Commentary

Oakmark Equity and Income Fund: Third Quarter 2020

September 30, 2020

Oakmark Equity and Income Fund – Investor Class
Average Annual Total Returns 09/30/20
Since Inception 11/01/95 9.29%
10-year 6.87%
5-year 5.72%
1-year -0.90%
3-month 4.76%

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.

It Has Been 25 Years!
By the time shareholders receive the hard copy of this report, the Equity and Income Fund will have celebrated its 25th birthday. The Fund’s early years were marked by the dot-com mania, a less than salubrious environment for a value fund, but we persisted. The Fund’s fortunes improved with the turn of the millennium and the long-term result has been a fund that has approximately matched the return to stocks (as measured by the S&P 500 Index) but with less volatility. We normally thank our investors for their commitment to this Fund at the end of the letter, but this time we wish to lead off with thanks for those of you who have been with us from the beginning. We also wish to thank our former co-managers, Edward Studzinski, Matthew Logan and Edward Wojciechowski, for their considerable contributions to the success of this Fund.

Market Distortions
Over the Fund’s long history, the stock market has gone through many phases that were identifiable either mid-stream or in hindsight. Earlier, we mentioned the dot-com mania of the late 1990s, which was very difficult for value investors like ourselves. The past few years have been another difficult period. One way to characterize it is to look at the returns of Russell’s sub-indexes. Since January 2018, the Russell 1000 Growth Index has bested its 1000 Value Index by over 19% per year. The spread in 2020 to date is an all-time record: 36%! Professor Kenneth French of Dartmouth looked at this factor by studying 10-year periods.1 In the 90-such 10-year periods for which he had data, growth outperformed value only eight times. Five of those eight time periods were the most recent five. In short, it has certainly been a challenging time for value investors.

Long-term Fund shareholders may recall that during the dot-com era we were critical of the valuations of some established companies. We could not understand why General Electric achieved a price/earnings ratio of more than 40 times, yet similar businesses were priced with multiples in the teens. Time has vindicated our skepticism. Over the past few years, GE’s share price has declined to single digits, making it very painful for anyone who purchased shares in 1999. Perhaps a better example is Cisco Systems, the company which attained the highest market value in the dot-com era. In 2000, Cisco’s market capitalization peaked at a multiple roughly equal to 200 times its annual revenue. Since then, its revenues have increased by 16 times and its stock has been added to the Dow Jones Industrial Average. Yet its share price remains below its 2000 peak.

Today, the stock that value investors complain the most about is Tesla, the manufacturer of battery-powered vehicles. We hesitate to quote many valuation measures for this company because its volatility quickly makes such statements obsolete. Nevertheless, during the recent quarter, its market capitalization exceeded a value of $1 million for each car it annually produces. Although the company reports profits, those profits are an outcome of its sale of environmental credits, i.e., it is not profitable on car sales alone. In contrast, Fund holding General Motors sells for less than $10,000 per annually produced vehicle and the company makes profits on those sales. Perhaps Snowflake, which went through its IPO in September, offers an even more salient example of extreme valuation. This eight-year-old company quickly attained a market capitalization similar to IBM’s, a company with 120 times as much revenue. In fact, IBM’s dividend payout alone is almost 10 times Snowflake’s annual revenue.

Now, we do not wish to equate current market conditions with the 1999 experience. Market history often rhymes, but it rarely repeats. The high-multiple stocks today are generally interesting, real businesses unlike some of the short-lived dot-coms 20 years ago. Nevertheless, Cisco also proved to be a real business and has stood the test of time, yet its stock price has never returned to its 2000 heights. The message is simple: price matters, and in the long run it matters a lot. We continue to have no ability to forecast when value investing will once again outperform growth, but we remain certain that as long as human nature does not change, value investing will work. History suggests that value investing enjoys its greatest outperformance when it is most out of fashion. Waiting for this change demands patience, but we can point to the 1999-2000 experience when waiting eventually paid off handsomely.

Do Balanced Funds Have a Future?
As you can well imagine, we absolutely believe that balanced funds, such as Equity and Income, can continue to benefit investors. We offer this assertion in response to the September 23 Financial Times2 article, “Investors wonder if the 60/40 portfolio has a future.” In this piece, the author suggests that balanced funds may be obsolete because of their forecasted underperformance given current stock and bond prices. But, underperformance versus what, we ask? And the answer is underperformance compared to balanced funds’ previous returns. Indeed, those historic returns have been generous: 7% per annum for the past 40 years and 9% per annum since 1926, for a 60/40 S&P 500/Treasury note portfolio. We agree that a generic portfolio is unlikely to generate those returns today, but in our opinion, this oversimplifies the issue.

The Equity and Income Fund is a flexible balanced fund and its asset allocation and security selection reflect Harris Associates’ ever-evolving understanding of value. When equity opportunities are abundant, the equity allocation will be high, and in times of scarcity, the fixed income allocation increases. The Fund is eclectic. It invests in both U.S.- and internationally domiciled equities and bonds and it is agnostic with regards to capitalization. In its fixed income holdings, the Fund invests in investment grade and high-yield corporate debt, government and government agency debt, bank debt, and preferred stocks. This flexibility provides a key advantage because it allows us to pursue return opportunities wherever we perceive them. And we manage the Fund with high conviction (i.e., concentration) and low turnover.

