Bill Nygren Market Commentary | 4Q14
December 31, 2014
“It’s one of the most frustrating aspects of mutual fund investing: paying capital gains taxes when you haven’t sold a single share.”
-Beverly Goodman, Barron’s December 13, 2014 “Fund Investors Get Hit With Surprising Capital Gains”
Like much of the mutual fund industry, our Oakmark Funds had higher than normal capital gains distributions in 2014. Going into year six of the market advance, there just weren’t many losses left to offset the gains realized on stocks we sold. The Oakmark Select Fund, with a distribution of 12% of its value, unfortunately made some lists of tax-unfriendly funds due to its double-digit distribution. Oakmark Select’s 2014 performance benefited from three mergers: DirecTV being acquired by AT&T, Forest Laboratories by Actavis and TRW Automotive Holdings by ZF Friedrichshafen. A year ago those three acquirees accounted for 18% of the Oakmark Select portfolio, and their sales accounted for the majority of our gains. Unless we wanted to hold stock in the acquiring companies, there simply wasn’t a good way to avoid recognizing those taxable gains. But given the disconnect between our large distributions this year and our claims to be a tax-sensitive fund family, an explanation might be helpful.
Mutual funds are one of the only securities that require owners to pay capital gains before they sell their shares. Every mutual fund annually has to total up the capital gains it realized during the year and distribute the net gain proportionately to its shareholders. The shareholders are taxed currently on that gain despite not selling their shares. When a shareholder does eventually sell, the gain on sale is reduced by the amount of the gains recognized each year that the shares were held. In the end, capital gains taxes are paid on the exact amount of the total gain, but some of that gain was “prepaid” via the annual taxable distributions.
As an aside, I believe mutual funds present a great opportunity for tax simplification. Given that many investors now have a short-term outlook (most Oakmark investors aside, thankfully), the value to the government of the “prepayment” is trivial relative to the record-keeping costs it generates. Taxing fund shareholders only when they sell shares would cost the government next to nothing, reduce administrative expenses and encourage fund investors to improve their own performance by reducing their turnover. But alas, for now the rules are what they are.
At Oakmark our goals are to maximize long-term returns and—more specifically—to take every reasonable opportunity to maximize after-tax returns when those actions don’t harm our tax-free shareholders. Some funds that claim to be “tax-efficient” focus so much on minimizing taxes that they also inadvertently reduce their returns. We want to minimize the hole in the donut that is lost to taxes, but do so without reducing the size of the donut.
One of the most obvious ways we reduce shareholders’ tax burden is by using our long-term approach, which typically produces long-term gains. For most individuals long-term capital gains are taxed at less than half the rate paid on short-term gains. Based on distributions paid last year, over 20% of the average mutual fund capital gain distribution was short-term gain. The Oakmark Fund has paid out nearly $15 per share in gains since 2000. Of that, only $0.08 was short-term gain, about half of one percent. Since its inception in 1996, Oakmark Select has distributed $0.56 of short-term gain, a little over 2% of total gains. When our stocks appreciate quickly and hit sell targets before we’ve held them for a full year, unless we see unusually high risk in continuing to hold, we will generally wait to sell until our holding period exceeds one year so that we get the less expensive long-term gain rate. You might wonder why our Global Select Fund would keep such a small position in Medtronic. The answer is that we have a nice gain in those shares and that they have not yet turned long-term.
In some cases when a company gets a stock acquisition offer—as one of our holdings, Forest Laboratories, did earlier this year—we protect the gain while we wait for shares to turn long-term by selling shares of the acquirer short. Mutual funds generally don’t engage in short sales because they are perceived to be higher risk, but in this case, we believe the short sale both reduces taxes and risk.
We also capture tax losses to net against our gains. We look at our holdings by tax lot and will routinely sell any individual tax lot that has a loss of 20% or more. Many value funds don’t take this step because value investors typically believe stocks that have gone down in price have become more attractive. Though we often agree, when we have a loss to capture, we will either sell some shares immediately and repurchase in 31 days (to avoid wash sales rules) or buy more immediately and sell those shares in 31 days. We do this throughout the year, which allows us to maintain our core positions in the stocks we believe are most attractive while still capturing losses and reducing our net gain. Further, we believe this benefit to our taxable shareholders has been achieved without harming our tax-free holders. So when you see our portfolio turnover spike, as when the Oakmark Fund’s hit 62% in the 2009 turmoil, check to see if we might be engaging in tax-loss selling before you conclude we’ve abandoned our long-term approach.
