Dana Emery: You're Not Getting a Valuation Discount for Free

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NOTE: A previous version of this mentioned collective investment trusts. Dodge & Cox does not offer them.

Our guest on this week’s podcast today is Dana Emery, chief executive officer, president, and co-director of fixed income at Dodge & Cox. Dodge & Cox is a privately held firm that was founded in 1930; it manages six mutual funds and separately managed accounts. The firm uses a value-oriented approach across asset classes.

Dana joined Dodge & Cox in 1983 and serves as comanager on Dodge & Cox Income DODIX, Dodge & Cox Balanced DODBX, and Dodge & Cox Global Bond DODLX; she became Dodge & Cox’s chief executive officer in 2013. She is also president and a trustee of the Dodge & Cox Funds.

Background Dana Emery Bio

Morningstar Analyst Report for Dodge & Cox Income Morningstar Analyst Report for Dodge & Cox Balanced Morningstar Analyst Report for Dodge & Cox Global Bond

Stewardship "Here's What Warren Buffett's Hero Jack Bogle Is Most Worried About in the Markets Right Now," by John Melloy, CNBC.com, March 21, 2017.

"Dodge & Cox: Built to Last," by Andrew Daniels, Morningstar.com, Nov. 16, 2017.

"Is Any Mutual Fund Company Better Than Vanguard? 1 Comes Close," by Daren Fonda, Barron's, Sept. 7, 2019.

"An Old School Investment Manager That Builds Wealth Quietly," by Landon Thomas, Jr., The New York Times, Oct. 13, 2017.

"The Top Fund Families," by Michael Laske, Morningstar blog, Feb. 22, 2019.

"Morningstar Fund Family 150," Morningstar Direct, July 1, 2019.

Dodge & Cox "People" Page (including management tenure and fund ownership), Morningstar.com

Dodge & Cox "Parent" Page, Morningstar.com

Portfolio Management and Strategy "Investment Risk Management," Dodge & Cox, April 2017

Government-sponsored enterprise (GSE), Wikipedia.

Senior and Subordinated Debt, Corporate Finance Institute.

"Finding Value in BBB Debt--Not All Corporate Bonds Are Created Equal," Dodge & Cox, October 2019. "A Value Investor's Case for European Financials," Dodge & Cox, April 2019. "Understanding the Case for Active Management," Dodge & Cox, October 2016. Women in Fund Management "Fund Family with 25% Women Managers Far Exceeds Industry Average," by Liz Skinner, InvestmentNews, June 2, 2015.

"Who Runs Mutual Funds? Very Few Women," by Jeff Sommer, The New York Times, May 4, 2018. Girls Who Invest

ESG "Evaluating Environmental, Social, and Governance Factors as Active Owners," Dodge & Cox, April 2018.

"Dodge & Cox's Approach to Evaluating ESG Factors," Dodge & Cox, January 2019.

Transcript

Christine Benz: Hi, and welcome to The Long View. I'm Christine Benz, director of personal finance for Morningstar, Inc.

Jeff Ptak: And I'm Jeff Ptak, global director of manager research for Morningstar Research Services.

Benz: Our guest on the podcast today is Dana Emery, chief executive officer, president and co-director of fixed income at Dodge & Cox. Dodge & Cox is a privately held firm that was founded in 1930. It manages six mutual funds and separately managed accounts. The firm uses a value-oriented approach across asset classes. Dana joined Dodge & Cox in 1983 and serves as comanager on Dodge & Cox Income and Dodge & Cox Global Bond. She became Dodge & Cox's chief executive officer in 2013. She is also president and a trustee of the Dodge & Cox funds.

Dana, welcome to The Long View.

Dana Emery: Thank you for having me.

Benz: Thanks so much for being here. So, we want to start by talking about Dodge & Cox at large: You are the CEO of Dodge & Cox. And I want to start with something that Jack Bogle used to say, which is that, he thought that asset managers have this intractable conflict of interest. So, they're trying to serve their fund shareholders and they're also trying to serve company stakeholders. It seems like Dodge & Cox has been able to thread that needle and probably serve both sets of constituencies pretty well. Is there something to being private that makes that easier? Can you talk about that?

Emery: Yeah. I would say our culture is one where we try to stay very aligned with our clients. And it's always been the case throughout our history. And so, we do that by being investment led. We are in our fourth generation of leadership at the firm. The leaders of our firm have always been actively involved in investing. And Charles Pohl and I are the current leads of the firm and we work closely with our board and other senior leaders around the firm to run the firm. So, it's kind of a flat organization in many ways. And I would say that being investment-led keeps us incredibly aligned because we focus on our most important task, which is to provide good outcomes for our clients and shareholders. So, I think that just by staying incredibly focused on investing, we're incredibly aligned with our shareholders.

In addition, we try to make decisions on the long-term best interest of clients. You'll never see advertising dollars for Dodge & Cox. We’re a firm that believes that if we do our job well, we will attract new business. So, the focus is more on the current client than on growth. And I think that it's just turning that around in the sense that if we do our job well, we will have growth opportunities where we will see opportunities as a firm. So, we try to stay incredibly aligned with our end shareholders. And we think that that can be a virtuous cycle in the sense of keeping the fees reasonable, focusing on the long term, and not trying to be all things to all people, stay in areas better aligned with our investment philosophy and our investment approach and staying in incredibly focused in what we do. We think that keeps us incredibly aligned.

