Oakmark Equity and Income Fund - Investor Class
Average Annual Total Returns 03/31/14
Since Inception 11/01/95 11.16%
Gross Expense Ratio as of 09/30/13 was 0.77%
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. To obtain the most recent month-end performance data, view it here.
Former Federal Reserve Chairman Paul Volcker has remarked that the only useful financial innovation over the past few decades is the ATM. While we have a slightly less extreme view, we are sympathetic to his point and are naturally suspect of new financial products and services. A recent “innovation” about which some of our shareholders have asked is the “target-date fund.” A target-date fund is a mutual fund that automatically changes its asset allocation over time using a preset “glide path” such that the stock allocation is steadily reduced while the fixed income allocation is increased. The purpose of this is to automate the conventional wisdom that says investors should reduce their equity exposure as they age. We won’t challenge this conventional wisdom (though some studies suggest that investors should actually increase their equity allocation throughout retirement), but we are concerned with its incorporation into the target-date model.
In our view, the problem is that a rigid adherence to a “glide path” might be prudent much of the time, but it’s not prudent all of the time. Mindlessly shifting from stocks to bonds over time using a static plan fails to account for just how dynamic the world is. Bonds aren’t inherently less risky than stocks, and stocks aren’t inherently higher returning than bonds. It all depends on price. And as recent experience has shown, prices change a lot. During the tech bubble of the late 1990s, the S&P 500 was priced so high that the return over the next decade was actually lower than that provided by bonds. Conversely, at the start of last year when interest rates were near record lows, bonds not only were priced to offer paltry returns relative to equities, but they also presented considerable risk, as a modest rise in rates would lower the value of bonds and more than offset the income earned.
It’s not just this problematic passive approach to asset allocation that concerns us. We are also concerned that target-date funds emphasize asset allocation to the point of distracting investors from focusing on the performance of the assets within the allocation. Investors should pay close attention to the composition of a target-date fund, as the whole will perform no better than the weighted average of the parts (i.e., the equity “sleeve” and the fixed income “sleeve”).
Unlike target-date funds, the Oakmark Equity and Income Fund has a flexible asset allocation policy (equities can range from 40% to 75% of the Fund, while fixed income and cash can vary between 25% and 60%); a relentless focus on security selection within each asset class (with a long record of outstanding equity performance); its managers’ interests are aligned with shareholders through sizeable personal investments (not typically found in target-date funds); and the Fund’s expense ratio is 15% lower than that of the average target-date fund (based on Morningstar’s analysis of the 2012 average1). We believe these factors are critical advantages over target-date funds and that they will help us achieve our goal of producing competitive absolute returns over the long run for our shareholders.
During the quarter, the S&P 500 was up a modest 2%. While that result hardly seems noteworthy, underlying it was a reasonable amount of volatility, including intra-quarter swings in excess of 5% due largely to geopolitical concerns. As one would expect in this environment, fixed income securities did well. Over this time period, the Equity & Income Fund returned 2%, which was in line with the Lipper Balanced Fund Index’s return of 2%.
Top contributors to the Fund’s return this quarter were Baker Hughes, General Dynamics, Bank of America, Oracle and UnitedHealth Group, while detractors included General Motors, MasterCard, FedEx, Scripps Network and Philip Morris International. Based solely on the individual stock’s total return, Ultra Petroleum, Baker Hughes, Bruker, General Dynamics and HNI led the pack with Blount, General Motors, Atlas Air, Scripps Networks and MasterCard bringing up the rear. In the case of both lists, the causes of the stand-out performances were stock specific with no overarching investment themes of note.
GM is one laggard worth touching on, given its size in the portfolio. After advancing sharply in 2013, GM shares fell early in the quarter after management projected 2014 earnings that were lower than many investors were expecting, largely as a result of transient factors. Shares were further pressured in the quarter after it came to light that GM potentially mishandled a recall of discontinued models. While we obviously aren’t pleased with either development, we believe GM’s low valuation (its shares trade at just seven times consensus estimates for next year’s earnings) more than compensates for these issues, and we remain comfortable with it being a top holding of the Fund.
After spending much of 2013 with an equity weighting near the Fund’s prospectus maximum of 75%, we have moved the equity allocation down to 65%. Following last year’s strong upward move in the market, we believe valuations are generally less attractive on a risk-adjusted basis, and we are therefore finding more stocks meeting our sell criteria than our buy criteria.
