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 (3/31/99) AS COMPARED TO THE LIPPER BALANCED FUND INDEX |
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| 3/31/99 NAV $15.03 |
Total Return Last 3 mos. |
Average Annual Total Return* Through 3/31/99 From Fund Inception 11/1/95 |
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| The Oakmark Equity & Income Fund | 0.0% | 16.4% |
| Lipper Balanced Fund Index** | 1.6% | 16.1% |
| Lehman Govt./Corp. Bond** | -1.2% | 7.0% |
| S&P 500 w/inc** | 5.0% | 28.5% |
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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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UNCHANGED
The quarter ended March 31 produced an odd outcome for The Oakmark Equity and Income Fund: the Fund's price was unchanged over the period. This outcome is probably a good analogy for our investment approach at Harris Associates. Though the stock market's willingness to place incredible valuations on a few businesses continues to surprise us, we are not shaken (or stirred). We are confident that our reasons for owning the companies in which we have invested for our clients will stand the test of time. Fads are, by definition, short-term in nature and we are secure in our belief that much of the market's current activity is simply a fad.
It is interesting, however, to note the frustration evident at several companies held in the Fund. Juno Lighting was one of my initial purchases. While a profitable investment, the stock price has never seemed to reflect the company's 15% net profit margins and its wonderful balance sheet. In the last week of the quarter, Juno's management announced that the company would offer its shareholders the opportunity to approve a public recapitalization whereby 87% of the stock would be retired at $25/share. This announcement has produced a solid increase in the price of Juno's stock, but we believe that the price would have been much higher in a different environment for smaller stocks.
As I began to write this letter, one of my partners walked in to tell me a story about one of his clients. The family's magnificent house has been put up for sale at a comparatively modest price. The low price derives from the home's obscure location. Here in Chicago, the same house would sell for many times its current offering price. In real estate, the old maxim is "location, location, location." For at least the last 18 months, the same has held true in the stock market. If one's holdings were concentrated in the mega-cap or Internet "location," all has been heavenly, while other locations have stayed on the bargain table.
I see no reason for this analogy to hold for long. Unlike real estate, capital is mobile and will flow quickly to higher return spaces. Furthermore, businesses are dynamic, creating and destroying value daily. Investment bankers are working overtime to bring capital into the sectors of the market which are "hot" today, thereby ensuring intense competition (and lower returns) for those sectors in the near future. Your Fund is invested in less trendy areas. But be assured that these businesses have managers who are committed to increasing their company's value per share and who perceive their shareholders to be their partners in this effort. History teaches us that investments in these kinds of companies will handsomely reward patient investors.
BONDS MASQUERADING AS STOCKS
For much of our country's economic history, dividends have provided half of the total return from owning common stocks. That percentage has shrunk over the last 15 years, due to the combination of unusually strong price returns to stocks and below average dividend growth. Ibbotson Associates calculates that for the period from 1925 through 1998, dividends contributed 40% of the total return to equities. Were that percentage to hold going into the future, equity investors would be sorely disappointed. With dividend yields for "the market" under 1.5% today, investors obviously expect to make almost all of their return through capital appreciation.
My goal in managing The Equity and Income Fund is to produce as much income as possible without sacrificing total return to artificial and unnecessary restrictions. Unlike other income-oriented funds, Equity and Income will hold stocks that do not currently pay a dividend. In fact, more than 20% of the current equity holdings do not pay a dividend and the most important stock in the Fund's history, Lexmark International, shares that "defect." While the current group of fixed income holdings all have high cash yields, the Fund achieved its highest return in this segment through an Everen Capital issue which began its life as a "payment in kind" security.
Nevertheless, I am happy to report that the schizophrenic stock market environment has begun to bring forth a good flow of attractive income-oriented ideas. In fact, the addition of several of these "bonds masquerading as stocks" to the equity portfolio has given the Fund its fully invested appearance.
