Oakmark Equity and Income Fund: Third Quarter 2013
September 30, 2013
A Good September Quarter Surprise
“Sell in May and go away” is a well-known phrase in the investing community. It derives from empirical observations that the summer months are often difficult for the stock market. September has a particularly high propensity to produce losses. Academics spend considerable effort attempting to explain these market tendencies, yet the past two years will only make their job more difficult: in both years the September quarters have been quite rewarding to investors.
The Equity and Income Fund participated in the September quarter’s strength, earning 8% in the period, which contrasts to a 5% gain for the Lipper Balanced Fund Index, the Fund’s performance benchmark. For the nine months of the calendar year the returns are 16% for the Fund, and 10% for the Lipper Index. Finally, for the Funds’ fiscal year ending September 30, the return to the Fund was 18%, while the Lipper Index returned 12%. 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%.
Rockwell Automation, Cimarex Energy, Dover, FedEx and General Dynamics contributed most significantly to the past quarter’s returns. The largest detractors were Foot Locker, Ultra Petroleum (purchased during the quarter—see below), Laboratory Corporation of America, Range Resources (sold early in the quarter) and Staples. The price declines for the detractors were all quite small. Over the past nine months, detractors included Walter Energy (sold), Cenovus Energy, EnCana, Blount International and Apache (sold). The largest contributors to portfolio return were Dover, United Health, General Dynamics, MasterCard and Cimarex Energy. Finally, for the Fund’s fiscal year, the largest contributors were Dover, Rockwell Automation, General Dynamics, MasterCard and Flowserve (sold in the quarter). The largest 12-month detractors were Walter Energy, Cenovus Energy, EnCana, Apache and Devon Energy. The detractors were all energy resource companies, although Walter primarily produces coal used in the production of steel.
We write this letter at a time of unusual macroeconomic uncertainty given the twin possibilities for governmental shutdown and federal debt default. We see little value in ruminating about the various possibilities, especially since this may all be resolved in the time between letter completion and its distribution. We leave it to our friends in the trading community to attempt to profit from the volatility surrounding the political controversy. We will continue to focus on understanding the long-term fundamental values of the Fund’s holdings, both current and prospective. We believe that, regardless of the maneuvering in Washington, the employees of the companies in which we invest will go home at the end of each day knowing that they have helped to increase their employer’s value.
Our activity in the September quarter favored the sell side as we eliminated five holdings while initiating only one. As noted above, absolute returns have been strong over the past 12 months. To produce this level of return, many stocks within the portfolio have excelled--and several more reached--our sell targets. To review our process, as value managers we establish buy and sell targets for the stock of any company that is voted onto our firm’s approved list. Buy targets are normally set at 60% of our estimate of the company’s intrinsic value and sell targets at 90%. Of course, our targets are not static. With new information and the passage of time, our targets evolve to reflect a business’ current fundamentals better. Generally, when a stock approaches the sell target we begin to reduce the size of the holding because its relative attraction has diminished. Its higher price makes it less able to compete for portfolio space. Sometimes, however, the stock price jumps to the area of its sell target because of a merger offer, which is what happened this past quarter to one of the Fund’s smallest companies, Kaydon. Kaydon is a quality manufacturer with strong market shares in specialty industrial products such as bearings and seals. SKF, a Swedish industrial company, recognized Kaydon’s attractiveness and agreed to purchase the company during the quarter.
The other four portfolio eliminations also had an industrial orientation. Northrop Grumman is a major defense and aerospace contractor. The company is well-managed and shareholder-friendly with a solid history of dividends and share repurchase. Teledyne Technologies also has products in aerospace and defense electronics as well as digital imaging, although instrumentation is its largest segment. Range Resources is an exploration and production company with major leaseholds in the Marcellus Shale. Natural gas prices have been low for many months, and the outlook is for prices to stay low well into the future. This means that controlling production costs is essential for profitability, and Range’s costs are among the industry’s lowest. Last, but hardly least, is Flowserve, a leading manufacturer of pumps, valves and seals. Flowserve served the Equity and Income Fund well during its nearly three years in the portfolio, and we wish to thank our recently retired long-time partner John Raitt for this successful idea (as well as many others). We did not enjoy eliminating any of these five holdings from the portfolio as each company had been performing well and meeting or exceeding expectations. Nevertheless, our discipline demands that we move on whenever price and our estimate of intrinsic value per share come together.
