Oakmark Equity and Income Fund: First Quarter 2021

A Truly Extraordinary 12 Months
Perhaps readers do not wish to be reminded, but one year ago in this report, we were recounting the effects of the new pandemic on society, the economy and the securities markets. Forgive us for quoting a previous report extensively, but it seems appropriate at this moment to dramatize how the investment context has changed. One year ago, we wrote:

“Fastest decline into a bear market ever. Shortest time spent in a bear market ever. Eight consecutive days when the market either rose or fell by over 4%. Largest one-day stock market gain since 1933. Second-largest one-day drop ever. A collapse in the price of oil. Remarkable individual stock volatility. Growth outperforms value by a near-record amount. Small- and mid-cap issues suffer major price declines, far in excess of large caps. The U.S. registers the largest number of weekly unemployment claims ever by a factor of more than three times. The Federal Reserve reduces the Fed funds rate to 0%. Congress passes an economic stimulus package of more than $2 trillion. We are truly living and investing in an extraordinary time.

History teaches us that it takes time for the market to stabilize and regain its footing after such an amazing disruption. We believe that our proper course of action in such a time is to attempt to seize moments of extreme price dislocation and to improve the Fund’s tax position for our taxable clients. To that end, we have been fairly active. Market turmoil has affected the Fund’s asset allocation, and we are working to realign the portfolio appropriately. Our most important advice to clients at this tumultuous time is to take the same action we are—rebalance. If two months ago your asset allocation was appropriate for your circumstances, you probably need to act to return to that allocation.”

All time periods are unique by definition, and the 12 months following this report certainly qualify. The pandemic proved far more lethal and contagious than any other viral outbreak in the past 100 years, and the consequent limitations on activity crushed some economic sectors while enhancing others. Some of these favorable outcomes were completely unexpected even by knowledgeable industry insiders. Taking an example from the Equity and Income Fund portfolio, one year ago we purchased shares of Thor, a manufacturer of towable trailers and motorized recreational vehicles. We had previously owned shares in the company, admired the management team and perceived Thor’s industry competitive dynamics to be favorable. The company’s share price declined significantly in the first quarter of 2020, and we merely thought that we were being offered a bargain price for a good company. What we did not foresee was that families would gravitate to recreational vehicles as a method of vacationing safely during the pandemic. Thor’s business began to boom during the summer of 2020 and this has helped the share price nearly to triple from our acquisition price.

Growth outperforming value was another story that we described often last year. Through October, growth stocks trounced value names partly because investors believed that technology companies would benefit from the pandemic. But interest rates may have been the most important factor to growth’s success. When it became clear that the pandemic was depressing economic activity, the Federal Reserve’s response was to drive short-term interest rates nearly to zero. This benefited the shares of companies that show little or no profitability in the present but that grow rapidly. That’s because when these companies are discounted due to low interest rates, their future earnings become more valuable. This narrative began to shift late last year as price inflation became more evident in the economy, helping to push the yield on the benchmark 10-year U.S. Treasury from a low of 0.5% to a recent high around 1.75%. The Fed has continued to suppress short rates, but higher long-term yields have helped relative performance in equities to shift.

This rotation in favor of value can be seen across the equities in the Fund. As of March 31, 2020, 19 of the Fund’s 41 holdings showed losses since their purchase. Compare that to March 31 of this year, when only one very recent purchase shows even a small loss. In fact, since March 2020, 10 of the Fund’s equity holdings have more than doubled in price and this group ranges from previously mentioned Thor to a financial company (Ally Financial), a hospital chain (HCA Healthcare) and a company supposedly disrupted by technological change (General Motors). We welcome this development in the investing environment and have begun to reposition the portfolio given the new opportunity set. In the section quoted above from last year’s report, we advised rebalancing to return to one’s desired asset allocation. Circumstances are far different today, but our advice once again is to review one’s positioning and rebalance, if needed.

Quarter Review
The Equity and Income Fund gained 10.3% in the quarter, which contrasts to a 5.4% return for the Lipper Balanced Fund Index, the Fund’s performance benchmark. For the fiscal six months, the Fund showed a gain of 28.0% compared to 15.5% for the Lipper Index. Since inception in 1995, the Fund’s compound annual rate of return is 10.2%, while the corresponding return to the Lipper Index is 7.4%. One factor that contributed to the Fund’s relative performance in the quarter was the short duration of the fixed income allocation. We have argued for several years that longer term bonds had become biased toward risk rather than return. At least in the recent quarter that assertion proved prophetic as the benchmark 10-year U.S. Treasury lost roughly 7%.

The largest contributors to portfolio return in the quarter were General Motors (GM), Bank of America, Alphabet, Ally and BorgWarner. Interestingly, GM, Bank of America and Ally were all on the largest detractor list for the quarter one year ago. Charter Communications led the detractors’ list, followed by Nestlé, Arconic, Mastercard, and Gaming and Leisure Properties. For the first six months of the Fund’s fiscal year, the contributors’ list was almost the same: GM, Bank of America, Alphabet, Ally and Howmet Aerospace. Only three companies detracted: Nestlé, Regeneron Pharmaceuticals and new purchase Salesforce. One year ago in this report, we noted that the pandemic had convinced investors to flee financial company stocks. We suggested that financials entered the pandemic in far better shape than the 2008 financial crisis and that—combined with the extraordinary support that governments worldwide were throwing at the economy—financial company shares were undervalued. In the past six months, the financials sector has been the second-best performer in the S&P 500 Index and the top contributing sector for the Equity and Income Fund. Were interest rates to increase materially, we believe that this industry could continue to perform well.