Real estate equities often provide some of the highest income yields, and this holds true today. The highest yielding equities in the Fund are real estate investment trusts, Legacy Hotels and Amli Residential Properties. Amli joined the portfolio in last year's second calendar quarter. I like this REIT because of management's clever use of outside capital to leverage their brand name. In addition, Amli probably has the most persistent pattern of insider buying of any entity we track. We expect regular increases in the dividend from current levels to add to the already substantial income return. Legacy Hotels, a group of Canadian hotel properties, is a more recent addition to the Fund. Selling for less than stated book value with below average leverage and rising earnings, Legacy almost defines opportunity for the income-oriented value investor.
My third and final example comes from the financial services sector. IPC Holdings, along with PartnerRe, comprises the Fund's commitment to the Bermuda-based reinsurance industry. IPC specializes in reinsuring property catastrophe risk, generally the most profitable segment in the reinsurance industry. The stock sells at a discount to its stated book value and its dividend yield with year-end extra distributions should approach 10%.
Several reports ago I asked, "What is a poor income manager to do?" The answer then, as now, is to continue to probe all sectors of the market while not compromising our standards.
Please feel free to e-mail me with your comments, questions, or ideas for quarterly reports.
CLYDE S. MCGREGOR
Portfolio Manager
mcgregor@oakmark.com
April 6, 1999
THE OAKMARK EQUITY AND INCOME FUND |
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Shares |
Market |
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| Equity and Equivalents—61.7% | ||
| Food & Beverage—2.2% | ||
| UST Inc. | 50,000 | $1,306,250 |
| Other Consumer Goods & Services—3.6% | ||
| H&R Block, Inc. | 33,000 | $1,563,375 |
| National Presto Industries, Inc. | 17,000 | 602,437 |
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| 2,165,812 | ||
| Banks & Thrifts—2.2% | ||
| Bank One Corporation | 23,674 | $1,303,550 |
| Insurance—3.2% | ||
| IPC Holdings, Ltd. (b) | 50,000 | $993,750 |
| PartnerRe Ltd. (b) | 23,000 | 931,500 |
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| 1,925,250 | ||
| Other Financial—2.0% | ||
| Heller Financial, Inc. | 50,000 | $1,175,000 |
| TV Programming—2.7% | ||
| AT&T Corp.–Liberty Media Group, Class A (a) | 30,800 | $1,620,850 |
| Publishing—2.1% | ||
| Lee Enterprises, Inc. | 43,900 | $1,273,100 |
| Information Services—3.0% | ||
| The Dun & Bradstreet Corporation | 51,500 | $1,834,688 |
| Computer Services—9.7% | ||
| First Data Corporation | 55,000 | $2,351,250 |
| Electronic Data Systems Corporation | 37,500 | 1,825,781 |
| The Reynolds and Reynolds Company, Class A | 87,500 | 1,662,500 |
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| 5,839,531 | ||
| Data Storage—4.8% | ||
| Imation Corp. (a) | 175,000 | $2,887,500 |
| Medical Products—3.2% | ||
| Sybron International Corporation (a) | 78,000 | $1,950,000 |
| Automotive—3.5% | ||
| Lear Corporation (a) | 50,000 | $2,134,375 |
| Transportation Services—1.5% | ||
| Tidewater Inc. | 35,000 | $905,625 |
| Building Materials & Construction—3.6% | ||
| Juno Lighting, Inc. | 96,300 | $2,160,731 |
| Other Industrial Goods & Services—3.1% | ||
| Premark International, Inc. | 56,500 | $1,860,969 |
| Real Estate—9.2% | ||
| Amli Residential Properties Trust | 100,000 | $2,062,500 |
| Catellus Development Corporation (a) | 137,728 | 1,842,112 |
| Legacy Hotels Real Estate Investment Trust (b) | 350,000 | 1,634,647 |
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| 5,539,259 | ||
