Oakmark Equity and Income Fund: Third Quarter 2015

Voilà! Volatility is Back
“In the history of the stock market this is the first year to have made it to July without breaching the 3.5% barrier in either direction…A newly awakened Rip van Winkle might think that this lack of directional volatility implied a very calm economy and world political environment, to which we would reply ‘Greece, Islamic State, negative first quarter GDP…’”

–Oakmark Equity and Income Fund June 30, 2015 Commentary 

Just one quarter ago we commented on the unusual lack of volatility in the stock market.  How quickly things change! Within seven weeks of writing our last quarterly letter, the market fell by 11% in just six trading days, and on two of those days it fell by more than 3%.  While the market has recovered some of those losses, it was still down 6% in the quarter.

So what has changed? As we alluded to in our commentary last quarter, despite the subdued movement in the market through the first half of the year, the world remained a volatile place.  It seems as if the market became more cognizant of this in the third quarter, after China surprised investors with weak economic indicators and equally surprising government responses.  And, so, market volatility reappeared, reminding investors it was merely in hibernation and not extinct.

As if the sudden reappearance of volatility wasn’t enough to rattle investors, technical issues further compounded the problem.  On Monday, August 24, some exchange traded funds (ETFs) opened down as much as 40% while the underlying net asset values were down a fraction of that. Even the shares of enormous, widely owned companies like GE, JPMorgan and CVS fell 20% in the early minutes of trading, before recovering to end the day down “just” low- to mid-single digit percentages.  
    
Such wild moves lend credence to the concerns that many have expressed about potential volatility in another asset class: bonds.  With bonds having been in a 30-year bull market, some are concerned that investors aren’t prepared for the repercussions that may follow the Federal Reserve’s rate hikes.  Making matters potentially worse, a greater percentage of the bond market is now controlled by flightier open-end mutual funds and exchange-traded funds; at the same time, large banks are playing a smaller role intermediating bond trading, as a result of post-financial crisis regulations.  The combined effect of all of this is that the bond market could be in for a period of unusual price swings.  Even plain vanilla Treasuries—long viewed as one of the most liquid markets in the world—could be “violently volatile,” according to JPMorgan Chairman and CEO Jamie Dimon. 

While orderly capital markets are essential to a resilient and growing economy, we wonder if too much has been made of this issue.  Yes, extreme volatility can cost investors who sell out during times of stress.  But that only exacerbates the real problem: panicking and selling during times of stress.  Certainly there are investors who need to sell merely out of unfortunate coincidence on days the market is under unusual strain.  But it seems many of the sellers on such days are reacting to nothing more than the decline in the market.  Indeed, the volume on Monday, August 24, was nearly twice the average experienced throughout the summer.  Investors would be well served on such days (and extended periods) simply to tune out the market and adhere to their long-term investment plans.  It’s the deviation from those investment plans in times of stress—and not the resultant trading costs—that is the real problem.

While we may not think the issues of liquidity and volatility are quite as deleterious as some have claimed, we still have taken great care to protect shareholders of the Oakmark Equity and Income Fund.  In general, we take a holistic approach to managing the Fund’s liquidity.  In addition to holding considerable levels of cash, commercial paper, and other short-term instruments—conventional sources of liquidity—the Fund also invests in numerous other securities that we believe can be at least partially liquidated with relative ease, such as government bonds and large capitalization equities.  While the composition of the portfolio will likely change over time to capitalize on the opportunity set, we seek to manage the Fund with a goal of maintaining ample total liquidity.

Regarding a rise in interest rates and any related dislocations in the fixed income markets, the Equity and Income Fund is intentionally positioned to mitigate the associated risks and ultimately, we believe, to take advantage of potential opportunities that may arise.   With cash and short-term investments amounting to 20% of assets, we believe the Fund has substantial liquidity to weather such an environment without being a seller of any bond holdings that may be under temporary pressure.  In fact, the Fund is positioned to be a net buyer of bonds in an environment where the risk-adjusted returns become compelling.  

Although it is impossible to foresee all of the knock-on effects from a potential sharp increase in rates, we believe the direct impact on the Fund from bond market turmoil related to a rise in rates should be relatively muted given the short duration of the fixed income holdings and the substantial liquidity. 

