Oakmark Equity and Income Fund: Fourth Quarter 2015

A Very Narrow Year
2015 was a year that market technicians describe as having bad breadth.  Simply put, this means that the capitalization-weighted averages earned positive returns, but the majority of stocks lost money.  This phenomenon occurs occasionally (see 1999, for example), but 2015 was probably a more extreme case in that a very small number of stocks succeeded in holding the market up.  If one owned equal amounts of the 10 largest companies as of the end of the calendar year, the return was approximately 20%.  Owning the remaining 490 issues in the S&P 500 resulted in a loss (before dividends) of roughly 3%.  The composite outcome in this circumstance was a very tight return range for the year, and momentum and growth factors trounced traditional value characteristics. 

After the market’s decline in the September quarter, the December quarter experienced a recovery, albeit with the momentum-versus-value dichotomy still firmly in place.  Perhaps the defining event of the quarter (in financial terms) was the Federal Reserve’s decision to increase short-term interest rates.  This was the first rate increase since 2006.  A prominent bank CEO noted that the majority of his employees had never seen a rate increase during their professional careers. 
 
The Equity and Income Fund earned 2% in the quarter, which contrasts to a 3% gain for the Lipper Balanced Fund Index, the Fund’s performance benchmark.  For calendar 2015 as a whole, the Fund showed a loss of 5%, compared to a small loss for the Lipper Index.  We are pleased to report that the annualized compound rate of return since the Fund’s inception in 1995 is 10% while the corresponding return to the Lipper Index is 7%. 

As noted above, for investors to thrive in 2015, they needed to own a small group of the largest companies.  We did not, finding those companies’ valuations to be inconsistent with the Equity and Income Fund’s mandate.  Weak energy and commodity markets hurt a wide range of companies in the Fund, including companies with rather indirect exposure.  In our opinion, these share price declines were out of proportion with any actual reduction in business value. 

General Motors, Bank of America, TE Connectivity, Lear and Bruker led the list of contributors to return in the quarter.  Foot Locker led the detractors (despite reporting strong earnings).  Other detractors included Baker Hughes, Union Pacific, HSN and Reinsurance Group of America.  For calendar 2015, Glencore, National Oilwell Varco, Oracle, Union Pacific and Flowserve detracted most from return.  The largest contributors to annual portfolio return were Lear, United Health Group, Omnicare (which CVS Health purchased for cash during the year), Foot Locker and MasterCard Class A.   

20-Year Retrospective
For the writer of this section, it is hard to believe that the Equity and Income Fund opened for business just over 20 years ago.  In the first quarterly report for the Fund, I stated objectives of producing attractive rates of return with attention to preservation of capital and current income.  As noted above, the Fund has generated a compound rate of return of 10% over its 20-year history. While I certainly would like to have done better, I am satisfied that clients could meet their economic needs with that rate of return, particularly given that price inflation in the general economy has stayed low.  Compared to my expectations in 1995, both the volatility of this return stream and the equity contribution to portfolio return have been higher.  Perhaps the key macro factor that I did not foresee was the long-term suppression of interest rates that began nine years ago.  Back in 1995, I naively believed that fixed income investments could be expected to produce yields of 6% over the Fund’s life.  I also did not predict the shift in emphasis at many companies from dividends to share repurchases. Although share repurchase has been helpful to the total return of many of the Fund’s equity holdings, it does nothing for the Fund’s current income generation.  As I look back, it is this shortfall of current income that has disappointed me most.

The Fund’s first report set three guiding principles for investing that are still in force today:  

1. A balanced fund such as the Equity and Income Fund is an integrated unit.  We understand the portfolio in its entirety, not as an aggregation of different types of securities.  All securities appropriate for the objectives of this Fund compete for space within the portfolio.  A word sometimes used in our industry that we find objectionable is “silo.” In this Fund, there are no silos. 
2. Our ability to identify attractive investment opportunities drives the Fund’s asset allocation.  At Harris Associates, our investing process has always moved from the bottom up, and this is a key differentiating factor for the Equity and Income Fund.  If attractive stocks are plentiful, the Fund’s equity allocation will approach its maximum.  Or, should expected returns from bonds become compelling, we will move the Fund in that direction.  Accordingly, the Fund’s asset allocation to equities has ranged from a high of 75% (the prospectus maximum) to a low of around 48% over the Fund’s history.  Investors should expect consistency of investing philosophy and style, not a stable asset allocation.
3. We do not equate volatility with risk.  For us, fluctuations in share prices do not define the riskiness of an issue.  We think of risk as the probability of losing money in an investment.  For all 20 years, we have focused on minimizing downside risk while positioning the portfolio to capture upside volatility.