| Diversified Conglomerates—2.1% | ||
| U.S. Industries, Inc. | 78,000 | $1,282,125 |
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| Total Equity and Equivalents (Cost: $32,163,788) | 37,164,615 | |
| Fixed Income—34.5% | ||
| Preferred Stock—5.7% | ||
| Banks & Thrifts—4.9% | ||
| Pennfed Capital Trust, Preferred, 8.90% | 27,500 | $718,437 |
| BBC Capital Trust I, Preferred, 9.50% | 28,000 | 703,500 |
| PennFirst Capital Trust I, Preferred, 8.625% | 70,000 | 700,000 |
| RBI Capital Trust I, Preferred, 9.10% | 42,500 | 425,000 |
| Fidelity Capital Trust I, Preferred, 8.375% | 43,500 | 418,688 |
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| 2,965,625 | ||
| Broadcasting & Cable TV—0.8% | ||
| MediaOne Finance Trust III, Preferred, 9.04% | 20,000 | $506,250 |
| Total Preferred Stock (Cost: $3,470,738) | 3,471,875 | |
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Principal |
Market |
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| Corporate Bonds—3.5% | ||
| Retail—1.0% | ||
| Ugly Duckling Corporation, 12.00% due 10/15/2003, Subordinated Debenture | $650,000 | $585,000 |
| Aerospace & Automotive—0.3% | ||
| Coltec Industries, Inc., 9.75% due 4/1/2000 | $150,000 | $159,188 |
| Coltec Industries, Inc., 9.75% due 11/1/1999 | 25,000 | 26,500 |
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| 185,688 | ||
| Building Materials & Construction—0.3% | ||
| USG Corporation, 9.25% due 9/15/2001, Senior Notes Series B | $150,000 | $159,375 |
| Utilities—0.4% | ||
| Midland Funding Corporation, 11.75% due 7/23/2005 | $200,000 | $229,250 |
| Other Industrial Goods & Services—1.5% | ||
| Scotsman Industries, Inc., 8.625% due 12/15/2007, Senior Subordinated Note | $615,000 | $619,612 |
| UCAR Global Enterprises Inc., 12.00% due 1/15/2005, Senior Subordinated Note | $300,000 | 315,750 |
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| 935,362 | ||
| Total Corporate Bonds (Cost: $2,001,836) | 2,094,675 | |
| Government and Agency Securities—25.3% | ||
| U.S. Government Bonds—24.8% | ||
| United States Treasury Notes, 7.50% due 5/15/2002 | $7,000,000 | $7,466,130 |
| United States Treasury Notes, 7.875% due 11/15/2004 | 4,750,000 | 5,336,958 |
| United States Treasury Notes, 6.25% due 2/15/2007 | 2,000,000 | 2,105,160 |
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| 14,908,248 | ||
| U.S. Government Agencies—0.5% | ||
| Federal Home Loan Bank, 6.405% due 4/10/2001, Consolidated Bond | $300,000 | $306,453 |
| Total Government and Agency Securities (Cost: $15,056,019) | 15,214,701 | |
| Total Fixed Income (Cost: $20,528,593) | 20,781,251 | |
| Short Term Investments—2.9% | ||
| Commercial Paper—1.7% | ||
| General Electric Capital Corporation, 5.00% due 4/1/1999 | $1,000,000 | $1,000,000 |
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| Total Commercial Paper (Cost: $1,000,000) | 1,000,000 | |
| Repurchase Agreements—1.2% | ||
| State Street Repurchase Agreement, 4.88% due 4/1/1999 | $716,000 | $716,000 |
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| Total Repurchase Agreements (Cost: $716,000) | 716,000 | |
| Total Short Term Investments (Cost: $1,716,000) | 1,716,000 | |
| Total Investments (Cost $54,408,381)—99.1% (c) | $59,661,866 | |
| Other Assets In Excess Of Other Liabilities—0.9% | 550,352 | |
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| Total Net Assets—100% | $60,212,218 | |
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(a) Non-income producing security.
(b) Represents a foreign domiciled corporation.
(c) At March 31, 1999, net unrealized appreciation of $5,253,568, for federal income tax purposes consisted of gross unrealized appreciation of $6,715,152 and gross unrealized depreciation of $1,461,584.