The Oakmark Equity and Income Fund
Report from Clyde S. McGregor, Portfolio Manager
The Oakmark Equity and Income FundReport from Clyde S. McGregor, Portfolio Manager |
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THE VALUE OF A $10,000 INVESTMENT IN THE OAKMARK EQUITY AND INCOME FUND FROM ITS INCEPTION (11/1/95) TO PRESENT (12/31/98) AS COMPARED TO THE LIPPER BALANCED FUND INDEX |
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12/31/98 NAV $15.03 |
Total Return |
Average Annual |
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The Oakmark Equity & Income Fund |
10.5% |
17.8% |
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Lipper Balanced Fund Index** |
11.5% |
16.9% |
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Lehman Govt./Corp. Bond** |
0.1% |
8.0% |
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S&P 500 w/inc** |
21.3% |
29.0% |
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*Total return includes change in share prices and in each case includes reinvestment of any dividends and capital gain distributions. **Each of the three indexes or averages is an unmanaged group of stocks or funds whose composition is different from the Fund. The Lipper Balanced Fund Index Composite is comprised of 30 balanced funds. The Lehman Govt./Corp. Bond Index includes the Lehman Government and Lehman Corporate indices. The S&P 500 is a broad market-weighted average dominated by blue-chip stocks. Past performance is no guarantee of future results. |
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GOODBYE TO 1998
Your Fund closed out the calendar year at a record high price (adjusted for the effect of November's dividend). Unfortunately, the portfolio took eight months to reach a new high, and it was disappointing returns of smaller and mid-cap stocks in the period which retarded portfolio progress. The Oakmark Equity and Income Fund is not oriented to small cap or mid cap equities—it is very much value oriented. And, of course, at any given time at least 35% of the portfolio is invested in fixed income securities. It is an interesting fact, however, that the S&P midcap index achieved its two peaks in 1998 on the same two days as the Fund. We, like most other value investors, have primarily discovered value outside of the 50 or so stocks which have dominated S&P 500 returns.
For value investors, 1998 was an incredibly frustrating year. Value investing is founded on the observation that price and value come together often enough to be profitably exploited. The corollary of this premise is that price and value will periodically diverge, creating the value opportunities on which value investors feast. Never in my 21-year career have divergences been as pronounced as we saw in 1998. For quite some time the stock market has discriminated in favor of larger capitalization companies. In fact, 1998 witnessed the largest difference in return ever recorded between the Russell 2000 index (smaller company stocks) and the S&P 500: 31%! Stock market volatility increased in 1998, and investors responded by moving to more liquid securities. As a rule, the market always overpays for liquidity, and we believe that the experience of 1998 will not prove to be an exception.
THE FRUITS OF A LIQUIDITY PANIC
Oftentimes the greatest value opportunities develop when the stock market experiences a period of momentary panic. A good example occurred early last quarter on October 8. Shortly after the market opened that day, one of our traders called me to describe the trading picture in Heller International, a finance company which we had monitored for some time. The stock had closed the night before at a price of $19.50. A brokerage firm called our trading desk with the news that they had a client with 100,000 shares to sell. I was wary of the market environment at that moment and told the trader to keep me informed should the price drop.
Wariness proved to be the correct attitude as the market took a dive that morning. Heller's price initially fell to $17.50 with few shares having traded. I decided to put in a $15.50/share bid for the block, just to make our interest known. Two other buyers eventually showed up at that level, and within the hour the block had traded at $15.50—down more than 20% on the day! Since October 8, Heller has made several favorable announcements, and the stock closed out the quarter at $29.375, an 84% increase over the Fund's average purchase price.
As value investors we prefer to buy securities when the seller is motivated to sell by reasons having nothing to do with any proprietary knowledge of the issue. (This explains why we rarely participate in initial public offerings.) When the market as a whole panics, many "informationless" trades take place. It is my job, as Fund Manager, to take advantage of this sort of situation for the benefit of The Fund.