Benz: So, we shouldn't be holding our breath for growth-focused Dodge & Cox funds?

Emery: No, I would say that our firm is very much a believer in how we manage money, which is, deep fundamental research-based valuation disciplined and long-term oriented. And we believe that investors that invest with us that share that long horizon will have an opportunity to succeed with us rather than someone with a more short-term mindset because we think that active investing takes patience, and you need that long-term horizon to be able to achieve that.

And I think we're different than a lot of firms because we're not constantly trying to create new products. The new products that we brought out have been very gradual over time, and they've been steeped in our investment philosophy. They tend to be broad-based and flexible strategies going where we see value. And we think that shows a real alignment with clients. I think we're also very unusual relative to other firms being one that has never obsoleted a fund in our history since 1930. And I think that there's a lot of fund families that actually have closed more funds than they actually currently have open, which is fascinating to us. Because we think that the approach that we've had, we only have six funds, relative to other large fund families—we are the 11th largest fund family in the U.S.; we only have six funds, and they're all invested with one investment philosophy. And I think that that shows incredible alignment with our clients.

The other thing that's interesting when you look at the data is that our investors, our policy members, have 100% ownership in our funds. So, we're incredibly aligned with our shareholders by investing alongside them. And many people across our firm have investments as well. But that 100% number, I think, really stands out. And also, investing for the long run, we have a low turnover, which that’s sort of that invisible headwind that's embedded in the cost of running a fund. Having that long horizon means that you don't have this turnover headwind that can eat into investment results. So, I think when you combine all that, I think it's very valuable.

Ptak: So, most firms haven't been as deliberate and judicious as you've been about thinking about what you want your strategy set to be, what you would define as your capabilities. And so, what do you attribute the firm's historical discipline as owing to, like, where you've gone through and you really thought carefully about what your capabilities are and brought out only a select few strategies that you think leverage those?

Emery: It really goes back to the very beginning of the firm. We were founded in 1930, just post the Great Depression and the founders of the firm saw a lot of conflicts in the business and really wanted to create an asset-management firm that was very aligned with clients. And so, that's permeated the investment decisions over the years. We started out as—we have one of the original balanced funds in the U.S., so equity and fixed income embedded in one strategy and working for high-net-worth individuals and many times, we're entrusted with their entire financial net worth. And our belief coming out of that is, almost the Hippocratic Oath, first do no harm, and look to stay focused and disciplined in our investment strategies to provide attractive returns for our clients over the long run. And that permeates the culture and the goals of the firm throughout our history. So, we're very careful and gradual and incremental in rolling out new strategies.

The evolution of the firm has been really starting in the 70s and 80s, as companies were globalizing, and we found that to be good investors—we started out just as domestic investors—to be good investors, as companies were competing globally, we needed to expand our research base. And so, it really came from wanting to be better investors, first and foremost, that drove the decision to start to look more globally for investment opportunities. And that gradually worked its way into being an actual strategy that we offer to the public. But our first view is, try to get as smart as possible as investors, be very open-minded to learning, and improving our capabilities as investors on an ongoing basis. So, that evolution to being more global. And also, one thing that's unusual is that we have integrated teams. So, we also have a really strong fixed-income capability in-house as well. And so, doing that together as an integrated team we think has made us better investors over time as well.

Benz: So, I want to talk about that, because I do think it's somewhat unusual in that your approach to covering companies as you cover them across the capital structure, so your fixed- income folks are connecting with the people who cover the company's equity. Let's talk about why you do it that way, why do you think it's advantageous and how do you think it's borne fruit for you over time.

Emery: We think it's incredibly advantageous. We're operating with one overarching investment philosophy across all our strategies, as I said. So, it's a fundamental deep research-based approach, valuation discipline and long term. So, it's the same philosophy. Many of the companies that have debt in size are value-oriented companies. So, it's an overlapping universe. So, our analysts are already looking at these companies. And we believe that by our analysts supporting both the equity and the fixed-income side of the business, we can have a larger and deeper team, which is sort of a virtuous cycle.

Looking at these companies together from both an equity and a credit perspective is value-add in both directions. Our equity teams are advocating equity ideas for equity committees, and they're also helping us formulate credit opinions by working closely with our credit analysts and our macro analysts to formulate credit recommendations. And so, when you're looking at the entire capital structure, one, you're looking at what the goals and objectives of the company are, what their strengths are, where are their weaknesses, the strengths of their products. It's very granular research where we're building our own models in sort of base up and downside case. Fixed income is really helpful in thinking about that downside case, because we're making loans to companies. When we buy a bond, we're making a loan to a company. So, we have to be very diligent about downside risk, because we don't have all that upside of the equity, but the best we do is get paid back in a timely manner. So, we need to focus on that downside risk. And in that there's a lot of detailed work that goes into looking at companies' funding profile, looking at their liquidity, looking at the terms and conditions on their debt instruments, their lines of credit. And by doing that together, I think, we get to a better result where we're both focused on the stable to improving, hopefully, company profile that will lead to a good equity outcome as well as protecting against the downside, and making sure that the company can weather a downturn in their business and industry or a cycle to be able to achieve that good outcome for both equity and fixed-income investors.

Ptak: Before we dive into the details of security selection and how you build portfolios, I also wondered if you could give a quick thumbnail to listeners that maybe aren't as familiar with the firm and the composition of your assets. I'm curious mainly how the composition of your client base has facilitated the way you've run the firm and I guess the conservative disciplined manner you've been able to operate it? Do you attribute some of that to the fact that you've been able to sell to clients who basically share your same set of investing values, for instance, your long-term orientation, or otherwise inculcated in your philosophy?

