International Equity Strategy—2023 Annual Investment Review

Julie Anne: Hello everyone, and welcome to the Dodge & Cox 2023 International Equity Review. I’m Julie Anne Wickes, a Vice President and Head of Investment Communications, and have been with Dodge & Cox for 17 years. It’s my pleasure to introduce Ray Mertens. Ray is a Senior Vice President and 20-year veteran of our firm. He serves on the Investment Committees for our International and Global Equity strategies. Ray, thanks for joining us today.

Ray: Hi Julie Anne. It’s great to be here.

Julie Anne: Over the next 20 minutes, we’ll provide an update on our International Equity strategy covering three main topics. First, the international equity market backdrop. Second, the International Stock Fund’s performance in 2023. And third, where we’ve been finding opportunities. Ray, are there any key messages that you’d like to share with the audience to frame our discussion?

Ray: Yes, Julie Anne. I hope to leave our audience with three key messages today. First, when facing an uncertain macro and geopolitical backdrop like we are today, it’s very important to stay focused on the long term. Next, I believe our bottom-up, long-term approach enables us to capitalize on the opportunities we’re seeing in the marketplace today. And then third, we’re pretty enthusiastic about the Fund’s portfolio, which is diversified by sector, geography, and investment thesis.

Julie Anne: Great. Well, let’s turn to page five, the international market backdrop. So Ray, can you set the stage for what happened in international equity markets in 2023?

Ray: Yeah, well, if you look in the upper-left quadrant, you could see that inflation is really beginning to moderate. In Q4, we saw inflation decelerate, and as a result, investors started to get very excited about the potential for a soft landing, and therefore, likely some rate cuts coming in 2024. So that really drove equity markets. In fact, if you look across regions, you see very strong performance across the board. Now, the one notable exception is China, which we’ll probably touch upon later. But even emerging markets, if you exclude China, throw on Europe, U.S., Japan, all were very strong performers as people got more excited about that economic outlook turning more positive. In fact, that’s also reflected in cyclicals outperforming defenses as we highlight in the bottom left-hand [corner]. Generally speaking, you can see in this quadrant that the cyclicals had stronger performance than the defensives on average. And lastly, I talked about some of the challenges in China. We are seeing some divergence across geographies. People are getting very excited about the potential of Japan with the many changes we’ve seen in corporate governance and the fact that shareholders are more top of mind these days. And we acknowledge that we’re excited about the longer term there. But it seems like in 2023 that came to the forefront, just as China became a greater concern, and we’ve seen big divergences there. We’re also seeing Europe looking quite attractive as well. So it’s another cut (slice of the market) and we see some divergence there, but overall markets had a pretty good year in 2023.

Julie Anne: Thanks, Ray. Let’s now turn to the Fund’s performance results on page six. So the headline message for 2023 was that the International Stock Fund posted strong, positive absolute returns for the year, outperformed the MSCI ACWI ex USA [Index¹], and underperformed the MSCI EAFE [Index²]. So as a side note for our listeners, the MSCI EAFE had a higher return than the ACWI ex USA because the EAFE doesn’t hold emerging markets, which were weaker in 2023. Looking at the Fund’s longer-term results, the International Stock Fund outperformed both the MSCI EAFE and ACWI ex USA for the 3-, 5-, and 20-year periods. So Ray, let’s drill down on the Fund’s relative performance in 2023, which is shown on page seven. Can you discuss the Fund’s attribution versus the MSCI EAFE in more detail?

Ray: Yeah, I’d be happy to, and I’d like to start with Financials. Despite the U.S. regional banking crisis leading to concerns about financial contagion that led to some weakness in the first half of 2023, we saw Financials contribute strongly throughout the full year as it recovered in the second half. In fact, the Fund’s Financials were up 29% compared to 19% for the [MSCI] EAFE sector. So being both overweight, as well as our stock selection, really helped results. In fact, in the eye of the financial storm, we were able to add to some select holdings, such as Banco Santander, which then did significantly outperform later in the year.³ We had holdings, such as UBS [Group], which benefited from the acquisition of Credit Suisse as well as its position as a leading global asset manager. That was up 70%. And then our Brazil holdings—both XP and Itau [Unibanco] (up 80% and 54%, respectively)—benefiting from a stronger outlook in Brazil as well as the strength of those franchises coming through in 2023. Next I’d like to mention Consumer Staples, which is another area of positive attribution for the Fund. That’s an area where, we’ll touch upon later, we’re seeing more opportunities and our relative performance there helped. And then lastly would be Materials, which is another area of performance. Now, there’s economic sensitivity there, and they face many of the headwinds that people got concerned about in Financials in the first half of the year. But we had some standout holdings—such as Holcim (a leading cement company that continues to execute on their plan)—that added to our performance.

