To Our Shareholders (unaudited)
The Dodge & Cox Stock Fund—Class I had a total return of 17.49% for the year ended December 31, 2023, compared to a return of 26.29% for the S&P 500 Index and 11.46% for the Russell 1000 Value Index.1
Market Commentary
U.S. equity markets rose during the fourth quarter of 2023 ending a standout year for stocks. The S&P 500 was up 11.7% during the quarter and 26.3% for the year, driven by a resilient U.S. economy, easing inflation, and market optimism about the prospect of lower interest rates.
In 2023, the S&P 500's performance was led by the outsized returns of the “Magnificent Seven” stocks2 and their respective sectors: Information Technology (Microsoft, Apple, and NVIDIA), Communication Services (Alphabet and Meta), and Consumer Discretionary (Amazon and Tesla). These seven stocks rose 76.2%,3 increasing their share of the S&P 500's market capitalization from 20% to 28% during the year. Utilities and Energy were the worst-performing sectors for the year, negatively impacted by rising interest rates and lower commodity prices, respectively.
In a reversal of 2022 trends, U.S. growth stocks outperformed value stocks4 during the year, and the valuation disparity between value and growth stocks widened. The Russell 1000 Value ended the year trading at 16.0 times forward earnings5 versus 26.8 times for the Russell 1000 Growth Index.6
Investment Strategy
For 2023, the Fund had a total return of 17.5%,7 trailing the S&P 500's and surpassing the Russell 1000 Value's performance. The Fund's underweight position and holdings in the Information Technology sector, along with its overweight position and holdings in the Financials sector, were the biggest detractors from its relative performance versus the S&P 500. Compared to the Russell 1000 Value, the Fund's holdings in the Consumer Discretionary sector were the biggest positive contributors.
At Dodge & Cox, we focus on companies' long-term fundamentals, conduct independent research, and employ a rigorous price discipline. This approach led us to reduce the Fund's exposures to companies whose valuations rose throughout the year (such as Broadcom (AVGO, Financial)/VMware (VMW, Financial), Meta (META, Financial), and Alphabet (GOOG, Financial)) and increase exposures to companies in more defensive and stable sectors with lower valuations, such as Health Care and Utilities.8
The Fund remains overweight the Financials, Health Care, and Communication Services sectors compared to both the S&P 500 and the Russell 1000 Value. Sectors we are underweight include Consumer Staples, Materials, Utilities, and Real Estate. Below we discuss the Fund's recent activity in Financials and Health Care, the sectors with the largest weights in the portfolio.
Where We Stand on Financials
The Financials sector was a significant detractor from the Fund's relative results versus both the S&P 500 and the Russell 1000 Value for the full year. In the first half of 2023, three U.S. regional banks, which had significant concentrations of uninsured deposits and large unrealized losses on their balance sheets, came under pressure and eventually failed. Although the Fund had no exposure to those banks, their failures weighed on the broader Financials sector. As confidence in bank funding improved and the likelihood of future interest rate hikes diminished, the Financials sector recovered and was the largest contributor to the Fund's relative performance during the fourth quarter versus both the S&P 500 and the Russell 1000 Value.
We revisited our investment theses for the Fund's Financials holdings and believe they are resilient and will remain profitable under various stressed scenarios. Our well-diversified portfolio is invested in global, systemically important banks that are subject to high regulatory capital standards (e.g., Bank of America, Wells Fargo) and capital markets institutions with relatively little credit risk exposure (e.g., Bank of New York Mellon (BK, Financial), Charles Schwab, Goldman Sachs (GS, Financial)). Recent credit quality concerns have been concentrated in commercial real estate, especially the office real estate market. The Fund's exposure is limited, as office real estate is a small portion of the overall loan portfolios of these companies.
At Dodge & Cox, we seek to invest in companies whose current valuations reflect pessimistic views about future earnings and cash flow prospects, and where our analysis reveals the possibility of more positive developments. Financials is a good example of this. Although shares of many Financials companies were under pressure during 2023, we have a positive view on the long-term prospects for the Fund's holdings. Valuations are relatively low, and we believe their long-term earnings potential is underappreciated. We maintained the Fund's overweight position in the Financials sector and added to several positions, including Bank of America, Truist Financial, Fidelity National Information Services, and Charles Schwab.
