Oakmark Equity and Income Fund: First Quarter 2018
March 31, 2018
The Return of Volatility
In our long history of writing these reports, the title above is one of the least creative we have ever posted for the opening section. But it is hard to ignore or underplay the considerable change in the investing environment that became evident in the recent quarter. To review, 2017 was the first so-called “perfect year,” meaning that the S&P 500 generated positive returns in each month. And these returns were accomplished with few individual days experiencing moves of 1% or more. In January 2018, this trend continued and even amplified as the S&P 500 returned nearly 6% in the month. But in February, market action changed drastically: returns shifted to negative and intraday volatility expanded. Market commentators ascribed this change to many factors, but trade war fears, a hint of increase in the rate of inflation and rising interest rates almost certainly contributed. Whatever the causes, this more volatile period is closer to typical for the stock market than the remarkable quiescence of 2017. We are usually more active in volatile time periods, and as you will see later in this report, we initiated holdings in an unusually large group of issues during the past quarter.
For the March quarter, the Equity and Income Fund showed a loss of 1.6%, compared to a 1.0% loss for the Lipper Balanced Fund Index, the Fund’s performance benchmark. For the six months of the Fund’s fiscal year, the Fund earned 2.5%, which contrasts to a 2.6% gain for the Lipper Index. We are pleased to report that the annualized compound rate of return since the Fund’s inception in 1995 is 10.2%, while the corresponding return to the Lipper Index is 6.9%.
The largest contributors to portfolio return in the quarter were Mastercard, TE Connectivity, Jones Lang LaSalle, Bank of America and HCA Healthcare. General Motors, CVS Health, Nestlé, Citigroup and Arconic detracted most. For the six months, Bank of America, TE Connectivity, Mastercard, Jones Lang LaSalle and UnitedHealth Group led the contributors, while CVS Health, General Motors, Baker Hughes, Philip Morris International and Nestlé detracted most from return.
Are Today’s Interest Rates the New Normal?
As value managers, we often are described as seeking “regression toward the mean” or mean reversion. Mean reversion is observed in many processes. Given that we are writing this during college basketball’s championship tournament, a good example is a team that starts a game with an extremely high three-point field goal shooting percentage. The pull of mean reversion suggests that this shooting will cool off as the game progresses to something closer to that team’s historic record. Relative to investing, we value investors look to identify equities selling for prices well below our estimate of their intrinsic value because history has taught us that the prices of these securities will converge toward their true worth. After purchasing a holding, we aim to sell it when its price has converged with—or exceeded—our intrinsic value estimate. Our type of value investing requires only that human nature stays constant (i.e., not perfectly rational) such that price and value diverge and converge periodically. Where value investors face meaningful error potential, however, is either from mis-estimating the intrinsic value to begin with or from ignoring that a company’s intrinsic value is declining.
As managers of a balanced fund, we also apply our value philosophy to fixed income investing. We look to identify fixed income issues that trade for less than we believe them to be worth, and we attempt to increase (or decrease) our fixed income portfolio weight when the term structure of interest rates is itself attractive (or unattractive). For much of the current decade, we have found interest rates generically to be too low. Low interest rates increase duration, an attribute that helps to describe the price volatility that a bond will exhibit, meaning that low interest rates amplify bond price volatility. We invest in bonds for the Equity and Income Fund in part to dampen volatility, so low interest rates are unhelpful to that effort. As well, most of us involved in investing today have considerable experience with periods of interest rates far in excess of today’s levels. Many of us believe that history represents the norm (the mean expectation) and that the current time period is extraordinary (from which rates should be reverting).
But what if the mean value for interest rates has itself shifted to a much lower level such that today’s term structure is the new normal? A recent paper published by the National Bureau of Economic Research makes that argument. The authors write, “Viewed from a long-run perspective, it may be fair to characterize the real safe rate as normally fluctuating around the levels that we see today, so that today’s level is not so unusual. Consequently, we think the puzzle may well be why was the safe rate so high in the mid-1980s rather than why has it declined ever since.” This argument suggests that those of us who began our careers in the 1980s may be allowing an anomalous period to influence our understanding of normal levels of interest rates. Of course, this argument also has broader implications for projected returns from pension plans, endowment funds, retirement savings, etc.
