TO OUR SHAREHOLDERS
The Dodge & Cox Global Stock Fund had a total return of 12.2% for the six months ended June 30, 2019, compared to a return of 17.0% for the MSCI World Index.
After declining in the fourth quarter of 2018, global equity markets rebounded strongly through the first half of 2019, taking the S&P 500 Index, MSCI EAFE Index, and MSCI Emerging Markets Index back to levels seen in the third quarter of last year. Every developed market and most emerging market countries posted positive equity returns. As debates about trade wars, global economic growth, and the durability of low interest rates continue, so do two ongoing market themes that have persisted over the last decade. First, will U.S. equities continue to outperform international equities; and second, will growth stocks continue to outperform value stocks.a
A COMPELLING STARTING POINT
Over the past 10 years, the U.S. equity market’s annualized total return was more than double that of international developed markets: the S&P 500 returned an average of 14.7% per annum compared to 6.9% for the MSCI EAFE.
While earnings growth has been higher in the United States over the past decade, the current valuation spread between the U.S. and international equity markets is now near a 15 -year high. The MSCI EAFE is trading at an attractive valuation of 13.5 times forward earnings, versus the S&P 500 at 17.3 times.b
Accordingly, the Fund’s portfolio is tilted toward international stocks and trades at a compelling 11.8 times forward earnings. History has demonstrated that starting valuations are significant drivers of long-term equity returns and lower starting valuations tend to produce more attractive long -term results. In addition, many of the Fund’s holdings have the potential to improve profitability and return meaningful amounts of capital to shareholders through dividends and share buybacks. We believe this combination provides a strong foundation for long-term returns.
AN OPPORTUNE TIME TO BE INVESTED IN VALUE STOCKS
The underperformance of value stocks has been another prominent global market trend. Over the past decade, the MSCI World Growth Index has outpaced the MSCI World Value Index by 76 percentage points, largely because of a valuation decline for the MSCI World Value. Earnings growth and dividend yield were actually higher for the value index.c
The valuation differential between value- and growth- oriented stocks remains wide by historical standards. Growth stocks are relatively expensive: 20.8 times forward earnings for MSCI World Growth versus 12.4 times for MSCI World Value. This valuation gap should narrow as market prices move to more closely reflect our assessment of fundamental value. Historically, many value stocks have tended to outperform when they are particularly inexpensive, as they are today.
In addition, interest rates around the world are low by historical standards, and there is an overwhelming expectation in the market that they will remain “lower for longer.” We believe current valuations may already reflect most of these beliefs about rates. The future market “surprise” may be interest rate increases from today’s low levels, and we think there is a strong likelihood this will happen over the long term. Any increase in interest rates should create meaningful upside for many value stocks, especially in the Financials sector.
We have conviction in our value-oriented, active investment approach and continue to believe now is an opportune time to be invested in value stocks. Importantly, the Fund remains overweight in sectors poised to benefit from a rebound in value stocks, notably Financials and Energy.
Investors have steeply discounted companies with greater macro sensitivity and higher stock price volatility, and the Financials sector embodies investors’ concerns about the macro picture (e.g., low interest rates, low global growth). Financials, the largest component of the value universe, comprised 24.6% of the MSCI World Value and 15.8% of the MSCI World, and constituted 29.1% of the Fund on June 30.
European & UK Financials
Over half of the Fund’s Financials exposure is invested in Europe and the United Kingdom.d The Fund’s European Financials have been a large detractor from performance for several years, mostly due to valuation compression; however, earnings have improved in aggregate. Our global industry analysts have retested our views by incorporating input from our macro research team, learnings from industry conferences, and insights from meetings with senior management teams of these companies, competitors, regulators, central bankers, and policymakers. Based on this work, we continue to believe the Fund’s European Financials investments represent some of the best long-term opportunities currently available in the market.
These companies are more resilient today than they were in previous periods of economic stress when valuations were at similar levels. They have greatly improved their underlying fundamentals by strengthening their balance sheets and increasing capital ratios, while pursuing initiatives to improve profitability. Hence, on a bottom-up basis, we recently added to the Fund’s positions in BNP Paribas, Credit Suisse Group, Societe Generale, and UniCredit.e While our baseline expectation is for a prolonged period of low growth and low interest rates in Europe, any improvement in the macroeconomic backdrop, notably higher interest rates, could drive further upside.