The Fund’s one new purchase is actually a return to a previous holding, Ultra Petroleum. During the past year, companies in the energy sector have experienced a wide variety of investment outcomes. A few, such as Cimarex and Range, have enjoyed strong share price increases, but others, such as Ultra, have trailed market returns. We sold the Fund’s Ultra holding 17 months ago to realize a tax loss but have watched the company carefully over the intervening period. In our opinion the discount to value in Ultra is simply too great to prevail indefinitely, particularly with its solid management team that is heavily invested in the company.
Fixed Income Management under Rate Suppression
Times remain unusual in the world of fixed income investing. The Federal Reserve continues to suppress interest rates through the purchase of Treasury and Agency securities. Although this policy does not appear to have had the desired effect of increasing business investment, it did produce negative real interest rates on 10-year Treasuries for all of 2012 and much of 2013. Negative real rates make the search for attractive fixed income instruments extremely difficult. Early in the summer interest rates increased fairly dramatically when the Fed suggested that monetary policy would soon become less accommodating (what became known as “the taper”), and we became hopeful that attractive opportunities would develop. In September, however, the Fed elected to maintain its previous policy, and rates have retraced some of their move upward. It is difficult to invest prudently in fixed income investments when rates are being managed to such low levels.
Our basic answer has been to accept credit, but not duration, risk. What this means in practice is that we have kept maturities of our investments very short, particularly for low-risk issuers such as governments and agencies, while we seek out opportunities to increase portfolio yield with what we think is well-priced corporate debt. During much of the past three years this has been difficult to execute when investors were pouring money into fixed income funds. Generally, managers of fixed income funds invest money as it comes in without regard for value considerations. In the most recent quarter, however, the competition was less fierce because investors were pulling money from bond funds.
We have made progress in building the Fund’s corporate debt allocation, but this process will take time because of our price and quality requirements, combined with these unusual market conditions. Even with some success to this effort, any increase in portfolio income yield will hardly be stunning. When we opened the Fund to investment in 1995, we naively assumed as our base case that the Fund would average 6% yields on its fixed income allocation. Those days passed very quickly. Although the search for fixed income return is less rewarding than in the past, we continue the search, always guided by our disciplined value philosophy.
Once again we thank our fellow shareholders for investing in the Equity and Income Fund and welcome your comments and questions.
Clyde S. McGregor, CFA
M. Colin Hudson, CFA
Matthew A. Logan, CFA
Edward J. Wojciechowski, CFA
As of 9/30/13, Rockwell Automation Inc. represented 2.9%, Cimarex Energy Co. 1.2%, Dover Corp. 3.5%, FedEx Corp. 2.7%, General Dynamics Corp. 3.0%, Foot Locker, Inc. 1.3%, Ultra Petroleum Corp. 0.4%, Laboratory Corp. of America Holdings 1.3%, Range Resources Corp. 0%, Staples, Inc. 0.4%, Walter Energy, Inc. 0%, Cenovus Energy, Inc. 1.0%, Encana Corp. 1.3%, Blount International, Inc. 0.1%, Apache Corp. 0%, UnitedHealth Group, Inc. 3.2%, MasterCard, Inc., Class A 1.8%, Flowserve Corp. 0%, Devon Energy Corp. 1.6%, Kaydon Corp. 0%, SKF AB 0%, Northrop Grumman Corp. 0%, and Teledyne Technologies, Inc. 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.
Click here to access the full list of holdings for The Oakmark Equity and Income Fund as of the most recent quarter-end.
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 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.