Oakmark Equity and Income Fund - Investor Class
Average Annual Total Returns 09/30/16
Since Inception 11/01/95 10.07%
Gross Expense Ratio as of 09/30/15 was 0.75%
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.
Quarter and Fiscal Year Review
After the market’s Brexit-related turbulence at the end of the June quarter, comparative calm marked the September quarter. At one point the stock market posted an unusually long streak of days without a 1% price change in the averages. The fact that this torpidity occurred during a time of worldwide political upheaval made it seem even odder.
The Equity and Income Fund found this investing environment to be favorable as it gained 5% in the quarter. This compares to 3% for the Lipper Balanced Funds Index, the Fund’s performance benchmark. For the nine months of the calendar year, the Fund returned 6%, compared to 6% for the Lipper. And for the twelve months ended September 30 (the Fund’s fiscal year), Equity and Income earned 7%, which compares to 10% for the Lipper Balanced Funds Index. The annualized compound rate of return since inception in 1995 is 10% while the corresponding return for the Lipper Index is 7%.
Bank of America, General Motors, Foot Locker, TD Ameritrade and Principal Financial Group provided the largest contribution to portfolio return in the quarter. CVS Health led the largest detractors list, apparently suffering collateral damage from the congressional hearings on pharmaceutical industry price increases. Other detractors included Kate Spade, HSN, Oracle and Carters. The largest contributors for the calendar year to date were Glencore, Dover, Oracle, UnitedHealth Group and Union Pacific. Bank of America, BorgWarner, CVS Health, Wells Fargo and Goldman Sachs were the leading detractors for the nine months. Finally, for the Fund’s fiscal year, the largest contributors were Dover, Glencore, Philip Morris International, Oracle and UnitedHealth Group. The stocks that detracted most were BorgWarner, HSN, Bank of America, Oceaneering International (sold) and CVS Health.
Is Value Investing Impaired?
As we all know, 2008 was the start of the Great Recession and a brutal year in the stock market. Less well known is the fact that 2008 also witnessed a significant change in stock market internal dynamics. Before 2008, measures of return for value stocks relative to growth stocks had favored value when measured over long time periods. Short-term, counter-trend moves were frequent, and some were extreme, such as the 1997-99 Internet boom. However, over the very long term, value dominated. Since 2008, though, growth stock indexes have persistently prevailed over value in terms of relative performance.
Many explanations have been given to explain this change in market dynamics, but as is usually the case, the simplest answer appears to be the best. In a period of slow or negative economic growth, those companies that can demonstrate meaningful growth in revenues and profits will generally outperform in the market regardless of valuation. Calendar year 2015 demonstrated this phenomenon to an extreme: the so-called FANG stocks (Facebook, Amazon, Netflix and Google, aka Alphabet) provided a majority of the S&P 500’s investment return. To have such a small number of equities dominate investment return to this degree was an unprecedented outcome.
So as fundamental value investors, what is to be done in such an investing environment? Simply put, we continue as before, knowing that over time price and value will come together often enough to be the basis of an effective investing strategy. We recently read a quote from a portfolio manager in a Financial Times article that stated “You have to believe [when] getting out of bed that you have a chance of outperforming, otherwise you wouldn’t bother.” This is not the way that we think about it. We would instead say that we believe when we come to work each day, we have the possibility of finding and investing in the next great value opportunity for our clients, and it is that search that energizes us. Value investing is unlike farming, however, in that we do not know when our crops will be ripe for harvesting. This means that periods of relative underperformance are inevitable, but the economic logic underpinning fundamental value investing should ensure satisfactory absolute returns when measured over a suitable time horizon. An unusual economy has favored growth for quite some time, but we believe fundamental value investing itself is not impaired.
We initiated two new positions in the September quarter while exiting one. Our one sale was Goldman Sachs, which we sold partly for tax reasons and partly to rebalance the portfolio, which had become somewhat heavy with financial industry issues. We believe Goldman Sachs is a great company with many desirable attributes, but we determined that the portfolio’s other financial company investments were more attractive at this time.
Alphabetically, our first new purchase was HCA Holdings, the largest operator of for-profit hospitals and related health care services in the U.S. The company benefits from scale and size advantages, an attractive geographic footprint in higher growth markets, best-in-class management and governance, and an equity-friendly approach to capital allocation. We expect HCA to grow operating income in the mid-single digits and EPS in the low double-digits over time. The company could also benefit from increased adoption of Medicaid expansion and/or increased enrollment on public exchanges. Uncertainty about health care reform and a rotation away from levered companies have caused HCA’s share price to sell below our estimate of intrinsic value, offering what we believe is an attractive entry point.
Our second new purchase, MGM Resorts International, offers several paths to being a successful investment. First, MGM Resorts is in the early stage of recovery from an industry downturn. Activity on the Las Vegas strip is strengthening, and this should enable MGM to benefit from operating leverage in its significant Las Vegas assets. Augmenting this is the company’s Profit Growth Plan, a cost-cutting and revenue-enhancement program that we believe will add substantial profitability. To our surprise, many investors have not yet fully incorporated this plan and its implications in their forecasts. Longer term, the investing story has a transformational element as well, due to the company’s geographically diverse and multifaceted development pipeline, its improving capital structure, and the secular trends in Las Vegas. We believe that the stock is not getting enough credit for these and other value creators, so we view it as an attractive opportunity.
The combined effect of our transaction activity and market price movements resulted in a small increase in the portfolio’s equity allocation. The Fund’s fixed income allocation experienced a significant number of maturities and calls in the quarter causing that allocation to fall and the cash reserve position to rise. We continue to seek out fixed income issues that will provide income and diversification benefits without too much sensitivity to an increase in interest rates. To that end, we have kept the portfolio’s fixed income duration relatively short.
As always, we thank you for entrusting us with your assets. Please feel welcome to send us your comments or questions.
The holdings mentioned above comprise the following percentages of the Oakmark Equity and Income Fund’s total net assets as of 09/30/16: Bank of America Corp. 3.8%, General Motors Co. 4.2%, Foot Locker, Inc. 2.7%, TD Ameritrade Holding Corp. 2.0%, Principal Financial Group, Inc. 1.9%, CVS Health Corp. 2.7%, Kate Spade & Co. 0.6%, HSN, Inc. 0.4%, Oracle Corp. 3.2%, Carters, Inc. 0.4%, Glencore PLC 0.6%, Dover Corp. 2.8%, UnitedHealth Group, Inc. 2.1%, Union Pacific Corp. 1.6%, BorgWarner, Inc. 1.6 %, Wells Fargo & Co. 0.9%, The Goldman Sachs Group, Inc. 0%, Philip Morris International, Inc. 1.9%, Oceaneering International, Inc. 0%, Facebook, Inc. 0%, Amazon.com, Inc. 0%, Netflix, Inc. 0%, Alphabet, Inc. 0%, HCA Holdings Inc. 0.6% and MGM Resorts International 0.2%. 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.
EPS refers to Earnings-Per-Share and is calculated by dividing total earnings by the number of shares outstanding.
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.
All information provided is as of 9/30/2016 unless otherwise specified.