Another way that economists discuss this is to estimate a neutral (or natural) rate of interest where the neutral rate is one that neither stimulates nor retards economic activity. Some postulate that the neutral rate is in part a function of economic productivity and population growth and that the low interest rate structure evident today reflects the current low productivity level.
All of this is problematic for investors and portfolio managers, even as it is advantageous for governments and other borrowers. We must work harder and perhaps differently to identify value in fixed income securities in a world of secular low rates. To dampen portfolio volatility, we may need to continue to hold higher levels of cash and other short-term instruments. And we may all have to become acclimated to a world with lower potential nominal returns.
The Fund was especially active in the quarter, adding six new positions and exiting three. The new additions were Anadarko, Carlisle, Comcast, Liberty Broadband (LBRDA, LBRDK), Qorvo and Regeneron. The Fund also built up a position in CoreLogic, having initiated it at the end of the previous quarter.
Anadarko acquires, explores, develops, produces and markets oil and natural gas. Anadarko has some of the highest quality assets in the U.S. onshore market, generating high returns on invested capital and holding a large inventory of undrilled locations. Its management team is one of the best in the industry and has a track record of operational excellence and value-accretive capital allocation. Despite these positives, the stock is trading at a discount to its E&P (exploration and production) peers.
Carlisle is a diversified manufacturing company, consisting of construction materials, interconnect technologies and other industrial products. A new management team is in the process of reshaping the portfolio through a series of acquisitions and divestitures. These activities depress short-term results but will add value in the long run. Additionally, raw material inflation has hurt the company’s current financials, but we believe these pressures should prove transitory as Carlisle should eventually be able to pass costs through to customers.
Our investments in Comcast and Liberty Broadband (which we view as a cheaper way to own Charter Communications) should be covered together. We believe that the cable business has become a much higher quality, internet connectivity-centric business, and that this fact is underappreciated by the market. In many markets, Charter and Comcast have the only fiber-rich networks capable of providing consumers with the high internet speeds they increasingly demand. Competitor efforts to enter the market have proven uneconomic due to the fractional penetration available to new entrants. Thus, barriers to entry are quite high, providing a long runway for growth for the incumbent cable operators. We have great respect for the management teams at both companies and think shareholders will continue to be rewarded by their stewardship. Further, the competitive position of these companies should enable them to capture much of the economics from U.S. corporate tax reform, yet the stocks both trade for lower prices than before the passage of the bill.
CoreLogic provides residential real estate information to the financial services sector. The shares have been weak due to near-term cyclical concerns about declining mortgage refinancing activity. We do not believe this has a long-term impact on business value. Unique data businesses tend to have great returns and are difficult to replicate. CoreLogic fits this mold. The management team has been good stewards of capital and has reduced the share count 30% since 2010. Management has been improving margins for years, and we believe there is more room for improvement going forward. Meanwhile, CoreLogic is selling well below public and private market values of other high-quality data providers.
Qorvo is a semiconductor company engaged in the design and production of the radio frequency modules that allow mobile handsets to communicate with wireless networks. Qorvo enjoys the favorable economics associated with being one of just three large competitors controlling 70% of a technically complex market. Over the long term, Qorvo and the radio frequency chip industry are exposed to many of the most favorable trends we see in the market today—increasing data consumption and mobile computer usage, internet-of-things, driverless vehicles, and a universal move toward a more connected world. We expect demand growth from these secular trends, coupled with recent design wins in the high-end of the market, to allow Qorvo to increase manufacturing utilization, which will significantly grow its margins and revenues.
