Global Equity Strategy—2023 Annual Investment Review

Lawrence: Welcome to Dodge & Cox’s 2023 Global Equity Review. I’m Lawrence Gu, a Client Portfolio Manager, and it is my pleasure to be joined today by Lily Beischer, Portfolio Director¹ and member of the Global Equity Investment Committee. That’s the central decision making body for the Global Stock Fund. Lily, thanks for joining.

Lily: Thank you, Lawrence. It’s great to be here.

Lawrence: Over the next 20 minutes, we’ll plan to cover several topics with you. First, the market backdrop. Second, Fund performance. And finally, where we’re finding opportunities. Now Lily, before we jump into this presentation, are there any key messages you’d like to share with us today?

Lily: Sure. Well, at a very high level, I hope our audience comes away with three key takeaways. The first is that markets can be volatile, especially in the near term. So we think it’s important to stay focused on longer-term opportunities. Second, our active, value-based approach combined with an experienced investment team helps us to capitalize on these longer-term opportunities. And finally, we are very enthusiastic about the portfolio today, which is both very well diversified and trades at an attractive valuation.

Lawrence: Thanks for that, Lily. Let’s turn to our first agenda item then, the market backdrop. What happened in global equity markets last year?

Lily: Well Lawrence, markets were up broadly. The MSCI ACWI [Index²] for example, finished the year up 22%. Now that looks like a pretty remarkable return for one year, but keep in mind the market was down 18% the year before. So if you turn to our first slide on page five titled “Global Market Backdrop”, you can see that many markets were up, but after seeing declines in the prior year. So the change across the two-year period was a lot more muted.

Lawrence: And what was the reason behind that dramatic turnaround?

Lily: Well, one overriding theme has definitely been inflation and higher interest rates. Monetary tightening of course triggers fears of a recession, which of course impacts equities and growth equities in particular. So that was the big fear in 2022 and even for many parts of 2023. But as you can see in the chart on the bottom right of this page, inflation has been coming down, so the market got excited about rates also coming down. Markets now again, of course are pulling back on fears that that may have been a bit overdone. But that inflation picture has improved significantly, so the direction of travel does appear to be positive.

Lawrence:And there was also the very concentrated performance of the “Magnificent Seven” last year, where seven growth stocks³ contributed to over 40% of the [MSCI] ACWI’s total return despite being only 17% of the Index.

Lily: Yes, that’s right. That was also a big driver, and of course it was also a main reason we saw growth outperform value again. You can see that the three sectors that contained the mega-cap growth stocks also saw a big reversal over the prior year.

Lawrence: Absolutely. For extra clarification, those seven stocks of course are Alphabet, Meta, Microsoft, Amazon, Apple, NVIDIA, and Tesla. Lily, was there anything notable that happened in global equities by region? I assume the U.S. was probably the strongest region given the performance of the Magnificent Seven.

Lily: Yes, U.S. was the strongest. That was up 26%. I should mention Lawrence, many other major markets also saw strong returns last year. Europe and Japan, for example, were each up over 20% as well, so not that far behind the U.S. And then some emerging markets were also very strong. Mexico was up over 40%, [and] India up over 20%. China was the notable exception, so that pulled back 10%. I think we’ve all seen the headlines there about the slowing economy and the regulatory uncertainty. But overall, what we saw last year I think was a good reminder that markets that decline can outperform in subsequent periods.

Lawrence: Certainly the case. Let me turn next to the Fund’s performance then. Returns for the Global Stock Fund were also very strong for the year, but we did underperform the market on a relative basis. If you turn to slide six, you can see the returns for the Fund overall on our reporting periods. So the Fund⁴ was up 20% versus the [MSCI] ACWI up 22%. The Fund’s outperformance however, remains for all the longer measurement periods that we report such as 3-, 5-, 10-year, and since inception. As a reminder, we would not be surprised to underperform in a growth rally given our value focus. But ultimately, what we’re trying to solve for here is for long-term performance.

Lily: Yes, and we do like our value positioning by the way, when solving for that long term, especially in a market that’s seen a big rebound. I do think it’s notable, in addition, that we were able to deliver very good returns despite being underweight the Magnificent Seven because other parts of the portfolio did very well.

Lawrence: That’s a great point, and I want to elaborate a little bit more on it. What were some of the parts that also did well?