Emery: I think we have to give them a lot of credit. I think that the firm evolved from managing private clients, as I mentioned before, to large institutions starting in the 70s and 80s. Many of those were defined-benefit plans, endowment/foundation plans, and in more recent years, 401(k) and intermediary clients. We still have a strong base of direct investing in our funds as well as our private client group. And I would say that working with investors that share our long-term view and that are patient investors, has been a great asset for the firm in the sense that we're very aligned with our investment goals. And as I said before, for clients to truly benefit from our strategies, they need to share our longer investment horizon. As value managers, you're not getting a valuation discount for free. There's something going on with the company or the industry that's causing a discount valuation. We try to use our research to ferret out, understand what the company's strategy will be to deal with whatever is holding down the valuation, and have the patience and conviction to stay with that investment over the long run that allows that valuation to move back towards fair value. And so, you need that patience and conviction to be able to achieve that and our clients that share that long-term view really benefit from our strategies.

Ptak: And so, as intermediaries have entered the picture, I would imagine they've become a bigger part of the mix as the years have gone on here. I mean, one of the things that we see in the industry is, they've become more intermediated, they succumbed to impulse and temptation. More often the intermediary is telling them, "we want this, or our client wants this," and it basically comes to shape the way they think about their investment capabilities and what it is they offer. Whereas with you, you've stayed fairly disciplined. You have a very small, by comparison, product set. So, how have you been able to manage that as you brought intermediaries into the fold, and maybe helping them to understand what their expectation should be of the firm?

Emery: Yeah, the bulk of our intermediary business is with large financial institutions that are building model portfolios for their clients. So, it's very similar to talking to a sophisticated institutional client that has really embedded in research and aims to understand our strategies and get a sense for how they'll do in a variety of environments as they're building the asset-allocation model for the end clients. So, a lot of our job is to keep them very informed about our strategies, our views, our outlook, be very honest in our communications about what works and what doesn't work and where we can be helpful. We want to be very careful about the business we take on because we know that to be successful and maintain our excellent reputation as careful stewards of assets, we need to make sure the clients are aligned with us. It's not a win-win if we take an assignment that we don't really truly believe we can do a great job in. So, we try to just have very open honest communications, ask a lot of questions upfront and make sure they understand us, and we understand them.

Many of the intermediaries, we go to their offices, of course, and they come to visit us, many times for multiple hour meetings to do deep due diligence. Many times, in that they're meeting the senior people, they're also meeting the investment committee members, they're meeting our analysts, and they're able to see that the culture of the firm is very pervasive. I mean, people really believe in it. They're very passionate about investing and are steeped in deep knowledge about the investments we're making. And I think that that really gives them that confidence. And we can get confident that they are taking the time to really understand us, and I think that creates a great partnership over the long run.

Benz: So, we've seen this tremendous stampede of assets out of active products into passively managed products. Do you think investors are overdoing that? It's a good thing that investors are cost-centric. But do you think that some investors and advisors are perhaps dumping actively managed funds indiscriminately? Do you have a read on that?

Emery: We've definitely seen some of that trend. And sometimes it's not necessarily—they might be making the right decision for their own particular circumstances. So, we do think that active and passive can coexist. And there's a lot of facts and circumstances that would lead to why someone might choose a passive strategy over an active strategy. And one of it is time horizon and risk tolerance. So, I would say that one of the things that's been confusing to us is that the industry seems to have painted the active management with one paintbrush that anything active is the same. And our view is, there's so many degrees of active.

What I've been pleased about in the industry is that the pricing and the transparency is getting better. It's not 100% there, but it's moving in the right direction. And I think that's in the interests of the end client. Dodge & Cox has always had the view that we want to price our strategies fairly. We're one of the unusual firms in the industry that only has one share class in our funds. So, we don't have lots of distribution payments embedded in share classes and we think that that creates a lot more transparency and less conflict in the structure. So, we aim to keep those fees reasonable in the context of our value add. That's always been our philosophy, and the industry seems to be coming in that direction. We've always also tried to keep the expenses low. So, we really just pass through the very small expenses and pay as many of those expenses out of our own assets to keep the overall value proposition attractive to our shareholders. So, that's been our philosophy on that.

Ptak: So, when you're wearing your CEO hat and you're thinking about the future success of the firm, I mean, you predicated to this point, I think it's something like if the investor wins, we win. Basically, if you deliver a good outcome, alpha for them, then there's going to be spillover to you as a business, right? Do you think that relationship holds in the future, especially with costs being as important as it seems to be in the marketplace, and an increasing move towards sort of outcome and solution centricity amongst investors, where maybe they're not as focused on investment alpha as they once were? How do you think about that as a business leader?

Emery: I believe really strongly that the outcome that we can be an important component of that outcome, or we can be the solution with one of our strategies, like our Dodge & Cox Balanced Fund. As we're more intermediated and the industry is becoming more outcome oriented, our strategies really are great value proposition in my opinion, and I think they can be an important component to helping people reach those outcomes. So, I think they actually are symbiotic in that sense.

