U.S. Equity Strategy—2024 Semi-Annual Investment Review

Kevin: Hello, welcome to Dodge & Cox’s Semi-Annual 2024 U.S. Equity Review. I’m Kevin Johnson, a VP and Client Portfolio Manager with Dodge & Cox for 34 years. With me today is Phil Barret, a Senior VP and [U.S. Equity] Investment Committee member, and a 19-year veteran of the firm. Thanks for joining us, Phil.

Phil: Hi Kevin, glad to be here.

Kevin: Today, we’ll provide an update on the U.S. equity market backdrop, our performance, and where we’ve been finding opportunities. You’ll see this agenda on page four. But before we get into the details, are there any headline comments, Phil, that you have as you reflect on the first half of 2024?

Phil: We believe this is an attractive market for long-term, bottom-up, value managers like ourselves. While we’re cautious on prospective broader market returns, we are encouraged by opportunities presented, by wider value dispersions, and on a bottom-up basis. The Stock Fund today is very different from the broader market, and we believe well positioned for a variety of market conditions.

Kevin: We’ll talk some about portfolio positioning in a few moments, but let’s first talk about the market environment. The first half of 2024 was a strong period for equities, extending the positive performance of 2023. What were the key drivers?

Phil: Well, Kevin, technology companies drove broader market returns for the past 18 months, year to date, and in 2023. If we look at the U.S. market backdrop slide [on page five], and looking at the top left, you can see that the Russell 1000 Growth Index¹ outperformed Russell 1000 Value [Index]² by a wide margin. Zooming in on the bottom left, substantially, most of the S&P 500 Index’s³ outperformance against the Russell 1000 Value was attributable to the “Magnificent Seven.”⁴ Stripping those out, the performance of S&P [500] was much more similar to the Russell 1000 Value. So it was really a handful of stocks that drove market results. You can see in the top right, in the second quarter, the S&P 500 outperformed the Russell 1000 Value by 6.5%, and substantially all of that outperformance was driven by results in Information Technology (IT) and Communication Services. So, on the bottom right, you can see the place to be over the past year has been high valuation stocks. Stocks trading over 25 times earnings have outperformed the other cohorts.

Kevin: Given the narrow market leadership and the strong performance by a small number of companies, what do valuations look like?

Phil: The broader markets are fully valued. The S&P 500 is trading at 21.6 times forward earnings.⁵ If we look at medium-term returns from those sorts of valuation levels, they tend to be poorer for the broader market. Moreover, when we double click on market expectations for double-digit EPS (earnings per share) growth,⁶ they seem optimistic to us, given risks from lag effects of higher rates on spending and investment, and other potential margin pressures that companies face. We think that expectations are lofty for certain sectors in the economy, particularly companies linked to AI (artificial intelligence) technologies, and those lofty expectations may be met with disappointment in the future. So given these concerns, we have positioned the Stock Fund very differently from the broad market.

Kevin: In this unusual environment, how did the Stock Fund perform?

Phil: Kevin, looking at the performance results slide [on page six], the Stock Fund for overall periods has outperformed the Russell 1000 Value and has underperformed the S&P 500 Index. Zooming in on the attribution of that underperformance versus S&P 500, over the past one year and five years, the underperformance has been attributable largely, almost entirely, to not holding NVIDIA, a single stock. So that concentration in the Index is quite unusual. As an aside, we’re very comfortable not holding NVIDIA. We think looking at its market capitalization,⁷ there’s a large gap between [current revenues and] the revenue needed to support that valuation by end users of AI. As well as NVIDIA maintaining near monopoly positions in AI chips with commiserate margins. The probability of those things both maintaining, we think is relatively low. But we think the current market sets up well for us. Wide valuation dispersions have been associated with future outperformance of value⁸ strategies like our own, and we would note that the S&P 500 is a significantly less diversified index today than in the past: 29% of the Index is held in five companies that trade at a valuation of 40 times LTM (last twelve months) earnings. So, in buying the S&P 500, investors are buying a fewer number of stocks trading at higher valuations, and we are avoiding many of those stocks.

Kevin: The Fund does emphasize a longer-term investment time horizon, and it has been a challenge for value investors to keep up with the broader indices over the past decade, given the strong performance of growth stocks. The Fund’s performance, though, has held up well despite these headwinds, and we’re optimistic that the Stock Fund will be a beneficiary if the value/growth trends reverse. And so, it is an interesting time to be a value investor given the extreme valuation disparities that we’re seeing. Let’s talk about attribution. In looking at the first half of the year’s relative performance, what were the most important factors?

Phil: Well, Kevin, if we look at the [page seven], attribution summary slide, the bottom line is: against the S&P 500, the Fund’s underweight position in IT was a key factor for relative underperformance. The biggest detractor by [a large] margin was not holding NVIDIA. Again, we’re skeptical that the growth in the market share can continue. To the positive, contributors included GE Aerospace⁹ in Industrials. Other detractors included Charter Communications in Communication Services and CVS [Health] in Health Care. But again, the Stock Fund is very different from the S&P 500. The S&P 500 has [a] 30% [average] weighting in IT, while the Stock Fund for the period mentioned had just a 9% [average] weighting.

Kevin: That’s very helpful perspective in thinking about how the portfolio did versus the S&P 500. What were the most important factors in thinking about relative performance versus the [Russell 1000] Value Index?

Phil: Against the [Russell 1000] Value Index, performance was broader across various industries. The key contributors included, GE Aerospace in Industrials, Wells Fargo in Financials, [and] Alphabet in Communication Services. Detractors—similar to the S&P [500]— included in Health Care, CVS [Health]. But again, I’d observe that the S&P 500 and Russell 1000 Value are very different indices today.

