Oakmark Equity and Income Fund: Third Quarter 2021

Is the “Taper” Visible on the Horizon?
For what seems like forever, we have been writing about historically low interest rates and the potential economic and stock market effects of such anomalous rates. Interest rates reflect the price of money itself, and this price influences the value of almost all other assets. Therefore, if interest rates decline to levels that no longer make economic sense, corporate managers may be encouraged to make overly aggressive allocations of capital. Although we cannot directly attribute the meltdowns at Archegos or Greensill nor the developing problems at China Evergrande Group to ultralow interest rates, we suspect that they have contributed to these crises.

Of course, the 40-year bull market in bonds did not begin with the Fed suppressing short-term rates. Older readers may recall the high levels of price inflation during the late 1970s and early 1980s. In response to this crisis, the Fed, then led by Chair Paul Volcker, pushed rates to record levels to force inflation down. Over the next few decades, higher productivity and globalization were factors contributing to a positive financial environment that helped allow rates to decline. Aggressive rate suppression only developed in the wake of the 2008 global financial crisis and has been repeated with Covid-19.

Given the U.S. economy’s strong recovery over the past few quarters, investors have looked for indications that the Fed would reduce its stimulus efforts, which include sizable monthly bond market purchases and maintaining a Fed funds rate between 0 and 0.25%. To date, rate suppression has continued. In its September meeting, however, the Fed’s governors suggested that the so-called “taper”—or the slowing down of the Fed’s purchasing of public market bonds—could soon begin. Eight years ago, when the Fed enacted its first such taper, it moderately destabilized the financial markets. Desiring to smooth the effects this time, the Fed is attempting to be transparent about its plans and has indicated that when (or if) the taper begins, it will continue to purchase bonds, just at diminishing levels. The plan is to keep short-term rates near zero until the purchasing program has ended.

The Fed could succeed in its effort to retreat smoothly from its record levels of economic stimulus, but we are not convinced. For several years, investors have taken up the mantra “TINA” (or “there is no alternative”), meaning that they must own stocks because fixed income returns are so meager (or even negative in Europe). Despite this year’s rally in U.S. stock prices, the earnings yield on stocks (earnings divided by price) is significantly greater than the yield of a 10-year U.S. Treasury note. So, when will there be a viable investment alternative to equities? Many have argued that growth stocks are the best bet today because future earnings are more valuable when they are discounted at our currently very low rates. Will the taper jumpstart the end of growth stocks’ decades-long domination? Interestingly, on days when the interest rate on the 10-year U.S. Treasury moves up noticeably, value stocks outperform their growth counterparts.

Approximately six years ago, we joked derisively about the first sightings of negative interest rates in Europe. Of course, the joke has been on us as negative interest rates have persisted abroad. Although U.S. rates have remained positive, the Fed implemented policies that are in close alignment with our European friends. As the Fed begins to unwind its unprecedented stimulus program, the next few years should prove quite interesting.

Quarter and Fiscal Year Review
The Equity and Income Fund returned 0.39% in the quarter, which compares to a loss of 0.32% for the Lipper Balanced Fund Index, the Fund’s performance benchmark. For the nine months of the calendar year, the Fund gained 17.3%, compared to a gain of 8.3% for the Lipper. For the 12 months ended September 30 (the Fund’s fiscal year), Equity and Income earned 36.2 %, which compares to 18.7% for the Lipper Balanced Fund Index. The annualized compound rate of return since inception in 1995 is 10.2%, while the corresponding return to the Lipper Index is 7.4%.

Alphabet, HCA Healthcare, Glencore, American International Group and Bank of America provided the largest contribution to portfolio return in the quarter. The largest detractors from return were General Motors, BorgWarner, Lear, Howmet Aerospace and ChampionX. The three largest detractors are all in the automotive sector. The entire automobile industry has suffered production problems because of a shortage of semiconductors. When the pandemic first took hold, automobile manufacturers cut back their orders for semiconductors in preparation for a serious economic downturn. Semiconductor manufacturers reoriented their production to supply industries with continuing demand and were therefore unprepared when, after an initial decline, auto sales took off in the second half of 2020. As inventories depleted, auto manufacturers have had to forego production because of parts shortages, and this affected our industry holdings in the recent quarter. Contributors for the calendar year to date were Alphabet, Bank of America, General Motors, Ally Financial and PDC Energy. Reinsurance Group of America, Zimmer Biomet, Humana, Constellation Brands and NOV were the largest detractors for the nine months. Finally, for the Fund’s fiscal year, the largest contributors were Alphabet, General Motors, Bank of America, Ally Financial and TE Connectivity. The only stocks to detract in the period were Nestlé, Humana and Fiserv.

