U.S. Equity Strategy—2023 Annual Investment Review

Kevin: Welcome to Dodge & Cox’s 2023 U.S. Equity Review. I’m Kevin Johnson, a Client Portfolio Manager with Dodge & Cox, and I’ve been with the firm for 34 years. With me today is Steve Voorhis. Steve is Senior Vice President and Director of Research, and Steve’s a 27-year veteran of the firm. Thanks for joining us, Steve.

Steve: Thank you, Kevin. Very happy to be here.

Kevin: The agenda we’re going to cover today is on page four, and in the next 20 minutes or so, we’ll provide an update on the U.S. Equity market. We’ll discuss our performance, and then we’ll talk about where we’ve been finding opportunities. But before we get into the details, are there any headline comments you have as you reflect on 2023, Steve?

Steve: I think the two key takeaways from 2023 would be 1) that the market went up very strongly, and 2) within that there were big divergences in performance between sectors. And so that’s creating new opportunities for us to look at as we try to analyze that dislocation. And we’ll talk about some of those opportunities in a few minutes. Lastly, I would just say that times of dislocation and volatility like that are very well suited to our long-term, detailed investment style.

Kevin: I think that’s a really useful way to put things in context. And as we think about the U.S. market, 2023 was a strong year for equities, really as the reversal of 2022, which was a very challenging year for the U.S. markets. What were the key drivers to 2023’s strong performance?

Steve: I think there were two, Kevin. So the first would be the enthusiasm for artificial intelligence (AI) after the launch of ChatGPT.¹ And we really saw that driving the performance of the so-called “Magnificent Seven”—the seven largest stocks in the S&P [500 Index²] by market cap, mostly technology companies—and their performance there really drove growth stocks in general. And then the second thing was positive economic data as the year unfolded, particularly into the second half as we saw inflation coming down, while the economy stayed reasonably strong and employment stayed strong. So, raising hopes that we might actually achieve a successful soft landing, and therefore boosting stocks going into 2024. As we look on slide five, we give a little bit more detail about what happened in the market in 2023. Maybe starting on the top left, you can see there was that big performance divergence between growth and value stocks.³ And so the S&P [500] overall up 26%, but the Russell 1000 Growth Index⁴ up 43% and the Russell 1000 Value Index⁵ up only 11%. Looking down on the bottom-left chart, you can see that the driver of the growth stock performance was that Magnificent Seven up 76% in the year with a quite dramatic outperformance. So much so that when you look at the S&P 500 excluding just those seven stocks, the other 493 were up only 14%. Then looking at the chart on the top right of page five, as we look at the performance by sector, you can see that of the sectors that underperformed, really it was heavily weighted among the defensive sectors of the market. So you can see Health Care, Consumer Staples, and Utilities all among the worst-performing areas in the market because they benefited neither from the enthusiasm about AI nor from the improving economic prospects.

Kevin: That’s a really helpful review. Given the strong market appreciation that we saw in 2023, where does that leave us in terms of valuations? What do they look like?

Steve: Well, so valuations overall look pretty high. The S&P 500 [is] about 20 times forward earnings,⁶ which is definitely not a bargain level, but given that very divergent performance in 2023, we’re seeing big variations in valuations as we head into 2024. And so if you look at the chart on the bottom right, you can see the Russell 1000 Growth Index is quite elevated relative to where it’s been in the past. The Russell 1000 Value Index is only about 16 times [forward] earnings, which is roughly in line with where it’s been in the past, and so much more comfortable valuations. Interestingly, the Dodge & Cox Stock Fund’s valuation is about 13 times forward earnings. And so I think that’s an indication that we’re finding a lot of interesting high-quality businesses trading at depressed valuations.

Kevin: That is a very meaningful discount to the broader market averages. Maybe turning to performance, given that strong market appreciation, how did the Stock Fund do in 2023?

Steve: So we give some details on slide six. The short answer is we had strong absolute results up about 17.5%. On a relative basis, that did trail the S&P 500, but was comfortably ahead of the Russell 1000 Value Index for the year. I would note that we include both of these benchmarks because we build our portfolios from the bottom up on a stock-by-stock basis rather than starting with any particular index and making variations relative to the index. And secondly, because we have clients that use both of these benchmarks in evaluating our performance, we want to make sure to include both sets of information.

Kevin: That’s helpful in terms of thinking about 2023. The firm and the Stock Fund really emphasize a long-term investment time horizon. How has the Fund performed over longer time periods?

