Oakmark Equity and Income Fund: Third Quarter 2017
September 30, 2017
Quarter and Fiscal Year Review
The Equity and Income Fund returned 3.7% in the quarter, compared to 3.2% for the Lipper Balanced Fund Index, the Fund’s performance benchmark. For the nine months of the calendar year, the Fund returned 9.8%, compared to 10.2% for Lipper. And, for the 12 months ended September 30 (the Fund’s fiscal year), Equity and Income earned 15.3%, which compares to 10.9% for the Lipper Balanced Fund Index. The annualized compound rate of return since inception in 1995 is 10.3%, while the corresponding return to the Lipper Index is 7%.
General Motors, MasterCard, Dover, BorgWarner and Lear provided the largest contributions to portfolio return in the quarter. We have believed for several years that automotive industry stocks were selling too cheaply, and we are pleased that this point of view bore fruit in the quarter. The detractors’ list included Foot Locker, Philip Morris International, HCA Healthcare, Oracle and Nestlé. Contributors for the calendar year to date were MasterCard, General Motors, Oracle, Bank of America and TE Connectivity. Foot Locker, Baker Hughes, Flowserve, Ultra Petroleum and CommScope Holding were the leading detractors for the nine months. Finally, for the Fund’s fiscal year, the largest contributors were Bank of America, General Motors, TE Connectivity, MasterCard and UnitedHealth Group. The stocks that detracted most were Foot Locker, CVS Health, Flowserve, Ultra Petroleum and CommScope.
We were active this quarter, adding four new positions and exiting three significant positions. The new additions were American International Group (AIG), Alphabet (GOOG), General Electric (GE) and LivaNova (LIVN). AIG is one of the world’s largest insurance companies, competing in both commercial and consumer lines. It is perhaps best known for being one of the companies that required significant government support during the financial crisis. Since the crisis, management has sold or exited numerous businesses, strengthened the balance sheet, repurchased over half the outstanding shares and improved AIG’s underwriting by significantly shrinking unprofitable insurance lines. These actions led to improved results, but the board decided to accelerate the process with new management. We think the hiring of long-time insurance executive Brian Duperreault was outstanding. Duperreault was instrumental in improving returns and growth when he served as CEO of ACE Limited and of Marsh & McLennan. We expect similar success at AIG, and believe that fair value is in excess of tangible book, compared to the current multiple of 0.8x.
Alphabet is the corporate parent of Google. Although this purchase may surprise some long-term shareholders, we believe that Alphabet fits quite well in this portfolio. It has dominant positions across search and “new” media businesses. These businesses are growing rapidly as they offer a superior value proposition to advertisers who can more easily target and track the effectiveness of their advertising. We believe the company’s management team thinks like owners and is appropriately investing for many years of better-than-average growth. Adjusting for the more than $130 per share of net cash, GOOG trades at a below-market multiple of earnings despite its competitively protected business, which we believe can grow at above market rates for many years.
GE makes a return appearance to the portfolio after being sold at higher prices last summer. The market is worried that new CEO John Flannery will need to reset earning guidance when he presents his first view of the business this November. Although this is likely, we take comfort that the business portfolio is composed of high return franchises that enjoy dominant market shares. Over 80% of the company’s profits are generated from durable, recurring maintenance revenue. We are especially excited about both the aviation and health care businesses, which constitute well over half of our estimate of value. We expect Flannery to cut costs aggressively and believe that earnings can grow favorably from the reset base. GE is trading at a large discount to our estimate of intrinsic value, and we are glad to welcome it back to the portfolio.
LivaNova manufactures medical devices for neurology and cardiology. The company’s largest division by profit is neuromodulation, which should produce high single-digit revenue growth because it produces an implantable, cost-effective device for severe epilepsy patients. The company’s cardiac surgery businesses will likely grow in the low single digits as LivaNova is a leader in equipment with new products in consumables and heart valves. During the past year, CEO Damien McDonald and CFO Thad Huston joined the management team from Danaher and Johnson & Johnson, respectively, and they are focusing on improving growth and margins, as well as exiting non-core businesses. The shares sell below public comparables and private market values. We believe that this talented new management team has numerous opportunities to create shareholder value.