Benz: I have a question about sort of Dodge & Cox's culture. Our analyst, our Morningstar analyst covering Dodge & Cox said that there are a lot of lifers within the firm, people who have been there for a very long time. And I think most company leaders would agree that that's what they're going for, that they want to try to retain great people over long time horizon. But how do you balance that having a lot of very senior people aboard against the desire to make sure that you're bringing fresh ideas into the company? And also, how do you make newer hires feel comfortable getting their voices heard and stepping up and speaking up?

Emery: Great. A lot of parts to that question. I would say that's one of my biggest roles as CEO of the firm and cohead of the firm with Charles, this idea of talent and talent development. We put a lot of effort around that. We believe strongly in our investment philosophy. And so, we think one of the best ways to retain that investment philosophy and have it permeate the culture is to bring people in early in their investment careers. But we've tried to do in our recruiting is have a nice look at them and make sure they're a good fit to the culture and that they share our philosophy and approach. And then, we believe we can train them in our way of investing. So, by bringing them in early I think that that's an advantage.

So, the way we've recruited our analysts has often been through a summer internship between years of business school, and that's we think a great long-term way, like almost like a long-term interview, as a way to get to know people, see how they attack a complex problem and see how they advocate. People that are successful in our firm are willing to do deep research and also willing to advocate their ideas and subject their ideas to scrutiny. And it's not for everybody. So, we have to make sure the person is going to feel comfortable in that environment and that we believe they can be successful in our environment. So, that summer internship is really valuable.

Another way that we've recruited is, each of our analysts has a research associate and that's a post-undergrad two- to four-year position at the firm. And many times, they'll go back to business school once their two to four years is finished at the firm. And many of them have wanted to come back to the firm. So, that's another really great pool because then we've gotten to know them over a much longer period and we can see what their passion for investing and their work ethic, et cetera. So, I think that's incredibly valuable.

For investing, we've got a whole range of experience. I think we have the longest average tenure of our analysts in the industry, about 15 years, and our investment committees are 20, 20-plus years. So, there's a lot of benefit to the institutional knowledge that builds up over that time. But we also have a nice cadence of new hires so that you're bringing in new fresh ideas that come into the firm from that experience. Our job in these leadership roles is also to make sure we're investing in the capabilities of the firm. Last many years we've added more capabilities in macro research to support our global fixed-income efforts. That's become very valuable all over the firm as we're making investments in emergent markets and understanding Brexit or thinking about political risks in various environments. So, having that team has been incredibly valuable. And many of them have PhDs and have a real quantitative approach. So, bringing in those quantitative tools to this bottom-up fundamental process and making sure we're making the most use of data, doing really good risk analysis in our portfolios has been incredibly additive too. So, bringing in that new talent, new fresh ways of looking at things—and this is not just on the investment side. We will bring in lateral hires across client service, operational capabilities, legal and they bring in a lot of knowledge from other firms that has been incredibly beneficial to us. So, we have this kind of range of lateral and developing people from within across the firm.

Benz: So, has recruiting into a value shop been challenging over the past, say, five or 10 years where we've seen strong outperformance among growth strategies, a lot of interest in private equity and venture capital and so forth? Has that been a little bit of a headwind for you?

Emery: It really hasn't, I think, because we only are trying to hire one or two people a year. So, we want to find people that are passionate about how we invest and are intellectually curious and have that kind of continuous learning mindset, open mindedness. So, we are always trying to look for those attributes when we're hiring people. And given that we're hiring one to two a year, it has not been an issue because we can find those people. And we've recruited all the top business schools, and many times our own employees can be really great at recruiting in the sense that they're keeping in touch or people are reaching out to them to ask questions about Dodge & Cox as they're thinking about their job opportunities.

Ptak: So, talent is obviously one of the very important investments that you'll make in the firm. As you reflect on the way investment in the firm has maybe evolved in time and naturally it will and then also try to imagine how that will look maybe five or 10 years hence, especially with the development of tools like robos; you have firms that are just giving stuff away, right, you don't necessarily have to emulate that, but I would imagine that those are things that you're cognizant of and they probably do inform in certain ways the way you would think about capital allocation to the firm. So, can you talk about maybe how it's changed in recent years, and maybe how it would further evolve as you gaze forward?

Emery: Yes. I would say that our technology spend has increased pretty significantly. And a lot of that's because there's a lot of tools out there that can make us more efficient as asset managers either in the trading area or in client servicing. And we want to make sure we take advantage of that because we want to focus first and foremost on investing. And we want these tools to help us be as efficient as possible in all aspects of running the firm from an operational, trading, client-servicing standpoint. So, a lot more investment there. We have various projects going on around the firm that we think will serve the firm and our clients well over the long run.

We've also been, as we've talked about bringing in some PhDs and more quantitative work, we've been bringing in some data experts. We've been finding that the data is there, you just want to be able to extract it and utilize it to the benefit of the client. And so, we bring in more data expertise, more quantitative tools to help us evaluate risks in the portfolio. So, these investments are not inexpensive. But we think they're important to the evolution of the firm and evolving our capabilities with actually the new information sources that are out there.

A lot of people ask us about sort of AI. And there are different applications across the ecosystem of a firm from the investment side through client servicing through operations. And we think it's early days for a firm like ours the true applicability of AI in the investment process, but we think that it's going to keep evolving. So, we're keeping a close look on that and we have a quantitative group that's monitoring opportunities there. We've made use of some third-party tools to help us be more efficient in terms of looking for any changes in language. So, sort of parsing out language in transcripts from CEO transcripts or CFO transcripts, as well as looking at disclosures across, the financial disclosures that companies make, to help us make sure we don't miss them. So, there's quantitative tools—our analysts are always reading them. But also, there's quantitative tools to make you more efficient and make sure that you don't have a human error where you actually miss something that's in there that's important to your investment thesis.

