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Google, Ebay: Why A Top Mutual Fund Likes Them

By: Investor's Business Daily
Posted: 3/4/2014 6:20:00 PM
Referenced Stocks: SCHW;UNH;COF;GOOG;NVR

In this corner stands Dodge & Cox Stock Fund , the top-ranked heavyweight. It outperformed all U.S. large-cap stock funds with at least $50 billion in assets over the 12 months ended Feb. 28, according to Morningstar Inc.

The $52.4 billion portfolio was up 32.86%. Within its Morningstar category, it topped 99% of its large-cap value peers. It was in the top 2% and 6% over the past three and five years respectively.

The fund's approach is as straightforward as Mike Tyson's in his ring days. It looks for stocks with favorable outlooks for long-term growth, and it buys them only when their share price is temporarily beaten down.

The fund is run by a nine-member team. Charles Pohl, 56 years old and chairman and chief investment officer of Dodge & Cox, and Diana Strandberg, 55 years old, director of international equity for Dodge & Cox, talked with IBD about their approach from their offices in San Francisco.

IBD: Many investors look for stocks with great long-term prospects. What do you do differently?

Pohl: There are a couple of ways in which we stand out from other large fund managers.

One of the most striking is that we have only five funds. Other firms have dozens or hundreds. That gives us much more focus.

When you look at the firms who have been able to generate the best performance for shareholders, it is usually the firms with the fewest numbers of funds. Our funds include DODGX, a U.S. stock fund; a non-U.S. stock fund, Dodge & Cox International ; and a global stock fund, Dodge & Cox Global . DODWX owns a subset of the stocks held in DODGX and DODFX. We also own a bond fund, Dodge & Cox Income , and a balanced fund, Dodge & Cox Balanced , which combines what we own in DODGX and DODIX.

And we have low fees, some of the lowest of any true active managers. Stock Fund's (DODGX's) expense ratio is just 0.52%.

We have low turnover too. We average about 17% annually over the past 10 years vs. close to 100% for the industry.

A couple of other things are different about us. We are independently owned by our active employees. We also have an anti-nepotism bylaw. People who work here are motivated to make a success of this business and for our clients. It's the only way we can succeed. There are no outside owners putting pressure on us.

And we do no real marketing. You've never seen an ad for Dodge & Cox. We don't pay commission to brokers. We don't charge loads. We don't have those costs, and we pass those savings on. It doesn't create a distraction for us as investors. We focus on trying to achieve solid long-term results, not selling people the flavor of the moment.

IBD: Is the widely expected slow-growth environment, with rates rising eventually, easier for your type of approach than it is for more aggressively growth-oriented funds?

Pohl: It doesn't make a great deal of difference to us. We're not macro or top-down driven. We're not short-term oriented. We realize there will be periods in, say, the next six years when the economy is stronger or weaker, when there are recessions and rallies, when rates rise or fall. We want companies that do well through a variety of economic outcomes.

We build upside and downside and base-case scenarios for stocks we're looking at. We try to stress each name to see how it performs under different scenarios. We don't expect the economy to surprise us.

IBD: Does the economic environment change your pool of prospects?

Strandberg: The disparity between the most and least expensive parts of the market are narrower than they were five years ago. This gives us opportunities, where there is skepticism about a company's growth prospects, to find companies with reasonable valuations with really attractive long-term growth prospects.

IBD: Does the rising rate outlook change your approach?

Strandberg: In an environment of low rates, selected companies have had significant earnings pressure.

Schwab ( SCHW ) is an example. At the time we were looking at making an investment, about one-third of its earnings were gone because of fee waivers on money market funds. We started buying in early 2010. They had a strong franchise in financial services, which had transitioned to fee-based from commission-based, and which had quite a conservative balance sheet, so they could withstand hard times and low rates.

When rates rise, this should help their earnings (on the float on customers' accounts). That would be a tail wind on earnings.

IBD: Four of your eight new buys in 2013 were in health care.UnitedHealth Group ( UNH ) was one. Do you like prospects for the company's Optum health services technology and analytics division? And do you expect ObamaCare to help or hurt?

Pohl: United doesn't have a lot of exposure to health care exchanges, so the impact of the Affordable Care Act will be more muted than it will be for a lot of other health care organizations.

We think they are well positioned to provide high-quality health care at lower prices, and do it through data-driven, analytical processes. Optum is a big part of that.

The help they can provide to other health entities is going to become more valuable over time as pressure builds industrywide to cut costs.

IBD: Why were financials your largest sector as of Dec. 31?

Pohl: Their P/Es are in line with where they've been historically. On price-to-book, they're cheaper.

Other things have improved greatly, not the least of which is capital ratios. Their liquidity is much improved. And the quality of their earnings is higher.

One thing that's been discounted too heavily in the market is that there's been a lot of consolidation in that industry. A small number of national players have emerged. In most industries, that leads to improved profitability. Time will tell if that happens here.

IBD: Do you thinkCapital One ( COF ) in particular has a strong franchise, good management and attractive growth opportunities?

Pohl: I agree with those factors. Also, its valuation is quite inexpensive.

If you look at how banking has evolved, they have a large portion of business from credit cards and they are technology-driven. They're able to expand that into automobile lending. And they have the biggest direct-mail deposit-taking.

All are branchless activities. They do have a branch structure. But it's reasonable to assume as they move forward in time, more financial services will not require as much branch structure as in the past. They are well positioned for that industry evolution.

