Oakmark Equity and Income Fund: First Quarter 2012
March 31, 2012
Continuing the December quarter’s rally, stock prices moved substantially higher in the first calendar quarter while fixed-income investments generated modest returns. The result for the Equity and Income Fund in the quarter was an 8% gain, which matches the 8% for the Lipper Balanced Fund Index, the Fund’s performance benchmark. For the first six months of the Fund’s fiscal year, the Fund returned 18%, while the Lipper Index returned 15%. The annualized compound rate of return since the Fund’s inception in 1995 is 11%, while the corresponding return to the Lipper Index is 7%.
UnitedHealth Group, TJX, Cenovus Energy, Texas Instruments and Diageo led the list of contributors to the Fund’s quarterly return. The largest detractors were Patterson-UTI Energy, Ultra Petroleum, Range Resources, PharMerica and Walter Energy. All of the detractors are energy or natural resource companies with the exception of PharMerica, which declined after Fund holding Omnicare withdrew its offer to purchase the company. Detractors from return for the fiscal six months were Ultra Petroleum, Patterson-UTI Energy, Boston Scientific, PharMerica and Hospira. The largest contributors were Philip Morris International, Flowserve, General Dynamics, Diageo and UnitedHealth.
Aside from Omnicare ending its effort to purchase PharMerica, the Fund’s only merger/acquisition activity in the quarter involved long-term holding Pentair, the stock which enjoyed the Fund’s largest percentage price increase in the period. This well-managed smaller industrial concern announced a deal in late March to merge with the fluid-handling operations of Tyco International. In 2011, Tyco, which is held in the Oakmark Fund, announced a plan to divide into three parts, and Pentair’s management spied an opportunity to increase its scale in its most important business line. The transaction itself is complicated, but the resulting merger of equals will use the Pentair name and have its legal domicile in Switzerland.
During the quarter, shareholders expressed concern to me about the increased volatility in the Fund’s daily share price. I discussed volatility at length in our September 30 shareholder letter, but I will review that discussion here. The mathematics of security pricing demands that volatility be a function of interest rates. As interest rates decline, the prices of securities become more sensitive to market-moving news. Interest rates are extraordinarily low today, so higher volatility can be expected. I have worked to reduce potential volatility by keeping the average maturity structure of the Fund’s fixed-income allocation very short. But increasing the equity allocation has increased the potential for price volatility, as equities are very long duration assets. Although no one desires more short-term volatility in the Fund’s price, I believe that increased short-term volatility is necessary so that the Fund may meet its shareholders’ needs over the long term.
Based on the number of names purchased or sold as described below, it may appear that there were drastic changes to the portfolio in the quarter. The changes expressed in dollars, however, are far more modest. This outcome is not precisely what I had in mind, as the prices of several new equity purchases exceeded our buy price limits before we came close to our targeted share amount. One unusual characteristic of the recent stock market rally has been its tepid trading level. Establishing sizable new equity positions in a low-volume bull market has proven to be difficult. One outcome is that the Fund’s equity holdings count has grown to 53. I do not target a specific holdings number. As I have often written, I do not mind small positions in the portfolio as long as they have the appropriate valuation attributes. In the March quarter, the smallest equity holding had the fourth-greatest percentage increase in share price. Yes, it might have been better if our original buy price limit had been higher so that we might have accumulated more shares in the Fund, but by owning any shares at all, the Fund benefited. The sum of this purchase/sale activity and positive market action was to increase the equity allocation to nearly 70% from 66%.
On the fixed-income side, the allocation to corporate bonds more than doubled, growing their allocation only to 1% of the portfolio. Many new shareholders often ask why the Fund does not have a significant weighting in corporates, so I beg long-time owners’ indulgence to discuss this once again. As you probably expect, the reason derives from our value-investing philosophy. For most of the past 25 years, Harris Associates has found that investment-grade corporate debt offers insufficient incremental yield over Treasurys to compensate for the additional risk that such debt entails. These risks include, but are not limited to, economic/business risks, inadequate liquidity, and the possibility that the company will engage in a corporate transaction that will result in a downgrade (e.g., a leveraged buyout or a substantial acquisition). In our opinion, when it comes to corporate debt, the deck is stacked in the issuer’s favor. As evidence, the rating services’ ratio of upgrades to downgrades for investment-grade debt is skewed toward downgrades. Today the hunger for yield compounds the problem. Mutual funds specializing in corporate debt continue to grow in size, and their demand to accumulate holdings is generally not governed by value considerations. The Harris Associates fixed-income team and I are working hard to build up the allocation to corporates in the Fund, but current market conditions, combined with our value discipline, slow this process. The net of our fixed-income activity in the quarter was to keep the overall portfolio fixed-income allocation and duration virtually unchanged.
