-term core bond categories. So, the idea there is that you are getting pretty low returns--and it will ebb and flow based on the time period--not great returns, but you're getting great stabilization for your portfolio. If the idea is that you're getting closer to needing your money for spending, which is why most people own bonds, that you want to keep things pretty bland and boring, and short and intermediate-term bonds tend to deliver--they tend to perform well in periods when equities are falling, which is what you want from your bond portfolio.

Dziubinski: Now, let's assume I have those bases covered. I have my short-term needs covered; I have the intermediate-term bond portion of my portfolio. Should I ever venture out beyond that into any of these specialized categories?

Benz: One of the key categories that comes to mind would be Treasury Inflation-Protected Securities. So, a key thing to know about bonds in general is that inflation is the natural enemy. It's your natural enemy as a bond investor, because it eats away at the purchasing power of the interest that you earn from that bond. And so, Treasury Inflation-Protected Securities nicely address that problem by offering a little bit of a bump up in your principal value when inflation is running up. Recently, inflation hasn't been anything to worry about. But I think that it's worth keeping in the back of your mind because you don't know when inflation will flare up. It's really hard to predict. So, I think that this is an interesting sort of secondary category to consider. You definitely want to hold them within the confines of a tax-sheltered account because they are taxable bonds and plus that inflation adjustment that you receive is also taxable.

Dziubinski: So, do all bond investors, should they all be considering TIPS funds?

Benz: Well, it's interesting. When I look at the allocations that our colleagues in Morningstar Investment Management put together, they really only start getting interested in TIPS, Treasury Inflation-Protected Securities, for people getting close to or in retirement, that the allocation start building there for a couple of reasons. One is that if you're in retirement, you're not earning that paycheck from your job anymore. So, you're not eligible for those COLA adjustments that you are getting when you were working. You may get an adjustment in your Social Security income. But the part of your portfolio that you're withdrawing for your living expenses--that's not getting inflation-adjusted to the extent that it's in bonds. So, you'd want to think about it, especially as you're getting close to or certainly in retirement. If you're still earning a paycheck and you're owning bonds mainly to provide diversification for your total portfolio, there's less of a reason to own TIPS.

Dziubinski: Makes sense. Christine, what about international exposure? When we talk about the equity portion of our portfolios, we often talk about adding some international exposure for diversification. What about with fixed income? Should we be thinking about it the same way?

Benz: Well, it's a controversial topic. And I guess a key point I would make in the realm of bond funds is that international-bond funds are really broad basket. So, you have some very safe products where they're hedging the foreign-currency exposure into the dollar. And what you get is a performance pattern that's quite similar to what you might get with a U.S. short- or intermediate-term bond fund except you're maybe getting some different interest-rate exposures. But there are also some very aggressive products that fall under the international bond umbrella, some that might be unhedged in terms of their currency exposure. So, they might incorporate a lot more fluctuations associated with foreign currencies. My bias would be more toward the very safe set of funds, the ones that do hedge their foreign-currency exposure. I would say for investors who want to diversify and they are owning international bonds mainly to be stabilizers and diversifiers for their portfolio, they probably want to concentrate their attentions there.

Dziubinski: The types of funds we've been talking about, in general, tend to favor higher-quality securities.

Benz: Yes.

Dziubinski: Should investors be thinking about going down their credit-quality ladder with floating-rate loans, or high-yield bond funds? And what should they be thinking about if they do choose to do that?

Benz: Yeah, certainly, yields are much more tantalizing in that area. The thing is, though, these products tend to be pretty volatile. We've been talking about products that exhibit equitylike characteristics. And I would say, many of these products do exhibit sort of hybrid performance. Maybe they're not quite as volatile as equities, but directionally they're similar. And we saw that during the financial crisis as well, where, even though junk bonds and floating-rate loans didn't lose quite as much as the S&P 500 when stocks were down, directionally they moved in sympathy. So, you want to keep that in mind that there's a trade-off. Even though yields are higher, you are picking up more sensitivity to the equity market. You're picking up more sensitivity to what's going on in the economic cycle. So, I think of them as very supporting players. I think of them, kind of, in the realm of small growth in your equity portfolio. This is sort of the aggressive kicker component of your fixed-income portfolio.

Dziubinski: Interesting. Great things for us to think about when it comes to diversifying our bonds. Thank you, Christine, for joining us today.

Benz: Thank you, Susan.

Dziubinski: I'm Susan Dziubinski for Morningstar.com. Thanks for tuning in.

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Tony Thomas: Morningstar sees Dodge & Cox as a model fund family, and when it comes to investing in stocks, the firm’s domestic, international, and global offerings have solid long-term records. Many people wonder what the firm’s secret is, but the answer really comes down to a few key points: It’s willing to go against the grain with its picks, it has the courage to be patient, and it has deep and collaborative investment teams. These features define the firm and are keys to its success.  

