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Same Process, Different Portfolio at Dodge & Cox

Laura Lallos

Laura Lallos: Hello. I'm Laura Lallos, a fund analyst here at Morningstar.

We have with us today guests from Dodge & Cox, Charles Pohl and Diana Strandberg. Thank you very much for coming.

Diana Strandberg: Hi, Laura.

Charles Pohl: Hi, Laura.

Lallos: I was hoping we could start off talking about technology, because your portfolios represent a pretty broad range of tech names, from Hewlett-Packard to Google. Could you talk about how such different picks fit into your process?

Pohl: Well, I think those two names are a good illustration of the nature of our process, because our process involves a very thorough bottom-up fundamental analysis of companies. We're looking for companies that have good potential for growth in earnings and cash flow, looking for companies with strong business franchises, and companies with high-quality management teams that are oriented towards creating shareholder value. So that's one half of the equation. And the other half of the equation for us is valuation. And so the process of decision-making is a weighing of those fundamentals against the valuation that we see in the marketplace.

In the case of Google and Hewlett-Packard, the equation is a little different. In Hewlett-Packard you have very low valuation relative to what we think the long-term earnings power of the company is. But some of the fundamentals are a little weaker than in a company like Google, where we think you've got some very strong fundamentals, and a little bit higher valuation. But in each case, when weighing both sides of it, we think that they're attractive situations.

Lallos: Hewlett-Packard is currently the largest holding in your domestic stock fund, Dodge & Cox Stock, and that's, I assume, because the valuation is so compelling.

Pohl: Yes. Hewlett has an exceptionally low valuation. We think that the long-term earnings power of that company is $3.50, maybe $4 a share. It's trading at a little less than $20 a share, and so a very low multiple of what we think the company potentially could earn. But the company also has some attractive fundamentals, particularly the printer business, we think, is a business with a lot of barriers to entry; they have very large market shares. And even in some of the other businesses--PC is certainly under a lot of pressure now, as are their other services businesses--but those are fundamentally pretty good businesses for the company, as are the server and storage businesses.

So a reasonable set of fundamentals. We think the management situation there has been greatly improved over the last year or so since Meg Whitman came in and some of the changes she made throughout the organization, and you saw some of the effects of that in the first quarter. So we have an improving management situation, some reasonably attractive businesses, and a very low valuation, and those things combine to make it an attractive investment for us.

Lallos: Overall your exposure to technology, as well as media names and telecom, and also health care, have increased dramatically since 1999, and I was hoping you could talk about why these are areas that are attractive today.

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Strandberg: We don't focus specifically on industries. We're bottom-up, and what attracts us are valuations, which are vastly different in tech companies, media companies, telecom companies and pharma companies--which collectively represent roughly half of the portfolio today.

The valuations are vastly different from where they were in 1999. In that era, we had significant premiums to earnings, cash flow, revenues, other companies in the market, and significant premiums to their histories. And even though the fundamentals seemed very attractive, we had to differentiate between good companies and good investments. When the valuation is too high, a good company may not be a good investment, and that's indeed what we saw in the aftermath of the tech bubble.

Today, the valuations are markedly different. Pharma companies are trading at discounts to the market, typically 10, 11, 12 times earnings, prodigious cash flows, which they're sharing not only in high dividends, but share buybacks, and we think the innovation pipelines are starting to bear fruit. We're seeing more R&D productivity, more consolidation in the industry driving earnings and cash flow growth. And similarly at tech companies, the valuations are quite reasonable to inexpensive on metrics of free cash flow, earnings, revenues, and we see attractive growth prospects fueled by intellectual property.

Lallos: These are areas where you're finding opportunities, not just in the U.S., but globally as well.

Strandberg: Around the world, yes.

Lallos: Financials is another significant area for you, and you sort of bravely dove in after the financial crisis, and you consistently built these positions, and they paid off very nicely last year. Can you talk about the attractions there and why it still continues to be a good area to be in?

Pohl: Well, in the U.S. what you've seen in the financials, particularly in the banks, which is really where the majority of our overweight is, is a situation where you have very low valuations relative to history. Even with this increase in the stock prices, they're still, as a multiple of book value, certainly at quite attractive prices relative to their longer-term history.

