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 (12/31/99) AS COMPARED TO THE LIPPER BALANCED FUND INDEX | ||
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| 12/31/99 NAV $14.40 |
Total Return Last 3 mos. |
Average Annual Total Return* Through 12/31/99 From Fund Inception 11/1/95 |
| The Oakmark Equity & Income Fund | 3.4% | 15.3% |
| Lipper Balanced Fund Index** | 7.1% | 14.9% |
| Lehman Govt./Corp. Bond** | -.4% | 5.5% |
| S&P 500 w/inc** | 14.9% | 27.1% |
| * 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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Quarter Review
The Oakmark Equity and Income Fund returned 3.4% in the recently ended quarter. While consistent with the Fund's long term record of returns, this number lagged the Lipper Balanced Fund Index by more than 3% and relative to that benchmark was the worst quarter in the Fund's history. The shortfall in the quarter originated primarily in the portfolio's financial stocks, which returned a negative 11%. It was also a tough period for the Fund's fixed income investments in the high yield sector. Success stories included anything with a technology flavor, especially Sterling Commerce which gained nearly 84% in the quarter. Congratulations to management at Sterling for recognizing the opportunity which the stock market provided in the fall. Sterling used more than half of its substantial cash hoard to repurchase shares at bargain prices.
Heller Financial vs. GE
As noted above, financial stocks languished in 1999. My particular interest in this section is the company about which I wrote one year ago, Heller Financial. Last January I rejoiced at the fact that the Heller shares I purchased in the panic of October, 1998, had experienced a price increase of 84% in less than three months. Unfortunately, my celebration proved premature as the share price fell 32% in 1999.
Heller is a diversified financial services firm. The company finances the economic activity of a myriad of enterprises that typically fall just below the radar screen of the conventional banking industry. Activities include equipment leasing, asset based lending, and receivables factoring. The company has a strong presence in Europe. Its balance sheet is in fine shape, and management continues to put away excess reserves for bad loans.
General Electric's largest business unit is GE Capital, its finance operation. GE Capital engages in many of the same activities as Heller Financial, though on a grander scale. Rumors suggest that GE attempted to buy Heller before the company executed its initial public offering two years ago. These rumors, if accurate, speak eloquently to GE's respect for Heller's business model and market position.
Last quarter, both GE and Heller hosted meetings for investment analysts. At each meeting, the hosting CEO articulated a positive view of his company's future along with a forecast of 15% annual earnings growth. The reaction of investors, however, could hardly have been more divergent. GE's stock enjoyed a significant rally, while Heller's declined roughly 20%. At year-end GE traded for 42 times year 2000 earnings estimates while Heller languished at 7.5 times.
As I considered this conundrum, I looked at GE's other business units. With a few small exceptions I concluded that, on their own, most of these lines of business would not deserve high multiples of earnings. It is also hard to argue that GE's diversification is an advantage in the current investing environment.
To date I have not been able to bridge this valuation chasm. GE is undoubtedly a great company, one that has always commanded a premium valuation. And, Heller is still relatively unseasoned as a public company. But, with Heller priced at one-half its earnings growth rate and a discount to book value versus GE at three times its earnings growth rate and 12 times book value, the choice of which to own is easy.
The Joy (?) of Income
The Oakmark Equity and Income Fund is, as its name suggests, the most income-oriented of our group's mutual funds. In fact, the prospectus states that the first goal of the Fund is "high current income." At any point in time, I target a level of income yield for the Fund based on the prevailing interest rate structure. I do not limit the Fund's equity holdings to issues that produce income, but when presented with two issues with similar total return characteristics, I will select the higher-yielding choice.
At various times, all of us value managers have commented on the many idiosyncrasies of 1999 which made the year so challenging. I wish to close this letter by describing one of the more obscure outcomes of the year that had a retarding effect on the returns of the portfolio.
In most time periods, income is positively correlated with total return. In 1999 this was not the case. To study this, we looked at all companies that were public at the start of the year and had market capitalizations of at least $100 million. We divided them into those that paid a dividend and those that did not. For the year as a whole, the average return for the no-dividends group was a robust 46.8%, for the dividend payers a paltry 3.7%. One of the many amazing facts about this outcome is that it occurred during a period of rising interest rates. Economic theory states that as interest rates rise the value of dollars in the future decreases. This means that income-paying equities, particularly those with growing dividends, should dominate while rates are rising.
Now it has been 22 years since I graduated from business school, and during that time many new theories have been developed. I do not believe, however, that concepts such as net present value and duration have been discarded. Between the Heller/GE story above and this income paradox, I think that we should all write off 1999 as an aberrant experience and look forward to more rational outcomes in 2000. As always, please feel free to e-mail me with your questions or comments.