Transaction Activity
We were active in the quarter and initiated four new holdings, but our selling was limited to cutting back positions that approached their sell targets (i.e., no complete eliminations). In the first section of this report, we discussed the market’s rotation toward value stocks. This rotation has produced opportunities in market sectors previously unrepresented in the portfolio. Proceeding alphabetically, we purchased shares of Facebook, the company that controls two of the world’s most dominant social networking platforms, Facebook and Instagram. Facebook’s unprecedented global reach and ad-targeting capabilities have made these platforms some of the most sought after and effective advertising platforms ever created. We believe that the long-term outlook for digital advertising remains bright, and we expect Facebook’s advertising market share to increase. Excluding its large net cash balance, the company is trading at a modest discount to the S&P 500, based on next year’s consensus earnings forecast, even though those estimates include little to no contribution from valuable assets like WhatsApp and AR/VR (augmented reality/virtual reality), which Facebook has yet to monetize meaningfully. We believe this is an attractive valuation for a company that is projected to grow its revenue in the double digits for the foreseeable future and we think that Facebook’s operating margin potential is substantially higher than what the company is likely to report in the coming years.

Our second new purchase was Fiserv. Following its transformative acquisition of First Data Corporation in 2019, Fiserv is now a top provider of digital banking solutions, core account processing software and merchant acquiring services in the U.S. The company’s mission-critical software and services generate recurring revenue and are tied to strong secular growth trends within both digital payments and banking. We expect Fiserv’s revenue to grow in the mid- to high-single-digits over the coming years and that the company will enjoy significant margin expansion as it realizes the cost synergies from the First Data acquisition. In our estimate, this would produce near-term earnings per share growth of over 20%. Furthermore, with its significant free cash flow generation and excess debt capacity, the company should be able to return something like 35% of its market capitalization through dividends and share repurchases over the next five years, in our view. We believe the risk-adjusted return potential is attractive for this well-managed, above-average business that’s trading for a market multiple on our estimate of normal earnings.

The third new purchase was Humana, the industry leader and near pure play in the fastest growing sector of managed care, Medicare Advantage. Each year, more seniors choose Medicare Advantage over traditional Medicare due to the compelling combination of lower costs and expanded benefits. Humana’s scale advantages and focus on senior care allow the company to make targeted investments in its members’ health, resulting in fewer unnecessary hospitalizations and lower chronic care costs. Much of these savings are then reinvested in the health plan, resulting in a continuously improving customer value proposition. The company’s brand also resonates well in the marketplace and has helped drive double-digit annual membership growth over the past decade—well above the rest of the industry. Further, we believe Humana has a long runway ahead as it benefits from an aging population and continued conversion of the approximately 60% of seniors who are still enrolled in traditional Medicare. Yet Humana’s shares are currently trading at a nearly 20% discount to the S&P 500 earnings multiple, which we believe doesn’t give the company enough credit for its durable competitive advantages and strong secular growth outlook.

Salesforce was the final new portfolio addition. The company is executing a tried-and-true strategy in the software space of buying young, best-of-breed software companies and then driving these products into their massive installed base. Companies like Tableau, ExactTarget and Mulesoft have considerably more reach in the hands of Salesforce than they could have achieved as standalone companies. However, when Salesforce announced a deal to buy Slack Technologies, the market reduced Salesforce’s pre-announcement market capitalization by roughly $40 billion, effectively offering investors the opportunity to get Slack for free. We believe management should be given the benefit of the doubt. Slack has the potential to be a game-changing technology with a huge addressable market, and management’s track record on acquisitions has been superb. We estimate that the company’s shares now trade at a material discount to industry peer Microsoft, despite showing nearly twice the growth, giving investors the chance to own a top-tier software company at a bottom-tier multiple.

We thank our shareholders for investing alongside us in the Equity and Income Fund and wish you good health and safety.

The securities mentioned above comprise the following percentages of the Oakmark Equity and Income Fund’s total net assets as of 03/31/21: Ally Financial 2.5%, Alphabet Cl A 5.0%, Arconic 0.6%, Bank of America 5.1%, BorgWarner 2.0%, Charter Communications Cl A 2.3%, Facebook Cl A 0.8%, Fiserv 0.5%, Gaming and Leisure Properties 0.5%, General Motors 4.2%, HCA Healthcare 1.7%, Howmet Aerospace 2.1%, Humana 0.5%, Mastercard Cl A 1.0%, Microsoft 0.0%, Nestlé ADR 1.0%, Regeneron Pharmaceuticals 0.7%, salesforce.com 0.8% and Thor Industries 1.4%. 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.

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.

The S&P 500 Shiller CAPE Ratio, also known as the Cyclically Adjusted Price-Earnings ratio, is defined as the ratio the S&P 500’s current price divided by the 10-year moving average of inflation-adjusted earnings.

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 03/31/2021 unless otherwise specified.