Kevin: I think that’s great context, Phil. As we start to think about where the portfolio’s positioned, where is the team finding opportunities?

Phil: Well, Kevin, I think, one, the team is finding opportunities in sectors that we’ve been lightly invested in, in the past. Quite significantly, year to date, we have two new holdings in Utilities and Real Estate, which are sectors that, over the past 20 years, we’ve had little representation. In the first half of the year, we started a position in AEP (American Electric Power), which is a regulated utility that we believe has significant scope for operating improvement [and is] trading at a low valuation with a high dividend yield. We also started a position in Sun Communities, which is a leading operator of manufactured housing parks, again, trading at what we think is a quite attractive valuation. [In Industrials,] we also started a position in Ashtead, which is a leading equipment rental company with scale advantages and a growth runway, we believe, and has less cyclical risk than perceived. Some of the sectors that in the past have been viewed as bond proxies had high valuations and high stability, but low growth. Today, many of those industries have come down in valuation, and we think are more attractive on a standalone basis and relative to the broader market.

Another significant add during the first half of the year was in Health Care services. We started a new position in Humana and significantly added to CVS Health. Both companies have significant business in Medicare Advantage (MA), which is a healthcare services program for senior citizens. The longer-term outlook for MA growth is attractive, we believe, driven by aging populations, increasing product penetration, and rising medical costs. Post-pandemic, medical costs have increased, leading to higher medical loss ratios, which is the share of insurance premium spent on medical claims. But we believe over time, as Health Care insurance is a short-tailed¹⁰ insurance product, that medical loss ratios will come down as repricing decisions are made, and margins will improve. Against expectations for improving margins, Humana and CVS [Health] trade at low valuations.

Kevin: So in summary, we’ve been finding new opportunities across a variety of industries, reflecting changes in the opportunity set. Even with the highly concentrated market, we’re still finding some very interesting situations to add to the portfolio. How has the Investment Committee been managing the portfolio in the current environment of a slowing economy and the upcoming U.S. presidential election?

Phil: We’d like to say we’re in the preparation, not the prediction business. We want a portfolio that will work with higher rates and lower rates, higher economic growth and lower economic growth. So, it’s a lot about what’s priced in on a bottom-up level to specific stocks. I think we’re finding more value in companies that are less cyclical and/or have wider valuation discounts. We’re cautious about future market returns given high valuations and expectations. So, we’re generally taking countercyclical actions. If you look at the portfolio structure slide [on page nine], again on Information Technology, we have as significant an underweight in IT in the Stock Fund versus S&P 500 as in the internet bubble some 20+ years ago [in] the early 2000s. So that’s the last time we were this underweight Information Technology. We’re not averse to Information Technology. We’ve been overweight at many times versus S&P 500 over the past 20 years. But today, valuations are so extreme, we’re in fact also underweight the Russell 1000 Value.

Where we’ve been finding more opportunity is [in] sectors like Health Care, which again has less economic sensitivity and low valuations; Financials, where we see bad news priced into many stocks; and some other sectors like Communication Services. But again, we look very differently versus [the] S&P 500 and the Russell 1000 Value because they’re very different indices. But one commonality is, if you look at valuation, the Stock Fund—looking at the bottom left of the page—is cheap against the S&P 500 and the Russell 1000 Value, both on price-to-earnings, and price-to-cash flow, and [also] price-to-sales, and price-to-book value. So pretty much, no matter how you look at it, the Stock Fund is trading at a low valuation. It also has a historically low beta¹¹ and a high active share.¹²

Kevin: So we’re maintaining our investment discipline and valuation discipline. You mentioned Financials, Phil. It’s still an important area of the portfolio, although we have been trimming some here recently. Can you talk about our outlook in the Financials area?

Phil: On a headline basis, Financials are attractively valued, have negative outcomes priced in, and have high current capital returns to shareholders through dividends and buybacks. On a relative basis, the valuation setup’s attractive. When you look and double click on our Financials portfolio, it’s very different from the broad market. We believe we have Financials that have lower credit sensitivity, lower credit risk embedded in them on their balance sheet. These include stocks like Charles Schwab, State Street, BNY (Bank of New York Mellon), and UBS [Group] that take less credit risk as a part of their business. We also have significant weightings and stocks that are classified as Financials, but are really more business services firms, like Fiserv and FIS (Fidelity National Information Services). So, while we have a high Financials weighting, we think it is different from the market and should do well in an adverse economic environment because it has less credit sensitivity.

Kevin: And you mentioned that we have recently found some new opportunities in Utilities, but the Fund is significantly underweight in some sectors, like Utilities. How is the Committee thinking about those areas that we’re significantly underweight the indices?

Phil: Kevin, again, it looks very different versus the S&P 500 and Russell 1000 Value. As I mentioned before, these kind of bond proxy industries—like Consumer Staples, Utilities, [and] Real Estate—have been low growth, high valuation. We didn’t find that an attractive combination in that environment. But now, valuations have come down for a lot of those stocks. The returns look better on a relative basis to the market, and a lot of these are really strong franchises within the group, so they’re certainly raising our attention more than in the past.

Kevin: Thanks, Phil. That was a really helpful review of the portfolio positioning and where we’re finding opportunities. I think the key takeaways from your comments are that there’s a small number of very large companies that have had an outsized impact on the broader market returns; our bottom-up, value-oriented approach has led us to construct a portfolio very different from the major indices; and we are excited about the portfolio’s current positioning and relative return potential. Is there anything you would add?

Phil: I think you summarized it well, Kevin.

Kevin: We appreciate your time today, Phil. Thank you for sharing your thoughts on the market environment and our portfolio positioning. We also want to thank our listeners and hope you found our discussion interesting. We appreciate the trust and confidence you’ve placed in Dodge & Cox and look forward to speaking with you soon. Thank you