So, there's a lot of tools out there. We're trying to be careful, because some of it's hype, at this point, in our opinion, and some of it's a little too short term for our long-term investment horizon. But we're very open-minded to it and we're monitoring those tools and will integrate them as they become valuable to making us better investors over the long run.

Benz: So, we want to switch gears because you wear two hats at Dodge & Cox; you're CEO but you're also codirector of fixed-income strategies. So, you're a manager on Dodge & Cox Income as well as Dodge & Cox Global Bond. So, we want to talk about investing, and bonds are a good place to start. So, many market watchers are expecting very little from bonds over the next decade, citing the very low yields that we have today. Do you agree should investors temper their expectations for bonds, and maybe talk about what role you think bonds serve in investors' portfolios, because I think a lot of investors and advisors are kind of wrestling with that sort of cash versus bond question? If yields are not that different why wouldn't I just put the safe part of my portfolio in cash?

Emery: A lot of parts to that question. Maybe I'll start with the role in the portfolio. We think that fixed income plays an important role in a broad strategy in terms of income generation, stability, predictability. When you think about the movement towards more outcome-based investing, the fixed income, that stabilizer role and that current income can really give investors confidence to stay the course even in a down equity market. So, I think being a little bit of a buffer there can be very important.

You hit on an important point, though, because interest rates are very low. Obviously, one of our macro-analysts was looking at this and you could almost look at the level of interest rates now over centuries, and they're near the lowest level they've been. And I think, because you're starting with a low starting yield, your total returns absolutely have to be tempered because the starting yield is one of your best predictors of what your total return will be. And so, we've thought about this a lot. I think that investors many times will anchor on sort of stability, but you have to pay for that. It's not free. So, if you go really short and have a stable portfolio, you may be giving up return opportunities that exists further out the curve. But then, when you think about benchmarks, they've lengthened out so much because of issuance patterns and the low rates, just the math of bonds. So, you have to be really careful about not thinking of the benchmark as risk neutral. So, we think an active approach to fixed income is very important.

From interest-rate exposure, we've kind of settled on more of an intermediate. We think we're enough out the curve that we can generate income that is higher than the benchmarks, but in a very careful way based on bottom-up research. So, we've been hovering around the three to four-year—depending on the strategy—duration, and we think that that is a nice middle ground. The curve is relatively flat, as you mentioned, but we think that you've locked in the interest rate a little bit longer. So, you don't have as much reinvestment risk as you do if you are in a short strategy. But you're not so long that you're taking a significant price risk in the portfolio if interest rates rise from here. Because we think that embedded in market pricing right now is a lot of pessimism. It's interesting because the equity markets have been strong. But the bond market seems to be pricing in a lot more pessimism when you take a look at where rates are, especially, in the treasury market and across the globe with negative rates. So, if you look at treasuries right now, you're really barely keeping up with inflation, if at all. And so, it's not a compelling investment opportunity. If you extend out your investment horizon, we think through active management and careful bottom-up research, you can find really attractive instruments that can produce a better total return than just sitting there in the safety of a money market fund or in the safety from a credit quality standpoint of treasuries. But part and parcel that is the investment horizon. I think you have to extend out your investment horizon to be able to benefit from that active management.

Ptak: Maybe for the benefit of listeners who are less familiar with how you add value in fixed income, many of them will be because they invest with you, but some won't. And so, maybe can you boil that down? There's some firms that, you know, they wheel around and try to make a good duration call, or they play the curve, or they're more credit specialists. And so, I know that you don't focus on any one thing. But when you go an expectation set with investors and try to help them to understand how you add value, what does that expectation setting sound like? Do you say, you know, we're going to do it through duration, it's mainly going to be through credit, maybe we'll get yield curve right? What does that sound like?

Emery: I think people think of us as bottom-up security selectors and true investors in the securities where buying for our portfolios, and that we're doing that over the long term. And we think that there's both opportunity in being a bottom-up security selector as well as risk control, in the sense that we can see where there's opportunities, we use our fundamental research to understand or get a sense for the range of outcomes of the credit worthiness of an issuer. I can go into more detail there. But also, overlaying that with the valuation, what is your starting yield, what is the total return prospect for that investment, and looking at that in ranges so that we make sure that we have a sense for how good and potentially how bad that investment can be. So, that bottom-up process is both a sense of opportunity as well as risk control in the portfolio. So, we spend a significant amount of time thinking about downside risk in the investments that we're making, because given that you're getting a relatively low reward in this environment, focusing on protecting that downside is incredibly important in fixed-income investing. And I think if you just buy the benchmark, you're not getting the benefit of that selectivity that an active manager can bring to bear.

Also, we tend to overweight credit. People think of us pretty much as a credit investor. But having a flexible broad-based approach allows us to go where we see value. The mindset that we have is that we're rebuying our portfolio every day for the next three to five years, and we go into our investments with that mindset. But if the market moves, and we had that in the last year where there was a big risk-off environment in the fourth quarter of '18, and this year credit spreads have recovered quite a bit, we will lean in when we're getting better paid based on fundamental research, and then we'll lean out. So, there's a lot of room for more dynamic asset management in a flexible strategy. Because if we think we're not getting well paid to take credit, you'll see us upgrading the portfolio.