Charles Schwab
Charles Schwab (SCHW, Financial) is a leading financial services company that provides securities brokerage, banking, money management, and financial advisory services to individuals and institutional clients. The company's ability to deliver services at a lower cost has enabled it to grow market share in attractive segments, fueling the company's long record of growing customer assets and earnings.
During the regional bank crisis in 2023, market concerns about Schwab's deposit outflows and the impact of unrealized securities losses on its balance sheet weighed on its stock price. Customers shifting cash out of deposit accounts into money-market funds led to higher funding costs, and proposed regulatory capital rules have reduced the potential for share repurchases over the near term. We believe these headwinds are transitory and were reflected in the stock's lower valuation. In line with our valuation focus and long-term orientation, we increased the Fund's position in Schwab. While the stock trailed the broader market in the first nine months of 2023, Schwab was a top contributor to the Fund's relative return versus both the S&P 500 and the Russell 1000 Value during the fourth quarter.
Market Developments and Portfolio Actions in Health Care
The Health Care sector was another area that underperformed the major indices during 2023. Investor enthusiasm for Information
Technology, artificial intelligence, and the Magnificent Seven dampened interest in more stable, defensive areas like Health Care. In addition, regulatory concerns weighed on the sector, and the increased use of GLP-1 inhibitors,9 like Ozempic, have created uncertainty regarding potential shifts in demand for certain health care services and consumer-related products. We believe that the current environment presents challenges in the near term, but also has created attractive long-term opportunities, such as Baxter International and Cigna, for a value-oriented investor.
Baxter International
During the third quarter, we initiated a position in Baxter International (BAX, Financial), a leading medical supply firm. Baxter holds a large market share in its major markets but has faced considerable headwinds recently. Issues include inflationary cost pressures, the questionable acquisition of hospital bed company Hillrom (and the increase in debt related to the purchase), and concerns about GLP-1's potential to reduce demand for dialysis supplies. These factors contributed to a share price decline of more than 50% over the last two years.
Looking past these near-term headwinds, we think that the company has a strong underlying business and will be able to maintain stable growth, increase margins, and pay down its debt. Moreover, dialysis demand from chronic kidney patients is unlikely to drastically change over our three to five year investment horizon, despite GLP-1's potential to reduce obesity. Based on these factors, the company's valuation at 13.0 times forward earnings and dividend yield of 3.0% presented an attractive opportunity to start a position.
Cigna
Cigna (CI, Financial) is one of the largest and most diversified health care insurers and service providers in the United States. The company underperformed the market and its peers during 2023. There were concerns that the company could pursue a large acquisition and faces regulatory risks in its Pharmacy Benefit Management business. Regulatory changes may require Cigna to terminate certain business practices that are thought to contribute to higher drug prices for consumers, such as creating narrow networks for retail pharmacies or retaining profits from rebates and fees negotiated with drug manufacturers.
We evaluated the potential impacts of these regulatory changes on Cigna's earnings prospects and concluded that the decline in its stock price was overdone. The company continues to execute on its 10 to 13% long-term earnings growth10 plans, while still generating significant cash flow that has led to a reduction in shares outstanding by 9% over the past two years, along with debt repayment. The recent share price decline provided an opportunity for us to add to an industry leader at a low valuation of 10.6 times forward earnings.
In Closing
We continue to be optimistic about the long-term outlook for the Fund, which is diversified across a broad range of sectors and investment themes. We are also encouraged by the Fund's attractive valuation of 13.0 times forward earnings, compared to 20.4 and 16.0 times for the S&P 500 and the Russell 1000 Value, respectively. Thank you for your continued confidence in Dodge & Cox. As always, we welcome your comments and questions.
For the Board of Trustees,
Dana M. Emery
Chair and President
January 31, 2024
Returns represent past performance and do not guarantee future results. Investment return and share price will fluctuate with market conditions, and investors may have a gain or loss when shares are sold. Fund performance changes over time and currently may be significantly lower than stated. Performance is updated and published monthly. Visit the Fund's website at dodgeandcox.com or call 800-621-3979 for current performance figures.
