What Went Wrong at Dodge & Cox

Can You Feel the Hate
I wouldn't say everybody hates Dodge & Cox now. Judging from my e-mail, though, the firm has ticked off a lot of people. All five of the boutique's funds have gotten slaughtered in 2008, especially its domestic and international equity funds which, this year, loaded up on many of the poster children of the crash of 2008.

I've been getting a steady stream of messages asking, "Have they lost it? Fannie Mae? AIG? Wachovia? What were they thinking? I thought these managers were supposed to be experienced and smart! Couldn't they see this coming? How could you still recommend this fund?"

A lot of investors haven't waited for an answer. Shareholders have streamed out of the fund as fast as they were piling into it a few years ago. For the year through Oct. 27, the firm saw $6.7 billion go out the door of its mutual funds, according to Morningstar estimates. The stock and balance funds have been hit the hardest with more than $2 billion and $3.3 billion in outflows, respectively, so far. Redemptions at  Dodge & Cox International , however, have accelerated in recent months as that fund has foundered.

What Were They Thinking?
I think investors selling these funds are mistaken. But they have a right to be disappointed and even angry. Dodge & Cox has made some colossal blunders. As far back as 2003 the firm cautioned investors that future equity returns were unlikely to be as strong as they had been, but the magnitude of what has transpired makes those warnings seem weak.

And just what happened? How did a firm with such an enviable long-term track record and reputation for sober, in-depth fundamental analysis end up with so many time bombs? Based on recent and past conversations my colleagues and I have had with the firm's managers, as well as the funds' portfolios and shareholder reports, I don't think they lost their minds or chucked their process. Indeed, they seemed cognizant of the financial sector's risks. As recently as 2006 the Stock fund had less money in financials than its benchmark and peers because the managers thought the stocks' valuations unrealistically assumed profits would stay high and credit losses low. Even after boosting its financials stake after the credit crisis broke late in 2007, buying  AIG , adding to Wachovia , and in the first half of 2008 picking up  Fannie Mae , the managers were hardly cheerleaders.

In the firm's June 30 semiannual shareholder reports, they acknowledged the companies faced big challenges, but noted they also had raised significant capital. The managers even tried to model what the stocks would be worth in worse case scenarios, such as if AIG had to absorb significant losses from its derivative, credit default swap and mortgage insurance portfolios. The problem was reality turned out much worse than their worse case scenarios--a costly error made by many others, including  Legg Mason Value's Bill Miller and  Selected American's Chris Davis and Ken Feinberg.

Wachovia is a good example of went wrong. The managers liked the bank's strong retail franchise, solid base of deposits and tight lending standards. They acknowledged the housing crisis and slowing economy could make things difficult for the company, perhaps even forcing it to raise more capital and cut its dividend. But the company's share price reflected an even more dire future than that, the managers said.

They weren't pessimistic enough, it turns out. Fannie Mae,  Freddie Mac , Lehman Brothers,  Merrill Lynch , AIG, Washington Mutual, Wachovia each met ignominious ends via failure, government seizure, or forced mergers as panic gripped Wall Street. Dodge & Cox knew AIG would need a lot of cash, but not $85 billion (a sum that reportedly stunned even former CEO Hank Greenberg). It knew the housing crisis would get worse before it got better and companies like Fannie Mae and Wachovia would struggle, but it did not assign a high enough probability to the chaotic unraveling we witnessed and the government's aggressive, uncompromising response to it.

Future Present
This is not Dodge & Cox's finest moment. But no amount of Monday morning quarterbacking will undo the firm's miscalculations. The questions for investors now are these: Does this dismal patch of performance reveal some tragic flaw? And can Dodge & Cox learn from this and move beyond the crisis?

The firm gets an F for failing to accurately handicap extremely rare, but potentially catastrophic events, or, in the words of author Nassim Nicholas Taleb, "black swans." Especially as a housing-ignited credit meltdown wasn't completely unforeseeable. Authors like Taleb, economists like Robert Schiller, and investors like FPA's Bob Rodriquez and GMO's Jeremy Grantham had warned of a real estate and credit bubble for years. Furthermore, making big bets on AIG, Wachovia, and Royal Bank of Scotland, another bank that needed a lifeline, as  Dodge & Cox Global did after Bear Stearns collapsed and conditions got increasingly weird, looks almost reckless in hindsight.

Yet, I don't expect Dodge & Cox to excel at predicting panics, bank runs, and emergency government interventions. I expect them to look for stocks and bonds trading at prices that underestimate the companies' long-term earnings potential, and to invest where they have a lot of conviction. True value contrarians go where others fear to tread, so Dodge & Cox's foray into financials was consistent with their time-tested style. And despite what some investors came to believe this decade, that style has its risks. The strong performance of value strategies in the 2000-02 bear market and in subsequent years lulled some into believing funds like Dodge & Cox would protect them in every bear market. That even the best-performing value funds have fallen hard this year and veteran bargain hunters such as  Weitz Value's Wally Weitz and  Third Avenue Value's Marty Whitman have struggled should disabuse people of that notion. It should also remind them that even seasoned, accomplished managers can stumble--hard.

They've Fallen and They Can Get Up
I think the firm can and already has learned from this experience. In the short term it has assigned a team of fixed-income specialists to examine the balance sheets of the firm's equity and bond holdings to make sure the issuing companies have enough cash to survive a prolonged credit market lock down. The long-term lessons are still being learned because this drama is still playing out. But if any firm has the temperament and perspicacity to turn this distressing experience into something useful, I think it is Dodge & Cox. The average manager there has more tenure than the vast majority people running funds today. The senior investment team members have lived through rough periods before and are some of the most thoughtful and long-term focused people I've encountered in nearly a decade of writing about funds. I don't expect radical modifications to the firm's investing process. In fact, I'd be more worried if they did decide to go back to the drawing board. I do, however, expect the historic events of the past year to augment the firm's store of institutional knowledge that stretches back eight decades and informs everything they do.

I'd also be more concerned if Dodge & Cox hadn't lagged its peers and benchmark only to bounce back before. In 1998 the Stock fund trailed 88% of its competitors and the S&P 500 and Russell 1000 Value indexes by wider margins than it does today. Though the equity and Balanced funds did make money that year (which is far easier to take than 40% losses), many still asked if the firm had lost its touch then, too. But the fund followed up with seven straight calendar campaigns in the large-value category's top fourth and beat the S&P 500 in seven of the next nine years.

There's no guarantee Dodge & Cox funds will snap back like they did in the past. Sure, you could switch to another manager who hasn't yet hit the skids or to an index fund. But Dodge & Cox retains many simple, enduring long-term advantages besides experience and a long memory. Its process is consistent and has been tested and found worthy in previous crises. Its expense ratios are among the lowest offered by active managers; and the firm's culture remains trustworthy due to its focus on investing and its investors rather than marketing. These are all traits that we at Morningstar and others have found to correlate with long-term success.

Plus, the firm doesn't just need financial stocks to come back to regain ground (though it would help). For years the Stock fund also has been building positions in more growth-oriented stocks in the health-care and technology sectors whose share prices, prior to tanking with everything else this year, hadn't kept up with their improving profitability. More recently the fund also has been adding to hard-hit consumer-services stocks. Such holdings give the firm's equity funds a good shot at participating in a recovery no matter what style or sector leads the market out of this trough.

So, while Dodge & Cox has not been the firm of the moment, it is still a good fund family for the future.