Oakmark Fund: Second Quarter 2022

The Oakmark Fund returned -17.8% during the second quarter, underperforming the S&P 500 Index’s return of -16.1%. As discussed more thoroughly in Bill Nygren’s market commentary, today’s stubbornly high inflation has forced the Fed to aggressively raise interest rates, which many macro prognosticators believe will ultimately result in a recession. While these forecasts may indeed come to fruition, we don’t attempt to time the market or construct portfolios based on short-term macroeconomic expectations at Oakmark. Instead, we adhere to a disciplined, bottom-up approach to investing and value our businesses using mid-cycle or “normal” estimates of earnings, which take into account both good times and bad. Should our businesses over- or under-earn for a period of time, the impact to long-term business values is typically modest. This approach, coupled with our longer time horizon and broader definition of value, enables us to uncover attractive investment opportunities.

While all sectors declined this quarter, our outsized weightings in the financials and communication services sectors most negatively impacted quarterly results. Some of our least economically sensitive names, including Constellation Brands and Reinsurance Group of America, were our best individual contributors for the period, while our holdings in Netflix and Ally Financial detracted the most.

Netflix’s stock price was down considerably after providing a weaker than expected outlook for both subscriber growth and profit margins. After meeting with management and scrutinizing our investment thesis, we lowered our estimate of business value to account for the company’s softer near-term guidance. However, we believe the decline in the company’s share price more than adjusts for this. Indeed, Netflix now trades for a discount to the S&P 500 Index on next year’s GAAP earnings despite our view that the company remains a much better than average business run by a highly accomplished management team. We believe the company’s lead in streaming remains intact and we expect terminal operating margins to be substantially higher than they are today. Furthermore, we are encouraged by Netflix’s potential to enhance revenue growth through advertising, the monetization of password sharing and further penetrating international markets. As for Ally Financial, fears of a recession drove the stock price down more than 20% for the period, but business fundamentals have remained strong and the shares now trade for just a mid-single-digit multiple of current earnings. We believe today’s price ignores the funding cost improvements and well-capitalized nature of Ally’s balance sheet. We continue to own both investments given their significant discounts to our estimates of business value.

The current environment has provided us with the opportunity to add several new positions to the Fund and rebalance toward companies with higher risk-adjusted returns, largely by eliminating holdings that have withstood the downturn well. Our decision to exit CVS Health, Constellation Brands, DXC Technology, General Dynamics, Keurig Dr Pepper and Visa would all fit this description as each business is now approaching our estimate of intrinsic value. Specifically to Constellation Brands, while we applaud the company’s recommendation to eliminate its super-voting shares, we were disappointed by the large conversion premium, which we believe extracts too much value from public shareholders. Lastly, we eliminated our small position in Qurate due to business results that underperformed expectations.

The following is a brief description of our new holdings:

Disney is one of the most beloved consumer companies in the world. Its media business has a rich library of intellectual property, which provides a powerful engine for creating new content across the Disney, Pixar, Marvel and Star Wars brands. This content also contributes to the success of Disney’s theme parks, which generated nearly half the company’s earnings and grew more than 10% annually in the decade prior to the pandemic. Shares have fallen nearly 50% over the past year as investors worried about the company’s ability to transition its media business to a direct-to-consumer streaming world. This transition has required management to make investments in its Disney+ streaming service that are depressing profitability today. However, we believe these investments will ultimately produce attractive returns as Disney+ continues to grow subscribers and increase pricing over time. As a result, we were able to purchase shares at a substantial discount to our estimate of intrinsic value.