As described in the previous section, value equities have underperformed for the past decade, such that return possibilities remain significant in that sector. In part, this underperformance results from the fact that market returns have been concentrated in a small number of very large-capitalization growth equities. But while the exalted few have been marching ceaselessly upward, others have been steadily increasing their intrinsic value without recognition in the stock market, creating ever greater opportunity.

It is hard to make the case for generic fixed income investing today. Thirty-year Treasury notes actually yield less than the S&P 500, something that except for a brief moment in the great financial crisis last occurred in the 1950s. Of course, for quite some time we have been warning of the increased riskiness in fixed income investments. This is pure math—when rates shrink to minimal levels, bond prices react more violently to changes in rates. A 10-year Treasury yielding 0.65% offers a modest return with high vulnerability to changing market conditions. But even in this environment, our go-anywhere flexibility enables our fixed income investing team to find pockets of opportunity with which to enhance the Fund’s return.

Most importantly, we think that the Financial Times’ argument fails because returns are not the only reason for investors to stick with a balanced fund. Balanced funds have endured because they help investors cope with the frailties of human nature. Many of us know individuals who have sold out of equities shortly before the bottom of a bear market period. With the buffered volatility of a balanced fund, investors have generally proven to be better able to maintain their allocation and avoid this kind of error.

To conclude, we believe that balanced funds fill an important role for many investors and that a value-oriented fund, such as Equity and Income, has the potential to meet investor needs even in the current environment. To that end, each of this Fund’s managers has added to their holdings in the Fund in 2020.

Quarter and Fiscal-Year Review
The Equity and Income Fund returned 4.8% in the quarter, which compares to 6.2% for the Lipper Balanced Fund Index, the Fund’s performance benchmark. For the nine months of the calendar year, the Fund lost 6.4%, compared to a gain of 3.6% for the Lipper. For the 12 months ended September 30 (the Fund’s fiscal year), Equity and Income earned -0.9%, which compares to 8.9% for the Lipper Balanced Fund Index. The annualized compound rate of return since inception in 1995 is 9.3%, while the corresponding return for the Lipper Index is 6.9%.

TE Connectivity, General Motors, Charter Communications, Ally Financial and Mastercard provided the largest contribution to portfolio return in the quarter. The largest detractors from return were Citigroup, CVS Health, Diamondback Energy, American International Group and Thor. Contributors for the calendar year to date were Charter Communications, Thor, Regeneron Pharmaceuticals, Mastercard and Alphabet. Bank of America, Citigroup, General Motors, Howmet Aerospace and ChampionX were the leading detractors for the nine months. Finally, for the Fund’s fiscal year, the largest contributors were Charter Communications, Mastercard, Regeneron, UnitedHealth Group and Thor. The stocks that detracted most were Citigroup, General Motors, Howmet Aerospace, Bank of America and Howard Hughes.

Transaction Activity
Our transaction activity was modest in the quarter in terms of new purchases and eliminations. We exited CoreLogic, which received a takeover offer at the end of the June quarter that came close to our estimate of the company’s intrinsic value. Our trading was far more active than this one elimination indicates, however, as we took advantage of intra-quarter market volatility and worked to become more tax-efficient.

We thank our shareholders for entrusting their assets to the Fund and welcome your questions and comments.

1Professor Kenneth French reference: https://www.advisorperspectives.com/commentaries/2020/07/20/value-is-dead-long-live-value-investing

2Financial Times article: https://www.ft.com/content/fdb793a4-712e-477f-9a81-7f67aefda21a

The securities mentioned above comprise the following percentages of the Oakmark Equity and Income Fund’s total net assets as of 09/30/20:   Ally Financial 2.2%, Alphabet Cl A 5.1%, American International Group 0.5%, Bank of America 5.2%, ChampionX 0.3%, Charter Communications Cl A 2.9%, Cisco Systems 0%, Citigroup 1.8%, CoreLogic 0%, CVS Health 2.8%, Diamondback Energy 0.2%, General Electric 0%, General Motors 4.2%, Howard Hughes 0.5%, Howmet Aerospace 1.5%, IBM 0%, Mastercard Cl A 3.2%, Regeneron Pharmaceuticals 0.9%, Snowflake 0%, TE Connectivity 4.6%, Tesla 0%, Thor Industries 1.0% and UnitedHealth Group 1.5%. 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.

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 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 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 09/30/2020 unless otherwise specified.

Clyde McGregor- Portfolio Manager- Headshot
Clyde S. McGregor, CFA

Portfolio Manager

Colin Hudson- Portfolio Manager- Headshot
M. Colin Hudson, CFA

Portfolio Manager

Adam Abbas portrait
Adam D. Abbas

Portfolio Manager