Oakmark Equity and Income Fund: Third Quarter 2018
September 30, 2018
Some investment industry commentators have questioned the substandard performance history of traditional value equities following the financial crisis and have posited that recent economic changes have made traditional value factors, especially price-to-book ratios, obsolete. The basic argument is that intangible assets (e.g., patents, trademarks, research & development (R&D) spending, etc.) have become an increasingly dominant proportion of a modern company’s net worth and current accounting conventions fail to capture these assets adequately. In support of this view, in 1975, over 80% of the stock market value of an average company was represented by tangible book value, with intangibles representing the rest. Today those metrics are flip-flopped.
Regular readers of the Oakmark Funds’ group quarterly reports know that our colleague Bill Nygren recently addressed the inadequacies of GAAP accounting. Expenditures for property, plant and equipment are capitalized as an asset on the balance sheet and depreciated over the estimated life of that equipment. But other expenditures that yield long-term benefits, such as the R&D that a pharmaceutical company puts toward a new drug or the upfront marketing expense that a software company incurs to acquire a new customer, are expensed immediately and generate no corresponding asset. To confuse things further, an intangible asset that is acquired is treated differently than one that is developed internally.
This is all very interesting, but what does this mean for us as managers of the Equity and Income Fund? Our job is to seek value wherever we can find it in both the equity and the fixed income market. To do that, however, we must recognize that value itself is always evolving and we must also evolve to keep up. When considering investing in an equity, we always ask, “What is the price we could pay for this company and earn a fair return if we had to purchase it in its entirety and could never sell it again?” When we can estimate that price and can buy the equity at a sufficient discount, we believe that we have uncovered true value. But our analysis must continually progress for us to avoid an obsolete understanding of business value.
Several decades ago, some disciples of Benjamin Graham limited their investing to companies that were selling for less than the net value of their current assets minus all liabilities (net-nets). Over time, this investing method lost relevance as the economy developed and net-nets disappeared. Similarly, we must strive to stay ahead of the wave rather than fighting to catch up. One tactic that we use to fight obsolescence is to regularly hire new investment analysts, who, although fundamentally value oriented, have different ways of understanding exactly what that means. Another is our “devil’s advocate reviews” in which an analyst is charged with attacking our collective thinking on an issue. “Evolve or die out” is true in nature, and we realize that this also applies to our investing.
Quarter and Fiscal-Year Review
The Equity and Income Fund returned 2.5% in the quarter, which compares to 3.1% for the Lipper Balanced Fund Index, the Fund’s performance benchmark. For the nine months of the calendar year, the Fund returned 1.0%, compared to 3.2% for the Lipper Balanced Fund Index. And for the 12 months ended September 30 (the Fund’s fiscal year), Equity and Income earned 5.3%, which compares to 6.9% for the Lipper Balanced Fund Index. The annualized compound rate of return since inception in 1995 is 10.1%, while the corresponding return to the Lipper Balanced Fund Index is 7.0%.
HCA Healthcare, CVS, Mastercard, Dover and Oracle provided the largest contribution to portfolio return in the quarter. Detractors included General Motors (GM), Lear, PDC Energy, State Street and TE Connectivity. Contributors for the calendar year to date were MasterCard, HCA Healthcare, UnitedHealth Group, National Oilwell Varco and Charter Communications. GM, Philip Morris International, Arconic, Lear and TE Connectivity were the leading detractors for the nine months. Finally, for the Fund’s fiscal year, the largest contributors were Mastercard, Bank of America, UnitedHealth Group, HCA Healthcare and Dover. The stocks that detracted most were GM, Philip Morris International, Lear, Baker Hughes and BorgWarner.
One year ago, we wrote about the strong performance of the automotive industry stocks in the portfolio. This proved to be a premature celebration, as the 12-month detractor list demonstrates all too well. We continue to believe that the automotive sector is attractively priced. Concerning GM, the Fund’s second largest holding, we were very intrigued by Softbank’s $2.25 billion investment in GM’s Cruise Automation subsidiary. If Softbank is correct that GM’s stake in Cruise Automation is worth around $9 billion, then the valuation of GM’s traditional business is less than 5x EPS, which seems absurdly cheap. GM now trades near the price where it went public in 2010 ($33). Since then, the company has cumulatively earned more than $33/share and paid out nearly $7 in dividends. Critics of the stock will point to the current economic cycle, tariffs and the long-term threat from autonomous vehicles and ride-sharing. These concerns fail to take into account our estimate that nearly 75% of GM’s earnings come from pickup trucks and large SUVs—a market segment where the company has a dominant and protected competitive moat. We believe this part of the business alone is worth more than the current stock price, even without giving credit for Cruise or GM’s valuable China business.