But then there are some other attractive things that have happened in the industry. The credit issues of 2008 have largely been put behind the industry, and you have improving credit. You have much stronger capital ratios than you had historically with these companies. And then you've had a lot of consolidation in the industry. And that helps industry a lot. too. … We were talking earlier about the mortgage business, and Wells Fargo is an example. There, if you looked pre-2008, that was a highly fragmented industry, mortgage origination, and today it's consolidated a great deal, and Wells has a dominant share of that, and is making very good money in it. So that consolidation has taken place. The reduction in the amount of competition has been a benefit to the industry, and it's probably going to be a long-term structural benefit to the U.S. companies as well.

Strandberg: And you rightly point out, there are positions that we've been nudging really since 2009 in the portfolio, and that nudging really rests on, we want lots of opportunities to evaluate the fundamentals and the valuation. So to bring our deep-dive, from the research standpoint, into the individual companies, into the policy committees, where we're bringing some experience and judgment to bear, we want lots of opportunities to revisit our thinking and test it at various valuations, so that those continued nudges, then, are really a reflection of our weighing valuations becoming more attractive over time in terms of building capital, in terms of having more durable sources of funding against valuations, which really have not recovered.

Lallos: At Morningstar we like to talk about companies having moats and barriers to competition, and it sounds like, from your perspective, this is another area where these financial names have improved.

Strandberg: Well, they have. One of the things that we think, appropriately, investors are focused on is the scrutiny that financials have, particularly from the regulators, and whether regulatory requirements will become more severe, and certainly there is an eye to wanting to hold more capital, to limiting geographic or line-of-business reach at financials--I'm speaking generally.

What we would find is that these can often raise barriers to entry. So, having to hold more capital makes it more expensive for a competitor to be in a particular line of business. If they're not already a dominant player with a profit pool, it becomes less attractive, then, for a new entrant to come in.

And where we find opportunity in our portfolios generally is in the dominant players that are already quite good at those particular lines of business they're in.

Lallos: One thing we've noticed about your funds, and you've commented on it, too, is that they look more volatile in recent years than they had in the past. As you noted, areas like technology, financials are more volatile areas to be in. Can you talk about how you consider risk and incorporate that into your strategy?

Strandberg: We think about risk at every level of our investigation into companies, and if we step back, investors are really forgoing current consumption to build their assets in real terms over time. So our first job at Dodge & Cox is to try to avoid permanent loss of capital. That then gets into why we spend so much time looking in-depth into individual companies, understanding the managements, the financing, valuation of a company, and building diversified portfolios are ways to mitigate the possibility of a permanent loss of capital.

But we can't just think about risk from the standpoint of playing defense. Avoiding loss is not a way to build long-term real return. If you look out over 10, 15, 20 years, which is not unreasonable for an investor's time horizon, inflation is a silent evaporation of several percent a year, and that stacks up over time. So we have to play offense, too, and think about real, long-term growth. Charles, you talked about that as we looked at Google, for example, and many other companies in the portfolio, we have to focus on being able to capture those opportunities for investors.

Pohl: It's really an equation of balancing risk versus potential reward, as Diana said. In some sense, the … bottom-up, research-intensive process that we have mitigates, we think, risk, and the role that valuation plays in our process also mitigates risk, because if you buy something right--you buy a good property at a cheap price--the downside is lower than if you've overpaid for it or bought something that was a flimsier franchise.

Strandberg: You'll notice we didn't talk over much about volatility, and that's because with our long-term horizon, we think in the short-term it can create opportunities for us to nudge, and in the long term it tends to dampen down quite significantly.

Lallos: So day-to-day volatility is not the priority. The focus is always on long-term returns.

Pohl: As always with Dodge & Cox, we're all about the long term.

Lallos: Well, thank you both so much for coming in and talking with us today.

Pohl: Well, thanks for having us.

Strandberg: Thank you, Laura.

Lallos: Thank you. This is Laura Lallos for Morningstar.