Another way we seek to capture losses is to replace losing stocks with similar, but equally attractive, stocks. An example in the Oakmark Fund from this past quarter was selling our remaining Cenovus shares and redeploying the proceeds into Chesapeake. We believe Cenovus is a fine, well-managed company, but due to rapidly declining oil prices, it had fallen beneath our purchase price. Another company we believed was also fine and well-managed, Chesapeake, had fallen to a price where it appeared to us to be more attractive than Cenovus. So even though Cenovus was far beneath our sell target, we captured the loss, increased our exposure to an energy sector we thought was cheap and switched to a stock we believed was somewhat more attractive.
When Kevin Grant and I started managing the Oakmark Fund in 2000, we inherited a portfolio full of cheap stocks that had been left behind in the Internet boom. Because the Fund had suffered heavy redemptions, the portfolio had fewer positions in it than we thought was appropriate, especially given how many other stocks were also priced inexpensively. So we sold the high-cost tax lots from each position and reinvested in other cheap stocks. The resulting capital loss carry forward allowed us to fully shelter our gains until a distribution was finally required in 2006.
Making sure almost all of our gains are long-term before we realize them actually reduces the total amount of tax our shareholders pay. The other steps—tax trading around a core position, swapping loss positions into stocks with similar exposures, as well as transactions involving short sales, stock options, merger arbitrage and exchanges of similar securities—simply delay the tax, deferring as much tax as possible until the time the shareholders sell their position in the fund. We go to these lengths because we believe there is a lot of value gained from compounding returns on that deferred tax.
So when you see a large capital gains distribution from an Oakmark Fund, first, realize it might be a good thing. We only make distributions when we’ve made money on our holdings. But also realize we’ve tried to do everything we reasonably can to minimize that distribution without decreasing your actual gain. And if you have a spare minute, contact your representatives to suggest a very sensible tax reform!
All of us at Oakmark thank you for your investment, and wish you and your family a happy, healthy and prosperous 2015.
William C. Nygren, CFA
View other commentary and letters from Bill here.
At Oakmark, we are long-term investors. We attempt to identify growing businesses that are managed to benefit their shareholders. We will purchase stock in those businesses only when priced substantially below our estimate of intrinsic value. After purchase, we patiently wait for the gap between stock price and intrinsic value to close.
As of 12/31/14 DIRECTV represented 0%, AT&T Corp. 0%, Forest Laboratories, Inc. 0%, Actavis PLC 0%, TRW Automotive Holdings Corp 0%, ZF Friedrichshafen AG 0%, Medtronic 1.9%, Cenovus Energy, Inc. 0% and Chesapeake Energy Corporation 1.2% of the Oakmark Fund’s portfolio of net assets. Portfolio holdings are subject to change without notice and are not intended as recommendations of individual stocks.
As of 12/31/14 DIRECTV represented 0%, AT&T Corp. 0%, Forest Laboratories, Inc. 0%, Actavis PLC 0%, TRW Automotive Holdings Corp 0%, ZF Friedrichshafen AG 0%, Medtronic 3.7%, Cenovus Energy, Inc. 0% and Chesapeake Energy Corporation 3.5% of the Oakmark Select Fund’s portfolio of net assets. Portfolio holdings are subject to change without notice and are not intended as recommendations of individual stocks.
As of 12/31/14 DIRECTV represented 0%, AT&T Corp. 0%, Forest Laboratories, Inc. 0%, Actavis PLC 0%, TRW Automotive Holdings Corp 0%, ZF Friedrichshafen AG 0%, Medtronic 0.8%, Cenovus Energy, Inc. 0% and Chesapeake Energy Corporation 0% of the Oakmark Global Select Fund’s portfolio of 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 Fund as of the most recent quarter-end.
Click here to access the full list of holdings for The Oakmark Select Fund as of the most recent quarter-end.
Click here to access the full list of holdings for The Oakmark Global Select Fund as of the most recent quarter-end.
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.
Oakmark Select Fund and Oakmark Global Select Fund: Because the Fund is non-diversified, the performance of each holding will have a greater impact on the Fund's total return, and may make the Fund's returns more volatile than a more diversified fund.
Oakmark Select Fund: The stocks of medium-sized companies tend to be more volatile than those of large companies and have underperformed the stocks of small and large companies during some periods.
Oakmark Global Select Fund: Investing in foreign securities presents risks that in some ways may be greater than U.S. investments. Those risks include: currency fluctuation; different regulation, accounting standards, trading practices and levels of available information; generally higher transaction costs; and political risks.
The above information should not be considered tax advice. Please consult your tax advisor for detailed information applicable to your unique situation.
The discussion of the Funds’ investments and investment strategy (including current investment themes, the portfolio managers' research and investment process, and portfolio characteristics) represents the Funds’ investments and the views of the portfolio managers and Harris Associates L.P., the Funds' investment adviser, at the time of this letter, and are subject to change without notice.