International Equity Strategy—2024 Semi-Annual Investment Review

Julie Anne: Hello everyone and welcome to the Dodge & Cox 2024 Semi-Annual International Equity Review. I’m Julie Anne Wickes, a Vice President and Head of Investment Communications and have been with Dodge & Cox for 18 years. It’s my pleasure to introduce Bert Bangayan, a member of our International Equity Investment Committee and Global Industry Analyst, who’s been with our firm for 22 years. Bert, thanks for joining us today.

Bert: 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 while covering three main topics. First, the international equity market backdrop; second, the International Stock Fund’s performance in the first half of 2024; and third, where we’ve been finding opportunities. Bert, before we get started, are there any headline thoughts that you’d like to share with the audience?

Bert: Yes, Julie Anne, there are two points that I want to highlight. First, there were some interesting valuation changes across sectors and regions that created some compelling idiosyncratic investment opportunities, which we’ll discuss in more depth today. And second, international equity markets are attractively valued on both an absolute and relative basis and, in particular, international value stocks¹ are especially inexpensive.

Julie Anne: Great, well I look forward to discussing these topics in more detail. Let’s turn to page five, the international market backdrop. Bert, can you set the stage for what happened in international equity markets in the first half of the year?

Bert: Sure. As you can see in the upper-left quadrant, economists are less concerned about a potential recession in the Eurozone, United Kingdom, and United States compared to the start of the year. Given this improved economic outlook, international equity markets were pretty strong during the first half of the year. All the major regions of the benchmark were up roughly mid-single digits, with emerging markets particularly strong. As shown in the bottom left, three sectors—Information Technology, Financials, and Health Care—drove the MSCI ACWI ex USA [Index]’s² total return. These three sectors represent 45% of the Index but generated 82% of the benchmark’s return. In [Information] Technology, similar to what we’ve seen in the U.S., excitement about artificial intelligence (AI) drove really healthy returns in the Semiconductors industry. Financials also continue to do well, extending the trend that started three years ago. On a three-year horizon, Financials is the second-best performing sector after Energy. Lastly, in Health Care, performance was driven largely by Novo Nordisk and enthusiasm for GLP-1³ weight loss drugs, like Ozempic. Regionally, valuations have diverged significantly since the beginning of 2024. In China, equity markets were up around 7% in the second quarter after disappointing returns in prior years. But even given that performance in the second quarter, valuations in China remain depressed relative to other regions, while Japan continues to trade at a premium, largely based on what we think is exuberant enthusiasm for corporate governance reforms in that country.

Julie Anne: Yes, and despite the overall improved economic outlook that you mentioned for international developed markets, international equities still trade a substantial discount to U.S. equities with the MSCI ACWI ex USA trading at 13.4 times forward earnings⁴ compared to 21.6 times for the S&P 500 Index.⁵ So we think this is a good time to be diversified and have equity exposure outside the United States.

Bert: Exactly. And I would also highlight the valuation disparity within international equities. Growth stocks trade [at] 20 times forward earnings and are twice as expensive as value stocks, which are quite attractive at only 10 times [forward earnings]. Putting this in historical context, the spread between value and growth stocks is wide at 1.6 times standard deviations.⁶

Julie Anne: Thanks Bert. Let’s now turn to the Fund’s performance results on page six. We’d like to note for our audience that we recently changed the International Stock Fund’s primary benchmark from the MSCI EAFE [Index]⁷ to the MSCI ACWI ex USA. We believe that the MSCI ACWI ex USA is a more appropriate benchmark for the Fund because it includes emerging markets and, thus, better reflects our investible universe. It’s also important to note that since we are benchmark agnostic, this new benchmark will have no impact on how we construct the portfolio.

Looking at performance on this page, the Fund posted strong, positive returns for the year-to-date and one-year periods but underperformed on a relative basis. As a reminder, we focus on the long term and have a three- to five-year investment horizon. The Fund outperformed over the past three, five, and 20 years. Bert, can you discuss the Fund’s attribution versus the MSCI ACWI ex USA for the first half of the year?