Lily: Let’s turn to the next slide then and cover attribution. So the biggest detractor to our relative performance was by far our underweight in Information Technology. This was partly offset by our holdings in Financials, [Consumer] Staples, and Communication Services. I should point out our Information Technology holdings were actually up very strong—46% returns for the year—but we were underweight the area. And then we were pleased to see Financials and Communication [Services] become two of the largest contributors to performance because they happen to be two of our largest overweights as well.

Lawrence: Okay, so given the strong contribution from Financials, Lily, could you provide some examples of what helped there and why did they do so well? Our Financials holdings were up 24% as a group, so they outperformed the overall market as well.

Lily: Yes, our Financials did outperform the market. So let’s talk about UBS [Group] as an example, since that was the largest contributor to our Financials performance.⁵As you may know, UBS is the leading wealth management firm worldwide. Wealth management, by the way, is a very attractive business with high returns on capital and the ability to grow alongside with global wealth. In addition to that, UBS also happens to be very well run and, as I mentioned earlier, they’re the market leader. But last year the stock really benefited in particular because their largest competitor, Credit Suisse, experienced a crisis of confidence. That resulted in an emergency rescue plan that allowed UBS to buy their largest competitor on highly favorable terms with the approval of the regulator. We’ll obviously have to see how that plays out from here because mergers can be tough also, but it did result in UBS appreciating 70% in the year. That’s a position, by the way, we’ve owned for a very long time.

Lawrence: Got it. Lily, anything else you’d call out within Financials?

Lily: Sure. Another group of top contributors would be our Financials [holdings] in Brazil. Those benefited from better fundamentals in terms of either better cost efficiency or higher net interest margins,⁶ but also lower rates was a common theme. Several markets, like Brazil, moved sooner to lower rates than the United States, for example, so that helped.

Lawrence: Yes, well, Financials has been a particularly unloved part of the market for years now, so it’s good to know that it can be a strong contributor to returns. Next, let’s turn to portfolio positioning. Lily, can you speak to portfolio positioning in context of the changes in the market? It seems like there is always a lot going on in the world.

Lily: Yes, Lawrence. There is always a lot going on in the world, but change of course is also what provides our opportunity. So how do we deal with the potential for constant change? We deal with it a couple ways. One, by being diversified and remaining diversified. Two, being value-oriented. And then three, being active. What we don’t want to do is overpay for something that is already bid up by the markets. We want to find investment ideas that are not already well appreciated. And then we want to evaluate new information on an ongoing basis, as well as new prices, and make adjustments to the portfolio. So today we feel very good about our portfolio because it is a portfolio that is both well diversified with exposure to many different themes and it trades at a very attractive valuation. And we do adjust it over time with new information.

Lawrence: I like that construct. Could you tell me then about our key portfolio exposures?

Lily: Of course, if you turn to the next slide—which is slide eight—you can see our key areas of overweights and underweights. We’re overweight Financials, which we’ve mentioned, because we think that provides meaningful value today. And then we’re also overweight Communication Services. As we mentioned, we do own several of the Magnificent Seven, we own four of them. We’re actually overweight Alphabet of that Magnificent Seven, and we’re equal weight another one, which is Meta. And both of those are in the Communication Services sector. And then we’re overweight sectors like Energy and Materials—those have provided a good hedge against inflation for our investors. Then of course, we have a large part of the portfolio in defensive areas of the market like Health Care. In summary, I would say we do own growth equities, including names with AI (artificial intelligence) exposure, for example, but overall the portfolio does lean towards defensives and, of course, value equities.

Lawrence: It certainly looks diversified, and you can also see that it’s attractively valued. On the same page, you can see that the portfolio trades at a very attractive 11.0 times [forward] earnings,⁷ which is a significant discount not only to the [MSCI] ACWI at 16.6 times, but even against the [MSCI] ACWI Value [Index⁸] at 12.6 times. Slightly switching gears now, Lily, what about changes you’re making in the portfolio? Could you speak to key changes we made and why we made them?

Lily: Well, we were very active last year, which you might expect given how much change has been occurring in the market. We started 12 new positions in total and exited 15 names. At a high level, I would say we moved from areas that outperformed into areas that underperformed, as you might guess. The key changes were trims to Information Technology and Communication Services, and then adds to more defensive parts of the market, such as Health Care. So in [Information] Technology and Communication Services, there was quite a bit of excitement as you might have heard around the AI theme, and a lot of that got added to stock prices. In light of this, we trimmed our holdings in VMware, which was then acquired by Broadcom, and then we also exited Broadcom. We also trimmed Microsoft, which benefited a lot from that AI enthusiasm. And then we also trimmed Google and Meta. Those names benefited more from a cyclical rebound in digital ad spending. Then as I mentioned earlier, Financials was the largest contributor to our returns, so that became the second-largest area of trims in the [fourth] quarter. 2023 Annual Global Equity Review On-Demand Audio Transcript | January 2024 3

Lawrence: Lily, while it was a large source of trims for the quarter, I did notice that we started a position in Financials earlier in the year.