Julie Anne: And Booking Holdings was another strong performer. So Ray, why did it outperform and what’s your outlook for Booking?

Ray: Yeah, well, it starts with the recovery of travel. That really benefited the company and earnings were quite strong. But I think also the market really recognized the strength of the franchise, just given the fact that they were able to gain share, they were also able to drive higher margins, and then lastly, they’re returning significant capital to shareholders. In fact, they’ve always generated prolific cash flow prior to COVID. Now in this COVID recovery we’re seeing that return. In fact, the company came with additional discipline through navigating the difficulties of COVID, and they’re at a point now where they’re able to return over a hundred percent of their free cash flow to shareholders.⁴ All of that really led to strong earnings as well as multiple expansion5 for the company in 2023.

Julie Anne: And are there any key detractors that you’d like to highlight?

Ray: Yeah, there are a few. First, I’d start with the Fund’s overweight in China Internet.⁶ You know, we’ll talk about Greater China later, but our China Internet holdings were a detractor. Also, our underweight in Industrials—that was an area that did very well in the market that we were underweight. And then, IT (Information Technology), another area we’re underweight, was a detractor. And finally, Health Care—a combination of the weakness of that sector as well as a few of our individual holdings—all were detractors from returns.

Julie Anne: Well, let’s now turn to the Fund’s positioning on page eight. Can you discuss the key overweight and underweight positions in the portfolio?

Ray: Yes, I’d be happy to. First, if you look across the top of the slide, you could see our relative positioning by sector. In the bottom right, you could see how we’re positioned by geography. And then in the bottom left, you can see some key characteristics of the Fund relative to the broader-based benchmarks. All of this I think is very helpful information, Julie Anne, but I’d like to just take a higher level approach as I describe what our shareholders get when they own the Dodge & Cox International Stock Fund versus what they get if they own the broader-based benchmarks. So if we think about the areas we’re overweight, I’d really say it would be in two of three major buckets, if we broke down the investable universe that way. So the first two buckets where we have found the most opportunities are what I would call the deep-value opportunities—which would be sectors such as Financials, Materials, and Energy—as well as another bucket that we call reasonably priced secular growth. This includes areas of Health Care, China Internet, and other technology holdings. If you add up those sectors, that would account for about 80% of the Fund’s holdings.⁷ But if you own the [MSCI ACWI ex USA] Index, that would only be about 60% of your exposure. So we’re pretty excited about our individual holdings there and leaning into those sectors. Again, we got there [on a] bottom-up [basis], but we think that our active approach and leaning into those more attractive opportunities should really help the Fund’s performance over the next three to five years. Now, that does leave the remaining portfolio. That’s in sectors such as the other defensives outside of Health Care—such as Consumer Staples and Utilities—as well as the cyclical areas that we don’t think are as attractively priced, such as Industrials. Now, this doesn’t mean we don’t find individual opportunities there. We’ve found some great opportunities, we believe, just less so than the other buckets I described. We like our positioning. I hope that helps our listeners understand where we’re finding most of our opportunities today.

Julie Anne: And how did the Committee navigate through the market uncertainty in 2023 to unearth these new opportunities and adjust portfolio positioning?

Ray: Well, it helps that we’ve lived through many of these cycles before. Particularly when you take a contrarian approach like we do, often the things you are buying, or where you have the biggest overweights as you’re leaning into new areas, don’t do well out of the gate. It’s very hard to call the bottom or to call the top, and we recognize that through our experience—that’s both at the Investment Committee level and the Analyst level. But I will say that by having industry specialists at the Analyst level, they’re out there scouring for opportunities day in, day out, even when valuations aren’t working in our favor. And that’s what they were doing ahead of last year, which prepared us to capitalize on the opportunities that we did see. When they arose, we were already prepared and were able to take action. So examples of that would be what we did in the Financials space during the concerns over financial contagion in the first half of the year. But then throughout the year, we’ve been able to find opportunities in many areas of the Consumer sector as another example. So I think it’s that disciplined approach and that deep institutional knowledge both at the Investment Committee and the Analyst level that allows us to be really prepared when markets react in surprising ways. We’re able to stay objective, follow the data, [and] take advantage of all that hard work people are putting in ahead of time to be able to move the portfolio accordingly.

Julie Anne: And volatility presented opportunities for us to adjust the Fund’s exposures in Financials, consumer-related (like you just mentioned), and China.

