Oakmark Equity and Income Fund: Second Quarter 2020

July 8, 2020

Oakmark Equity and Income Fund – Investor Class
Average Annual Total Returns 06/30/20
Since Inception 11/01/95 9.19%
10-year 6.98%
5-year 3.25%
1-year -5.25%
3-month 14.63%

Gross Expense Ratio as of 09/30/19 was 0.91%
Net Expense Ratio as of 09/30/19 was 0.81%

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.

To the astonishment of many, the stock market staged a strong recovery in the second quarter. What or who deserves credit for this rapid rebound? While the coronavirus news was better than the worst fears, it was not universally positive. Many of the earliest, hardest hit states have seen a consistent drop in cases and deaths, but cases have been increasing in many states that were spared from the initial wave. Emerging reports about a vaccine seem encouraging, but no one can say for certain how successful it will be or when it will arrive. Early economic reports indicate that spending has recovered from very depressed levels, but many industries have seen only a tepid rebound and could have to contend with lasting damage. Given this, how were stocks actually up for the year at one point in June? We believe a primary reason for this was the Federal Reserve’s aggressive stance.

The Fed has taken multiple actions to stabilize the economy. First, it took the federal funds rate to zero and signaled that it would keep rates there until at least 2022. It also announced plans to support the corporate bond and short-term liquidity markets. All of these actions were taken to help reduce borrowing costs and improve liquidity for corporations. These actions had an immediate impact. Both investment-grade and high-yield markets saw a record surge of issuance at yields much lower than March highs. The Fed’s actions also helped spawn a recovery in equity markets, especially among growth stocks—many of which are actually up strongly this year. While it is well understood that a drop in yields is beneficial for long-dated bonds, it is less understood that this will also benefit growth stocks over value stocks. This is because growth stocks have a much higher percentage of expected cash flows well out into the future, so, in essence, they are similar to long-dated bonds. Whether these growth stocks can grow at the expected rate or if the distant cash flows should be discounted at today’s very low interest rates is debatable. Another effect of the Fed stimulus was that it seemed to ignite the animal spirits among retail investors. Many of the most indebted companies enjoyed huge rallies during the second quarter. Bankrupt Hertz’s stock price doubled and the company actually contemplated issuing equity for a brief period until the SEC advised against it.

Although these are unusual times, Oakmark is still practicing the same value philosophy it always has. We attempt to identify companies that consistently grow per share value, are run by capable management teams and are trading at a large discount to our estimate of intrinsic value. Our analysts are paying especially close attention to balance sheets along with companies’ cash needs over the next several years. Although many businesses may be able to survive what they otherwise wouldn’t have, if not for the Fed’s actions, it seems likely, in our opinion, that they will emerge with much more debt, which could ultimately undermine their equity value. For example, if some airlines, retailers and cruise lines survive, their equity value may be damaged due to the large debt balances they have taken on. Our analysts are also working hard to identify well-capitalized businesses that have suffered temporary earnings disruptions but whose long-term earnings power remains intact. Our auto-related stocks are a good example of this. We believe their earnings will rebound sharply as auto production returns to previous levels in a few years. Financial stocks also look attractive. The ones we own now trade well below book value and at less than 10x normalized earnings due to worries about coronavirus losses. We believe that these losses will be an earnings event rather than a capital one because these companies have much higher starting capital levels than they did during the financial crisis of 2008. Current valuations also ignore financial companies’ improved balance sheets, better underwriting and de-risked loan portfolios.

Quarter Review and Transaction Activity
The Oakmark Equity and Income Fund increased 14.6% in the second quarter, compared to a 12.0% increase for the Lipper Balanced Fund Index. Year to date, the Fund is down 10.6%, compared to a 2.4% decline for the Lipper Index. Longer term performance remains strong as the Fund is up 9.2% annually since inception versus 6.8% for the Lipper Index. The Fund’s near-term performance continues to be hurt by an overweight in financials and economically sensitive stocks (value stocks) and an underweight in technology stocks (growth stocks). The outperformance of growth stocks has been remarkable: the Russell 1000 Growth Index is up 9.8% this year versus the Russell 1000 Value Index, which is down 16.3% this year. Longer term performance is similar. Over the past three years, the Russell 1000 Growth is up 19.0% annually versus 1.8% annually for the Russell 1000 Value. We believe that many value stocks have been overly penalized for short-term fundamental weakness, even though their long-term outlooks remain relatively unchanged.