And one thing that people often don't think about for Dodge & Cox is that we've added a lot of value through security selection in structured products. So, thinking about mortgage-backed securities, mostly GSE mortgages as well as asset-backed securities. And they've always played an important role in our portfolio in sort of high-quality intermediate yield. And our job as security selectors there is to try to mitigate the uncertainty of prepayment risk, because mortgages can be prepaid at any time by doing the deep research on the underlying loans and the geographic diversity, the servicer characteristics and select securities with the characteristics that we think can mitigate some of that uncertainty of cash flow, and earn the yield that they offer for the investor. And they often make really good substitutes for taking treasuries because we think you're giving up almost too much yield many times for that safety, and then corporates where you're taking on credit risk, you only want to do that when you're compensated for that. Otherwise, you might as well find other types of securities that can generate a nice return. So, having that flexible approach, bottom-up security selection drives our strategies. And then, we try to find the right spot in terms of interest-rate exposure as we talked about earlier.

Benz: So, you mentioned it's this ongoing sort of assessment of whether to lean into take a little more risk or back off. Where we sit today in sort of mid-October, it feels like things are pretty picked over everywhere. But I'm wondering where you are with respect to leaning into taking more risk or sort of backing off of risk.

Emery: We've been more in the backing off because of the compensation that we're getting. So, we actively, as I mentioned before, are thinking about each of our investments in the portfolio, we look at them on a constant basis whether you're getting properly compensated for the variety of risks that you're taking. But having said that, we still have about 44% of our portfolio—using our Income Fund as an example—in credit. It's not like we don't find credit opportunities with an extended horizon. And using your research to ferret out the downside risk, the incremental yield that you can earn from investing in credit, it can be very powerful over a longer time horizon and lead to better results than opting for pure safety. So, it's a time horizon issue. And then, you're leveraging that fundamental research.

In this environment, we've been finding some interesting opportunities. A lot of companies have been doing M&A. Some of those deals are at least in part financed with debt. Many are financed with debt. And many times, companies to achieve a long-term goal, maybe a consolidation goal, a cost cutting or maybe to move into new areas, will take on more debt to do that in order to finance that, and many times, they'll take a downgrade for that to happen. And that may sound bad, but it actually can often create a real great entry point to be a lender to that company, because many times the valuation widens out and you're getting a better yield. And you have an alignment with the company management. Companies are run for the shareholders and other stakeholders as you know, but the fixed income is really, they're just making a promise to pay you back in a timely manner. So, when you're really aligned where the company is going to prioritize their cash flow for deleveraging, we think that that is a really great entry point as a lender to the company, because their goal will be to shore up their balance sheet, improve their credit profile, and leave themselves flexible for whatever investments they need to make in their company. So, I think that that's been a really interesting area for us.

Another has been, some companies have been issuing debt more junior in the capital structure. So, a lot of our analytic work is around looking at the pricing differentials between the senior debt and the subordinated debt and assessing based on the company's profile whether taking that additional risk, which would be being further down in the capital structure, is warranted based on how much you're getting compensated. So, some examples of that are some hybrid debt, also subordinated debt in bank capital structures. Banks in the post-financial-crisis world have had to shore up their capital, as you know, and create more liquidity and have through behavioral changes improve their overall asset quality. So, that's been a great place in our mind to collect some incremental yield over and above investing in the senior securities. So, there's lots of pockets of opportunity for long-term investors that we're really excited about, but in the context of a much lower-return environment.

Benz: So, you are involved in the Global Bond Fund. So, I'd like to talk about the U.S. versus non-U.S. question in terms of where you think more opportunities seem to be arising. And of course, that's a huge generalization.

Emery: Yeah, it's a big generalization. So, we really go around the globe. We build out models on interest rates around the globe, as well as our views on the major currencies around the globe. And we think that in our Global Bond Fund, we can find attractive opportunities across credit, rates, and currency. But we operate with more of a hedged mindset and really only want to take currency risk when we think we're being compensated for that through the carry or improving fundamentals. And in this environment, a lot of the developed market currencies don't look overly attractive because you can earn a better return in U.S. dollars. But that's a generalization to say that we can still find pockets of opportunity in various markets that look interesting to us, either in credit. Sometimes the same issue we will be issuing in different currencies with the same indenture terms behind it. But for whatever reason, just maybe technical reasons or investor preferences, you can earn a better return in another currency, even if you hedge it back to dollars.

Benz: Interesting.

Emery: So, we spend a lot of time with that analysis and building out models to monitor those opportunities around the globe. And we have analysts that just really focus on that and look for those pockets of opportunity. Where you're getting more yield but you're also taking on more risk is in the emerging markets, where we have a combination of local currency debt, as well as hard currency debt for corporate debt and emerging markets. And it's the same process of this deep research model-based trying to be forward-looking and forecasting where we think the range of outcomes will be from an economic standpoint and interest rate standpoint, and then look at what can you earn on the current securities and whether that can translate into an attractive total return relative to just staying in U.S. dollars. So, we really like the global bond universe. And having that hedged mindset, we think opens up that opportunity set. Even despite the fact that many parts of the world are in negative yields, we can find very interesting opportunities due to lots of technicalities that happen all over given there's just literally thousands and thousands of CUSIPs and various interests that cause some inefficiencies in the bond market.