The teams at Dodge & Cox are value investors. To them, that means looking for opportunities to pick up good businesses at cheap prices--often when other investors are heading for the exits. To protect against “value traps,” Dodge & Cox wants firms to have strong competitive advantages and capable leaders that can weather the storm affecting the business or industry in question.

Today, the Dodge & Cox portfolios are full of unpopular plays. With negative interest rates and slow growth in Europe, its international and global portfolios have stocked up on the continent’s leading banks, such as BNP Paribas and UBS. With talk of “Medicare for All” and concerns about drug pricing and addiction weighing on U.S. pharmaceuticals, Dodge & Cox has seen opportunities to add European firms like Roche and Sanofi. Problems at individual companies also open doors for the Dodge & Cox teams: They’ve added to their long-standing Wells Fargo stake in recent years, and they’ve bought more Bayer stock as that firm deals with its acquisition of Monsanto and litigation surrounding its Roundup herbicide. 

Not all of these contrarian picks pan out. The firm made some bad financials bets in the global financial crisis a decade ago, and more recently its energy names have languished even as oil prices have firmed up a bit. But it’s important to be patient, and Dodge & Cox excels at that. Its managers keep portfolio turnover low compared to many actively managed peers.

Because it takes discipline to be a contrarian investor and a patient trader, it helps that investment teams manage the Dodge & Cox portfolios. There are domestic, international, and global investment committees ranging in size from seven to 10 members. Each member has been at Dodge & Cox for at least a decade, and others are among the firm’s most senior investors. This mix of experience and youth greatly reduces key-person risk and reinforces the firm’s investment culture. It also fosters consistent execution across the firm’s strategies.

All of these strong points have been hallmarks of the Dodge & Cox approach to its stock investing throughout its 89-year history, and the fact that they’re so deeply engrained in the firm’s culture helps give us confidence that its stock funds are fine options going forward. 

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Anna Baran: We believe that Intercept, an emerging biotechnology company, is very undervalued by the market. We think that Intercept could have the first approved drug for a very serious but common liver disease known as NASH. I'll mention two points.

First, its timeline: Intercept is significantly ahead of its competitors. It just filed for approval for its drug OCA in the United States. And if the company gets priority review, it could have an approval as early as six months. This is years ahead of its competition. We predict that its competitors won't be entering the market until 2022 and 2023.

Second, we think that the market is overly concerned about the drug's side effects, which we view as manageable. We think that OCA could be taking the majority of patient share early on to do with strong efficacy and a limited number of other treatment options. This would mean that Intercept would enjoy strong returns for several years before other competitors come in and start gaining share.

Overall, while we give Intercept a very high uncertainty rating, due to its strong reliance on this one drug, we see ample upside from the stock's current levels.

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Dave Sekera: The fixed-income market generated relatively strong returns in the third quarter driven mainly by the continued decrease in interest rates, which pushed bond prices higher across the board.

In the U.S. Treasury bond market, the overall yield curve declined, but the curve also flattened as interest rates in the longer end of the curve fell further than that of the shorter end. In the short end of the curve, the 2-year declined by only 13 basis points to 1.62%, whereas in the longer end, the 10-year declined 35 basis points to 1.66%, close to its multiyear lows.

As a result, the Morningstar Core Bond Index, our broadest measure of the fixed-income universe, rose by 2.28%, well in excess of the yield carry it generated over the quarter. Underlying the broader index, the short-term index rose a little under 1%, and the intermediate index rose a little over 1%, while with its long duration, the long-term index outperformed with a 5.5% return.

Among corporate bonds, the investment-grade bond market outperformed the high-yield market this past quarter as investment-grade bonds generally have a longer duration than that of the high yield. As a result, the Morningstar Corporate Bond Index, which is our proxy for the investment-grade market, rose 3%, whereas the ICE BofA Merrill Lynch High Yield Index only rose 1.25%.

After tightening earlier this year, the corporate credit spreads ended the third quarter close to where they began. The average credit spread in the investment-grade market was unchanged at a spread of 119 basis points over Treasuries. The high-yield market only tightened 5 basis points to a spread of 402 basis points over Treasuries.

Although emerging markets have generated robust returns year to date, economic weakness in Asia and the strong dollar combined to form a strong headwind throughout the third quarter. The Morningstar Emerging Market Composite Index rose almost 1.4%; however, there was a wide distribution of performance across the underlying components. The Emerging Market Corporate Bond Index rose by almost 2.5%, which was partially offset by a loss of 0.2% in the Emerging Market Sovereign Index. With its high correlation to economic activity in Asia, the Emerging Market High Yield Index was the worst performer among our indexes this past quarter, posting a 1.30% loss.