Bert: Sure. Let’s start by looking at the top three contributors to relative results. First, the Fund’s Industrials holdings, particularly Mitsubishi Electric and Johnson Controls, performed well.⁸ Second, stock selection in Consumer Staples was positive. This is an area of the portfolio where we have been finding more opportunities, which we’ll discuss later. And third, Holcim in the Materials sector outperformed due to robust pricing, steady volume outlooks in its key markets, and plans to list its North American business in the United States with a full capital market separation expected to occur in the first half of 2025. But the Fund ultimately underperformed due to a few factors. First, our European Health Care holdings, notably Bayer, underperformed. The market was disappointed that the new CEO didn’t announce a dramatic change to the structure of the company, such as the sale of a major division, and is instead just planning to optimize operations by cutting costs and continuing to delever the balance sheet. In addition, not owning Novo Nordisk also hurt the Fund’s relative results. Enthusiasm for GLP-1 drugs boosted Novo Nordisk’s product sales, and the stock had a total return of 40%. Second, our underweight position in the Information Technology sector hurt results. Information Technology was the best-performing sector in the market and up 17%. The AI craze propelled the Semiconductor industry, where we’re underweight. Lastly, our Brazilian Financials holdings, namely Itau Unibanco and XP, underperformed as broader concerns weighed on Brazilian equity markets. These concerns included persistent inflation, policy-making uncertainty, and the negative economic impact from widespread flooding in the southern part of the country.

Julie Anne: Thank you. Looking at the Fund’s positioning on page eight, can you discuss the key overweight and underweight positions in the portfolio?

Bert: Yes. So, we continue to be overweight traditional value sectors such as Financials, Energy, and Materials, but that overweight is smaller than it has been recently. Within the defensive areas of the market, we continue to be overweight Health Care, but it’s important to point out that our historic underweight in Consumer Staples has now become an overweight for the first time in over a decade, as valuations have become more attractive in that sector. And zooming out, the overall valuation for the Fund’s holdings is meaningfully lower than that of the benchmark as valuation spreads continue to be wide, and we believe that the risk/reward trade-off is more favorable in the cheaper portion of the market.

Julie Anne: What are some of the attractive idiosyncratic investment opportunities that you found in the first half of the year?

Bert: Our analyst team has been very busy during the first six months of the year. We meaningfully reduced the Fund’s position in Financials as well as Energy based on continued outperformance from these two sectors. As a reminder, the Fund’s holdings in these sectors were trading at extremely depressed valuation levels a few years ago. They’re still attractive from a fundamental and valuation perspective. We redeployed those proceeds across new ideas in a variety of sectors and purchased eight new holdings in the first six months of the year. In Industrials, which is actually an expensive sector on a headline basis, we were able to identify opportunities in the cheaper portion of the sector. We started three new positions: the first was in Ashtead, a global leader in the equipment rental industry; Daikin [Industries], a Japanese-based leader in air conditioning; and DHL [Group], which is one of the three leading global freight companies. Turning to Consumer Staples and Consumer Discretionary, these two sectors continue to get cheaper as many companies settle into a more normalized growth rate post-COVID[-19]. We were able to start positions in Diageo, which is the leading alcoholic spirits company in the world; Coupang, the leading Korean e-commerce player; and Kering, which is the luxury goods conglomerate that owns the Gucci brand. Lastly, we purchased BP in the Energy sector and Tencent in Communication Services.

Julie Anne: The Fund’s European Financials holdings outperformed strongly over the past year and you recently trimmed them. What’s your outlook for these holdings?

Bert: Yes, our European banking and insurance companies have done well, not just in the past year but over the prior three years. I would highlight that this is an area of the market that was extremely challenged in the late 2010s given zero interest-rate policies and sluggish European economic growth. We built up a meaningful overweight based on the combination of those very depressed valuations in our view that the fundamentals of the companies weren’t as dire as implied by those valuations. Their relative outperformance over the past three years is a great testament to our ability to be patient and long-term oriented investors. So today, fundamentals have improved with much stronger capital ratios and much higher earnings levels based on higher net interest income. We’ve trimmed on strength and because other areas of the market have become relatively more attractive, but we still have a modest overweight because valuations in our opinion are still very compelling. To quantify this, the [forward] P/E [price-to-earnings ratio] of European banks is around half of the overall market and this relative [forward] P/E is near ten-year lows.

Julie Anne: In Energy, the Committee’s been quite active. While you trimmed Energy overall, there’s been a lot going on under the hood, including starting a position in BP and selling Ovintiv. So, can you tell us more about what’s been driving that?

Bert: Sure. So, we have been gradually reducing the Fund’s overweight position in Energy and optimizing the composition of our Energy holdings. For context, it’s important to emphasize that Energy has been the best-performing sector over the past three years, and similar to Financials, we actually established our overweight position in the late 2010s before things started to turn. This was based on our thesis that oil prices at the time would be higher for longer and that the energy transition would also take longer than experts had predicted at the time. Oil prices have risen and been in the $80 range for the past couple years, which reflects our base-case scenario. Looking out over the long term, we are less optimistic that oil prices will remain as robust, primarily based on supply concerns, looking out to the 2030s. So, within the portfolio, we’ve adjusted our position based on the relative strengths and weaknesses of the different assets at the company level. We sold Ovintiv because it is primarily a North American shale company and, unfortunately, management doesn’t really have a meaningful strategy of how to adjust and adapt its portfolio with the pending energy transition. In contrast, we did start a position in BP, which is a company that we know very well but have never owned. During the pandemic, the company made a strategic pivot to lean very aggressively into the energy transition. At the time, we really didn’t agree with that strategy because we thought the company wasn’t making the most optimal investments with their capital. The CEO that led that pivot has since left the company, and the prior CFO has been promoted to CEO and he has reversed that strategy partially. We really like that reversal and believe that the fundamentals for the company are attractive over the long term and that its valuation is exceptionally compelling with a double-digit return of capital yield.