Regeneron is a biotech company that is an industry leader in research and development (R&D). The company is led by its founder Leonard Schleifer who maintains a culture focused on developing novel drugs. He continues to hold a significant equity stake. Recent drug approvals provide a long growth runway, and we expect the company’s largest drug, Eylea, will be sustainable for at least several more years. Regeneron spends significantly more than its peers on R&D, which—when combined with its elevated selling, general and administrative (SG&A) spending on recent drug launches—has caused its margins to look unusually low compared to its peers. However, we believe that Regeneron will earn above-average returns on its R&D spend and that its launch costs will normalize over time. Although the company’s consensus multiples appear high, if its R&D costs are adjusted and its launch costs are normalized, Regeneron would be trading at a low-teens earnings multiple. We believe this is a compelling valuation for a growing business with a proven management team that is aligned with shareholders.
During the quarter, the Fund sold positions in Black Knight (received into the portfolio as a distribution from Fidelity National Financial), Manitowoc and Principal Financial. All three stocks reached their target prices and performed well during our holding period. The proceeds from these sales were used to purchase more attractively priced alternatives.
As always, we thank our fellow shareholders for investing in the Equity and Income Fund and welcome your questions or comments.
Clyde S. McGregor, CFA
M. Colin Hudson, CFA
Edward J. Wojciechowski, CFA
The securities mentioned above comprise the following percentages of the Oakmark Equity and Income Fund’s total net assets as of 03/31/18: MasterCard, Inc., Class A 2.8%, TE Connectivity, Ltd. 4.1%, Jones Lang LaSalle, Inc. 0.6%, Bank of America Corp. 4.8%, HCA Healthcare, Inc. 1.3%, General Motors Co. 4.7%, CVS Health Corp. 1.9%, Nestlé ADR 2.8%, Citigroup Inc. 2.2%, Arconic, Inc. 1.1%, UnitedHealth Group, Inc. 2.4%, Baker Hughes a GE Co. 0.5%, Philip Morris International, Inc. 2.0%, Anadarko Petroleum Corp. 0.5%, Carlisle Companies, Inc. 0.2%, Comcast Corp., Class A 1.0%, CoreLogic, Inc. 0.4%, Liberty Broadband Corp., Class C 0.4%, Liberty Broadband Corp. Class A 0.1%, Qorvo Inc. 0.3%, Regeneration Pharmaceuticals, Inc. 0.5%, Charter Communications, Inc. 0%, Black Knight, Inc. 0%, Fidelity National Financial Inc. 0%, The Manitowoc Co., Inc. 0% and Principal Financial Group, Inc. 0%. Portfolio holdings are subject to change without notice and are not intended as recommendations of individual stocks.
Access the full list of holdings for the Oakmark Equity and Income Fund as of the most recent quarter-end.
Jordà, Ò, Knoll, K., Kuvshinov, D., Schularick, M., & Taylor, A. (2017). The Rate of Return on Everything, 1870–2015. The National Bureau of Economic Research. doi:10.3386/w24112.
The net expense ratio reflects a contractual advisory fee waiver agreement through January 28, 2019.
The S&P 500 Total Return Index is a float-adjusted, capitalization-weighted index of 500 U.S. large-capitalization stocks representing all major industries. It is a widely recognized index of broad, U.S. equity market performance. Returns reflect the reinvestment of dividends. This index is unmanaged and investors cannot invest directly in this index.
The Lipper Balanced Fund Index measures the equal-weighted performance of the 30 largest U.S. balanced funds as defined by Lipper. This index is unmanaged and investors cannot invest directly in this index.
The Fund invests in medium- and lower-quality debt securities that have higher yield potential but present greater investment and credit risk than higher-quality securities, which may result in greater share price volatility. An economic downturn could severely disrupt the market in medium or lower grade debt securities and adversely affect the value of outstanding bonds and the ability of the issuers to repay principal and interest.
The Oakmark Equity and Income 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.
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.
All information provided is as of 03/31/2018 unless otherwise specified.