Dodge & Cox International Stock Fund

We talked with a Dodge & Cox representative on 9/22/2010 about their International Stock Fund. This is one of the “core” funds we typically use in client portfolios (and our own). Dodge & Cox is employee owned; you cannot own shares if you are not currently an employee. There are a significant number of long-tenured employees, and Dodge & Cox has low employee turnover. Everyone is compensated based on firm performance. They feel that is appropriate because it encourages idea and information sharing and because the analysts work on multiple funds

The International Stock Fund has assets under management (AUM) of about $33 billion. It is a low cost fund with an annual management fee of 0.65%. Morningstar calculates that the average fund in the category has an expense ratio of 1.44%. The Fund typically holds from 70-100 names. At the end of the second quarter it had 92 names.

Like all Dodge & Cox funds (they only have five), the International Stock Fund is value oriented. The portfolio is built stock by stock from the universe of companies domiciled outside the U.S. with a minimum market cap of $2 billion. The responsibility for finding the stocks for the portfolio is placed on the firm’s analysts. The analysts typically have global responsibility for multiple industries. They look at a variety of valuation metrics:--price to book, price to cash flow and price to earnings--but there is not one that is dominant. They also look across a company’s entire capital structure given that Dodge & Cox has a bond and a balanced fund.

Analysts develop financial models with 3-5 year forecasts that look at downside, base case and upside surprises as part of a comprehensive assessment of the investment merits of a particular company. Beginning in 2008 Dodge & Cox started formally assigning a devil’s advocate to every investment idea to try to poke holes in the investment thesis. Investment ideas are presented first to a sector committee to vet the analyst’s research and then it is presented to the Policy Committee. This committee not only discusses the investment idea, it also sets the target weights. (Typically an initial position is ½% of AUM, emerging markets positions might start smaller.) The Policy Committee also has responsibility for monitoring regional, industry and sector weightings. Still, the portfolio is built stock by stock with the best ideas from its analysts.

There are very few prospectus restrictions on what the fund can own, how many countries it needs to be in and how many sectors need to be represented. However, the portfolio has been invested in almost all sectors (as defined by Dodge & Cox) almost all the time and has been invested in a minimum of 18 different countries since the fund was started. So, in practice, the fund has been much more diversified than required by prospectus.

The fund currently has a weighting of over 20% in emerging markets. Again there is no prospectus limit but that is the highest it has ever been and seems to be near an informal limit. While the fund continues to have no investments in China because of concern over governance issues, it does own a number of stocks with exposure to China.

Currently, the firm is very excited about equities across the globe. Given the global focus of their analysts, it is interesting to note they are finding, more ideas in the U.S., on the margin, than they have at other times.

We really like the Dodge & Cox International Stock Fund. The research driven, consistent pursuit of the best ideas outside of the United States has led to excellent long term results. While the fund can be volatile (as seen during the 2008-2009 period), we think it is a great way to get exposure to international stocks. We respect the firm’s decision to avoid China, but recognize that will keep the fund out of one of the faster growing, more important countries in the world. We do view it as a core fund for many of our clients.

Returns through 8/31/2010

	YTD	1 Year	3 Years	5 Years	Since Inception*
Int’l Stock Fund	-5.02%	2.68%	-8.35%	2.89%	7.66%
MSCI EAFE	-7.97%	-2.36%	-10.76%	0.95%	2.90%

Source is Dodge & Cox
* Inception is 5/1/2001

(Harvest Financial Partners owns the Dodge & Cox International Stock fund in client portfolios.  The authors own it and the Dodge & Cox Stock Fund in their personal portfolios.  Positions may change at any time)

The Fairholme Fund

On her August 27, 2010 show, Wealthtrack, Consuelo Mack interviewed Bruce Berkowitz of the Fairholme Fund.  (Here is a link to the transcript and to the video.) We like Fairholme and have used the fund for our clients since we started Harvest (and have personally invested in the fund for much longer).  The fund and its managers have rewarded that decision, having a fantastic relative and absolute 10 year track record, so fantastic that Morningstar named Mr. Berkowitz its domestic stock fund manager of the decade. 