Ptak: I think you mentioned credit isn't cheap. But when you scan across and look at corporate balance sheets, I know there's quite a bit of discussion about sort of the strength or fragility of corporate balance sheets, and that debate continues to rage. What do you see when you scan across the different issuers that you are evaluating or that are on your radar for other reasons?

Emery: Yeah, I mean, I think if you looked at post-financial crisis, they really hunkered down, built up the cash on their balance sheets, and slowed their investing in their business or share buybacks, and that gradually over the last 10 years has creeped back in. And so, we try to understand the company's capital-allocation goals through ongoing conversations. We do benefit from having an integrated team and having a strong base of equity and fixed income. Because companies are constantly talking to us as an equity investor or potential equity investor. In fixed income, oftentimes you talk to the issuer more around the time of an issuance. But I think having both capabilities in-house has been really beneficial to our ability to talk with management, really get a sense for what their capital-allocation goals are. And so, I think companies are trying to have an attractive return on equity and reward their shareholders over time, but they've got to keep that in balance with their own business profile, their own cash flow generation ability, and the risks that they'll take on by taking on leverage. So, we see a lot of companies trying to find that right spot for their company, and only episodically taking on debt to achieve a corporate goal many times in the case of M&A or sort of regular share buybacks that are more predictable.

So, I would say that leverage has creeped up. If you look at things in aggregate, that leverage has creeped up, but it started to stabilize. Companies have shored up their overall liquidity profile, which gives you more staying power in a downturn. But we always try to go in with a skeptical mind on each individual investment we're making and make sure that we understand what the range of outcomes is likely to be, as well as really look at their liquidity profile and their funding profile and access to capital if there is a downturn in their business or industry. So, that might be saleable assets, that might be securitizable assets, it might be a line of credit that is wide open so they can draw on it if they need it. That we think is really crucial so that they can weather any downturn that potentially happens in their industry, or their own company.

Benz: So, I want to switch gears yet again and just get your perspective on what it's like to be a prominent woman in the asset-management industry. Does it affect your view on hiring people, does it affect your thoughts on managing people? Talk about that.

Emery: Yeah, I mean, I guess, I don't spend a lot of time thinking about myself as sort of prominent in the industry. I focus a lot on managing our own firm. But I think to the extent that I'm in a role, a leadership role, and that can be a role model for others in the industry, I embrace that. I've had a lot of young people in our industry say that, you know, seeing a woman leader is something that attracted them to the firm. And so, I think that's wonderful. I think, our industry, as you know, is still not diverse.

Benz: No.

Emery: And last Morningstar study, I saw that Dodge & Cox had the highest percentage of women in investment decision-making roles in the industry at 30%. So, I wouldn't call that a victory. But I would say that it's just parser through our culture. We have a culture that regardless of background, we're all trying to grow together and get the best investment outcomes and we've always operated with lean teams. And I think that one of the things you hear about big firms is just being able to get that visibility and get those prime projects or things where you can shine. And our firm is small. And we do everything in teams. So, there's a lot of opportunity for people to show their work ethic, their preparedness and advocate for different investment ideas. And that's noticed. When people really roll up their sleeves and help the firm get better, that is noticed. When I started at the firm, it was only 35 people and three people in the fixed-income group. So, there was really no choice. I had to roll up my sleeves and I had to raise my hand for opportunities. And we try to keep that culture now and encourage people.

So, we know that the industry and ourselves need to be deliberate in attracting diverse talent because I think that people don't really understand our industry. I think we had Wall Street-type of bad behaviors I think tainted the industry a little bit post the financial crisis. And I think a lot of times we found when we were talking with students out on campuses, they don't totally understand the ecosystem of what an asset manager is, what an investment bank is. And so, we try to do a lot of education there. And then, we've also tried to support organizations that are attracting women and minorities to the business. There's a great nonprofit called Girls Who Invest that is doing kind of like a boot camp on college campuses where they'll go in for six weeks and get intensive training in financial analysis. And then, they'll get placed out into a whole variety of asset managers. And I think that those types of initiatives as you try to bring in young people to our industry and make them understand the important social purpose of our industry, and that it's a great place to make a career regardless of your background, we want that diverse talent attracted to our industry and our firm. So, we've made a lot of our own efforts, but we see the firm, the industry, and various firms in the industry making various degrees of effort in that regard.

Benz: So, you are based in San Francisco. Can you discuss to what extent you've thought about ESG? Does it inform the way you invest in any way? Do you get any sort of push from clients to have a bigger emphasis on ESG, or perhaps even an ESG-specific equity product, for example?

Emery: Yeah, we've followed more of an integrated approach. Many times, we are in a fiduciary role, and we're trying to produce the best outcomes and we think that this integrated approach to ESG is commensurate with that. Throughout our history we've always as long-term investors focused on the governance side, really making sure that the interests are aligned, as I've been talking about, between the company's goals and trying to produce attractive long-term results for shareholders. And so, that's always been part of what we do. The E and S is, I think, a work in progress for the whole industry. I think there's different definitions of what's important from an environmental and social standpoint.

We actually had one of our analysts look through various environmental and social factors and zero in on things that we thought would be very important to long-term shareholder value. And our analysts integrate that into their process and incorporate that in their investment advocacies. And we think that that is an important role for active managers, especially as sort of vigilantes overseeing, we can vote with our feet, we can either invest or not invest. And these ESG factors are very important to making those decisions. They are one piece of it. And I think we can keep the feet to the fire to various companies to make sure, one, that they're being good actors, we think that goes with creating long-term shareholder value, but also disclosing as much as possible so that there's just more information out there about how being a good actor on all three levels will lead to better investment outcomes and more data that's out there and the more transparency, the more we can all embrace this. We've not decided to do an ESG-only fund. We think the integrated approach is the right way in an environment where we're trying to produce the overall best outcomes for our clients.

