Oakmark Equity and Income Fund: Second Quarter 2012
June 30, 2012
For the third consecutive year, deteriorating European economic conditions have spurred a stock market correction and a concomitant bond market rally. The result for the Equity and Income Fund in the quarter was a disappointing 3% loss, which contrasts to a 2% loss for the Lipper Balanced Fund Index, the Fund’s performance benchmark. For the calendar six months, the returns are still positive: 4% for the Fund and 6% for the Lipper Index. Finally, for the fiscal year’s nine months, the return to the Fund was 13%, while the Lipper Index also returned 13%. The annualized compound rate of return since the Fund’s inception in 1995 is 11%, while the corresponding return to the Lipper Index is 6%. Scripps Networks Interactive Class A led the contributors’ list for the quarter, followed by Diageo, TJX, C.R. Bard and Encana. The largest detractors were Cimarex Energy, Texas Instruments, Cenovus Energy, Dover and Rockwell Automation. For the second consecutive quarter, the detractors list is heavy with energy industry names. This largely reflects the oversupply situation that shale drilling has created in the North American natural gas market. Fears about the economic cycle caused a drop in oil prices during the June quarter, which also contributed to the energy sector’s negative results. Detractors from return for the calendar six months were Walter Energy, Patterson-UTI Energy, Varian, Staples and Dover. The largest contributors to portfolio return were TJX, Diageo, United Health Group, Scripps Networks Interactive and Flowserve. Finally, for the Fund’s fiscal year to date, the largest contributors were Diageo, Philip Morris International, Flowserve, TJX and United Health Group. Detractors for the nine months were Walter Energy, Staples, Hospira, Lear and Patterson-UTI Energy.
Despite considerable market volatility and a moderate amount of trading, the Fund’s overall asset allocation changed little in the June quarter. I initiated four new equity positions and eliminated four holdings. Beginning with the sales, in last quarter’s report I noted that long-term Fund holding Pentair had risen in price after entering into a merger agreement with a division of Tyco. After a careful review of this transaction, I eliminated the holding, believing that the increase in the share price after this announcement reduced the valuation discount to uninteresting levels. I sold Ultra Petroleum in order to harvest a tax loss. Ultra is a good company, but one that is very exposed to the natural gas oversupply situation. I redeployed the proceeds into what I believe are better positioned energy concerns. I sold Pepsico after concluding that management’s strategy to increase shareholder value was insufficiently compelling. Finally, I eliminated the small Xylem holding that the Fund received when ITT broke into three parts.
The four new purchases are Baker Hughes, Blount International, Devon Energy and FedEx. Baker Hughes is one of only four global oil service companies. Over time, this industry benefits from the fact that incremental hydrocarbon reserves require increasing service intensity to develop. In the short term, however, the recent increase in North American natural gas production has caused an oversupply of gas, and this has caused exploration and production companies to reduce their drilling. We believe that this oversupply is temporary and that Baker Hughes will again be a beneficiary of positive secular trends in its industry. Blount is the global leader in the production of cutting chain for chainsaws. This is a classic “razor blade business,” as professional loggers need to replace their chains every 5-10 days. International sales, especially to emerging markets, are a large percentage of the total. Devon Energy is another exploration and production company, the stock of which has suffered because of declining commodity prices. We find it interesting that the financial press often characterizes Devon as a natural gas “play,” even though most of the company’s revenues come from liquids. Over the past three years, the stock has declined in price despite Devon’s significant growth in proved and probable reserves, as well as material debt reduction. Devon’s management understands capital allocation to be a paramount responsibility and has demonstrated this through savvy asset sales and purchases, and by accessing foreign capital through joint ventures. Turning to FedEx, our investment thesis is that the market undervalues the stock because of management’s extremely long-term investing horizon. FedEx continues to build out its domestic ground system and its Pacific parcel network. As shipping density improves over time, profit margins should increase meaningfully.
