To Our Shareholders
The Dodge & Cox Global Stock Fund had a total return of 20.8% for the year ended December 31, 2021, compared to a return of 21.8% for the MSCI World Index.
Market Commentary
U.S. markets posted exceptionally strong results in 2021, with the S&P 500 Index up 29% on the back of unprecedented stimulus and a solid economy. With strong consumer balance sheets and easy access to credit, demand continues to remain elevated. In contrast, COVID-19 variants, supply chain disruptions, and labor market frictions are affecting supply. As a result, inflation has hit levels last seen in the 1980s, and the Federal Reserve accelerated its plans to raise interest rates in 2022.
Internationally, developed markets also posted solid results for the year (the MSCI EAFE Index appreciated 11%), as economic growth in most developed market countries rebounded to above pre-pandemic levels. However, the MSCI Emerging Markets Index declined 3%. China’s stock market dropped 22% amid ongoing regulatory interventions by the government and concerns about a slowdown in economic growth. Internet-related companies in particular were impacted, with the CSI China Internet Index down 49%.
During the first half of 2021, the global value indices appreciated and outperformed their growth counterparts.a But in the second half of the year, value underperformed growth amid concerns about COVID-19 variants. Hence, while valuations remain above average for the market overall, wide valuation disparities remain between value and growth stocks. The MSCI World Value Index currently trades at 14.2 times forward earnings compared to a lofty 31.2 times for the MSCI World Growth Index.b This market divergence is so rare it now rounds to the 100th percentile of historical experience. The discount for stocks that benefit from rising rates also continues to be extremely wide. This valuation spread is particularly extraordinary given the remarkably low level of nominal and real interest rates, and would appear to suggest a greater likelihood of rates staying lower for longer than we believe is warranted.
Investment Strategy
These two wide valuation disparities provide attractive opportunities for active, value-oriented, bottom-up investment managers like Dodge & Cox. The Fund is overweight low-valuation stocks, which we believe are positioned to benefit from accelerating economic growth and higher interest rates. In contrast, the Fund is underweight high-priced growth stocks, which have benefited from a low rate environment, and we believe are less attractive due to their high valuations and high expectations.
In 2021, we actively trimmed many of the Fund’s holdings as they outperformed the overall market, particularly in the more cyclical parts of the market. However, the Fund remains overweight Financials and Energy. The Fund’s Financials holdings are inexpensive, well capitalized, and could return meaningful amounts of capital to shareholders in 2022. Higher interest rates could further propel earnings growth.
In Energy, oil prices rose 51% in 2021, as demand continued to rebound from pandemic-induced lows, outpacing supply. Many energy companies have also improved capital discipline by restraining spending on oil and gas projects. The Fund’s energy holdings trade at attractive valuations and generate substantial free cash flow. Hence, these investments also look poised to increase capital returns to shareholders at attractive yields.
As we trimmed strong outperformers throughout the year, we added to the Fund's Health Care and China Internet holdings, which underperformed the market.
Health Care
As investors rotated into the more economically sensitive parts of the market in 2021, Health Care underperformed, along with other more defensive parts of the market. The Fund reinvested capital into several attractive health care businesses, increasing the Fund’s Health Care weighting from 14.3% to 20.0% by year end. Based on our value-oriented approach and analysis of the fundamentals, we added to large pharmaceutical franchises, such as GlaxoSmithKline, Sanofi, and Novartis.c These holdings now represent three of the Fund’s five largest positions. These companies have leading franchises, low relative valuations, and various innovation-driven opportunities. We also started positions in the health care services company Fresenius Medical Care (leading dialysis provider) and two biopharmaceutical companies: Regeneron Pharmaceuticals and Incyte.
Fresenius Medical Care
Fresenius (FMS, Financial) (0.8% position) is the world’s largest vertically integrated provider of dialysis products and services. This business benefits from highly concentrated market share, high barriers to entry, economies of scale, and strong recurring revenues. In recent years, its share price has underperformed due to missed earnings and headwinds from COVID-19 which appear more temporary in nature. The company is also now restructuring to reduce costs, while positioning itself to capitalize on the growing need for its dialysis services. Combined with a valuation of 15 times forward earnings, we believe Fresenius is an attractive investment over our three- to five-year investment horizon.
