The managers of this Kiplinger 25 fund see good deals in the pharmaceutical sector. By Bob Frick, Senior Editor July 28, 2011 The managers of Dodge & Cox Stock (symbol DODGX) think the market is wrong about drug stocks. In their view, investors are overly pessimistic about the group, and that has led to a large number of bargains. So they have loaded their fund, a member of the Kiplinger 25, with drug stocks. Dodge & Cox’s long-term record suggests that the managers are more likely to be right than wrong. Despite a hiccup during the 2007-09 bear market, D&C Stock returned an annualized 5.2% over the past ten years (through July 26). That beat Standard & Poor’s 500-stock index and the typical large-company value fund by an average of 2.2 and 1.6 percentage points per year, respectively. Year to date, the fund has returned 5.8%, lagging the S&P 500 by 1.2 points and leading the average large value fund by 0.5 point. Dodge & Cox is a low-key San Francisco money-management firm with a taste for good deals. Its stock funds, all team-managed, buy bargain-priced merchandise with the idea of holding companies for three to five years -- usually time enough for the market to realize its mistake and bid up the prices of stocks in D&C portfolios. Here’s how Charles Pohl, D&C’s co-president and chief investment officer, sees the pharmaceutical sector: Drug-stock valuations are at historic lows. That’s because investors worry that “you’ve had very few new blockbuster drugs that have been introduced, plus you have a number of really big drugs that will be going off patent.” On the surface, he says, the chance of drug companies maintaining, let alone boosting, their profits, seems dim. The unknowns surrounding health care reform also weigh on the sector. Advertisement But the managers and analysts at D&C think others don’t appreciate all the new products that will soon come out of the industry’s labs. Expect several companies to win regulatory approval for drugs that have the potential to be blockbusters, Pohl says. Another plus: Developing nations now account for 20% to 30% of big pharma’s sales, says Pohl. He expects that percentage to rise as people in emerging nations “get more disposable income to spend on health care to improve their quality of life.” As for health care reform, the Dodge & Cox managers see it as a nonissue, perhaps even a plus. “Pharma companies came through the legislation in pretty good shape because they avoided price controls,” says Pohl. The legislation will increase demand for health care services, including drugs, he adds. Although any serious budget-deficit-reduction legislation will lead to “a lot of pressure on health care costs,” says Pohl, cuts will generally have little impact on drugs. All told, Dodge & Cox Stock at last report had 21% of its $44 billion in assets in health care stocks, mostly drug companies. That compares with a 12% allocation in health stocks for the S&P 500. Top drug holdings include Merck (MRK), Switzerland’s Novartis (NVS) and the United Kingdom’s GlaxoSmithKline (GSK). Advertisement In contrast to its big overweighting in health stocks, Dodge & Cox Stock has only a slightly above average allocation to financial stocks -- 16.3% in the fund compared with 14.8% in the S&P 500. This was a sector that contributed mightily to the fund’s downfall during the 2007-09 bear market, when Dodge & Cox misread the severity of the financial crisis and held on too long to the likes of Wachovia, Fannie Mae and American International Group. In June 2008, fund officials told clients that the stocks were good values because their prices had sunk more than their businesses had deteriorated. Of course, prices would fall much further. It was a rare and costly slip for Dodge & Cox Stock, which, since its 1965 launch, has generally done a fine job of making judgments at both the company and industry levels. Pohl admits, though, that his team is having trouble reading the political tea leaves, particularly as they pertain to Europe’s credit woes and our own budget-deficit and debt-ceiling problems. “Some of this political stuff is really hard to handicap,” he says.