Steve: We’ve included that data on the right-hand side of page six. Over a three-year time horizon, the Fund is ahead of both benchmarks, the S&P [500] and the Russell Value Index. Over 5-, 10-, and 20-year periods you can see that we’re in between the two, so lagging behind the S&P 500 but ahead of the Russell [1000] Value Index.⁷

Kevin: If we think about that performance relative to the S&P 500, what would you attribute the underperformance to over those longer time periods?

Steve: Well, it has been a tough time to be a value investor, and so you can see for all those time periods, the Russell Value [1000] Index is well behind the S&P 500. We think our consistent value discipline will serve our investors well over long time periods, but it has been a headwind in the past periods.

Kevin: In looking at 2023’s relative performance, what would you say were the most important factors?

Steve: So we’ve given you some data on slide seven of the contributors and detractors to performance by sector. As you can see, it was the [Information] Technology sector that accounted for the biggest portion of our underperformance relative to the S&P 500 benchmark. That’s primarily from our underweight position in the high value set of technology companies that performed so well in 2023. In particular, we do own some of the Magnificent Seven, but our total weight among those seven stocks is about 9% of the portfolio versus 28% of the S&P 500. For example, we’re underweight Microsoft significantly, and we don’t own NVIDIA or Apple at all.⁸ Outside of [Information]Technology, the most important things that I would call out are one, our overweight in Financials and in Health Care was a negative during the year as both of those sectors underperformed the S&P 500. Conversely, our underweight in Consumer Staples and in Utilities helped performance as both of those sectors also lagged the S&P 500, so being underweight was a positive for our performance.

Kevin: Steve, we do have, as you mentioned earlier, many clients that compare us to the Russell 1000 Value benchmark. What would you say in terms of the attribution versus the [Russell 1000] Value Index?

Steve: We’ve got some data on that on slide eight, and interestingly, actually Information Technology was a significant contributor to our performance relative to the Russell [1000] Value benchmark because we’re quite overweight relative to that Index. We also had positive contribution from our stock selection in a range of different sectors, across most sectors actually. But most particularly in Consumer Discretionary, in Consumer Staples, in Health Care, and in Materials.

Kevin: Steve, that was a very thorough review of 2023. If we’re looking forward now, where is the team finding opportunities?

Steve: Well, on slide nine, we give some information about the composition of our portfolio by different sectors. So looking at those bars across the top, the brown bar in each set is the Stock Fund, the light blue is the S&P, and the dark blue is the Value benchmark. You can see we’re most overweight in the two areas on the far left—Financials and Health Care. So I think that’s clearly where we’re finding the most opportunities today.

Kevin: How has the Investment Committee been managing the portfolio in this environment of volatile interest rates and the uncertain economic outlook?

Steve: I think an environment like that creates a lot of opportunities for us. Probably the two that I would call out the most prominently are that we have been adding to our holdings in Finance and in Health Care. In Finance, we had opportunity as a result of the regional bank turmoil in March of this year, and in particular the collapse of Silicon Valley Bank (SVB). So I think that downfall was brought about by the combination of two things. One, their significant investments in fixed-rate government securities, which created mark-to-market losses as interest rates rose through 2022 and into 2023. Secondly, and very importantly, a highly concentrated base of depositors with large, therefore mostly uninsured deposits. As a result of the collapse of the bank, any financial institutions which had either of those characteristics came under significant pressure in the stock market. In our portfolio, one company whose share price was affected was Charles Schwab because they also have a large investment book that lost value as interest rates rose. However, a critical difference—that became very apparent to us as we dug in doing our research on this—is that unlike SVB, 86% of Schwab’s deposits are insured because they come from millions of account holders who keep their transactional brokerage account cash with Schwab, and the average balance is only [approximately] $10,000 in cash. As a result, Schwab never experienced any kind of runs similar to what happened to SVB, and in fact, has continued to bring in net new client assets throughout the year. So we took advantage of the low share price by adding to our position in 2023. Similarly, the shares of both Bank of America and Truist [Financial] were hit by the crisis, but we think both banks also have strong diversified deposit bases and multiple sources of earnings strength. We added to both of those positions on weakness as well.

Kevin: You mentioned that Health Care is also an area of emphasis. What’s been the activity in in the Health Care sector?