During the quarter, we initiated one new holding and also eliminated one. New holding Flex is undergoing a business transformation that should result in improved margins and less cyclical, faster earnings growth. A decade ago, the company, then known as Flextronics, looked like a classic contract manufacturer. Like its peers, the company had a concentrated customer base, composed almost entirely of electronics companies, and it would manufacture products to meet customer specifications. Contract manufacturers have few meaningful competitive advantages in the low-margin manufacturing business, as their main value-add is locating production in low-cost regions.
However, since Mike McNamara took over as CEO in 2006, Flex has been diversifying its customer base to include industries such as medical, automotive and even shoe manufacturing for Nike. The company is also investing in what it calls “sketch-to-scale” capabilities, in which Flex’s engineers are actually involved in the design phase of customers’ products. This is a better business than contract manufacturing due to higher barriers to entry, stickier customer relationships and higher profit margins. Sketch-to-scale arrangements account for about 27% of revenues today and should be close to 40% by 2020. Recently, the stock price has been hurt by worries about tariffs and component shortages, as well as a surge in new orders, which has pressured margins and free cash flow as the company has added capacity and inventory to fulfill these orders. None of these worries will have a meaningful impact on long-term business value, and at about 10x year next 12 months EPS plus amortization, the stock is much too cheap, given the durable earnings growth and high return on invested capital we see ahead.
The only portfolio elimination was Wells Fargo. The Fund has a substantial commitment to the financial industry generally, and we sold Wells Fargo to fund purchases of more attractively valued securities.
Fixed Income/Fund Distributions
Over the past few years, we have often argued that “income is overpriced,” which is simply another way of saying that interest rates/dividend yields are too low. Recognize that this statement has consequences: if interest rates go up from these historically low levels, bond prices go down. Given that we have struggled to find true value in income for quite some time, we have maintained a conservative, risk-averse posture in our fixed income investing. This positioning has served us well this year. With the 10-year U.S. Treasury yield finally breaking through the 3% level, the Bloomberg Barclays U.S. Aggregate Bond Index looks likely to be down for the year, only the fourth time since 1990.
The fixed income portion of our portfolio, however, has shown positive returns. Given the increase in interest rates, we are finally beginning to see more attractive opportunities in the fixed income market. Of course, the danger is that this increased competition from bonds could pull money away from stocks with negative consequences for equities, so we must not see this interest rate move as entirely positive. But we hope that the changing environment will give us the opportunity to increase portfolio yield and, thereby, allow for larger income distributions.
Periodically, we receive queries from shareholders along the following lines: “Why does a fund with the word ‘income’ in its name not provide more in the way of income distributions?” Although we are all too aware of our failings in managing this Fund, less than anticipated income may be the one that nags at us most. When we incepted the Fund in 1995, fixed income interest rates and equity dividend yields were much higher than what soon became available to us in managing the Fund. In 1995, we lived in a world where we could generate 5-8% yields in the bond portfolio and earn 2-4% dividend yields on stocks. This could allow for something like a 3% income yield on the Fund portfolio, which would be available for distribution to shareholders. Several things occurred to change this math, however. First, interest rates declined almost continuously until their 2016 bottom when the rate on the 10-year Treasury hit 1.36%. Second, corporate leaders deemphasized dividends in favor of share repurchases. And last but not least, equity prices rose, perforce reducing dividend yields.
As noted above, we are finally beginning to see more attractive opportunities in the fixed income market. We hope that the changing environment will give us the opportunity to increase portfolio yield and, thereby, allow for larger income distributions. We thank our shareholders for entrusting their assets to the Fund, especially our long-suffering income-oriented investors. We welcome 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 09/30/18: HCA Healthcare, Inc. 1.6%, CVS Health Corp. 2.5%, MasterCard, Inc., Class A 3.6%, Dover Corp. 1.6%, Oracle Corp. 1.6%, General Motors Co. 4.0%, Lear 1.2%, PDC Energy 0.6%, State Street 0.8%, TE Connectivity, Ltd. 3.7%, UnitedHealth Group, Inc. 2.6%, National Oilwell Varco, Inc. 1.9%, Charter Communications, Inc., Class A 1.6%, Philip Morris International, Inc. 2.1%, Arconic, Inc. 0.9%, Bank of America Corp. 4.8%, Baker Hughes a GE Co. 0.5%, BorgWarner 1.2%, Softbank 0%, Flex 0.2%, Nike 0% and Wells Fargo 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 net expense ratio reflects a contractual advisory fee waiver agreement through January 28, 2019.
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 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 Bloomberg Barclays U.S. Aggregate Bond Index is a broad-based benchmark that measures the investment grade, U.S. dollar-denominated, fixed-rate taxable bond market. The index includes Treasuries, government-related and corporate securities, mortgage-backed securities (agency fixed-rate and hybrid ARM pass-throughs), asset-backed securities and commercial mortgage-backed securities (agency and non-agency). This index is unmanaged and investors cannot invest directly in this index.
The Price to Book Ratio is a stock’s capitalization divided by its book value.
EPS refers to Earnings Per Share and is calculated by dividing total earnings by the number of shares outstanding.
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 09/30/2018 unless otherwise specified.