Mass Market Financial Masochism
Gillian Tett, columnist for the Financial Times newspaper, has coined the phrase above to describe the actions of American bond market investors. Ms. Tett uses “financial masochism” to differentiate from “financial repression [which] occurs when governments engineer a situation in which investors feel compelled to buy bonds at unfavorable rates, i.e., below the prevailing rate of inflation, thus helping to reduce national debt.” She argues that, in America, “investors are gobbling up government debt at unfavorable rates without needing to be repressed at all….Anybody buying Treasuries, in other words, is essentially agreeing to subsidize the U.S. government in coming years—unless you believe that deep deflation looms. Call it, if you like, a form of ‘voluntary' repression; either way, it will almost certainly end up helping the U.S. state, to the detriment of investors.” Or, as Princeton professor Burton Malkiel has written, “The current era of financial repression may well lead once again to the euthanasia of the bondholding class.”
Of course, many commentators have also noted that extremely low interest rates on U.S. Treasury debt have been critical for holding the fiscal deficit down, even as the outstanding debt total continues to rise. Although altruism may be causing some investors to be purchasing Treasury notes at these rates, we believe that most Treasury purchasers today are not so charitable, but have instead entered into what Longleaf Partners portfolio manager Staley Cates terms a “flight-to-safety bubble.”
As value investors with an income objective, we find the current environment to be awkward. We have previously noted that we find income to be overpriced in the securities markets, and that continues to be our overall impression. Someone looking at the Equity and Income portfolio for the first time will observe a low fixed-income duration (1.7 years) and a 70% equity allocation and surmise that the Fund is positioned with an explicit forecast for higher interest rates. Although that is how we would position the Fund if we had an explicit interest rate forecast for higher rates, we do not actually think about investing the portfolio in that manner. Instead, our thought process is to move the portfolio away from the asset class with the greatest long-term risk (currently bonds) and toward the asset class with the higher risk-adjusted expected return (currently equities). For the moment, equities continue to show meaningfully greater daily price volatility than bonds, but this volatility is not the same as risk of permanent capital loss. The equities in which the Fund is invested are underpriced in the market, and they continue to grow their intrinsic value per share. A bond cannot do that. So, while we do not explicitly forecast higher interest rates, we do believe that high-quality bonds offer minimal value to investors today. We have no idea when interest rates will return to historically typical levels, so we must counsel patience.
Closing with another quote from Professor Malkiel, “Today ‘death of equities’ talk is equally widespread [as in the 1970’s]. No one can tell when global equity markets will shake off the intractable pessimism that characterizes investors. But I would submit that equity investments in today’s market environment entail less risk than the ‘haven’ bond investments favored by so many investors.” Well said.
Clyde S. McGregor, CFA
Average Annual Total Returns (6/30/12)
Expense Ratio as of 9/30/11 was 0.77%
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.
The Oakmark Equity and Income Fund closed to certain new investors as of 5/13/10.
As of 6/30/12 Scripps Networks Interactive, Inc., Class A represented 2.0%, Diageo ADR 3.0%, The TJX Cos., Inc. 1.7%, CR Bard, Inc. 1.6%, Encana Corp. 1.8%, Cimarex Energy Co. 1.2%, Texas Instruments, Inc. 1.7%, Cenovus Energy, Inc. 3.0%, Dover Corp. 2.3%, Rockwell Automation Inc. 1.7%, Walter Energy, Inc. 0.9%, Patterson-UTI Energy, Inc. 0.6%, Varian Medical Systems, Inc. 1.8%, Staples, Inc. 0.9%, UnitedHealth Group, Inc. 3.4%, Flowserve Corp. 2.2%, Philip Morris International, Inc. 3.0%, Hospira, Inc. 1.1%, Lear Corp. 0.9%, Pentair, Inc. 0%, Tyco International, Ltd. 0%, Ultra Petroleum Corp. 0%, PepsiCo., Inc. 0%, Xylem, Inc. 0%, ITT Corp. 0%, Baker Hughes, Inc. 1.2%, Blount International, Inc. 0.05%, Devon Energy Corporation 1.2%, and FedEx Corp. 1.1% 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.
The quoted passages by Gillian Tett are taken from “Repression on bonds heralds masochism” published by Financial Times on May 10, 2012.
The quoted passages by Burton Malkiel are taken from “Bond buyers should be mindful of history” published by Financial Times on June 11, 2012.
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 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.