We became interested in Etsy when Josh Silverman took over as CEO in 2017. The company had long been recognized as a great marketplace, but prior management was not focused on maximizing shareholder value. In short order, Silverman transformed Etsy from a borderline non-profit into a higher margin, faster growing enterprise. The pandemic helped accelerate already strong fundamental business results as millions of new customers were introduced to the platform while stuck at home. But like so many other Covid-19 “winners,” Etsy has since fallen deeply out of favor with investors, which prompted us to take a closer look. Following a 75% decline in its stock price, the company now trades for 3.5x next year’s revenue or just a low double-digit multiple of operating profit using our estimate of normalized margins. We believe this is an attractive price to pay for a unique digital marketplace with a long runway for future growth. Note that our exposure to Etsy is currently established via options.

We believe the market is failing to properly reward Masco, a leader in home improvement products, for the significant upgrade of its business mix over the past decade. Having previously sold its more cyclical, lower return businesses, such as insulation, windows and cabinets, what remains are some of the strongest and most recognizable brands in the industry. The company’s portfolio of products—primarily coatings (Behr) and plumbing fixtures (Delta, Hansgrohe)—are more resilient, lower ticket and higher margin categories. Both segments compete within heavily consolidated industries, exhibit strong pricing power and skew meaningfully toward the less cyclical repair and remodel market. Despite its greatly improved business mix, Masco trades for just 10x next year’s expected earnings, which is a discount to historical levels and comfortably below a market multiple. We believe this dislocation presents an attractive opportunity to invest in a well-managed, high-quality portfolio in a sector that’s currently out of favor.

The sell-off in the enterprise software sector, combined with the complexity related to the acquisition of Cerner, provided an opportunity for us to re-establish a position in Oracle. Oracle is one of the world’s largest and most profitable software companies—generating more than $42 billion in revenue and 40% operating margins. We have always admired the stability of Oracle’s business and the strength of its customer relationships. Now, the company’s organic growth is beginning to accelerate. Specifically, total revenue grew 7% in fiscal year 2022 and 10% in the fourth fiscal quarter. In addition, management believes that Cerner’s growth and margins can be higher under Oracle’s ownership than it could on a standalone basis. Finally, we commend Oracle’s repurchase of roughly half its share base over the past decade, which has nearly doubled each remaining share’s interest in the business. Trading for only 12x calendar 2023 earnings ex-cash, we believe Oracle’s risk/reward is attractive.

A former long-time holding, Parker Hannifin made its way back into the Fund this quarter. We believe investors’ perception of the company as a short-cycle, diversified manufacturer that’s heavily tied to industrial production has become stale. Since becoming CEO in 2015, Thomas Williams has vastly improved operations and shifted the portfolio to longer cycle, higher growth and higher return end markets. With the expected closing of the Meggitt acquisition this calendar year, Parker Hannifin’s highly depressed aerospace segment will become its largest end market. We anticipate a rebound in aerospace revenue, which—combined with the company’s strong position in attractive businesses like clean energy technologies and factory automation—should further accelerate revenue growth. Parker Hannifin trades at a discount to other high-quality industrials, which we believe is unwarranted since its growth and returns should be as good or better than peers. At 12x next year’s cash earnings, Parker Hannifin is an attractive investment, in our view.

We thank you, our fellow shareholders, for your investment and continued support of the Oakmark Fund.

The securities mentioned above comprise the following percentages of the Oakmark Fund’s total net assets as of 06/30/2022: Ally Financial 3.1%, Constellation Brands 0%, CVS Health 0%,, DXC Technology 0%, Etsy 0%, General Dynamics 0%, Keurig Dr. Pepper 0%, Masco 1.2%, Netflix 2.1%, Oracle 1.1%, Parker-Hannifin 1.1%, Qurate 0%, Reinsurance Group 1.2%, Visa 0% and Walt Disney 1.0%. 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 Fund as of the most recent quarter-end.

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 Oakmark 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.

Options may be used for hedging purposes, but also entail risks related to liquidity, market conditions and credit that may increase volatility. The value of the fund’s positions in options may fluctuate in response to changes in the value of the underlying asset. Selling call options may limit returns in a rising market.

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 06/30/2022 unless otherwise specified.