Regeneron Pharmaceuticals
Regeneron (REGN, Financial) is a biotech company focused on antibody treatments for ophthalmology, immunology, and cancer. Its antibody discovery platform has led to multiple commercial drugs, including two of the industry’s most valuable blockbusters, Eylea (ophthalmology) and Dupixent (immunology). The company has also made substantial investments in understanding the genetic basis of disease, as well as in new technologies like RNAi (with Alnylam) and CRISPR (with Intellia). The company is still led by its founding duo, CEO Len Schleifer and CSO George Yancopoulos, who are significant shareholders. Both are MD/PhDs and their strategy to focus on long-term value creation through innovation has proven highly successful. We think Regeneron offers an opportunity to increase the Fund’s exposure to innovation at an attractive price.
Incyte
Incyte (INCY, Financial) (1.0% position) is a U.S.-based biopharmaceutical company that discovers, develops, and commercializes proprietary therapeutics, largely focused on oncology. The company has a profitable legacy portfolio, and management has continued to reinvest profits from these franchises into its R&D pipeline. The team is working on avenues to extend its main Jakafi franchise beyond its patent expiry in 2027 and discover the next big drug to transform the company. In recent years, the company has improved R&D productivity and launched three new products, which could collectively generate $1 billion in sales annually. In addition, the company’s strong corporate governance and representation of long-term investors on the board align its interests with those of other long-term shareholders.
China Internet
The Fund’s China Internet holdings underperformed last year, after regulatory tightening in China increased in both pace and severity. More recently, these concerns were compounded by news of slowing economic growth in China, increasing competition, and accelerating plans to delist China ADRs from U.S. exchanges.
How do we evaluate investment merits in the face of uncertainties? By remaining disciplined in applying our bottom-up investment approach and focusing on valuation. We consider a range of possible scenarios based on our extensive research, which includes in-depth conversations with company management teams, internet industry experts, legal experts, and China policy experts. We revisit our investment theses and adjust our models, taking into account current valuations and what risks might already be priced in. Our Global Equity Investment Committee then weighs and debates a range of scenario forecasts against valuation, and the potential investment opportunity relative to the overall portfolio. Valuation is an important input into this process. Notably, the Fund trimmed back its China Internet holdings in the prior year after strong outperformance and rising valuations. Today, the reverse is true. The CSI China Internet Index pulled back 62% last year off its February peak in a strong reaction to recent events. However, the actual financial impact of those events appears to be manageable. The government has also reached out to investors and the public to highlight the importance of innovation and expressed its continued support for private enterprise. With valuations near a five-year low, this would appear to be a very attractively valued part of the market relative to fundamentals. We believe this contrast positions the Fund well to offer attractive long-term investment potential.
This has resulted in net adds to China Internet in 2021, including Alibaba (BABA, Financial), Baidu (BIDU, Financial), JD.com (JD, Financial), and Naspers (JSE:NPN, Financial) (which derives significant value from its underlying stake in Tencent). In addition, we recently started a position in NetEase (NTES, Financial), which develops and operates some of the most popular PC and mobile games in China. The Fund's China Internet holdingsd plus NetEase collectively comprised 6.4% of the Fund at the end of the year.
In Closing
Going forward, we continue to be optimistic about the long-term outlook for the Fund. While timing is uncertain, we believe interest rates could increase further, which should benefit the Fund’s portfolio. Even if interest rates do not rise, the Fund could still benefit if the currently wide valuation discount narrowed for stocks likely to benefit from rising rates. Finally, we believe the Fund is also well diversified and balanced across a range of investment themes. Over half of the Fund is invested in sectors and industries that benefit from innovation, in areas such as Media, Health Care, and Information Technology.
Thank you for your continued confidence in our firm. As always, we welcome your comments and questions.
For the Board of Trustees,
Charles F. Pohl, Chairman
Dana M. Emery, President
February 1, 2022
- Generally, stocks that have lower valuations are considered “value” stocks, while those with higher valuations are considered “growth” stocks.
- Unless otherwise specified, all weightings and characteristics are as of December 31, 2021.
- The use of specific examples does not imply that they are more or less attractive investments than the portfolio’s other holdings.
- The Fund’s China Internet holdings are Alibaba, Baidu, JD.com, Naspers, and Prosus.