THE SECOND PRESSING OF THE DUCK
I noted above that the Fund's equity holdings are not oriented to any size of company. DaimlerChrysler and Juno Lighting both happily inhabit the same portfolio. This is not the case for the Fund's corporate fixed income investments. The degree of efficiency in pricing corporate debt is a direct function of the size of the issue, so our search for undervalued securities generally leads us to more obscure regions.
Steve Reid holds shares of Ugly Duckling Corporation (the Duck) in The Oakmark Small Cap Fund. In October, Steve informed me that the Duck had initiated an unusual exchange offering for its shareholders: $6.50 of a new issue of 5-year debentures for each share of common stock tendered. The 12% interest rate on the debentures would have been enough to capture my attention, but the kicker was the fact that the stock was trading around $5.00.
Steve wrote about this company and its management last January (the first pressing). Our respect for both has only deepened over the last twelve months. Ernie Garcia, CEO, owns nearly 30% of the company, and my appetite for high yield debt is always enhanced when management is heavily committed. I purchased shares for your Fund at an average price of $4.75 per share. The company accepted all shares tendered into the exchange offering. The annualized yield to maturity if held to term exceeds 20% given the Fund's cost. This figure could even go higher if the company calls the debentures in ahead of schedule, as we expect.
This story illustrates how the different activities of our funds' group support each other. Steve had no interest in owning the Duck debenture in Small Cap but immediately recognized the value it would have for the Equity and Income Fund portfolio. And, the Duck debenture is a perfect example of inefficient pricing in the small cap sector of the fixed income market.
As always, I welcome your e-mails.
CLYDE S. McGREGOR
Portfolio Manager
mcgregor@oakmark.com
January 8, 1999
THE OAKMARK EQUITY AND INCOME FUND |
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Shares |
Market |
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Equity and Equivalents—60.3% |
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Food & Beverage—1.8% |
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UST Inc. |
35,000 |
$1,220,625 |
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Office Equipment—3.9% |
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Lexmark International Group, Inc., Class A (a) |
26,000 |
$2,613,000 |
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Other Consumer Goods & Services—3.3% |
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H&R Block, Inc. |
33,000 |
$1,485,000 |
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National Presto Industries, Inc. |
17,000 |
724,625 |
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2,209,625 |
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Banks & Thrifts—1.8% |
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Bank One Corporation |
23,674 |
$1,208,854 |
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Insurance—2.9% |
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PartnerRe Ltd. (b) |
23,000 |
$1,052,250 |
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Old Republic International Corporation |
38,250 |
860,625 |
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1,912,875 |
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Other Financial—2.2% |
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Heller Financial, Inc. |
50,000 |
$1,468,750 |
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TV Programming—3.7% |
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Tele-Communications, Liberty Media, Class A (a) |
52,800 |
$2,432,100 |
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Publishing—2.1% |
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Lee Enterprises, Inc. |
43,900 |
$1,382,850 |
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Information Services—3.1% |
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The Dun & Bradstreet Corporation |
65,000 |
$2,051,562 |
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Computer Services—6.8% |
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Electronic Data Systems Corporation |
45,000 |
$2,261,250 |
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First Data Corporation |
70,000 |
2,218,125 |
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4,479,375 |
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Data Storage—3.3% |
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Imation Corp. (a) |
125,000 |
$2,187,500 |
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Medical Products—3.4% |
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Sybron International Corporation (a) |
83,000 |
$2,256,562 |
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Automotive—7.1% |
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DaimlerChrysler AG |
26,187 |
$2,515,589 |
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Lear Corporation (a) |
56,000 |
2,156,000 |
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4,671,589 |
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Transportation Services—1.2% |
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Tidewater Inc. |
35,000 |
$811,563 |
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Building Materials & Construction—2.7% |
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Juno Lighting, Inc. |
76,300 |
$1,783,513 |
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Other Industrial Goods & Services—3.0% |
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Premark International, Inc. |
56,500 |
$1,956,312 |
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Real Estate—5.8% |
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Amli Residential Properties Trust |
90,000 |
$2,002,500 |
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Catellus Development Corporation (a) |
