Oakmark Equity and Income Fund – Investor Class
Average Annual Total Returns 12/31/18
Since Inception 11/01/95 9.50%
Gross Expense Ratio as of 09/30/18 was 0.88%
Net Expense Ratio as of 09/30/18 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. To obtain the most recent month-end performance data, view it here.
Do You Still Remember 2017?
Our previous year-end report was titled “2017, We Will Miss You.” Rarely are we so prophetic in our report titles! In some ways, 2017 was the inverse of 2018. It was the first “perfect year” in which the S&P 500 realized a positive return each month, something that had never happened before (and certainly did not occur in 2018). Volatility was modest—so modest that a popular trade was to sell options on volatility contracts. One would think that the investing environment was quite benign, but this was not really the case. Worldwide trouble spots continued to be troubled, the Fed raised interest rates three times and U.S. politics became more unpredictable. Yet, the stock market continued on its way with insouciance.
Calendar-year 2018 actually started off with a bang—what some described as a “melt-up.” But by the end of January, this move upward reversed in its entirety in merely a few days, thereby setting the stage for the rest of 2018, a year of increased volatility and one in which most asset classes suffered price declines. Although many of 2018’s economic fundamentals were also present in 2017, investors’ responses were quite different. Relative to corporate earnings, 2018 experienced the second-best annual percentage increase since the 1980s, yet the stock market suffered its worst year since 2008. Rising earnings and declining prices meant compressed stock valuations and this price/earnings contraction was the largest since 2002. An erratic, volatile year like 2018 offers many anomalies, such as the stock market decline on Christmas Eve—which was almost four times worse than anything ever experienced before on that day—or the rally the next trading day, when the Dow Jones Industrial Average shot up by more than 1,000 points for the first time ever.
But the real question all of this provokes is, “What has caused this change in the character of stock market action?” Sadly, we do not really know, just as we cannot effectively explain why 2017 was so favorable. Most market-affecting issues that did not resolve in 2017 remain unresolved at the end of 2018: tariff skirmishes perhaps developing into a serious trade war, rising interest rates possibly resulting in an inverted yield curve, extraordinary volatility in the price of oil, widening yield spreads between high-quality and low-quality bond issues, European problems, especially in the U.K. with its Brexit negotiations, France with its civil unrest, and Italy with its political challenges, as well as the social strains caused by migrations from south to north, etc.
Although we cannot explain why markets behaved so differently in 2017 and 2018, we can recall that valuation compression like that experienced in 2018 generally precedes strong returns. And even though we are unable to forecast the economy, we do not see evidence of the kinds of excess or duress that preceded the previous two downturns. One important difference between 2008 and 2018 is that the financial industry’s balance sheets are much stronger. Balance sheets of the Fund’s holdings, both financial industry and otherwise, are also in good shape. Another factor that we monitor is trading by corporate insiders in their own stocks. Earlier in the year, purchase activity was very light, but it picked up as prices declined during the past quarter. Finally, we note that, though 2018 ended badly, the combined investment returns of 2017 and 2018 for both the market and the Fund are still positive. In addition, market turbulence has created value opportunities to be exploited in the future, but admittedly, 2017 was a lot more relaxing.
Quarter and Annual Review
The Fund lost 9.3% in the quarter, which compares to a loss of 7.7% for the Lipper Balanced Fund Index, the Fund’s performance benchmark. For all of 2018, the Fund lost 8.3%, compared to 4.7% for the Lipper. Value has underperformed growth (as measured by the Russell 1000 Value and Russell 1000 Growth Indexes) by 4% per year since the end of 2008, and this has pressured the Fund’s relative returns. Another factor that we are unable to predict is when the market will return to favoring value, but we will note that the annualized compound rate of return for the Fund since inception in 1995 is 9.5%, while the corresponding return to the Lipper Index is 6.5%.
