Oakmark Equity and Income Fund - Investor Class
Average Annual Total Returns 03/31/13
Since Inception 11/01/95 10.72%
Gross Expense Ratio as of 09/30/12 was 0.78%
Past performance is no guarantee of future results. The performance data quoted represents past performance. Current performance may be lower or higher than the performance data quoted. The investment return and principal value vary so that an investor’s shares when redeemed may be worth more or less than the original cost. The most recent month-end performance data can be found here.
U.S. stocks enjoyed a sizable rally in the first calendar quarter. Fixed income investment returns were minimal, albeit positive after including income. For the past quarter, the Equity and Income Fund returned 6% while the Lipper Balanced Fund Index, the Fund’s performance benchmark, returned 5%. For the fiscal year’s six months, the Fund returned 8%, which compares with the Lipper Index’s 7%. The annualized compound rate of return since the Fund’s inception in 1995 is 11% while the corresponding return to the Lipper Index is 7%.
Flowserve, Nestle, Dover, Cimarex Energy and Philip Morris International led the contributors’ list for the quarter, while the detractors were Cenovus Energy, Walter Energy, Quest Diagnostics, Apache (sold) and Blount International. The stock market showed much more discrimination concerning energy industry investments in this quarter, rewarding our holdings that reported good finding costs and resource additions (e.g., Cimarex and Range Resources, the sixth-largest contributor), while penalizing Apache and the Fund’s two Canadian holdings, Cenovus and EnCana, for differing reasons. I discuss the sale of Apache in the next section of the report. EnCana’s announcement that its well-regarded CEO was taking early retirement surprised and disappointed investors. In the case of Cenovus, price realizations for Canadian heavy oil have been weak, thereby reducing profitability. During the first six months of our fiscal year, the largest contributors were Flowserve, Dover, Rockwell Automation, MasterCard and Nestle, and the leading detractors were Cenovus, Apache, EnCana, Quest Diagnostics and Devon Energy.
Out of the five top contributors to fiscal-year return, none led in terms of pure price appreciation. The five leading price performers (Patterson-UTI Energy, Lear, Bruker, Crane and TD Ameritrade) are all smaller holdings in the Fund, meaning that their outsized price increases did not make them leading contributors. Although one might wish that the Fund had held more shares in those names, their market capitalizations would have made this difficult. Nevertheless, we are glad for each share that we did own. The Fund has always been invested across market capitalizations (i.e., it is an all-cap fund), and in most investing environments, shareholders should expect a wide market cap range in the Fund’s holdings.
I eliminated five holdings during the quarter, three that had excelled, one that disappointed and one that fell in between. To begin on a happy note, it was only one year ago that I wrote of the eBay purchase, so this idea came to investment maturity quite rapidly. In January 2012, we had what proved to be a fleeting opportunity to purchase eBay shares after the announcement of an unexpected management departure. We took advantage of the opportunity based on our belief that the company’s PayPal unit was a “crown jewel” that investors did not fully appreciate. We sold our shares in eBay at close to our target sell price after holding the position for a little more than one year, thereby attaining long-term taxation status. Although many of the Fund’s shareholders may not care about tax considerations, others do hold their Fund shares in taxable accounts. We attempt to manage all of our Funds in a tax-friendly fashion, and our long-term investing horizon is a good match for that objective. Occasionally a holding’s price may jump soon after purchase, however, and this outcome demands portfolio manager delicacy. That said, investment decisions always take priority over tax considerations.
I also eliminated holdings of Apache, Mohawk, Mine Safety Appliances and Texas Instruments. Apache was the signal disappointment within this group of sales. As noted in an earlier paragraph, when investors consider exploration and production company stocks, they are increasingly looking for companies that can find and produce oil and gas efficiently and at low cost. For many years, Apache was seen by its peers as a cost leader, but the company’s statistics have been eroding meaningfully, which has limited its ability to grow intrinsic value per share, a characteristic that we demand in our investments. In contrast, both Mohawk and Mine Safety Appliance have produced solid fundamental results that translated into share prices that met our sell targets. Finally, the sale of our shares in Texas Instruments helped fund the purchase of a new holding, Oracle.
I initiated three new positions in the quarter: Atlas Air, AFLAC and the aforementioned Oracle. Starting with the latter, we hope our investment in Oracle will resemble our experience with eBay, although we certainly are not counting on it to do so as quickly. We purchased Oracle after the company’s shares declined because of an earnings report in which the company minimally missed investor expectations. To be fair, many investors have been anxiously probing Oracle’s reports for the past few years to discern whether trends in data management and enterprise software are moving away from the company’s strengths, and the recent quarter’s report did little to assuage those fears. On the positive side, Oracle has a huge installed base, and clients would incur enormous switching costs to move to alternative database schemes and software vendors. In addition, most new entrants into the market are niche players – they will win some business, but the truly large customers will find it difficult to risk moving central parts of their functionality to a small, young enterprise.