The three significant positions that we sold this quarter were Flowserve, Union Pacific and U.S. Bancorp. Flowserve has performed poorly due to low energy prices, which have led to soft demand, excess capacity and a weak pricing environment. Although we believe that industry conditions will improve and that Flowserve is still an attractive opportunity, we decided to recognize the tax loss and use the proceeds to invest more in our other energy stocks, which we believe are even more attractive. Both U.S. Bancorp and Union Pacific were added to the portfolio in 2013. They both have been strong performers on an absolute basis. Although we believe both are still modestly undervalued, we decided that the Fund’s new additions traded at an even bigger discount to value. We also eliminated a very small holding in Ultra Petroleum, which the Fund received in a bond reorganization.
Are Your Investing Goals Coherent?
Passive investing continues to garner a large share of newly invested funds. As described by Howard Marks of Oaktree, “Passive investing can be thought of as a low-risk…and non-opinionated way to participate in ‘the market’….” Note that Marks uses the term “low-risk” here in a relativistic sense—i.e., relative to equity returns generally. And, given the reality that professionally invested funds are generally “benchmarked” to market indexes, the incentive for fund managers to hug the index is palpable. But does this method of investing optimize the individual investor’s wealth creation or appropriately marry with his/her risk tolerance? As you can guess, we think not.
Daniel Godfrey of The People’s Trust writes, “The purpose of investment could be defined as sustainable wealth creation. Success delivers long-term absolute returns to investors.” The Equity and Income Fund has always been invested with the objective to produce absolute rates of return that make it possible for its owners to meet their financial goals. We don’t know what the index may earn and, in many respects, we don’t particularly care. What we do know is that if we invest our shareholders’ hard-earned funds in companies that are undervalued and that persistently grow their intrinsic value per share, these equities should generate positive long-term returns. And we know that if we combine these equity holdings with a value-oriented fixed income allocation, we can produce a portfolio with buffered volatility, which makes it easier for investors to stay the course when times are tough. We report returns versus a competitive benchmark (the Lipper Balanced Fund Index), but only because the industry demands it. We much prefer stating a goal in terms of absolute returns—e.g., to earn 3% per year more than the consumer price index. We are somewhat proud that the Equity and Income Fund has produced positive annual rates of return in all but three of its nearly 22 years, but we do rue those three down years. We look forward to improving upon that record.
In closing this section, we ask you, our shareholders, to review your investment goals. Are they reasonable? (Our firm once presented to a prospective client, a CEO of a public company, who stated that his goal was an absolute return of 50% per year. That was not reasonable.) Are these goals stated in relative or absolute terms? If relative, have you thought through what a significant down year in the index will mean to your financial health? If your investments are aligned with your risk tolerance and your financial needs, you truly can sleep well.
Once again, we thank you for your support. We invite your questions and 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 09/30/17: General Motors 5.1%, MasterCard 3.1%, Dover 2.6%, BorgWarner 1.6%, Lear 1.4%, Foot Locker 1.3%, Philip Morris International 2.1%, HCA Healthcare 1.1%, Oracle 2.4%, Nestle SA ADR 2.9%, Bank of America 5.0%, TE Connectivity 3.5%, Baker Hughes 1.1%, Flowserve 0%, Ultra Petroleum 0%, CommScope Holding 0.7%, UnitedHealth Group 2.7%, CVS Health 2.5%, American International Group 0.5%, Alphabet, Class C 1.6%, General Electric 0.5%, LivaNova 0.2%, ACE Limited 0%, Marsh & McLennan 0%, Danaher Corporation 0%, Johnson & Johnson 0%, Union Pacific 0%, and U.S. Bancorp 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.
The Lipper Balanced Fund Index measures the performance of the 30 largest U.S. balanced funds tracked by Lipper. This index is unmanaged and investors cannot invest directly in this index.
The quoted passage is taken from a memo from Howard Marks of Oaktree titled “Yet Again?” dated September 7, 2017 https://www.oaktreecapital.com/insights/howard-marks-memos
The quoted passage is taken from an article by Daniel Godfrey titled “Why Warren Buffet is right, but so wrong” from the Financial Times dated September 5, 2017.
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 09/30/2017 unless otherwise specified.