The Fund eliminated six positions this quarter: three that worked out well (Cimarex Energy, Concho Resources and Crane) and three that didn’t (Encana, Hospira and Quest Diagnostics). Cimarex and Concho are oil and gas companies where the Fund invested with what we believe are strong management teams for long-term and highly successful investments. We would like to thank both management teams for their contributions to the Fund’s returns. The last winner – and in this case the least (in terms of weightings) – is Crane. Crane was purchased with the idea that its transition from a holding company with a collection of high quality, niche businesses to a fully integrated, operations-focused business would result in high returns, improved margins and a better stock price. Almost immediately upon initiating a position, the market came to similar conclusions, and we were unable to establish a meaningful position.
Hospira was a longtime holding of the Fund, tracing its roots back to the Fund’s investment in Abbott Laboratories, which spun-off Hospira ten years ago. Over the past few years, the company suffered from numerous manufacturing quality issues that caused us to lower our appraisal of value. After management made considerable progress remedying those issues, the stock approached our new, lower sell target, and we exited the position. In the case of Encana and Quest Diagnostics, fundamental underperformance caused us to reexamine our investment cases. We have discussed Encana in previous letters, but a combination of significant management changes, pipeline politics and the exploding growth of North American shale gas production caused us to redeploy the money elsewhere. With Quest, its weakening market share and tougher industry conditions caused us to reduce our exposure to this industry.
We added two new stocks of significance to the portfolio: Knowles and Wells Fargo. With Knowles, a supplier of acoustic solutions to mobile phone makers and hearing aid manufacturers, we didn’t buy the shares on the open market, but rather received them through a tax-free spinoff from longtime Oakmark Equity and Income Fund holding Dover Corporation. Even though Dover prides itself on being a diversified industrial company with businesses ranging from drilling equipment for oil and gas companies to refrigerators for retailers, the company decided Knowles could best create shareholder value as a standalone company. Knowles has grown rapidly over the years as consumers demand higher acoustic features in each new generation of smartphones and hearing aids, and we expect this trend to continue, which should drive above average top-line growth. Aided by their Dover experience, Knowles’ management team should, in our view, continue to operate the business well and allocate capital wisely.
Our other material addition, Wells Fargo, is the second-largest deposit bank in the United States, holding over 10% of the nation’s deposits. We think Wells Fargo has one of the best franchises in retail banking, driven by high local market shares and a relentless focus on cross-selling other banking products like mortgages and credit cards, which increases customer “stickiness.” Due to its low-cost deposit base and strong management team, Wells Fargo has earned consistently high returns on equity and, through its purchase of Wachovia (a geographically complementary bank), it was one of the few financial companies able to take advantage of the financial crisis to grow its earning power per share. We believe that its significant capital base and relatively simple business model should enable Wells Fargo to continue to produce strong results.
We thank our shareholders for their support and welcome their questions and comments.
As of 03/31/14, Baker Hughes, Inc. represented 2.4%, General Dynamics Corp. 2.2%, Bank of America Corp. 3.2%, Oracle Corp. 3.5%, UnitedHealth Group, Inc. 2.5%, General Motors Co. 3.0%, MasterCard, Inc., Class A 1.9%, FedEx Corp. 2.6%, Scripps Networks Interactive, Inc., Class A 1.4%, Philip Morris International, Inc. 2.4%, Ultra Petroleum Corp. 0.7%, Bruker Corp. 0.3%, HNI Corp. 0.04%, Blount International, Inc. 0.1%, Atlas Air Worldwide Holdings, Inc. 0.1%, Cimarex Energy Co. 0%, Concho Resources Inc. 0%, Crane Co. 0%, Encana Corp. 0%, Hospira, Inc. 0%, Abbott Laboratories 0%, Quest Diagnostic, Inc. 0%, Knowles Corp. 0.5%, Dover Corp. 2.7%, and Wells Fargo & Co. 1.0% 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.
1Mornigstar Fund Research Target-Date Series Research Paper 2013 Survey Page 46 of 69. Morningstar average expense ratio is 0.91% compared to Oakmark Equity & Income Fund expense ratio of 0.77%.
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 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.