Quarter Review
The Fund has not come out of this period of volatility unscathed.  For the quarter, the Fund declined 7% while the Lipper Balanced Index, the Fund’s performance benchmark, declined 5%.  For the fiscal year ended September 30, the Fund declined 3% compared to the Lipper Balanced Index, which was down 1%.  Top contributors for the quarter were Foot Locker, Precision Castparts, Broadridge Financial Solutions, Omnicare and Nestle.  The largest detractors were Glencore, BorgWarner, Dover, Flowserve and Oracle.  For the fiscal year, UnitedHealth Group, Foot Locker, Omnicare, CVS Health and Lear contributed the most, while Glencore, National Oilwell Varco, Dover, Flowserve and Ultra Petroleum were the largest detractors.  Much like in previous quarters, the consumer and health care names did well while weak commodity prices hurt the shares of some of the largest detractors. We are glad to note that Precision Castparts, as well as Remy International, accepted acquisition offers during the quarter.

The stock prices of many of our equity holdings have fallen, in some cases substantially.  In most instances, we believe the stock price declines have been much greater than the changes in business values.  In these situations, we have often added to the holding, as we expect, over time, that stock prices and business value will converge when this current period of increased volatility subsides. In our view, the Fund’s strong liquidity position enables us to be patient, long-term equity and fixed income investors.  The Fund’s overall asset allocation was slightly more skewed toward fixed income and cash than last quarter, with 61% of assets in equities and 39% in fixed income and cash.

Transaction Activity
During the quarter, we initiated a new position in Oceaneering International, as well as a small position in Howard Hughes Corporation, and we eliminated three holdings: Aflac, Omnicare and Remy.  Omnicare left the portfolio as the result of an acquisition by fellow Fund holding CVS. Omnicare was a long-term, successful holding, and we would like to thank CEO Nitin Sahney and his team for doing a fantastic job.

As for the addition of Oceaneering International to the portfolio, this company offers various niche products and services used in deepwater oil and gas exploration and production.  In our view, management has done a terrific job of growing market share and profitability through strong execution and wise capital allocation.  Although the large decline in oil prices will affect near-term demand for deepwater services, we still believe that deepwater production will be necessary to meet future oil demand.  Given Oceaneering’s strong balance sheet, we can wait for demand to recover, and we believe that Oceaneering trades at a low teens multiple of normalized earnings.

As always, we thank our shareholders for entrusting their assets to the Fund and welcome your questions and comments.

As of 09/30/15, General Electric Co. represented 0.5%, JPMorgan Chase & Co. 0%, CVS Health Corp. 2.6%, Foot Locker, Inc. 2.9%, Precision Castparts Corp. 1.0%, Broadridge Financial Solutions, Inc. 1.0%, Omnicare, Inc. 0%, Nestle SA 3.3%, Glencore PLC 0.3%, BorgWarner, Inc. 1.6%, Dover Corp. 2.2%, Flowserve Corp. 1.7%, Oracle Corp. 3.5%, UnitedHealth Group, Inc. 1.8%, Lear Corp. 1.6%, National Oilwell Varco 0.3%, Ultra Petroleum Corp. 0.02%, Remy International, Inc. 0%, Oceaneering International, Inc. 0.5%, Howard Hughes Corp. 0.3%, and Aflac, Inc. 0% of the Oakmark Equity and Income Fund’s total net assets. Portfolio holdings are subject to change without notice and are not intended as recommendations of individual stocks.

Click here to access the full list of holdings for The Oakmark Equity and Income Fund as of the most recent quarter-end.

The S&P 500 Total Return Index is a market capitalization-weighted index of 500 large-capitalization stocks commonly used to represent the U.S. equity market.  All returns reflect reinvested dividends and capital gains distributions.  This index is unmanaged and investors cannot invest directly in this index.

The Lipper Balanced Funds Index measures the performance of the 30 largest U.S. balanced funds tracked by Lipper. This index is unmanaged and investors cannot invest directly in this index.

The Fund invests in medium- and lower-quality debt securities that have higher yield potential but present greater investment and credit risk than higher-quality securities, which may result in greater share price volatility. An economic downturn could severely disrupt the market in medium or lower grade debt securities and adversely affect the value of outstanding bonds and the ability of the issuers to repay principal and interest.

The Oakmark Equity and Income Fund’s portfolio tends to be invested in a relatively small number of stocks. As a result, the appreciation or depreciation of any one security held by the Fund will have a greater impact on the Fund’s net asset value than it would if the Fund invested in a larger number of securities. Although that strategy has the potential to generate attractive returns over time, it also increases the Fund’s volatility.

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.