Transaction Activity
Our transaction activity was modest in the quarter. We initiated three new holdings, one of which, Paycor HCM, we purchased on its initial offering and then quickly sold after its share price exceeded our price expectations. New purchase Charles Schwab is sort of a return appearance in the Fund as Schwab was the purchaser of previous Fund holding TD Ameritrade. Schwab is the largest discount brokerage firm in the U.S. with over $7 trillion in client assets spread across more than 30 million active client accounts. This size provides Schwab with meaningful scale advantages, which the company uses to reinvest in providing the best service quality and pricing in the industry—or what Schwab’s management calls its “no trade-offs” policy. These customer-friendly investments attract even more clients to its platform, furthering a virtuous cycle that has enabled Schwab to gain share of U.S. investible assets for more than four decades. The company’s client assets have recently grown at a double-digit rate, and we believe this growth will continue given its low share of total U.S. investment assets. Over the next few years, we believe Schwab will also benefit from significant cost synergies related to its recent Ameritrade acquisition and from meaningful interest income growth as a result of higher interest rates. The combination should drive the company’s EPS to more than $5 per share in the coming years, which means we are currently paying a below market multiple for this high-quality and well managed franchise.

The final purchase in the quarter was Warner Music Group, the third largest player in recorded music and music publishing rights globally. Warner owns a portfolio of record labels (Atlantic, Warner, Parlaphone, Elektra and Asylum) and a publishing arm (Warner Chappell) that control one-sixth of the world’s recorded music. Controlling irreplaceable, must-have content allows the company to collect a toll on the secular growth in digital music. After being disrupted by the internet and piracy at the start of the millennium, the major record labels smartly repositioned their business models to benefit from the rising demand for streaming music. The music industry finally returned to growth in 2015, and 69% of Warner’s total revenue now comes from digital sources. Music is severely under-monetized today, with per capita music spend meaningfully below the prior peak in 1999. We expect the monetization gap will narrow as streaming music subscriptions are adopted more broadly and as Warner strikes innovative licensing agreements for new use cases like social media, gaming and connected fitness. The shift from physical to digital also provides a nice margin tailwind. The market does not fully appreciate the ongoing transformation or the positive implications on Warner’s revenue growth rate and margins. The company’s earnings power will expand significantly as monetization improves and the business mix continues to shift toward digital formats. We believe Warner Music is an outstanding business trading at an unwarranted discount to its closest public peer (Universal Music Group) and private market multiples for publishing catalogs/record labels.

We thank our shareholders for entrusting their assets to the Fund and welcome your questions and comments.

The securities mentioned above comprise the following preliminary percentages of the Oakmark Equity and Income Fund’s total net assets as of 09/30/21: Ally Financial 2.7%, Alphabet Cl A 5.2%, American Intl Group 1.0%, Bank of America 3.8%, BorgWarner 1.7%, ChampionX 0.8%, Charles Schwab 0.5%, Constellation Brands Cl A 0.8%, Fiserv 0.5%, General Motors 3.2%, Glencore 1.7%, HCA Healthcare 2.0%, Howmet Aerospace 1.2%, Humana 1.0%, Lear 1.7%, Nestlé ADR 0.7%, NOV 0.3%, Paycor HCM 0%, PDC Energy 1.4%, Reinsurance Group 1.5%, TD Ameritrade 0%, TE Connectivity 2.8%, Universal Music Group 0%, Warner Music 0.1% and Zimmer Biomet 0.4%. 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 Equity and Income Fund as of the most recent quarter-end.

The Lipper Balanced Fund Index measures the equal-weighted performance of the 30 largest U.S. balanced funds as defined by Lipper. This index is unmanaged and investors cannot invest directly in this index.

EPS refers to Earnings Per Share and is calculated by dividing total earnings by the number of shares outstanding.

The compound return is the rate of return, usually expressed as a percentage that represents the cumulative effect that a series of gains or losses has on an original amount of capital over a period of time. Compound returns are usually expressed in annual terms, meaning that the percentage number that is reported represents the annualized rate at which capital has compounded over time.

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 information, data, analyses, and opinions presented herein (including current investment themes, the portfolio managers’ research and investment process, and portfolio characteristics) are for informational purposes only and represent the investments and views of the portfolio managers and Harris Associates L.P. as of the date written and are subject to change and may change based on market and other conditions and without notice. This content is not a recommendation of or an offer to buy or sell a security and is not warranted to be correct, complete or accurate.

Certain comments herein are based on current expectations and are considered “forward-looking statements”. These forward looking statements reflect assumptions and analyses made by the portfolio managers and Harris Associates L.P. based on their experience and perception of historical trends, current conditions, expected future developments, and other factors they believe are relevant. Actual future results are subject to a number of investment and other risks and may prove to be different from expectations. Readers are cautioned not to place undue reliance on the forward-looking statements.

All information provided is as of 09/30/2021 unless otherwise specified.