Oakmark Equity and Income Fund - Investor Class
Average Annual Total Returns 12/31/13
Since Inception 11/01/95 11.21%
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.
Quite a Quarter, Quite a Year
Strategists charged with making forecasts of annual stock market returns usually cluster their output around the historic average of 10%. We have observed, however, that one isolated calendar year is unlikely to produce the historic mean return and that volatile outcomes, both positive and negative, are more common. Several quarters ago we wrote that in the prevailing environment investors should “embrace volatility” rather than hold on to the risk aversion that the 2008 downturn encouraged. 2013 clearly demonstrates that the stock market still offers opportunities for significant positive volatility.
After a year such as 2013, investors begin to hear words such as “bubble” or “excessive” from market commentators. Although we have few examples of time periods following +30% years to draw from, this very limited record has been surprisingly positive. We will make no effort here to forecast 2014’s market outcome, but we will admit that after this substantial equity market price increase it is harder to identify dominant investing opportunities.
The Equity and Income Fund had its second consecutive strong quarter in both relative and absolute terms. The Fund earned 7% in the period, which contrasts with the 5% gain for the Lipper Balanced Fund Index, the Fund’s performance benchmark. For calendar 2013 the returns are 24% for the Fund and 16% for the Lipper Index. 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%.
FedEx, Oracle, MasterCard Class A, General Motors and CVS provided the largest contribution to return in the quarter. The largest detractors were Quest Diagnostics, Laboratory Corporation of America, Carter’s, Atlas Air Worldwide Holdings and Bruker. Detractors from return for 2013 as a whole were Walter Energy (sold), Cenovus Energy (sold in the December quarter—see below), EnCana, Quest Diagnostics and Apache (sold). The largest contributors to 2013 portfolio return were Dover, FedEx, MasterCard, United Health and General Dynamics.
Asset Allocation/Morningstar Category/ Transaction Activity
Long-time Fund investors know that for the past few years we have actively increased the Fund’s equity allocation toward the maximum allowed in our prospectus. During the December quarter, however, our trading activity brought the equity allocation down below 70% for the first time in over a year. To review, the Fund’s equity weighting can vary from 40% to 75%. Every issue, whether bond or stock, fights for its share of the portfolio every day. The allocation breakdown between stocks and bonds will most importantly depend on our ability to populate the portfolio with dominant equity holdings, i.e. issues that meet all of our demanding criteria for investment. With interest rates at record lows last winter and stocks attractively priced, we increased the equity allocation toward the maximum 75% level, which we maintained for most of 2013. We did not consider this to be a more aggressive investment weighting; instead, we believed this position to be the most prudent given how richly valued fixed income securities were at the time. Fortunately, this asset allocation proved to be rewarding. The broad stock market increased sharply in 2013 (and our stocks outperformed) while fixed income indices generally had negative returns. After such a strong year for equities and with the 10-year Treasury now yielding roughly 125 basis points more than at the start of the year, it is logical to ask whether this equity allocation is still appropriate. We still believe that equities are more attractive than fixed income investments, but as prices rose, we reduced the equity weighting to 69%. The Fund’s target asset allocation remains 60% equity/40% fixed income in normal economic circumstances. However, our evaluation of current market opportunities and risks will serve as the final determinant.
During the quarter Morningstar, the mutual fund evaluation service, moved the Equity and Income Fund to a more aggressive investment category for comparison purposes because of the recent higher equity allocation. This surprised us because we continue to manage the Fund in the same way—the higher equity allocation is merely our response to an unusual investing environment. The Fund has always had a flexible mandate, meaning that the asset allocation evolves based on our ability to populate the portfolio appropriately. As stated in the preceding paragraph, we anticipated that our move to a higher equity allocation would be seen as a sign of risk-aversion rather than aggression because to us, bonds had become the higher risk asset class. Regardless of how one interprets this allocation decision, investors should understand that the fundamental philosophy underlying the management of the Fund is the same.