We initiated eight new equity holdings in the quarter. Beginning in alphabetical order, eBay is well-known for its auction websites, but the company’s crown jewel may be Paypal, which it purchased in 2002. As value investors, we always prefer investment opportunities that are propelled by natural economic momentum, and that is certainly the case with eBay. E-commerce appears likely to grow at above-average rates, and eBay should participate in this growth. The Paypal division also benefits from growth in e-commerce, and new payment technologies at physical retailers, especially those involving smart phones, may give Paypal another boost. We had the opportunity to purchase shares at a good price when the company announced a management change. As with most of our March quarter opportunities, however, the best price opportunity did not last for long.
As the portfolio’s equity allocation has increased, I have paid attention to income generation by seeking issues that we believe have attractive and growing dividends. Illinois Tool Works (ITW), Northrop Grumman, Republic Services and Staples were four such names added in the March quarter. Investors have long lauded ITW for its management, which relentlessly employs the 80/20 rule to focus on businesses that are adding the most value to the entire enterprise. While ITW is somewhat cyclical and has exposure to housing and weaker European economies, we believe that its broad diversification and dominant market shares in niche product lines will enable the company to continue to grow per-share value while returning cash to shareholders. Northrop Grumman attracted us with its shipyard business spinoff. Operational performance at the remainder of the company has been strong, and the balance sheet is cash-rich. We expect the company to undertake significant share repurchases. Republic Services is the second-largest company in the waste collection and disposal industry. The company benefits from its industry’s high barriers to entry. We anticipate that improved U.S. industrial activity will increase Republic’s profits. Staples is best known for its retail stores, but the company is also the second-largest Internet reseller. We believe that the stock’s valuation is more appropriate for a troubled office-supply retailer than a well-managed company that is evolving with the economy while returning cash to shareholders.
Other purchases in the quarter were Lear, Parker Hannifin and TD Ameritrade. We last owned Lear in the Equity and Income Fund in 2000. Since then, the company has gone through reorganization and has re-emerged with a strong balance sheet and new senior management. Having suffered terrible times in the Great Recession, the auto parts industry, in our opinion, is now well-positioned to benefit from increasing automobile demand in emerging markets, as well as a cyclical rebound in demand in the U.S., and we expect Lear will participate in this rebound. Parker Hannifin is a diversified manufacturer of motion and control technologies primarily used in machinery and vehicles. The company has persistently improved its key financial characteristics, and management recently instituted an aggressive share repurchase program. TD Ameritrade has consistently gained share in the online brokerage market. Today’s exceptionally low interest rates have depressed TD Ameritrade’s earnings, providing us with what we deem a good investment opportunity. If short-term rates rebound to average levels, we expect the company’s earnings will grow significantly.
As you might expect in a strong quarter for stocks, several issues attained their sell targets, and the Fund sold L-3 Communications, Martin Marietta Materials, Sara Lee and Tractor Supply. Tractor Supply has been a superb example of a strongly positioned company with a management team dedicated to per-share value growth. I hate to say goodbye to such a company — perhaps some day another value opportunity may arise in this name.
Clyde S. McGregor, CFA
The Oakmark Equity and Income Fund closed to certain new investors as of 5/13/10.
As of 3/31/12, UnitedHealth Group, Inc. represented 3.3%, The TJX Cos., Inc. 1.9%, Texas Instruments, Inc. 2.6%, Diageo ADR 3.2%, Patterson-UTI Energy, Inc. 0.6%, Ultra Petroleum Corp. 0.2%, Range Resources Corp. 0.7%, PharMerica Corp. 0.1%, Walter Energy, Inc. 1.2%, Omnicare, Inc. 0.9%, Boston Scientific Corp. 1.2%, Hospira, Inc. 1.6%, Philip Morris International, Inc. 2.9%, Flowserve Corp. 2.1%, General Dynamics Corp. 3.0%, Pentair, Inc. 1.0%, Tyco International Ltd., 0%, eBay Inc. 0.7%, PayPal Inc. 0%, Illinois Tool Works, Inc. 0.5%, Northrop Grumman Corp. 0.6%, Republic Services, Inc. 1.3%, Staples Inc. 0.6%, Lear Corp. 1.0%, Parker Hannifin Corp. 0.7%, TD Ameritrade Holding Corp. 0.3%, L-3 Communications Holdings, Inc. 0%, Martin Marietta Materials, Inc. 0%, Sara Lee Corp. 0%, Tractor Supply Co. 0% of the Oakmark Equity and Income Fund’s total net assets.
Portfolio holdings are subject to change without notice and are not intended as recommendations of individual stocks.
The Lipper Balanced Fund 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.
Equity and Income 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 discussion of the Funds’ investments and investment strategy (including current investment themes, the portfolio managers' research and investment process, and portfolio characteristics) represents the Funds’ investments and the views of the portfolio managers and Harris Associates L.P., the Funds' investment adviser, at the time of this letter, and are subject to change without notice.