While we are comfortable with the people, the investment philosophy and the implementation of that philosophy, we are watching two developments with the fund.  First is size, not surprisingly Fairholme has attracted a lot of new investors, pushing the fund size to $15 billion.  Historically, as the size of a fund has increased, relative outperformance has declined. No less an investor than Warren Buffett made that same point.  He wrote in his latest Berkshire Hathaway shareholder’s letter (as he has previously):

The big minus is that our performance advantage has shrunk dramatically as our size has grown, an unpleasant trend that is certain to continue..But huge sums forge their own anchor and our future advantage, if any, will be a small fraction of our historical edge.

Mr. Berkowitz, in the interview, claims that the large size of his fund is an advantage and that it gives him an opportunity to make investments he could not have made in the past.

The second area we are watching is Fairholme’s large position in financials such as AIG, MBIA, Citigroup, CIT, Bank of America and Goldman Sachs.  According to the interview these stocks represent about 60% of the fund’s stock holdings.  (Fairholme has one third of the fund in cash and fixed income.)  Our issue with financials, particularly banks, is that it is difficult to know what the assets are really worth even after looking at the companies’ financial statements.  In the interview, Mr. Berkowitz discusses why he thinks financial stocks are good values with limited downside.

Now if any manager has earned the benefit of the doubt, it’s Bruce Berkowitz and his team at Fairholme.  And while we would not call ourselves doubters, we will be watching to see how the fund manages the size issue and how the large investment in financials plays out.

(Harvest Financial Partners holds this fund in some of its clients' portfolios. The principals of Harvest also own the Fairholme Fund. Holdings may change over time.)

Why We Love Dividend Growth

As this column from the Financial Times shows, owning stocks that grow their dividends often provides many happy and profitable returns. That's one of the reasons we are willing to own a stock that might not be paying a high dividend currently but shows the capacity to grow its dividend in the future.

(If you cannot read the article on FT's website, email us.)

The Jensen Portfolio

We had a call with the Jensen Portfolio (JENSX) on February 19th 2010. We spoke with Richard Clark Director of Sales and Marketing and Bob Millen, the Chairman and Portfolio Manager. Here is what we found out:

Jensen wants to own 25-30 quality growth companies in the fund. In order to find those names it looks for companies with a minimum market capitalization of $1 billion. It narrows this universe of stocks by looking for those companies that have generated a minimum of a 15% return on equity (ROE) for at least ten consecutive years. The 15% ROE for ten years is based on academic research from a Harvard professor who studied firms with these two characteristics over the period 1965-75. The research indicated that ten years of 15% ROEs was long enough and sufficiently difficult to achieve to demonstrate that the business had a sustainable competitive advantage. Jensen has continued to examine this conclusion over its 21 years in existence and finds the 15% ROE continues to be a good proxy for a return greater than the cost of capital. Ten years also seems to show a good time period for a sustainable completive advantage.

Quality for Jensen means:
• Good financial strength
• Consistency in business performance
• Sustainable competitive advantage
• Shareholder friendly management and

The 15% ROE for 10 consecutive years hurdle limits their universe to about 200 stocks. The fund only buys US based companies as they find them easier to analyze. Jensen feels they can obtain foreign exposure through foreign sales of these companies.

Finalists for inclusion in the portfolio have a 40-50 page business report prepared with detailed models. The reports contain the information you would want “if you were considering buying the whole company.” They then visit management and determine a target price.

Jensen values companies based on a discounted cash flow (DCF) analysis and only will buy those companies that trade at a significant discount to this value. Jensen’s DCF analysis has grown more sophisticated over time by incorporating year-by-year cash flows and alternative DCF models, some using industry and others company specific discount rates. Jensen also enhanced its analytical capabilities by adding three experienced analysts.

In constructing the portfolio, Jensen does not pay a lot of attention to a company’s or a sector’s weight in the S&P 500 (the index against which it measures itself) but is certainly aware how it compares to the index. Decisions are made by 8 member investment committee. And turnover has averaged 15-20% (implying a holding period of 5 years).

