Oakmark Fund: First Quarter 2013
March 31, 201
The Oakmark Fund increased by 10% in the past quarter, bringing the gain for the first half of our fiscal year to 13%. The S&P 500 also increased significantly, up 11% and 10% for the quarter and six months, respectively. Despite these increases, we believe stocks remain moderately undervalued relative to their own history and extremely undervalued versus bonds.
Our best performing stock in the quarter was Dell, up 42%. Dell is in the midst of a bidding war between a group headed by its CEO, Michael Dell, and groups led by Blackstone and Carl Icahn. We have decided, for now, to maintain our holding as we believe there is a reasonable probability that a higher bid will emerge. A more detailed discussion of our Dell position can be found in the commentary for the Oakmark and Oakmark Select Funds.
Our worst performer was Apple, down 16%, but because our weighting was less than that of the S&P 500, it didn’t hurt our relative performance. We also had single-digit declines in Cenovus (7%), Capital One (5%), Oracle (3%) and Aflac (1%). None of these companies are performing meaningfully worse than we were expecting, so we continue to hold the stocks.
We eliminated two holdings during the quarter: Viacom and Heinz. Viacom’s stock reached our sell target despite ratings for its main cable channels that continue to disappoint. Heinz announced its acquisition, and because the stock price immediately matched the proposed acquisition price, we sold all of our shares. We are very pleased with the performance of Heinz management over the many years we owned the stock. For a more complete discussion, read the Heinz piece we posted on our website during the quarter. We added one new holding, Forest Laboratories.
Forest Laboratories (FRX - $37)
Forest Labs is a mid-sized pharmaceutical company. It sells at almost 40 times trailing earnings at a time when many pharma stocks are priced at multiples less than half that. So it is fair for our investors to ask how we can possibly call Forest undervalued. When we evaluate most companies, we don’t need to adjust P/E ratios to reflect differing mixes of new versus old products. Pharma companies, however, are different. Even very large pharma companies often produce most of their earnings from just a small number of drugs. When patents on those drugs expire, earnings largely disappear. So a very low P/E is justified for companies facing patent cliffs. The opposite is true when drugs are first introduced. Launch costs can wipe out most of a new drug’s early earnings, so a very high P/E ratio is deserved.
Forest is in the unusual position of launching seven important new drugs. This results in very low current earnings compared to the earnings we expect several years from now. Our valuation of discounted future cash flows indicates that Forest is currently selling for just over two-thirds of value. Further, if a large pharma company owned Forest, economies of scale would meaningfully reduce Forest’s expenses, which leads us to believe its ultimate value is even higher. Finally, many pharma stocks have been strong performers because they pay high dividends, which appeals to bond investors looking for income in the stock market. Because Forest does not pay a dividend, it has not enjoyed such attention. Instead, over the past decade, its management has repurchased nearly 30% of the company’s shares. When we believe a stock is selling at a large discount to its value, there are few things we like better than management increasing our ownership by reducing the outstanding shares.
Thank you for your continued investment in our Fund.
William C. Nygren, CFA
Kevin G. Grant, CFA
Average Annual Total Returns (03/31/13)
Expense Ratio as of 9/30/12 was 1.03%
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. The most recent month-end performance data can be found here.
As of 3/31/13, Dell, Inc. represented 2.1%, Apple, Inc. 1.9%, Cenovus Energy, Inc. 1.4%, Capital One Financial Corp. 2.3%, Oracle Corp. 2.2%, Aflac, Inc. 1.9%, Viacom, Inc., Class B 0%, H.J. Heinz Co. 0%, and Forest Laboratories, Inc. 1.3% of the Oakmark Fund's total net assets. Portfolio holdings are subject to change without notice and are not intended as recommendations of individual stocks.
The S&P 500 Total Return Index is a market capitalization-weighted index of 500 large-capitalization stocks commonly used to represent the U.S. equity market. All returns reflect reinvested dividends and capital gains distributions. This index is unmanaged and investors cannot invest directly in this index.
The Price-Earnings Ratio (“P/E”) is the most common measure of the expensiveness of a stock.
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.
Investing in value stocks presents the risk that value stocks may fall out of favor with investors and underperform growth stocks during given periods.
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.