In this quarter, as in the September quarter, several stocks attained our sell targets, which prompted us either to sell them or to reduce our shares as they increased in price. We initiated three new holdings, but the activity reduced the equity allocation. We sold ARRIS Group, Cenovus Energy, Leggett & Platt, Patterson-UTI Energy and Staples. We added Bank of New York Mellon to the portfolio because of its valuation and its propensity to benefit from rising interest rates, and Rowan, which should benefit from increased offshore oil drilling. We also added Union Pacific, which is enjoying operating margin improvements after massive investment in system upgrades. We continue the search for dominant investment opportunities, even though, as noted in the first section, they are more difficult to find today.
Fixed Income Management with the Fed “Taper”
Last quarter we wrote about fixed income management under rate suppression. During the December quarter the Federal Reserve began to cut back (aka “taper”) the amount by which it attempts to stimulate the economy. Although this policy change and its six-month anticipation has produced losses for those who purchased 10-year Treasuries at their springtime prices, the fact is that the tapered monetary policy is still quite stimulative. In the Equity and Income Fund we have attempted to control the portfolio’s interest rate risk by keeping the duration (price sensitivity to interest rate moves) low. Although this has helped to mitigate losses during the recent rate increases, another aspect of our risk-reduction effort proved less fruitful in 2013. The largest and longest duration fixed income position in the Fund is its investment in inflation-indexed securities, often called TIPS. The economy in 2013 produced the worst possible outcome for TIPS: rising interest rates without a concomitant increase in inflation.
One of our firm’s founding partners (of Russian ancestry) frequently muttered that “the czar always debases the currency.” Those of us with gray hair matured as investors in a period with persistent price inflation, and prior Federal Reserve Chairs such as Paul Volcker, focused their efforts on bringing inflation down. Ben Bernanke’s term as Chair, however, has taken place in a low inflation era, and he has focused on stimulating the economy to increase employment. Inflation is a great enemy of traditional bonds because it diminishes the value of future payments to investors. TIPS were developed to neutralize this particular risk. We made TIPS the Fund’s largest bond allocation because we anticipated that Bernanke’s actions would prove to be inflationary, and we wished to protect the Fund from that possibility. Despite the Fed’s stimulus program, inflation (at least as the government measures it, which we will not analyze here) has been almost invisible recently. Japan has experienced a far longer period of low inflation or deflation that has engendered considerable study. Masaaki Shirakawa, the Bank of Japan’s former governor, has written a recent paper on the Japanese experience. In it he observes that inflation seems to correlate more persistently with the rate of change in the country’s working-age population than it does with monetary policy. While the U.S. working-age population is not shrinking like Japan’s, the rate of growth has slowed meaningfully, and the tendency for working-age individuals to leave the workforce amplifies this characteristic. Whether Shirakawa’s theory explains low U.S. inflation or not, the unexpected 2013 combination of rising rates and minimal inflation impaired the 2013 TIPS return.
We manage the fixed income allocation in the Equity and Income Fund to produce income and to buffer portfolio volatility. Our TIPS holdings have historically provided income while helping to provide some insurance against an unexpected acceleration in the rate of inflation. In 2013 that insurance policy proved to be somewhat costly. We continue to seek fixed income investments that offer the best mix of income with short duration. For now the TIPS remain part of that allocation, but as with all securities in the Fund, they must fight for space every day.
Once again we thank our fellow shareholders for investing in the Equity and Income Fund and welcome your comments and questions.
As of 12/31/13, FedEx Corp. represented 2.8%, Oracle Corp. 3.3%, MasterCard, Inc., Class A 2.2%, General Motors Co. 3.4%, CVS Caremark Corp. 1.8%, Quest Diagnostic, Inc. 1.1%, Laboratory Corp. of America Holdings 1.1%, Carters, Inc. 0.4%, Atlas Air Worldwide Holdings, Inc. 0.2%, Bruker Corp. 0.4%, Walter Energy, Inc. 0%, Cenovus Energy, Inc. 0%, Encana Corp. 0.7%, Apache Corp. 0%, Dover Corp. 3.2%, UnitedHealth Group, Inc. 2.7%, General Dynamics Corp. 2.7%, Arris Group, Inc. 0%, Leggett & Platt, Inc. 0%, Patterson-UTI Energy, Inc. 0%, Staples, Inc. 0%, Bank of New York Mellon Corp. 0.9%, Rowan Companies plc 0.2%, and Union Pacific Corp. 1.5% 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 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 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.