127,728 |
1,828,107 |
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3,830,607 |
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Diversified Conglomerates—2.2% |
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U.S. Industries, Inc. |
78,000 |
$1,452,750 |
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Total Equity and Equivalents (Cost: $30,379,837) |
39,930,012 |
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Fixed Income—33.4% |
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Preferred Stock—5.1% |
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Banks & Thrifts—4.3% |
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Pennfed Capital Trust, Preferred, 8.90% |
27,500 |
$701,250 |
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PennFirst Capital Trust 1, Preferred, 8.625% |
70,000 |
682,500 |
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BBC Capital Trust I, Preferred, 9.50% |
28,000 |
665,000 |
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Fidelity Capital Trust I, Preferred, 8.375% |
43,500 |
424,125 |
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RBI Capital Trust I, Preferred, 9.10% |
42,500 |
403,750 |
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2,876,625 |
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Broadcasting & Cable TV—0.8% |
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MediaOne Finance Trust III, Preferred, 9.04% |
20,000 |
$512,500 |
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Total Preferred Stock (Cost: $3,470,738) |
3,389,125 |
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Principal |
Market |
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Corporate Bonds—2.9% |
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Other Consumer Goods & Services—0.8% |
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Ugly Duckling Corporation, 12.00% due 10/15/2003, Subordinated Debenture |
$650,000 |
$525,000 |
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Aerospace & Automotive—0.3% |
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Coltec Industries, Inc., 9.75% due 4/1/2000 |
150,000 |
$159,562 |
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Coltec Industries, Inc., 9.75% due 11/1/1999 |
25,000 |
26,594 |
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186,156 |
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Building Materials & Construction—0.2% |
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USG Corporation, 9.25% due 9/15/2001, Senior Notes Series B |
$150,000 |
$158,063 |
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Utilities—0.3% |
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Midland Funding Corporation, 11.75% due 7/23/2005 |
150,000 |
$172,125 |
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Other Industrial Goods & Services—1.3% |
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Scotsman Industries, Inc., 8.625% due 12/15/2007, Senior Subordinated Note |
565,000 |
$552,287 |
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UCAR Global Enterprises Inc., 12.00% due 1/15/2005, Senior Subordinated Note |
300,000 |
308,250 |
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860,537 |
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Total Corporate Bonds (Cost: $1,898,939) |
1,901,881 |
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Government and Agency Securities—25.4% |
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U.S. Government Bonds—24.9% |
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United States Treasury Notes, 7.875% due 11/15/2004 |
6,000,000 |
$6,948,600 |
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United States Treasury Notes, 7.50% due 5/15/2002 |
6,000,000 |
6,518,280 |
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United States Treasury Notes, 6.25% due 2/15/2007 |
2,750,000 |
3,023,185 |
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16,490,065 |
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U.S. Government Agencies—0.5% |
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Federal Home Loan Bank, 6.405% due 4/10/2001, Consolidated Bond |
300,000 |
$309,612 |
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Total Government and Agency Securities (Cost: $16,170,654) |
16,799,677 |
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Total Fixed Income (Cost: $21,540,331) |
22,090,683 |
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Short Term Investments—5.8% |
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Commercial Paper—3.8% |
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American Express Credit Corp., 5.35% due 1/4/1999 |
$1,000,000 |
$1,000,000 |
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Ford Motor Credit Corp., 5.60% due 1/5/1999 |
500,000 |
500,000 |
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General Electric Capital Corporation, 4.70% due 1/4/1999 |
1,000,000 |
1,000,000 |
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Total Commercial Paper (Cost: $2,500,000) |
2,500,000 |
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Repurchase Agreements—2.0% |
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State Street Repurchase Agreement, 4.50% due 1/4/1999 |
$1,337,000 |
$1,337,000 |
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Total Repurchase Agreements (Cost: $1,337,000) |
1,337,000 |
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Total Short Term Investments (Cost: $3,837,000) |
3,837,000 |
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Total Investments (Cost $55,757,168)—99.5% |
$65,857,695 |
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Other Assets In Excess Of Other Liabilities—0.5% |
303,069 |
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Total Net Assets—100% |
$66,160,764 |
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(a) Non-income producing security.
(b) Represents an American Depositary Receipt.