The largest contributors to the portfolio return in the quarter were TE Connectivity, BorgWarner, Alphabet, General Motors and Mastercard. The biggest detractors were Reinsurance Group of America, Southwest Airlines, Carlisle and Philip Morris. For the year, the largest contributors were Thor Industries, Regeneron Pharmaceuticals, CoreLogic, Alphabet and Arconic. For the year, the largest detractors were Bank of America, General Motors, Citigroup, Howmet Aerospace and Ally Financial.

We continued to use market volatility to upgrade the equity portfolio. During the quarter, we initiated two new positions, Diamondback Energy and Sealed Air, and eliminated two, MGM Resorts and Southwest Airlines. Two holdings also underwent reorganizations. Arconic completed its split into Arconic and Howmet. We believe this split will allow both management teams to better focus on their individual end markets and better highlight the inherent value of each segment. Apergy completed its merger with ChampionX and took the latter’s name. The combined company is more geographically diverse and increases the product offerings across the production end markets. This merger will also increase cross-selling opportunities as both companies have diverse customer bases and it will also provide $75 million in cost-saving synergies.

We also initiated a position in a previous Fund holding, Diamondback Energy. Diamondback is an oil and gas producer with a high-quality acreage position in the Permian Basin. We have always liked the company’s low-cost position in the Permian as well as the management team’s focus on per share value. After oil prices collapsed in March, Diamondback was one of the first oil producers to reduce capital expenditures and hedge oil production. Management’s swift actions will ensure that the company can survive nearly any oil price environment. Diamondback has a good balance sheet with an investment-grade rating and plenty of liquidity and the company is maintaining its dividend. Oil prices have rebounded sharply due to an OPEC production agreement and North American production cuts. Diamondback trades at a significant discount to our estimate of the company’s net asset value, using 2019 oil prices, and given the company’s low cost positon, we expect it to generate significant free cash flow in the future.

The second new purchase was Sealed Air, a global provider of packaging solutions that operates under well-known brands, such as Bubble Wrap and Cryovac. The company holds a dominant market share in fresh protein packaging, where its scale, deep customer relationships and installed base of packing equipment form effective barriers to entry. It also has strong franchises in protective packaging for the e-commerce, electronics and industrial end markets, where it adds value by minimizing waste, protecting products from damage during shipping and increasing the efficiency of the packing process. Over the long term, the company’s stable end markets and strong competitive position should generate steady organic growth, high returns on invested capital and excellent free cash flow. However, the company has underperformed its peers and the broader market this year as investors seem to be overly focused on the near-term impacts of a slowdown in industrial markets and the temporary disruption to the food supply chain. This has created the opportunity to purchase the stock for less than 12x this year’s consensus earnings per share.

The two positions we eliminated were MGM Resorts International and Southwest Airlines. While we believe both stocks are still undervalued, we decided to utilize the embedded tax loss in both positions and add to holdings that were trading at larger discounts to our estimates of value.

We would like to thank our fellow shareholders for their investment in the Fund and welcome any questions or comments.

The securities mentioned above comprise the following preliminary percentages of the Oakmark Equity and Income Fund’s total net assets as of 06/30/20: Ally Financial 1.6%, Alphabet Cl A 4.8%, Apergy 0%, Arconic 0.3%, Bank of America 4.7%, BorgWarner 2.6%, Carlisle 1.0%, ChampionX 0.3%, Citigroup 2.2%, CoreLogic 0.7%, Diamondback Energy 0.5%, General Motors 3.5%, Howmet Aerospace 1.3%, Hertz 0%, Mastercard Cl A 3.9%, MGM Resorts International 0%, Philip Morris Intl 2.3%, Regeneron Pharmaceuticals 1.0%, Reinsurance Group 1.0%, Sealed Air 0.1%, Southwest Airlines 0%, TE Connectivity 4.9% and Thor Industries 1.1%. 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 net expense ratio reflects a contractual advisory fee waiver agreement through January 27, 2021.

EPS refers to Earnings Per Share and is calculated by dividing total earnings by the number of shares outstanding.

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 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 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 06/30/2020 unless otherwise specified.

Colin Hudson portrait
M. Colin Hudson, CFA

Portfolio Manager

Adam Abbas portrait
Adam D. Abbas

Portfolio Manager

Clyde S. McGregor, CFA

Portfolio Manager