Steve: Well, the biggest news, I think, in the Health Care sector in the last year has been the positive news that we’ve seen on a set of drugs called GLP-1 inhibitors.⁹ They’ve been on the market for a long time for the treatment of diabetes, but they’ve generated very promising clinical data for weight loss. As a result, they’ve become very popular. And we’ve seen the use start to grow very, very rapidly, which is I think a wonderful positive thing for the country, in general, but has led people to wonder about which companies might be hurt by more people taking these drugs. And we think in some cases that speculation has gone a little bit too far in the stock market. One example would be a position we have in a company called Zimmer Biomet, which is one of the leading manufacturers of hip and knee implants. There is speculation that perhaps as millions of people take these weight loss drugs and successfully lose weight, they’ll put less pressure on their joints and there will be less need for hip and knee implants going forward. We recognize that is a possibility, but note that there are also many patients who have a need of a hip or knee implant, but are ineligible simply because of their weight. So in fact, if people are able to lose weight, that might result in more people becoming eligible as well as less. And so we saw the share price of Zimmer decline very sharply. Given that balance of risk and opportunities, it seemed like the new lower price was a great opportunity, and we added to our positions in Zimmer during the year. Another company in a similar situation is called Baxter International, and they make a variety of healthcare products, but among them are a set of products for patients on dialysis, patients with end-stage renal disease. So again, the hope is that the benefits of the GLP-1 inhibitors will lead to less patients advancing into end-stage renal disease. We’re hopeful, along with everyone else, that that will be the case. But as we looked deeply at the business of Baxter International and studied their mix of products on a geographic basis, and on product segments, and the patients that they’re serving, we think that the impact of GLP-1 inhibitors on their business is likely to be quite limited for many years to come. The stock was also hit by concerns about what might be happening, and we took advantage of that to start a position in Baxter in Q3 (third quarter) of last year.

Kevin: Outside of Finance and Health Care, where are you seeing opportunities?

Steve: One other area of the market that was very weak in 2023 was the Utilities sector. We haven’t had any Utilities holdings in our Fund for many years because their role as the substitute for fixed income investments during the period of very low interest rates following the Global Financial Crisis has, in our view, made them seem like pretty expensive investments. As rates rose in 2022 and 2023, relative performance of the sector has been quite weak, and so we think some bargains are starting to emerge. On top of the lower share prices is also the rising demand for electricity—due to the energy transition as we use more electricity for things like electric vehicles in place of gasoline, and as electricity demand is rising due to the cloud transition and more need for data centers. So we’re seeing an interesting combination of both rising demand and falling stock prices. We think that’s starting to create some interesting opportunities. We did make our first investment into a Utilities stock in many years in a company called Dominion Energy, which is an electric utility headquartered in Virginia that we think has attractive exposure to both renewable energy, in particular wind energy, as well as the growth in data center demand in Northern Virginia, which is turning out to be one of the global hubs of the data center business.

Kevin: We’ve also started a position in a company called Norfolk Southern. Can you tell us a little bit about the investment thesis for that company?

Steve: Sure, Norfolk Southern is one of the big four railroads in the U.S. They are an essential part of our transportation infrastructure. It would be almost impossible to build or replace now, currently, given how difficult it is to get the right of way to land and to build a project like that. They have a very stable business and a lot of pricing power. However, in the past—we’re certainly not the only investors who appreciate what a good business the railroads are—and so in the past, they’ve traded at what we thought was a pretty full valuation. Norfolk Southern unfortunately had a derailment on their line of a train carrying toxic chemicals, and that caused significant damage to the local community. So it’s a very unfortunate event. We think though, that it was not the fault of the railroad. It was the railroad car, which was a leased car, [that] had been traveling on another railroad, got switched onto Norfolk Southern, and just happened to be on their infrastructure when the car broke and caused this derailment. The company, we think is doing everything to meet their responsibilities to clean up the problem, to compensate local homeowners, but the hit to their share price was quite significant. As we look at the value of the company relative to its peers, it declined by about $8 billion as a result of this accident. We think that’s multiples of what the total cost of the incident will be to the company. We see this as an interesting opportunity to buy a great long-term business at a discounted valuation because of some current problems.

Kevin:Those are excellent examples of our bottom-up individual company analysis and really focus on the long-term. Thank you, Steve. I think a key takeaway from your comments also would be that our disciplined, long-term approach is well suited for periods of near-term uncertainty and volatile markets. Is there anything you would like to add?

Steve: I think I would just say that although broader market valuations are elevated, we are seeing attractive opportunities in a range of out-of-favor companies, and as you said, this is a great time for our disciplined approach given all of the dislocation in markets.

Kevin: Great. Well, with that, we 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 we look forward to speaking with you soon. Thank you.

Steve: Thank you.