We still believe that this sort of multi-asset class fund offers considerable utility to investors.  It can be a complete investing program or the core holding of a more complex portfolio. 

To close this retrospective, I must thank the scores of colleagues who have helped this Fund to be successful.  Harris Associates’ research department originates all of the ideas that eventually populate the Fund.  I am deeply grateful for the many good recommendations that our team of analysts has provided over the past 20 years.  I also thank my team of co-managers for the past 2 ½ years, and I look forward to more years of collaboration.  Finally, I must again express my deep gratitude to my retired co-manager of the Fund, Edward A. Studzinski, for his many years of contributing to the Fund’s success.

Transaction Activity
We initiated three new holdings in the quarter: Ally Financial, Gaming and Leisure Properties, and Oshkosh.  Ally was originally founded nearly a century ago as General Motors Acceptance Corporation.  Its purpose then was to provide financing to GM dealers and retail customers.  Today, Ally’s purpose is largely the same except that it is no longer owned by GM and now serves dealers and customers of many other automobile manufacturers, such as Ford, Chrysler, and Toyota.  Since Ally’s initial public offering in spring 2014, its shares have fallen over 20% while the S&P 500 has increased by over 15%.  Over this period, some investors have grown concerned that the business is at a cyclical peak, as U.S. auto sales are near record levels and credit losses are below long-term averages; as a result, some believe Ally’s earnings have nowhere to go but down.  But we believe cyclical pressures will be offset by continued internal improvements, such as funding cost reductions (as “legacy” liabilities are replaced with lower cost borrowings) and capital actions. With Ally’s stock trading at just 80% of tangible book value, we believe Ally is a compelling investment opportunity.

Gaming and Leisure Properties (GLPI) is a triple net real estate investment trust (REIT), formed from the tax-free spin-off of the real estate assets of Penn National Gaming.  It is currently trading at a sizable discount to our estimate of its intrinsic worth, as well as peer valuations. The discount stems from the newness of the regional gaming industry to the REIT category, interest rate concerns and the overhang created by an upcoming equity issuance associated with a recent acquisition.  In our opinion, regional casinos’ cash flows are well suited to the REIT structure, and we expect investors to appreciate this better in time.  We believe that the equity financing will be completed in the first half of 2016, which will reduce investor uncertainty.  GLPI is run by CEO Peter Carlino and CFO Bill Clifford—two proven value creators.  With their leadership, GLPI should have significant consolidation opportunities ahead.  Finally, GLPI pays an attractive dividend with a yield of 7.7%. 

Oshkosh manufactures aerial work platforms (access equipment), fire and emergency vehicles, heavy-duty commercial vehicles, and military vehicles. Access equipment generates the majority of corporate profits.  This business correlates closely with non-residential housing construction but also benefits from increasing housing starts.  The defense business offers significant upside to Oshkosh.  In August, the Department of Defense awarded Oshkosh the contract for its Joint Light Tactical Vehicle program, which will replace the Humvees currently used by the Army and Marines.  Lockheed Martin has protested this contract award, so the ultimate outcome is uncertain.  In the event that Oshkosh prevails, the large size of this program should prove quite rewarding. 

As always, we thank our fellow shareholders for investing in the Equity and Income Fund.  We especially thank those of you who have been with us for the past 20 years.

The holdings mentioned above comprise the following percentages of the Oakmark Equity and Income Fund’s total net assets as of 12/31/15:  General Motors Co. 4.2%, Bank of America Corp. 4.1%, TE Connectivity, Ltd. 2.8%, Lear Corp. 0.8%, Bruker Corp. 0.6%, Foot Locker, Inc. 2.4%, Baker Hughes, Inc. 1.8%, Union Pacific Corp. 1.4%, HSN, Inc. 0.7%, Reinsurance Group of America, Inc. 1.2%, Glencore PLC 0.4%, National Oilwell Varco, Inc. 0.3%, Oracle Corp. 3.7%, Flowserve Corp. 1.8%, UnitedHealth Group, Inc. 1.6%, Omnicare, Inc. 0%, CVS Health Corp. 2.8%, MasterCard, Inc., Class A 2.0%, Ally Financial Inc. 0.5%, Gaming and Leisure Properties 0.2%, Oshkosh Corporation 0.2%, Ford Motor Company 0%, Fiat Chrysler Automobiles N.V. 0%, and Toyota Motor Corporation 0%, Penn National Gaming, Inc. 0%, and Lockheed Martin Corporation 0%.  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.

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 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.