Compared with some of her co-managers at the $14 billion
Dodge & Cox Stock fund, Katherine Herrick Drake is a newbie: She's only been at the wheel for 22 years.
Nonetheless, the folks at the 73-year-old San Francisco fund firm decided she was seasoned enough to discuss the fund's strategy for this week's
. Actually, her 22 years is the average tenure of the 10 members on the fund's vaunted investment policy committee.
The Dodge & Cox Stock fund took in $6 billion in 2002, second only to the massive
American Funds Growth Fund of America, and for good reason. It's hard to find a reason not to love this fund. It has longevity -- it opened in 1965 -- and an experienced, deep management. It has an unwavering approach to value that helped it sidestep the disaster of the past few years. It has an extremely low turnover rate (13% annually) and a rock-bottom expense ratio (0.54%). It also has the performance: A three-year average annual return of 4.05%, five-year return of 4.39% and 10-year return of 12.68% -- all in the top 3% of its peers, according to Morningstar.
Needless to say, Dodge & Cox Stock fund doesn't need the publicity. But Drake was good enough to chat about the fund, what companies the managers like and what companies the fund is still avoiding.
Katherine Herrick Drake
Tenure: Co-manager since 1981
Assets: $14.036 Billion
Performance: 12.68% 10-Year Avg. Return (Top 2%)*
Expense Ratio: : 0.54% (Category Avg: 1.41%
Top Three Holdings: MDow Chemical, Bank One, Schering-Plough
Information: 1800 621 3979 or Web site
Source: Dodge & Cox, Morningstar
1. Let's start with a well-earned softball question. How has Dodge & Cox Stock fund managed to do what so few funds have been able to: Beat the market by a fairly substantial margin over the short and long term?
Hmm, I want to be careful about that because I don't want to be sound predictive.
It's been three things: Remaining focused on the long term, sticking with our value discipline and focusing on the fundamentals of the companies. The fact that we continued to steadfastly apply those principles during the wild past five years is really what enabled us to do a good job for our clients.
You managed to avoid making predictions.
(Laughs.) I would have the confidence to say that the organization is intact and the people will continue to apply those disciplines.
2. In recent shareholder letters, the managers have offered an interesting caveat: "The fund's unusually favorable relative performance is not likely to be repeated." The reason you give is that the gap between highly valued companies and undervalued companies has narrowed somewhat. Do you and your Dodge & Cox colleagues think the market is approaching a fair valuation? How does this affect your investment strategy, if at all?
When we think about the environment within which we have to work, we still consider investments using a three- to five-year time horizon, because we know we don't know what the next quarter or even 12 months will bring.
Given that framework, our sense is that yes, the equity market is much more reasonably valued than it was a few years ago. It has a much better starting point. Having said that, our best guess on equity returns over the next three years on a compounded annualized basis would be mid- to high-single digits. We're not expecting to get back to the very robust returns of the late 1990s.
That's the environment within which we think we'll be working. We're not expecting a whole lot of help from a strongly rising market over the next few years.
But the relative returns bear revisiting. As we look back over the past five years, it was an extraordinary period of speculative excess in the tech/telecom/Internet sector. Many people have likened it to a once-in-a-career/century period. The degree to which highly valued stocks became so completely overvalued has no comparison with any other period. Avoiding many, if not most, of those overvalued stocks clearly has enabled us to do what we have done the past few years. Staying out of the way of overvalued sectors and companies has a great deal to do with it.
Since we don't expect a repeat of the speculative overvaluation for a long time -- as long as investor memory, I suppose -- it doesn't allow for the opportunity for that kind of relative outperformance that we've had these past few years anytime soon. And that's fine, I don't think we want to live through that again.
The market is probably close to fairly valued, it's hard to say. There are still pockets that seem too optimistic. But overall, it's probably a reasonable market. So, we're back to having to earn our way by looking at good investments -- a combination of company and price -- over a three- to five-year period. We are just trying to manage expectations of our investors.
3. The fund hasn't been too closely correlated with the S&P 500 --
That's for sure! (Laughs)
Exactly. And that's been in large part because the managers have shied away from the "mega-cap companies" such as Microsoft (MSFT) - Get Report and General Electric (GE) - Get Report. What are you still shying away?
It's valuation, nothing more than that.
We don't particularly look at capitalization to determine how a company is going to perform. We look at fundamentals and price. Now, Microsoft is much lower than it previously was, but on a price-to-sales basis it's still enough of a premium that we're not intrigued with it as a long-term investment opportunity.
Valuation is causing us to continue to downplay many of the mega-cap stocks.
GE has come down enough that it's probably in a more reasonable position. But we're looking for undervalued companies, not just fairly valued companies. We still might think, for example, that GE is a reasonably valued company, but it needs to be undervalued for us to have some degree of confidence to repurchase it. We did own it for a while, but we sold it.
4. The managers did say in the recent letter that some companies that have fallen from high valuations now look attractive. AT&T (AT) - Get Report, Corning (GLW) - Get Report and Hewlett-Packard (HWP) turn up as recent investments. Any others?
I have to be a little careful, because I can't talk about positions we are building currently. We had a position in Hewlett-Packard, and we have added to that as its dropped somewhat in valuation.
You mentioned AT&T. Also
, which became cheap enough that it became attractive to us as a long-term investment. Those are good examples of finding increase value in the tech and telecom area.