Some recent buys in the fund include:
• C.R. Bard – manufactures catheters and is ranked #1 or 2 in 80% of its sales. The company has strong R&D and its products are relatively low cost and often part of a procedure so they fly under the reimbursement/cost containment radar.
• Oracle – management team has depth. Millen also believes that M&A has become a core competence, so now Oracle can offer the whole “stack” of products from database to middleware to applications unlike IBM or SAP.

They believe the portfolio is well positioned with an historically low price to value ratio, though not as low as in 2008. Typically, the Jensen portfolio has traded at a 25% premium to the S&P 500 price/earnings ratio, but now it is on a par with the index. This made Millen quite optimistic about the prospects for the portfolio.

Jensen has become a bit more active in its portfolio management, for example they will “tweak” portfolio weightings based on business performance and price/value so own more of its highest conviction names.

Jensen has three elements to its sell discipline:
• Company breaches the 15% ROE threshold – indicates a fundamental change in business prospects. This results in an immediate sale.
• Price exceeds intrinsic value – Jensen will sell the remainder of its position.
• lf they can replace a stock with one that represents better value

Some examples of recent stocks they have sold include:
• Wells Fargo – it breached the 15% ROE
• GE – they lost confidence in its ability to be a growth company

At this point the Jensen Fund is the firm’s the only mutual fund but in the near future Jensen will be offering a new fund based on some research they did into their universe. The new fund may place more emphasis on valuation than the current Jensen Fund. Currently they are in a quiet period so they could not discuss the new offering.

Overall, while their approach modestly differs from ours (for example Jensen does not require stocks they own to pay a dividend), Jensen has a number of high quality names in common with our portfolios. We like the disciplined approach that the company uses to construct its portfolio, but also are pleased to see that they are constantly looking for ways to improve their process. We continue to believe the Jensen Portfolio is a very worthwhile holding for investors.


(Harvest Financial Partner holds this fund in some of it client portfolios. Holdings may change over time)

4th Quarter 2009 Quarterly Letter to Clients

2009 was quite a year. We had one of the best years for the stock market in the last decade, but who would have guessed that last March? Back then, we wrote that stocks were due for a bounce, and boy what a bounce we got. We never expected a move of the magnitude we experienced, so we will chalk that up as a pleasant surprise—our favorite kind!

But as we look back over the year, we were generally cautious (and we still are). While we never moved out of the market, we also were not aggressive enough buyers last winter and spring. In retrospect, we held onto too much cash. Our goal is to protect our clients’ capital, and as stocks rapidly rose last year, we expected a pullback that never came. Our caution left us holding cash waiting for cheaper prices. We still are!

What has been interesting is that we are finding more intriguing ideas today than we have in several months. It is not because we have lowered our standards, but because there are quite a few companies that missed out on most of the market run up or who have seen a large improvement in operating performance. Our caution on the market and economy has not diminished, but we build stock portfolios one company at a time and there are still opportunities out there.

In the case of the mutual funds we use, we have faith that the managers will also remain disciplined. And we have to point out that a number of the mutual fund managers we invest with had stellar 2009 performance.

In addition, two of our managers – David Herro at Oakmark International Small Cap and Bruce Berkowitz at Fairholme won Morningstar’s Manager of the Decade awards for Foreign and Domestic equities, respectively. Mr. Berkowitz also was named the Domestic Equity manager of the year. We would also point out that over ten years ending 12/31/2009 the S&P 500 index returned negative 1% per year--the lost decade that so much has been written about. However, every one of the funds we use generated a positive ten year return (if they had been around for the entire decade).

As impressive as this past performance has been, we know it guarantees nothing. It does, however, reinforce a portion of our mutual fund selection process: we look for managers that utilize an understandable process which has successfully grown their investors’ capital over time. We plan to keep selecting mutual fund managers the same way and sincerely hope it continues to produce similar results.

The bottom line is that there are good investments available, but you just need to be careful and disciplined. We think that is true in any market environment. Our cash holdings have us ready for opportunities presented by the market. To quote Bruce Berkowitz: "cash becomes quite valuable under adverse conditions.”

We wish all of you a happy and healthy 2010. We intend to work hard on your behalf and remain available to help you with any financial matters. Please feel to contact us anytime with questions or concerns.