Oakmark Equity and Income Fund: First Quarter 2019
March 31, 2019
Is Value Investing Dead?
Historically, value stocks — i.e., those stocks with the lowest price to book and lowest trailing sales growth rates — have outperformed their growth brethren. However, in 2007, this trend started to reverse, and growth stocks have outperformed ever since. The reversal has been so sharp that the media and some investors have started to ask if value investing is dead. If one defines value investing as blindly buying a basket of low price-to-book and low growth stocks, we, too, are skeptical that such an approach will serve investors well over the long term.
We believe that the shift in growth stocks is the result of broader economic changes that have occurred over the past several decades. Companies’ budgets used to be heavily weighted toward buying and maintaining plants and equipment. Today, however, research and development (R&D) and marketing are more important. According to Empirical Research Partners, in the 1990s, publicly traded companies spent less than 40 cents of R&D for every dollar they invested in capital expenditures. Now, that number is 63 cents. Companies are maintaining fewer physical assets and focusing more on intangible assets. Because these intangible assets tend not to be captured on a balance sheet at fair value, earnings and book value are less correlated now than ever before.
This shift away from physical assets has implications not only for the balance sheets, but the income statements. That’s because accounting practices treat most physical assets as if they depreciate over many years, while marketing and R&D spending are expensed immediately even though, if done efficiently, they will create benefits that last years. In effect, this means that current earnings are often understated for companies that spend wisely on R&D and marketing. The changes to the economy do not mean that book value is now meaningless. It is still a very relevant metric in certain industries – it just isn’t as good of an indicator of earnings power as it used to be.
It may appear odd that, for most of history, stocks with lower trailing sales growth rates outperformed. Yet past growth rates were traditionally not very predicative of future growth rates and there was a strong tendency for reversion to the mean. This reversion to the mean was especially problematic for some of the fastest growing companies as investors would often extrapolate high growth rates and push stock valuations to extreme levels, only for the business fundamentals to disappoint. So what has changed? Revenue and earnings growth persistence have improved, especially among some of the largest technology companies whose earnings streams are protected by brand value, patents, technological leadership and network effect — all of which are much more durable advantages than simply having more fixed assets. On the flip side, several industries (media and retail) have been hurt by the “new economy” and have experienced large value declines. As a result, over the past decade, the returns of the growth and value indexes have been nearly identical on an equal-weighted basis. Large technology stocks have clearly shifted the dynamics for growth investments.
Has this change caused us to drastically overhaul our approach to value investing? Not really. Oakmark has never solely used statistical factors to define value. Instead, we have always done extensive due diligence on each company to estimate intrinsic value. Our analysis has always tried to account for the value of both physical and intangible assets. We also strive to produce earnings and cash flow forecasts that best reflect economic reality, not GAAP accounting. This could mean adding back amortization of intangible assets, adjusting for abnormally high R&D or marketing spending, or valuing a money-losing or an under-earning asset separately. Once we are comfortable that we have estimated intrinsic value to the best of our abilities, we purchase only those securities trading substantially below that estimate. The result is that our analysts find value in a wide range of industries and companies, and the Equity and Income portfolio reflects this.
Quarter and Fiscal Year-to-Date Review
Against a strong market backdrop, the Fund gained 8.8% in the quarter, a modest outperformance, compared to 8.5% for the Lipper Balanced Fund Index. This strong gain nearly offset a very weak first quarter of the Fund’s fiscal year. As a result, the Fund’s -1.3% return for the first six months of the fiscal year still trails the Lipper Index’s 0.2% mark. But, since inception, Equity and Income’s compounded annual rate of return stands at 9.8% versus the Index’s 6.8%.
The biggest positive contributors this quarter were Mastercard, Philip Morris International, Bank of America, General Motors and Nestlé, while the biggest detractors were CVS Health, Qurate Retail and Qorvo. On both ends of the spectrum, company-specific factors, rather than any industry or macro themes, drove stock outcomes. For the past six months, General Motors, Nestlé, Diageo, Foot Locker and Philip Morris led, primarily due to healthy consumer trends. Laggards were CVS Health, National Oilwell Varco, Bank of America, Anadarko and Citigroup. The common denominator among these stocks was exposure to the energy and financial industries, which performed poorly at the end of calendar 2018.
Transaction Activity and Asset Allocation
The sole new addition to the portfolio was Booking Holdings, whereas the subtractions were Dover Corporation, Flex Ltd. and Qorvo.
Booking Holdings (formerly known as Priceline) is a pioneer and global leader in the online travel industry. We believe that Booking’s strong brands, significant investment expenditures and scale advantages have given it a formidable network effect. Add to that the company’s geographic exposures, revenue mix and superior online traffic conversion, and it is clear that Booking has one of the best operating models in the industry. Yet share prices fell after the company issued weaker than expected quarterly guidance due to rising macroeconomic pressures in Europe and the company’s increased investment expenditures. Unlike investors focusing on the very short term, we believe Booking’s investment spending will enable the company to exceed average market growth rates for the long term. Factoring in the company’s net cash and investments, Booking’s stock trades at a discount to the market’s P/E ratio, despite the company’s superior growth outlook, above-average margin profile and high returns on incremental capital. Therefore, we find Booking stock an attractive investment opportunity.
Dover Corporation is a diversified manufacturer of industrial products. The Fund has owned Dover since 2011, and in that time, the business and the stock have performed reasonably well. The one area that has been disappointing is operating margin progression, which has trailed peers. To address this issue, the board hired respected industry veteran Richard Tobin as CEO. Tobin quickly initiated a significant cost-savings program that produced good early results and further long-term potential. As a result, the stock appreciated to near our estimate of fair value, so we sold our position.
Both Flex Ltd. and Qorvo were small positions for the Fund and their fundamentals fell short of our expectations. Although we still believe both companies are undervalued, we decided to recognize a tax loss and move the proceeds into Booking, which we believe is even more undervalued.
The Fund ended the quarter with an asset allocation of 61% invested in equities and 39% invested in fixed income. The fixed income portion of the Fund consists of 18% corporate bonds, 12% treasuries and treasury inflation protected securities, and 9% discount notes and commercial paper. We have increased the allocation to corporate bonds as they have become more attractive over the past several years due to rising interest rates and periodic spread widening versus treasuries. The duration of the Fund’s fixed income securities has increased slightly, but is only a little more than two years. We still do not see enough reward potential in long dated fixed income securities.
As always, we thank our fellow shareholders for investing in the Equity and Income Fund, and we 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 03/31/19: American Airlines Group 0.9%, Anadarko 0.9%, Bank of America 5.1%, Booking Holdings 0.5%, Citigroup 2.1%, CVS Health 2.1%, Diageo ADR 2.3%, Dover 0%, Flex 0%, Foot Locker 1.7%, General Motors 5.1%, Mastercard Cl A 3.5%, National Oilwell Varco 1.3%, Nestlé ADR 3.4%, Philip Morris Intl 2.6%, Qorvo 0%, Qurate Retail Cl A 0.2% and UnitedHealth Group 1.5%. 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.
The net expense ratio reflects a contractual advisory fee waiver agreement through January 27, 2020.
The Price to Book Ratio is a stock’s capitalization divided by its book value.
The Price-Earnings Ratio (“P/E”) is the most common measure of the expensiveness of a stock.
The compound return is the rate of return, usually expressed as a percentage, that represents the cumulative effect that a series of gains or losses has on an original amount of capital over a period of time. Compound returns are usually expressed in annual terms, meaning that the percentage number that is reported represents the annualized rate at which capital has compounded over time.
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 03/31/2019 unless otherwise specified.