What Went Wrong at Dodge & Cox?

There’s a lot to like about Dodge & Cox, the sedate San Francisco fund manager. The firm keeps a low profile. It doesn't advertise or chase fads.

Instead, its long-tenured managers focus on running just five low-cost funds. The managers and other Dodge & Cox employees own the firm and invest their wealth side by side with outside shareholders.

Over the years, D&C's disciplined and long-term-oriented investment process has handsomely rewarded loyal shareholders. For instance, during the 20 years through November 30, 2008, Dodge & Cox Stock (symbol DODGX returned an annualized 10.2%.

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That was an average of two percentage points per year better than Standard & Poor's 500-stock index, an impressive feat, and good enough to land Stock among the top 10% of all funds, according to Morningstar.

Recently, though, Dodge & Cox has seemed almost accident-prone, and all of its funds have posted weak results. D&C Stock, for example, lost 46% in the first 11 months of 2008, seven points worse than even the execrable performance of the S&P 500 and a basket of large-company value funds.

Dodge & Cox Stock has been mired in slumps before. From 1995 through 1999, the fund trailed the S&P index by an average of seven points a year (by contrast, the fund beat the index by a resounding 11 points a year from 2000 through 2006).

But in many ways today's slump is more painful. Not only are the actual losses of wealth severe, but the money invested in financial companies that collapsed is gone for good. This sin of commission is much worse than its sin of omission (no sin at all, really) in the late 1990s, when D&C managers stuck to their value-investing principles and declined to chase Internet and other ridiculously frothy stocks at the height of America's epic stock-market bubble.

Measured Process

So what's gone wrong at Dodge & Cox, and can it and its funds rebound? Before conducting a postmortem of Dodge & Cox's disastrous foray into the minefield of financial stocks, let's review the firm's disciplined, research-intensive investment process.

Most investment ideas (and stock-sale decisions) percolate up from the firm's analysts and are then carefully weighed by various investment-policy committees, which consist of seasoned portfolio managers. It's a collegial, consensus-driven, bottom-up process.

D&C analysts and managers, says the firm's chairman, John Gunn, focus on financial measures, such as com-panies' sales, earnings, cash flows and dividends, as well as qualitative aspects, such as strength of business franchise and management. They assess growth prospects over five years (considering a range of outcomes and risks), look at the current stock price and decide whether to strike.

When Dodge & Cox people say they invest for the long term, they really mean it. Vice-president Diana Strandberg speaks of investing in stocks that can be locked up in a safe-deposit box for five years (an average holding period). "It's a tremendous advantage to have a long-term compass in periods of intense volatility," she says.

Over the years, the rigorous research efforts and long-term horizon have paid off. For instance, D&C Stock has reaped large gains over the long run in stocks such as FedEx, Hewlett-Packard and Wells Fargo.Clearly, the professionals at Dodge & Cox are thoughtful, patient and sober investors. So where did they come unstuck? Their main error was to gravely underestimate the risks in financial stocks -- such as American International Group, Fannie Mae and Wachovia -- that its funds loaded up on.

At the end of 2006, Stock actually held a below-average weighting in financial stocks: 14%, compared with the sector's 22% weighting in the S&P 500. After the subprime-mortgage and credit crisis began to erupt in mid 2007, financial stocks started to tumble. As prices of financial stocks plunged in the second half of 2007 and the first half of 2008, Dodge & Cox was buying. By June 2008, Stock was overweight in financials, with a 17% allocation, compared with 14% in the index. In the letter to Stock shareholders reporting on the second quarter of 2008, the managers wrote: "We have selectively expanded the Fund's financials weighting because in our opinion their valuations have declined more than their underlying long-term fundamentals have deteriorated."

Just a few months later, the roof caved in on financial stocks.

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Gunn, who joined the firm in 1972, explains the debacle this way: Dodge & Cox had managed through banking crises before, including calamities in the early 1980s and early 1990s. Stock had historically made good money on bank shares, such as Wells Fargo, that were purchased during these periods of duress and distressed stock prices.

Gunn and D&C president Ken Olivier ascribe much of the blame today to unforeseen government actions and response to financial panic. In previous crises, Gunn says, the government practiced forbearance and provided the banks with enough breathing room and flexibility to tide them over during the emergencies. "What always happened was that regulators made sure there was a tomorrow," he says.

In the banking crisis of 2008, especially after the collapse of Lehman Brothers in September, the government massively intervened in the banks, in several cases virtually wiping out shareholders such as Dodge & Cox. "The government by its actions destroyed capital in the financial institutions and discouraged private capital," says Gunn. "It threw gasoline on the fire."