Ptak: Maybe I wanted to ask you to put on the hat of a financial advisor, I guess, it came to mind when you were characterizing the state of fixed income and you know, the way that can challenge somebody who's maybe a devoted fixed-income investor as many retirees are. And so, I'm curious to get your perspective, if I am a retiree, I've used fixed income as a sleeve of my portfolio to maybe provide some ballast and stability, and yet it looks really overpriced. Should I be thinking differently about my allocation to fixed income? Could it argue that perhaps there are some segments of the equity or other markets that I should be looking to make a bigger part of my retirement portfolio to ensure that I'm not unwittingly courting too much risk through fixed income?

Emery: Well, I guess, I'm a little bit biased, but I do I believe that having an active approach where the active manager is looking at interest-rate risk and incorporating that into how the portfolio is being built, is really important. And so, I think that fixed income can still have a role. We've seen allocations to fixed income vary depending on what the investment goal is. So, it's hard to say one paintbrush of how much fixed income should be in a portfolio. You need to see the whole financial picture for an individual. So, I would say that the advisors are really moving towards really understanding their clients on an individualized basis and building solutions based on their own specific circumstances. And it varies based on how much fixed income should be in there.

We do think that equity returns given GDP growth globally, demographics, that equity returns will also be lower in the future. So, the differential between fixed and equity may not be as wide as it's been in the past. So, we still think that in a lower return environment, both across equity and fixed income, that fixed income can still play an important role in that. But one thing that we do feel is that with longevity, people are living longer, that there should be an important equity component in the asset allocation to protect against those costs out into the future, healthcare costs and other costs that are very important to be able to cover as people age. So, we think the equity component gives people that inflation protection, that's going to be very important to be able to have a secure retirement.

Benz: You've mentioned on a couple of occasions that investors are getting a fair amount of duration risk if they're buying some sort of a total bond-market index product. Do you think investors might not be appreciating that risk factor? We've seen a lot of flows into the total bond-market products or various permutations thereof.

Emery: Yeah, I think that what's happened over time is that the typical index like the Bloomberg Aggregate Index, which is a broad-based index, is typically one that's used, or maybe the Global Aggregates are issuance-based indexes. And there's been a lot more issuance with our deficits of treasury securities. So, treasuries are a bigger component of it and sovereign debt in the global strategies. And also, given that interest rates are low, that the duration of these indexes has lengthened. Also, many companies have termed out their debt. So, there's more issuance further out the curve, which is a good thing, but they're issuing out 10- and 30-year debt as appropriate. And so, all of that confluence has led these indices to lengthen pretty dramatically. I mean, the Aggregate Index is six years, and you're getting only about a 2% yield. So, you're sort of—when you think about it from a yield per unit of duration standpoint, it's not the most compelling risk/reward. And the global indices are even longer, like seven years.

So, I guess our mindset is that that's not risk-neutral. It really should be about where can I produce the best total returns. And we think you need to take an active approach leaning into opportunities and out as the markets evolve over time. And one of those things we're trying to mitigate is that interest-rate risk. Because the belief structure we believe now is sort of that a recession, at least priced into the bond market, it looks like a recession is priced in. If that turns out to be wrong, we could see interest rates move back up. And given you're starting with such a low ongoing income stream, the price decline that could be associated with that could offset your income earned or even lead you into a negative total return environment. So, from our perspective, an active approach to fixed income does really make sense. And there are situations where the passive strategy can be very appropriate. But I believe for the long-term investor that the active approach, selective active approach, is very important.

Benz: OK. Dana, this has been a great discussion. Thank you so much for being so generous with your time. We've loved hearing your insights.

Emery: Thank you for having me.

Ptak: Thank you.

Emery: It was enjoyable. Thank you.

Benz: Thanks for joining us on The Long View. If you liked what you heard, please subscribe to and rate The Long View from Morningstar on iTunes, Google Play, Spotify, or wherever you get your podcasts. You can follow us on Twitter @Christine_Benz.

Ptak: And @syouth1, which is S-Y-O-U-T-H and the number 1.

Benz: Finally, we'd love to get your feedback. If you have a comment or a guest idea, please email us at TheLongView@Morningstar.com. Until next time, thanks for joining us.

(Disclaimer: This recording is for informational purposes only and should not be considered investment advice. Opinions expressed are as of the date of recording. Such opinions are subject to change. The views and opinions of guests on this program are not necessarily those of Morningstar, Inc. and its affiliates. Morningstar and its affiliates are not affiliated with this guest or his or her business affiliates unless otherwise stated. Morningstar does not guarantee the accuracy, or the completeness of the data presented herein. Jeff Ptak is an employee of Morningstar Research Services LLC. Morningstar Research Services is a subsidiary of Morningstar, Inc. and is registered with and governed by the U.S. Securities and Exchange Commission. Morningstar Research Services shall not be responsible for any trading decisions, damages or other losses resulting from or related to the information, data analysis or opinions or their use. Past performance is not a guarantee of future results. All investments are subject to investment risk, including possible loss of principal. Individuals should seriously consider if an investment is suitable for them by referencing their own financial position, investment objectives and risk profile before making any investment decisions.)