Oakmark Select Fund: Third Quarter 2018

The Oakmark Select Fund was up 0.3% for the quarter, trailing the S&P 500 Index’s 7.7% return. For the fiscal year ending September 30, 2018, the Oakmark Select Fund decreased by -0.1%, compared to the S&P 500’s 17.9% gain. As shareholders of the Fund and stewards of your capital, we are quite frustrated with this performance, but we continue to follow the same disciplined investment process that has led to our strong performance over the longer term.  As referenced in the third-quarter market commentary, the market’s recent general repudiation of our investment beliefs is magnified in the Select Fund, given its higher level of concentration. We’d like to use this letter to put this recent underperformance into context.

The Select Fund was started in November 1996. An investor who bought and held the S&P 500 from that date until now has earned slightly more than six times their initial investment. An investor who bought and held the Select Fund for the same period now has over 12 times their initial investment—more than twice the capital of the S&P 500 investor.

Even with that long-term record, the Fund has regularly endured long periods in which the S&P 500 fared better. In 50% of the Fund’s 252 rolling 12-month periods, the Select Fund has trailed the S&P 500.  Stretching the time period to three years, the Select Fund still trailed the S&P 500 43% of the time. Even when we move out to five years, the Select Fund fell short of the S&P 500 35% of the time. Yet despite all of these periods of underperformance, the Fund still generated more than double the S&P 500’s return over that 22-year period.

If an investor waited to see five years of market outperformance before investing in the Oakmark Select Fund and then sold the Fund after five years of underperformance, entering and selling the Fund each time one of those triggers was met, here are the results (based on an initial investment of $10,000 in November 1996):

Clearly, attempting to chase trailing performance has been a poor strategy. Long-time shareholders understand that we invest in companies that we believe are selling at large discounts to their intrinsic values, and these stocks are often terribly out of favor with other investors. But if we’re right about these companies’ underlying values, then their cash flows should eventually win out, the market will come around to our view, and the stock prices will eventually rise to our estimate of value. No one can tell the precise moment when this will happen, and if investors only focus on past results, they could miss out on periods of strong performance.

Patience, therefore, is a necessary virtue in value investing. But stubbornness in the face of contrary evidence most certainly is not. We conduct regular retrospective looks on all of the securities across the Oakmark fund complex. We particularly pay attention to companies that are falling short of our expectations. In fiscal 2018, new information led us to conclude that the negative consensus view was probably more accurate than our optimistic view for three holdings that fell short of our expectations: General Electric (GE), Harley-Davidson, and Adient. We sold Harley-Davidson. Both GE and Adient, however, brought in new management teams, and the most valuable parts of both companies’ businesses (Aviation and Healthcare within GE, and Seating within Adient) have been performing essentially in line with our expectations. We also believe that both companies are currently hobbled by less significant divisions (Power in GE, and Structures in Adient) that are relatively small components of their intrinsic values. Neither company will turn around over night, but we believe that these new management teams are quite capable and that each company is worth far more than its current stock price reflects.

Significantly, most of our underperforming stocks this year were pro-cyclical: these stocks tend to have more than a typical amount of sensitivity to the health of the broad economy. This list includes our banks, industrials, consumer durables (such as autos), energy, and travel-related companies. Had we simply judged our performance based on the business results these companies reported rather than their stock prices, we would have thought we had a pretty good year.

Of the 24 stocks we owned throughout fiscal 2018, only eight produced a total return of at least 10% while owned by the Fund (in a year in which the S&P 500 increased by 18%).  Of the 16 that fell short of this hurdle, three were the companies mentioned above that disappointed fundamentally relative to our expectations.  Of the remaining 13 holdings whose stocks underperformed, 11 actually produced earnings results broadly in line with our expectations, but investor fears of an upcoming recession grew throughout the year, heightened by concerns about the effects of tariffs on the broader economy, which resulted in poor stock prices, despite good business performance.

In only a slight oversimplification, if we identify a business we believe is worth $100 per share, we will set a buy target of $60 and a sell target of $90 for the stock.  At any given point in time, our portfolio is a mix of some stocks selling below the buy targets and others selling at all levels between the buy and sell targets. When business fundamentals outperform stock prices, stocks, in our view, become more attractive.  Today, 62% of the stocks held in Oakmark Select are below our buy targets.  That compares to a year ago when 25% were below the buy targets.  We are applying the same processes that created the long-term track record that was referenced earlier, and are applying at least the same level of talent and effort to making our investment decisions.  We believe the recent underperformance has made the Oakmark Select Fund more attractive – and we have been buying more shares of the Fund ourselves this year.  We hope you consider joining us to take advantage of the recent weakness.

Thank you, our fellow shareholders, for your continued investment in our Fund.

The securities mentioned above comprise the following percentages of the Oakmark Select Fund’s total net assets as of 09/30/18: General Electric Company 3.5%, Harley Davidson 0% and Adient 3.6%. Portfolio holdings are subject to change without notice and are not intended as recommendations of individual stocks.

Access the full list of holdings for the Oakmark Select Fund as of the most recent quarter-end.

The net expense ratio reflects a contractual advisory fee waiver agreement through January 28, 2019.

The S&P 500 Total Return Index is a float-adjusted, capitalization-weighted index of 500 U.S. large-capitalization stocks representing all major industries. It is a widely recognized index of broad, U.S. equity market performance. Returns reflect the reinvestment of dividends. This index is unmanaged and investors cannot invest directly in this index.

Because the Oakmark Select Fund is non-diversified, the performance of each holding will have a greater impact on the Fund’s total return, and may make the Fund’s returns more volatile than a more diversified fund.

Oakmark Select Fund: The stocks of medium-sized companies tend to be more volatile than those of large companies and have underperformed the stocks of small and large companies during some periods.

The discussion of the Fund’s investments and investment strategy (including current investment themes, the portfolio managers’ research and investment process, and portfolio characteristics) represents the Fund’s investments and the views of the portfolio managers and Harris Associates L.P., the Fund’s investment adviser, at the time of this letter, and are subject to change without notice.

All information provided is as of 09/30/2018 unless otherwise specified.