For instance, in the summer of 2008 the government said Fannie Mae was adequately capitalized. Three months later, in Gunn's words, the government "threw it under a bus." Gunn says his analysts researched and carefully stress-tested Wachovia. But after Washington Mutual unraveled and there was a run on Wachovia's deposits, the government engineered a shotgun wedding between Wachovia and Wells Fargo. The colossal government rescue of AIG protected bondholders but not shareholders. Stock's third-quarter letter says that "regulators crafted arrangements to address broader systemic concerns at the expense of each company's shareholders."

D&C's investment process and five-year models always build in pessimistic scenarios, says Olivier. But the firm's analysis never foresaw the prospect of government intervention. "With hindsight," Olivier says, "it's hard to defend our investments in the banks. We misjudged the situation."

Interestingly, other noted bargain hunters whose investments in financial stocks were similarly crushed in the maelstrom also blame government policies and actions. Legg Mason's famed Bill Miller writes that the government decision to let Lehman go bust was "a mistake of historic proportions," which "created a whole new crisis in global credit markets."

This tendency to blame bumbling, haphazard and inconsistent government action is understandable, but not entirely satisfactory or convincing. Some economists -- such as John Makin, of the American Enterprise Institute, Nouriel Roubini, of New York University, and John Hussman, of Hussman Funds -- had been warning for years about the gathering storm clouds and the real risk of systemic collapse stemming from excessive leverage, appalling lending standards and unregulated credit derivatives.

Nor were the prophets of doom all big-picture economists. At the FPA funds, Bob Rodriguez and Steve Romick had been warning for years about enormous risks building in the financial system. The pair boycotted bank stocks and bonds (except, in Romick's case, to bet against some financial stocks by selling them short).

Value investors, such as Bruce Berkowitz, of Fairholme fund, and John Osterweis, of Osterweis fund, say they analyzed AIG, which seemed dirt cheap on paper, but passed on the global insurance giant's stock because they decided that the balance sheet and derivatives accounting were too complex and opaque.

Complexity risk in financial stocks was a killer in this treacherous market. In January 2008, Ben Inker, of GMO, a large Boston money-management firm, wrote an essay titled "Our Financial House of Cards." In the piece, Inker cautioned that uncertainties were so great in the U.S. financial system that it was wise to avoid financial stocks entirely. "The magnitude of the unknowns is such that we mere mortal analysts cannot hope to know what the true values of the companies are," he wrote.

For whatever reason, D&C analysts and managers failed to grasp the possibility of systemic collapse and were therefore unable to identify worst-case scenarios for financial stocks. Says Gunn: "The threat to value investors is the 100-year flood. To some degree, this is the 100-year flood."

Another way to explain Dodge & Cox's blind spot is to go back to probability theory and statistics. On a bell curve of potential outcomes, the firm failed to recognize the statistical outliers -- possible but improbable events that can be hugely disruptive and destructive if they occur.

GMO's Jeremy Grantham, who presciently commented for years on the unfolding "slow-motion train wreck" in the financial sector, offers an intriguing theory about the minority of investors who were able to anticipate the 100-year storm. "They're all right-brained: more intuitive, more given to developing odd theories," he writes. "They are almost universally interested -- even obsessed -- with outlier events, and unique, new and different combinations of factors."

Not Just Financials

We'd be remiss if we didn't mention that Dodge & Cox also made a series of investment blunders outside the financial realm. For instance, it bought shares of both Ford Motor and General Motors in the first quarter of 2008. Its investments in Motorola and Sprint Nextel have been dreadful. In the cases of Citigroup, Motorola and Time Warner (another loser), Dodge & Cox seems to have been enticed by low valuations but underestimated the ability of poor executive teams and corporate cultures to destroy shareholder value over the years.

So how should an investor view Dodge & Cox? You may be surprised to learn that we still think Dodge & Cox funds are fine choices for long-term investors who seek to beat the indexes.

Why? This is a fine, proud, high-quality company populated with competitive and serious high achievers who have heavily invested in their own funds. They will learn from their investing mistakes. The firm's long-term record is outstanding, the investment process has worked, and the institutional memory is strong. Plus, annual fees are as low as they come for actively managed funds (Stock's annual expense ratio is 0.52%; International Stock's is 0.65%).

Still, Dodge & Cox could benefit from adding some intuitive, right-brained types to a staff replete with left-brained Stanford and Harvard graduates. That might help the firm anticipate the next 100-year storm before it hits.

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