Clyde S. McGregor
Portfolio Manager
mcgregor@oakmark.com
January 7, 2000
| THE OAKMARK EQUITY
AND INCOME FUND Schedule of Investment—December 31, 1999 (Unaudited) |
|
Market Value |
|
| Equity and Equivalents—61.2% | ||
| Banks & Thrifts—3.0% | ||
| Washington Mutual, Inc. | 67,000 | $1,742,000 |
| Insurance—2.6% | ||
| PartnerRe Ltd. (b) | 23,000 | $746,062 |
| IPC Holdings, Ltd. (b) | 50,000 | 743,750 |
| 1,489,812 | ||
| Other Financial—3.0% | ||
| Heller Financial, Inc. | 85,000 | $1,705,312 |
| Information Services—3.3% | ||
| The Dun & Bradstreet Corporation | 63,500 | $1,873,250 |
| Computer Services—16.2% | ||
| The Reynolds and Reynolds Company | 117,500 | $2,643,750 |
| First Data Corporation | 50,000 | 2,465,625 |
| Electronic Data Systems Corporation | 32,500 | 2,175,469 |
| Sterling Commerce, Inc. (a) | 60,000 | 2,043,750 |
| 9,328,594 | ||
| Data Storage—5.3% | ||
| Imation Corp. (a) | 91,500 | $3,070,969 |
| Publishing—2.4% | ||
| Lee Enterprises, Incorporated | 43,900 | $1,402,056 |
| Medical Products—2.9% | ||
| Sybron International Corporation (a) | 68,000 | $1,678,750 |
| Automotive—3.1% | ||
| Lear Corporation (a) | 55,000 | $1,760,000 |
| Agricultural Equipment—3.4% | ||
| Alamo Group Inc. | 196,350 | $1,963,500 |
| Building Materials & Construction—1.7% | ||
| Vulcan Materials Company | 25,000 | $998,438 |
| Real Estate—10.9% | ||
| Catellus Development Corporation (a) | 174,728 | $2,238,703 |
| Amli Residential Properties Trust | 100,000 | 2,018,750 |
| Legacy Hotels Real Estate Investment Trust (b) | 350,000 | 2,000,346 |
| 6,257,799 | ||
| Total Equity (Cost: $28,323,146) | 33,270,480 | |
| Convertible Preferred Stock—3.4% | ||
| Telecommunications—3.4% | ||
| Metromedia International Group, Inc., Convertible Preferred, 7.25% |
65,000 | $1,950,000 |
| Total Convertible Preferred Stock (Cost: $2,062,037) | 1,950,000 | |
| Total Equity and Equivalents (Cost: $30,385,183) | 35,220,480 | |
| Fixed Income—33.9% | ||
| Preferred Stock—5.0% | ||
| Banks & Thrifts—4.1% | ||
| Pennfed Capital Trust, Preferred, 8.90% | 27,500 | $608,438 |
| PennFirst Capital Trust I, Preferred, 8.625% | 70,000 | 560,000 |
| BBC Capital Trust I, Preferred, 9.50% | 28,000 | 490,000 |
| RBI Capital Trust I, Preferred, 9.10% | 42,500 | 353,281 |
| Fidelity Capital Trust I, Preferred, 8.375% | 43,500 | 337,125 |
| 2,348,844 | ||
| Telecommunications—0.9% | ||
| MediaOne Finance Trust III, Preferred, 9.04% | 20,000 | $503,750 |
| Total Preferred Stock (Cost: $3,470,738) | 2,852,594 | |
Par Value |
Market Value |
|
| Corporate Bonds—3.7% | ||
| Retail—0.9% | ||
| Ugly Duckling Corporation, 12.00% due 10/15/2003, Subordinated Debenture | 650,000 | $552,500 |
| Aerospace & Automotive—0.3% | ||
| Coltec Industries, Inc., 9.75% due 4/1/2000 | 150,000 | $150,938 |
| Building Materials & Construction—1.5% | ||
| Juno Lighting, Inc., 11.875% due 7/1/2009, Senior Subordinated Note | 750,000 | $690,000 |
| USG Corporation, 9.25% due 9/15/2001, Senior Notes Series B | 150,000 | 157,500 |
| 847,500 | ||
| Utilities—0.4% | ||
| Midland Funding Corporation, 11.75% due 7/23/2005 | 200,000 | $218,250 |
| Other Industrial Goods & Services—0.6% | ||
| UCAR Global Enterprises Inc., 12.00% due 1/15/2005, Senior Subordinated Note | 350,000 | $365,312 |
| Total Corporate Bonds (Cost: $2,153,294) | 2,134,500 | |
| Government and Agency Securities—25.2% | ||
| U.S. Government Bonds—24.7% | ||
| United States Treasury Notes, 6.625% due 5/15/2007 | 4,500,000 | $4,516,167 |
| United States Treasury Notes, 6.25% due 6/30/2002 | 4,000,000 | 3,997,240 |
| United States Treasury Notes, 4.75% due 2/15/2004 | 4,000,000 | 3,771,282 |
| United States Treasury Notes, 6.00% due 8/15/2009 | 2,000,000 | 1,937,593 |
| 14,222,282 | ||
| U.S. Government Agencies—0.5% | ||
| Federal Home Loan Bank, 6.405% due 4/10/2001, Consolidated Bond | 300,000 | $299,836 |
| Total Government and Agency Securities (Cost: $14,916,923) | 14,522,118 | |
| Total Fixed Income (Cost: $20,540,955) | 19,509,212 | |
| Short Term Investments—4.1% | ||
| Commercial Paper—0.9% | ||
| American Express Credit Corporation, 5.25% due 1/3/2000 | 500,000 | $500,000 |
| Total Commercial Paper (Cost: $500,000) | 500,000 | |
| Repurchase Agreements—3.2% | ||
| State Street Repurchase Agreement, 3.25% due 1/3/2000 | 1,876,000 | $1,876,000 |
| Total Repurchase Agreements (Cost: $1,876,000) | 1,876,000 | |
| Total Short Term Investments (Cost: $2,376,000) | 2,376,000 | |
| Total Investments (Cost $53,302,138)—99.2% | $57,105,692 | |
| Other Assets In Excess Of Other Liabilities—0.8% | 446,691 | |
| Total Net Assets—100% | $57,552,383 | |
(a) Non-income producing security.
(b) Represents foreign domiciled corporation.