AFLAC is a leading supplemental insurance provider with operations concentrated in Japan and the U.S. While its television commercials have helped to make the company well known in the States, the majority of its profits originate in Japan, where the company dominates the cancer insurance sector. Our opportunity to purchase the stock developed as the Japanese yen began to weaken meaningfully because of a change in government monetary policy. Yen weakness reduces the value of the company’s Japanese profits when expressed in dollars. Investors have also been skeptical of the company’s management of the large investment portfolio tied to its reserves. We believe, however, that the company has worked aggressively to reduce its risk exposures. The stock’s above-average dividend yield is another positive attribute.
Atlas Air Worldwide Holdings is an air freight and logistics company. We believe that the company’s substantial investment in new, fuel-efficient aircraft has created a sustainable competitive advantage. In its primary business, Atlas operates its aircraft fleet for customers who are responsible for all fuel costs. Customers sign long-term “take-or-pay” contracts for minimum volumes, thereby affording Atlas the financial strength with which to make the enormous investment in freighters. As more of the new aircraft are delivered, we expect profit margins to increase, although we believe the company would benefit most from increasing international trade.
Fixed Income Challenges
During the quarter, our team continued to work to shift the Fund’s fixed-income allocation in a yield-enhancing direction while remaining cognizant of risk. As I have stated often, this is incredibly difficult in a world where many investors chase income. Large fund flows into this sector exacerbate this trend. Our experience with a recent Heinz bond offering provides a good illustration. Warren Buffett’s Berkshire Hathaway and 3G Capital recently announced the acquisition of Heinz, effectively taking the company private. To help finance the acquisition, the purchasing entity announced a sizable bond offering with initial “price talk” suggesting an interest rate around 5%. Believing this to be attractive, we expressed interest in participating. Unfortunately, we were far from unique in holding this opinion, and expressions of interest kept pouring in such that the underwriters were able to both increase the size of the bond offering and reduce the interest rate to 4.25%, at which level we had no desire to participate. According to Charles Mead’s Bloomberg report, this “coupon is the lowest ever awarded for similar maturity secured debt issued by high-yield companies” and it is “similar to what average investment-grade issuers paid as recently as February 2011.” The Harris Associates fixed-income team and I will continue to work to build the Fund’s corporate debt allocation, but only on terms that we believe will favor our shareholders. The net of our fixed-income activity in the quarter was to shrink the U.S. Treasury allocation while keeping the overall portfolio fixed-income duration virtually unchanged.
As always, I thank our shareholders for entrusting their assets to the Fund. I welcome your questions and comments.
As of 3/31/13, Flowserve Corp. represented 2.6%, Nestlé SA – ADR 3.0%, Dover Corp. 3.2%, Cimarex Energy Co. 1.4%, Philip Morris International, Inc. 2.9%, Cenovus Energy, Inc. 2.5%, Walter Energy, Inc. 0.6%, Quest Diagnostic, Inc. 1.5%, Apache Corp. 0%, Blount International, Inc. 0.1%, Range Resources Corp. 1.4%, Encana Corp. 1.5%, Devon Energy Corp. 3.0%, Rockwell Automation Inc. 2.4%, MasterCard, Inc., Class A 2.7%, Patterson-UTI Energy, Inc. 0.2%, Lear Corp. 1.3%, Bruker Corp. 0.4%, Crane Co. 0.1%, TD Ameritrade Holding Corp. 1.2%, eBay, Inc. 0%, Mohawk Industries, Inc. 0%, Mine Safety Appliances Co. 0%, Texas Instruments, Inc. 0%, Oracle Corp. 2.0%, Aflac, Inc. 0.3%, Atlas Air Worldwide Holdings, Inc. 0.1%, H.J. Heinz Co. 0%, and Berkshire Hathaway, 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.
The Lipper Balanced Fund 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.
Charles Mead. Heinz Wins record Junk Rate for Buffet Deal: Corporate finance. Bloomberg, March 25, 2013.
Investing in value stocks presents the risk that value stocks may fall out of favor with investors and underperform growth stocks during given periods.
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 above information should not be considered tax advice. Please consult your tax advisor for detailed information applicable to your unique situation.
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.