IBD: You buy stocks when the share price is attractive. IsGoogle ( GOOG ) still attractive to you, given its long run-up?

Pohl: We started to invest in Q3 2012 when we saw valuation drop to the mid or high teens on earnings. Investors were skeptical about the company's transition to mobile search and whether they could maintain their dominance.

And spending on mobile and growing their display advertising and other services also pressured their margins.

Now the company has been quite successful in the mobile arena and monetizing expensive search franchises.

So we're asking ourselves, do we like their long-term growth prospects? Buy-and-hold does not mean buy-and-forget. We nudge positions up and down as situations change.

IBD: NVR's ( NVR ) earnings per share rose 13%, 71% and 77% the past three quarters. But this is a small position for you. What's your thesis?

Pohl: We've gone through a long and severe recession in homebuilding. There's a lot of pent-up demand. We've reached a high in terms of multigenerational households because younger people are not buying homes.

That makes the whole industry interesting, because that can correct and be a tail wind.

With NVR, the company spent time restructuring themselves as an efficient builder of homes. The way they design and construct homes, they almost manufacture them, and they do it in a more standardized and thoughtful way than many other homebuilders. That is attractive.

So our stake is not just a bet on a homebuilder recovery. It is a bet on a particular management team and business structure that delivers value to customers by building better products at lower cost.

IBD: You slightly trimmedComcast (CMCSA) between June 30 and Dec. 31. What were your concerns?

Pohl: I wouldn't say concerns. It's a wonderful franchise, wonderful management. Management is shareholder-oriented if for no other reason than they are big shareholders too. They've done quite well over the past year, so their valuation keeps getting higher. As value managers, as valuations get higher, we tend to trim.

IBD: You cut your stake inDow Chemical (DOW) to 17,187 from 10,651 from June to year-end as shares rose 38%. Another valuation cut?

Strandberg: They've weathered some extraordinary circumstances. They came through the financial crisis, transformed themselves into global leaders more focused on specialty than commodity chemicals. We saw more compelling opportunities elsewhere, and other investors were enamored of the company.

IDB: Express Scripts (ESRX) is another health name you added in 2013. Am I right in thinking you like the Medco Health acquisition?

Strandberg: We started our position in late 2013. They're the largest pharmacy benefit manager. We see scale in terms of enormous return on invested capital, with an asset-light model. And they generate significant free cash flow.

The ACA (Affordable Care Act) should help them generate more earnings as more people become insured and have access to medicine and doctors.

And there's synergy with the Medco acquisition.

IBD: You've boosted your stake inAOL (AOL) in your most recent six-month period. Why?

Pohl: They've had their traditional business going away over time, and their attempt to build a business that is relevant today. It's an Internet business with content and advertising.

Some of those projects, such as Patch (a local news and information platform), haven't worked out. Other parts have worked better.

They had an expensive patent portfolio, which they sold toMicrosoft (MSFT). That generated a lot of cash. It's an evolving situation, with a lot of moving parts.

IBD: McGraw Hill (MHFI) shares have trended higher despite earnings per share growth decelerating for two quarters in a row. What's your play?

Pohl: Their S&P unit's fixed income securities ratings are a big part of their business. We've noticed that S&P ratings are written into guidelines and contracts and, in some cases, laws. Many institutional investors have quality guidelines based on S&P and Moody's ratings, which prohibit them from investing in below-investment-grade securities, for instance.

So it's not easy for many institutional investors not to use S&P's services, which gives S&P pricing power. And we've seen a lot of opportunities of growth, not just in the U.S. but outside it as well.

IBD: You've boosted your stake ineBay (EBAY) to nearly 11.4 million shares in your most recent six-month period from 6.4 million. Why so much love?

Pohl: Over a long period of time, this is one of the great economic transformations in our era, the introduction of the Internet. So we see growth over time, real organic growth in eBay's base business.

We also see a lot of value and potential future value in PayPal. They continue to build that business and find ways to increase people's use of it.

So you've got two attractive growth engines. And unlike some Internet-related growthier businesses, they haven't taken on an exceptionally high multiple.

IBD: IsTE Connectivity 's (TEL) valuation still attractive, given its run-up since May 2012?

Pohl: People who make cars, things that use electronics, need connectors for electrical devices.

So the long-term story is that you have growth in electronics, which gives you growth in connectors.

TE Connectivity is the biggest company in this business, so they have an attractive market share. They have a strong management team. And it's a globalized business, so they have exposure to growth outside the U.S. And it still sells at a fairly reasonable valuation.

IBD: Connectors are not a sexy product.

Strandberg: The connector business is entrenched. Connectors aren't a big portion of the total cost of what goes into a car, but if it fails, it's a real disaster. So you want something with 100% reliability. When you have a reputation for quality and innovation, the way they do, it is a very strong position, very sustainable.

IBD: Merck (MRK) recently broke a streak of four quarters of declining earnings. Why did you stick with them through their rough patch?

Pohl: We like pharmaceuticals. It's inherently an area of organic growth with technological innovations plus demographic changes which lead to demand for more health care, including in emerging markets. The whole industry went through a period of patent expirations on big blockbuster drugs, and lot of years without new drugs.

But now there seems to be optimism that the industry will come out with attractive new compounds. Merck is one of the innovation leaders.