Julie Anne: During the quarter, we purchased a new Japanese holding in the Fund, Daikin Industries. Can you discuss that company and, more importantly, why the Fund remains underweight Japan?

Bert: Sure. Daikin is one of the leading players in the air conditioning industry with leading technology in inverters and heat pumps. They have a strong presence in Asia with their split air conditioning devices, and they’re the number one player in Europe with heat pumps, which are critical technologies for enabling the energy transition. Daikin is a company that we have long admired and wanted to own. In the second quarter, the price declined to our target price, based on concerns about growth in China and Europe, and we were finally able to start a position. Now, with regards to our overall underweight in Japan, I think it’s helpful just to emphasize some first principles that for every investment we look at. Regardless of region, we’re always looking for combination of the following factors: one, a strong business franchise; two, attractive growth prospects; three, management that’s working for the benefit of long-term shareholders; and four, a reasonable to cheap valuation. In Japan, we can often find three out of these four elements, but it’s really not easy to find all four. For example, companies that have attractive fundamentals and management teams that are trying to maximize shareholder value all too often trade at expensive valuations. What we’re seeing in Japan is that a lot of the hoped-for improvement in corporate governance—specifically what I mean is for companies to achieve ROEs (return on equity) of 10% or higher—has already been priced into higher valuations. So, it’s just much more difficult to find the companies that we’re trying to invest in there.

Julie Anne: You mentioned that the Committee has been finding more consumer-related opportunities. We previously held Diageo in the Fund from 2009 to 2013 and recently reinitiated a position. As the [Global Industry] Analyst for Diageo, can you discuss your due diligence process and why you believe it’s an attractive long-term investment?

Bert: Of course. So, for context, Diageo is the leading global spirits company, and like many other consumer companies that grew at high rates during the pandemic, has grown much more slowly recently. That has led the valuation to decline to 10-year lows on a forward earnings basis. We believe that low valuation reflects concerns on when growth can return to more historic rates, which have been in the mid single-digit range. I think many investors are afraid to invest right now because they’re concerned that the short-term trends will continue to get worse before they get better. I’m not an expert on when things will turn, but I think this is where our longer-term time horizon can serve as an advantage. From a due diligence perspective, I focused on two things. First was the health of the brand portfolio and whether or not the management team can continue to successfully invest and pivot the portfolio to changing consumer trends. We conducted extensive interviews with senior management, competitors, and industry experts, and we developed conviction that the company is actually very well positioned to maintain its leading position. Second, I tried to develop confidence around the company and industry’s ability to return to that mid-single-digit growth rate. It has historically achieved that over the past couple decades, and I don’t see that changing because I continue to see a continued shift in the alcoholic beverages industry from beer going to spirits. To be thorough though, we did analyze and try to quantify some risk factors such as the rise of substitutes that are coming from cannabis consumption and the growing health and wellness trend of drinking less. And then lastly, we did commission a proprietary consumer survey of households across the United States to assess if people have too much inventory in their home bars. That survey gave us confidence that there isn’t too much excess inventory in those home bars and gave us confidence that the industry overhang might not last as long as people fear.

Julie Anne: That’s a helpful overview of your process. Thanks for sharing that. Bert, what closing thoughts would you like to share with the audience today?

Bert: Well, first of all, thank you for listening today. I do want to leave you with three key messages. First, international equity markets are attractively valued on both an absolute and relative basis, and in particular, international value stocks are especially inexpensive. Second, we believe it’s important to maintain a long-term investment horizon and focus on those factors that ultimately drive long-term performance. Those would be valuation, the strength of the company’s business, its growth prospects, and the quality of the management team. This approach has enabled us to navigate short-term price fluctuations and capitalize on opportunities across various investment themes. I hope today I’ve been able to highlight that we continue to identify compelling, idiosyncratic opportunities that have arisen due to valuation changes that have changed over the past year. And then lastly, the Fund’s portfolio trades at a discount to the overall market and remains diversified by sector, geography, and investment thesis. We are very enthusiastic about the long-term outlook for the Fund. As always, thank you for your investments and interest in the International Stock Fund.

Julie Anne: Well, thank you Bert, we appreciate you sharing these insights with us today. 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.