5. A lot of individuals and institutions view these stocks as momentum plays. Are you concerned at all about how quickly these stocks have moved? Dodge & Cox Stock fund has a longer holding period, but do moves such as Corning's 107% rise shorten your holding period?
That's a good question. While we typically hold a company for a long time, we have to come in every morning and consider the current price and the long-term fundamentals.
If we buy a stock at $2 or $3 a share, which we did in a couple cases, and it is at $8 or $9 three months later, we may sell it less than a year from when we bought it. Because, at a triple or a double, it may to us no longer reflect an undervalued situation, even considering that we're looking on a three- to four-year basis.
We have and will continue to reapply anew our price and fundamental discipline. These are volatile stocks, and we have to be more nimble in terms of both adding to positions and being willing to sell positions. Not because we're momentum players, because we're not. If the investment opportunity evaporates because the stock rises so quickly, we say, "That's great news," and then we move on to something else.
Regarding Corning, our general policy is not to get into too many specific details on individual stocks.
6. Fair enough. The Stock fund has taken in $6 billion in 2002, the second-largest intake of new money. Are you having a hard time putting the money to work? Is it going to new stocks, or are you spreading it among the stocks you own?
The cash inflow has not really changed the portfolio composition. We haven't found a bunch of new companies to buy. Instead, we're adding to our existing companies across the portfolio.
In a general sense, we are adding it across the board, but we tend to favor companies that look especially attractive to us at a particular time.
7. Dodge & Cox is well known for its committee of analysts and portfolio managers who decide which stocks to buy. How do you go about choosing stocks with so many chefs in the kitchen?
The equity team has about 17 full-time analysts and 10 people on the policy committee, made up of strategists and portfolio managers.
The ideas go through the analysts who cover the particular industry or company. Even if it's an idea that begins with a manager, the analyst is the one who does the extensive research.
The 17 or so analysts do primary research. Then, they take advocacy positions -- on whether we should buy, add, trim or sell a particular company.
The entire team is in the same office -- on the same floor, in fact. So we discuss the stocks among each other on a regular basis. If it seems like a good idea, the analysts bring it to the policy committee. We ask questions and begin the process of getting to a consensus.
Sometime we disagree on price or whether a company represents a good investment. But we work on these matters until we reach an agreement either way.
Is it an entirely bottom's up process of stock-picking, or do you make some macro calls or say one sector looks good? For instance, the fund has a number of energy companies among the top picks.
The macro calls -- saying the economy looks poised to turn around, let's find cyclical companies that look poised to benefit -- are something we don't do. We have to make an assessment about the environment, but it doesn't drive broad calls.
However, an industry valuation is, to me, somewhat bottom's up. If the whole sector looks at a discount to the market and its historical valuation levels, then we'll ask our analysts to determine which companies within that industry look like the best investment opportunities.
8. Are there any companies that you have purchased that the rest of the market hasn't deemed as undervalued as the Dodge & Cox folks have? Any picks that have left you frustrated?
There are always companies like that for value managers (Laughs). As value managers, we are definitely looking to buy things that look undervalued. Sometimes, the stocks will work out in the first year or two. Others, it seems like the rest of the world hasn't caught on to what we see.
At this point, we have to ignore past price performance and ignore the sting of having owned it and having it not do very well. So, we approach it as if we're looking at it for the first time. We ask ourselves: At this price and at these fundamentals, would we buy this company? Employing that discipline answers the buy-and-sell side of the equation. You just try to not be influenced by what has passed.
would be such a company. I think other investors consider Xerox not out of the woods yet. It's at an extremely cheap valuation, in our view. Investors haven't entirely bought on to the notion that digital technology will transform the company. The stock is up from the bottom, but it's still very low.
But we try to keep in touch with the management to make sure they are still on track. Xerox is a much-improved company.
9. Speaking of management, how do you evaluate a management when picking stocks? How do you factor in the intangibles, and are there certain red flags that keep you away?
That's a really good question, it's also a really hard question to answer.
One thing we do is try to regularly meet with senior management of all the companies we hold. Since we are long-term investors, we try to keep track of what the executives said about goals and business plans and see how they are working out. We like to make sure there is a continuity about their plans.
We look at compensation, stock option plans. Also, we take a close look at mergers and acquisitions and restructuring activity, watching carefully what prices the companies are willing to pay for their expansion. That gives us insight about how they are reinvesting their capital.
The biggest red flag is getting a sense that a less-than-straightforward answer is being given. We respect that companies can't always tell us what they are going to be doing with, say, an acquisition. But, if we ask about an accounting change or some issue of corporate governance, it raises red flags if they aren't willing to discuss it openly. Transparency is really important.
That said, my personal experience has shown that most senior managers are very willing to discuss risks and opportunities. More often than not, we think companies are refreshingly honest about the road ahead.
10. Last question: What are the companies in your fund that enable you to sleep easily at night?
I might have answered that question four or five years ago, but I certainly wouldn't today! (Laughs).
There are even companies in our own portfolio, and I won't name names, that I would've thought were sleep-easy stocks that turned up in headlines where people might have questioned whether the accounting was overly aggressive or something.
There have been enough blow ups over the past few years that make it tough to sleep easy at night. But like I tell my family and others who invest in the fund, we lose sleep at night over the fund so you don't have to.