Credit Suisse (NYSE:CS)–a 1.5% position in the Fund–is a leading global wealth manager with attractive growth opportunities serving ultra-high net worth clients. The company recently completed a four-year restructuring program, which resulted in significant asset disposals, cost cuts, and balance sheet recapitalization. Significant litigation liabilities are largely behind the company. Today, Credit Suisse is increasingly generating and distributing capital through dividends and share buybacks. Yet, the company trades at less than nine times forward earnings, and we believe that over a longer-term horizon the company should be able to grow at attractive rates.
In the United States, financial services companies are trading near historically low valuations relative to the overall market. Banks, for example, are trading at 57% of the S&P 500 forward price- to-earnings multiple, the lowest relative level since the dotcom bubble in 1999. Why are bank stocks so inexpensive? Since September 2018, U.S. Treasury yields have declined by 100 basis points,f as have market expectations for the federal funds rate through 2020. For most banks, lower rates have a negative impact on earnings, but we believe this issue has been fully priced into current valuations.
Despite low valuations, company fundamentals have been resilient. The Fund’s U.S. bank holdings that were subjected to the Federal Reserve’s 2019 stress-testing process have received approval to return a weighted average of 10% of their market cap in dividends and buybacks in 2020. This total yield compares favorably with the broad market and notably income-oriented equities, such as in the Real Estate (e.g., Investment Trusts) and Utilities sectors. Banks’ capital levels are near historical highs, as are aggregate banking sector profits. In recent years, banks’ earnings growth has outpaced the broad market. We expect banks to offset the effects of lower interest rates through volume growth, cost controls, and share buybacks. Going forward, we are particularly constructive on the Fund’s national retail bank holdings–Bank of America and Wells Fargo–that are increasingly using their scale, advantages in technology, and marketing expertise to drive outsized deposit growth and profitability.
Energy is another significant component of the MSCI World Value. While the short-term direction of oil prices is difficult to forecast, the long- term fundamentals of supply and demand are constructive. We believe global demand will continue to grow at roughly 1% per year, or around 1.0 to 1.5 million additional barrels per day. From a supply perspective, U.S. shale oil growth is currently robust, but the rate of growth should taper as U.S. shale producers shift their priority from growing production to generating free cash flow. The rest of the industry will need to reinvest at higher rates to counteract the natural decline from existing fields and to meet new demand growth. It is likely that world oil prices at or above current levels will be needed to incentivize that higher level of investment.
When evaluating energy stocks, we look for companies with assets that are on the low end of the global cost curve, management teams that have deployed capital prudently through the cycle, and low-to- reasonable valuations. We continue to find long -term opportunities in selected upstream and oilfield services companies with these characteristics. On a bottom-up basis, we recently added to the portfolio’s energy holdings, notably Occidental Petroleum (NYSE:OXY) following its agreement to acquire Anadarko Petroleum, which is also held in the Fund.
In June, one of our global industry analysts met with Occidental’s management team at their headquarters in Houston, Texas to conduct due diligence on the company’s pending acquisition. While there are concerns about integration risk and the high cost of financing, we believe Occidental’s risk-reward profile is compelling due to its attractive valuation, strong operational capabilities, and diversified, free-cash-flow generative upstream portfolio that is supplemented by its midstream and chemicals businesses. From our previous research on Anadarko, we know that Anadarko’s asset portfolio has been meaningfully streamlined in recent years and the remaining assets are world class with large reserves and low break-even oil prices. In addition, Occidental aims to achieve $2 billion in cost synergies, and we believe there is a high probability these savings will be realized long term. On June 30, Occidental and Anadarko were 2.0% and 0.9% positions, respectively, in the Fund.
During a challenging decade for value investors, the Fund has outperformed the global value investment universe by 52 percentage points.g We are optimistic about the long- term outlook for the Fund, which remains tilted towards international stocks and sectors poised to benefit from a rebound in value stocks, such as Financials and Energy. As share prices and currencies can be volatile in the short term, we encourage shareholders to remain focused on the long term.
Thank you for your continued confidence in our firm. As always, we welcome your comments and questions. For the Board of Trustees,
Charles F. Pohl,
Dana M. Emery,
July 31, 2019
This article first appeared on GuruFocus.