Ray: Yes, it’s true. And I referenced some of the opportunities we took advantage of to lean into the concerns in the Financials sector in the first half of the year. In the second half of the year, we reversed somewhat. So I mentioned UBS one of the stronger performers in the Fund. We did trim that back. It’s still a large holding, it’s still a top 10 [holding]. At one point it was the largest holding, but we decided to redeploy that capital elsewhere. Consumer, I had mentioned. I’d also call out a consumer-related company, IFF (International Flavors and Fragrances). This is a global franchise that markets and produces flavors and fragrances that are sold into the consumer-branded goods sector—both food and personal care companies really rely heavily on the products of IFF. That makes this business a little bit more stable 2023 Annual International Equity Review On-Demand Audio Transcript | January 2024 3 than a typical materials company would be. But this is a company that really has had a lot of struggles. They did a large acquisition, paid a big price for it that hit the balance sheet. There’s been some management missteps in terms of the execution of that strategy and the integration of that deal. And as a result, the stock has gotten quite inexpensive. All of those headwinds we believe can be resolved and created a great opportunity for us to start a position in that company.

Julie Anne: And other consumer-related new purchases in 2023 included Adidas, Danone, and Yum China Holdings. So Ray, what’s your investment thesis for Danone, which was a 0.9% position on December 31?

Ray: Well, Danone is a global food company based in France. It has very attractive franchises in its three core businesses of dairy, nutrition, and differentiated high-end water brands. And what we’ve seen with Danone is a dramatic change in governance. This is a company that has been a French national champion, and while there is a lot of positives to that, there are some negatives. It’s a company that we really think has underperformed its potential for well over a decade. And there’s been opportunities for the company that have been missed under prior regimes, but the current Board of Directors recognized that it was time for change. And there were a few activists that showed up and had convinced the Board that not only did they need change at the board level, but at the management level. We have a lot of faith in the current Chairman who brought in the current CEO, who has been executing on a restructuring plan that is beginning to bear some fruit. So we really like the better alignment with shareholders, both at the board level and at the management level. We liked the strength of positioning of the individual franchises that the company holds. And lastly, we like what is still an attractive valuation. We think the market is still likely looking in the rear-view mirror when it comes to Danone or possibly focused on shorter-term concerns, like inflation that the company had faced over the last couple years. But you put it all together, and we think that the outlook is quite strong for the company.

Julie Anne: We also found opportunities concentrated in the Semiconductor space with new positions in Taiwan Semiconductor Manufacturing Co., also known as TSMC, and Infineon Technologies. So why did the Committee start a position in TSMC given Taiwan’s geopolitical risks with China?

Ray: Well, first I’ll acknowledge that the geopolitical concerns are real. We recognize that. But you do have to look at TSMC in a portfolio context. So I would point out that we are still underweight Greater China as a whole [versus the MSCI ACWI ex USA], despite starting the position in TSMC and despite adding to some of our other China holdings. So we think that there are attractive opportunities there, but nonetheless, there’s a lot of risks that are real, whether it be geopolitical or some of the macro concerns we referenced. So as a result, we think it’s important to take that into account in what weight you’re willing to assign to holdings in parts of the market that are as controversial as China is and TSMC, in particular. But what may be missed by the market, and why we still thought it made sense despite those risks to start a position, is the fact that this is a market-leading franchise. This is a dominant company. It has 60% market share in their fab (fabrication) manufacturing business, and they also benefit from these wonderful trends that have driven many other semiconductor stocks to much higher valuations. AI (artificial intelligence) being front and center, that is not in the price of the stock in our opinion, so that makes it very attractive. But we think, in addition to the geopolitical risks that you asked about Julie Anne, there’s also cyclical concerns because there is a semiconductor downturn occurring right now. So that also led to more multiple compression⁸ for TSMC and allows us to participate in what is a market-leading franchise that is incredibly well run and has good long-term secular growth even if it faces some short-term cyclical headwinds. So all of those reasons is why we thought it was a great time to start a position in TSMC.

Julie Anne: That’s helpful context, thank you. And you mentioned earlier how the Committee trimmed Financials to fund these new positions. So despite these reductions, Financials remains the Fund’s largest overweight position at 26% versus 19% for the [MSCI] EAFE. Why does the Fund remain so overweight?

Ray: Yeah, well we were really happy with the performance of Financials, and we’re fortunate enough to be able to trim some of those holdings back and be able to fund some new holdings like the ones we just discussed. But with that said, 26% of the Fund is still a meaningful position to have and a big overweight as you referenced. And the reason why is despite very strong performance in the year, if you take a longer historical context, Financials remain very inexpensive relative to the market. And this is despite the fact that we have improved profitability coming through. With rates rising, we’ve seen profitability come up. Now clearly rates may come back down, but very unlikely to get back to where they were. So as a result, you should still have very strong profitability out of these companies. Additionally, they’ve been very prudent in their lending standards so credit risks seem to be at bay. They also have much more resilient balance sheets than back in the days of the Global Financial Crisis or some of the other concerns that the European markets faced in particular. So strong balance sheets, improved profitability, and then I would add in attractive return of capital. All of these companies have been paying healthy dividends, and many of them been repurchasing shares too. I think it’s out of the vote of confidence from these management teams and what the prospects look like. And all of that at an inexpensive valuation leads us to believe that it’s still an area that deserves a very strong weighting in the portfolio.