Lily: Yes. Well, as you may remember earlier in the year three regional banks in the U.S. failed. Those banks had this unusual concentration of deposits, but it did create a downdraft in U.S. regionals and actually affected Financials more broadly on fears of global contagion. Truist [Financial] was one of those U.S. regionals that got caught in that downdraft even though it has a very different deposit profile. We did the work to confirm that that was the case, as well as understanding some of the downside protection that they had. You know, it’s a franchise that we knew well, so when it became available at a lower valuation, we were able to start a position.

Lawrence: That’s a really helpful example. Speaking of adds, I did notice also that Health Care was our largest source of adds both for the [fourth] quarter and the one year.

Lily: Yes, and that’s because Health Care underperformed. In fact, several of our new positions we started last year were in Health Care.

Lawrence: Could you elaborate on one or two of those new positions maybe?

Lily: I sure can. So in Health Care, there were quite a few names impacted last year by GLP-1’s, which was a big theme in the markets^.9 Or maybe more precisely the fear that GLP-1’s might reduce the need for certain treatments or procedures. One of these names was Zimmer Biomet, which is a medical device company that specializes in hips and knees. So the market became worried, of course, that GLP-1’s would reduce the demand for orthopedic procedures. Based on the research we’ve done, that does not appear to be that likely, and so we were able to start a position when that became available.

Lawrence: Got it. I also do see that we started a new position in IFF or International Flavors & Fragrances. What was the thesis behind that?

Lily: Yes. Well, as the name suggests, the company provides flavors and fragrances to the Food & Beverages and Consumer Products industries. It’s an oligopoly-like business that sells a crucial input to end customers, and those end customers sell consumables that we all use daily. So it’s a very defensive business. The stock had declined after three consecutive earnings resets, but the problems overall appear to be largely cyclical, and so we think they should recover over time. That gave us an opportunity though, to start a position in an excellent franchise due to near-term headwinds.

Lawrence: Great. Any last thoughts on portfolio positioning? What about positioning by region?

Lily: Sure. By region, we continue to be underweight the U.S. and overweight international markets. So a little over half the portfolio, or about 52%, is in the U.S. versus 63% in our benchmark. That puts us about 11 points underweight the [MSCI] ACWI. International markets are about 40% cheaper than the U.S. today, so it’s not a surprise to see that underweight.

Lawrence: And again, our underweight is a result of our individual security selection.

Lily: Yes, it is. It’s also really a story, by the way, of our value orientation and our underweight of the Magnificent Seven because by about 9.5 percentage points. And that explains a lot of that 11 [percentage] point underweight in the U.S.

Lawrence: Thanks, Lily. Well, we’re just about out of time now, but we certainly covered a lot of ground today. Lily, what would you say are your biggest takeaways?

Lily: Well, the few messages again I would leave our listeners with would be the following. One, the global portfolio is very well diversified. We have exposure to many different themes, including growth in AI, but we’re very disciplined about valuation in our entry and exit points. For this reason, we do continue to remain overweight Financials, Health Care, and Communication Services, and we continue to be underweight [Information] Tech. In fact, we added further to Health Care and reduced further our Tech and Communication Services exposure last year on the back of very strong performance in that latter group. Which again speaks to, I think, our valuation discipline and the bottom-up research process that guides us in our decision making. Second, the portfolio trades at a very attractive valuation. Now, we think attractive valuations are always a good idea, but it could prove to be especially so in today’s environment. And finally, just a reminder that markets can be unpredictable, which is why we stay diversified, focus on the long term, and look for opportunities that are not already well appreciated and bid up by others.

Lawrence: That’s right, and I think another distinct call out for me is that as active value managers, we continue to evaluate and adjust. A good example of this, as Lily brought up, was adding to Financials during the U.S. regional banking turmoil, such as Truist [Financial], and then trimming back on Financials after they outperformed in the back half of the year. Well, in closing, we also want to thank our listeners for your interest in this discussion. We’re certainly very grateful for the confidence you’ve placed in Dodge & Cox and look forward to speaking with you soon. Thanks and have a great day.