In such a difficult quarter, positive contributors to Fund performance were few: Foot Locker and Diageo. The most significant detractors from return were National Oilwell Varco, Bank of America, Citigroup, Mastercard and TE Connectivity. Financial issues underperformed during the quarter as the spread between short-term interest rates and longer term rates narrowed. A narrowing spread can restrain earnings for banks. Energy industry holdings, such as National Oilwell Varco, declined as the price of oil dropped as much as 40% in the quarter. Contributors for the calendar year were Mastercard, HCA Healthcare, UnitedHealth Group, Foot Locker and Jones Lang LaSalle (sold). Philip Morris International detracted most for all of 2018, followed by Bank of America, TE Connectivity, General Motors and Citigroup.
During the quarter we eliminated two holdings, CommScope Holding and Baker Hughes, a GE Company. Both holdings produced losses, which we used to offset gains taken earlier in the year. Baker Hughes suffered from the collapse in the price of oil. Investors also feared the overhang from General Electric’s (GE) dominant shareholding in the company. New management at GE has indicated a desire to monetize GE’s interest and this could pressure Baker Hughes’ share price. Our second portfolio sale, CommScope, announced in November that it would acquire Arris, a company involved in broadband, wireless and video technology. Although we have previous experience with Arris and find the company interesting, we are uncomfortable with CommScope making an acquisition of this size, especially because the company substantially increased its debt load to do so.
We did not initiate any new equity holdings in the period. This does not imply a lack of activity, however. Stock prices declined vigorously in October and December and this provided opportunities for us to add to existing holdings at more attractive prices.
A Note on Fixed Income
As we noted in our previous letter, we perceived the fixed income market to offer more attractive opportunities in the latter half of 2018 and we increased the portfolio’s fixed income allocation accordingly. This has also meant an increase in the effective duration of the bond portfolio to 2.35 years. Duration measures the sensitivity of an asset to changes in interest rates. The fixed income portfolio’s 2.35 duration implies that a +/-1% move across the term structure of interest rates would cause a +/- price move of 2.35% of the principal value. This is still a conservative posture relative to interest rate risk, and we anticipate increasing duration further should interest rates continue to rise.
Relative to credit risk (default risk), we continue to have an allocation to lower rated credits. When investing in high yield, we look at each issue similarly to how we analyze equities and we demand that any prospective holding have an equity-like expected return. High yield bonds can be sensitive to economic conditions, so it is important that we test our holdings for their likely performance under duress. In the absence of a serious recession, we believe that investment-grade and lower quality issues will provide above-average returns.
We thank our shareholders for entrusting their assets to the Fund and we welcome your questions and comments.
The securities mentioned above comprise the following percentages of the Oakmark Equity and Income Fund’s total net assets as of 12/31/18: Arris 0%, Baker Hughes 0%, Bank of America 4.8%, Citigroup 1.8%, CommScope Holding 0%, Diageo ADR 2.2%, Foot Locker 1.7%, General Motors 4.9%, HCA Healthcare 1.0%, Jones Lang LaSalle 0%, Mastercard Cl A 3.1%. National Oilwell Varco 1.4%, Philip Morris Intl 2.1%, TE Connectivity 3.9% and UnitedHealth Group 2.3%. Portfolio holdings are subject to change without notice and are not intended as recommendations of individual stocks.
The net expense ratio reflects a contractual advisory fee waiver agreement through January 27, 2020.
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 Dow Jones Industrial Average is a price-weighted measure of 30 U.S. blue-chip companies. The index covers all industries except transportation and utilities. This index is unmanaged and investors cannot invest directly in this index.
The Russell 1000® Value Index measures the performance of the large-cap value segment of the U.S. equity universe. It includes those Russell 1000® companies with lower price-to-book ratios and lower expected growth values. This index is unmanaged and investors cannot invest directly in this index.
The Russell 1000® Growth Index measures the performance of the large-cap growth segment of the U.S. equity universe. It includes those Russell 1000® companies with higher price-to-book ratios and higher forecasted growth values. 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.
All information provided is as of 12/31/2018 unless otherwise specified.