Julie Anne: We mentioned earlier that volatility created opportunities in China. Can you discuss the Committee’s recent actions and current thoughts on the Fund’s China Internet exposures?

Ray: Our China Internet holdings in particular really just faced a triple whammy of challenges. It’s everything from the geopolitical risk we’ve discussed, the macro headwinds as the Chinese economy disappointed, but then also these companies have really faced a higher level of competitive intensity. There’s been some threats to the margin structure of our businesses, new entrants that are quite successful, all of that, in addition to China concerns, have led to some underperformance. But what we do think the market may be missing is that these companies are responding. So first, we’ve seen corporate restructurings across many of our holdings. We’re also seeing cash returning to shareholders—these companies are in viable positions 2023 Annual International Equity Review On-Demand Audio Transcript | January 2024 4 of having very strong net cash positions. And it’s as their stock price has weakened, we’ve been happy to see them repurchase their shares as they’ve recognized that their stocks are probably too cheap. And again, that net cash position is a result of strong balance sheets that they have, which allows them, I think, to withstand some of this competitive intensity, be able to right the ship, and take advantage of what are still very good franchises at their core and some still strong secular tailwinds, even if they face some cyclical issues in the short term. But I do want to acknowledge, as I did earlier when we discussed TSMC, that we can’t predict geopolitical outcomes, nor can we predict where the Chinese economy is going to go. So as a result, while we’re excited about the opportunities there, the Fund does remain underweight Greater China [versus the MSCI ACWI ex USA]. So we’re leaning into certain areas that we think are most attractive and hopefully immune from some of the issues, particularly from a macro perspective. Secular opportunities for growth in China Internet are much better than say, Chinese banks, where maybe you’re going have some balance sheet issues and where you have more exposure to the real estate downturn that is really problematic in China. It’s going take a little while to work out, so we’d rather have exposure to our Internet holdings that in addition to e-commerce, can benefit from the rise in digital advertising, gaming, cloud, AI, [and] autonomous driving. These are all good secular exposures to have, in our opinion, as well as management teams that are doing their best to try to right the ship after a couple years of challenges. So volatility does remain high in China, and while I did focus on areas that we are most exposed to, it doesn’t mean it’s the only areas we’re looking for opportunity. You referenced starting a position in Yum Holding in your earlier comments. The reason we did that [is] because that’s another very strong franchise, a phenomenal brand, and it all comes with U.S. governance. This company is based in the U.S., has a very strong Board of Directors, is very focused on shareholder returns as it serves the Chinese consumer and takes advantage of its very early entry into the Chinese market. Again, there’s a lot of cyclical concerns with that stock that we think, if you have the patience that we’re able to do as long-term shareholders, should bode well for that holding. We’re quite excited about our China opportunities, but we would say that they’re controversial and subject to risk and that is why it is important to remember that we have 90% of the remaining portfolio elsewhere. So, excited about this potential when it comes to investing in China. Excited also to have a very diversified portfolio and sizing the opportunity appropriately when we put together the portfolio construction.

Julie Anne: Well, thank you Ray. What closing thoughts would you like to share with the audience today?

Ray: Well, first I’d really like to thank everyone for joining us today and listening to learn more about the Fund. And if I could, I’d like to leave the audience with three key takeaways. I’d finish where we started, which is when we’re facing uncertain macro and geopolitical backdrop like we are today, I really hope our listeners could do their best to stay focused on that long term. Next, our active, bottom-up approach allows us to capitalize on various opportunities because we’re able to take that long-term approach. It enables us to capitalize on the various investment themes—such as deep-value, idiosyncratic turnarounds, or mispriced secular growth—and equally important, to stick with them in the face of macro uncertainty if they’re not working out in the short term. And then lastly, we’re really enthusiastic about the Fund’s portfolio. The Fund’s portfolio is diversified by sector, geography, and investment thesis. I hope our listeners were able to get a sense of that from our discussion today. And with that, I would also just thank our audience and express our appreciation for your investment and interest in the International Stock Fund.

Julie Anne: Well, thank you Ray for sharing your insights with us today. And we also want to thank our listeners for your interest in our discussion. We’re grateful for the confidence that you’ve placed in Dodge & Cox and look forward to speaking with you soon. Thank you.