Oakmark Equity and Income Fund: Third Quarter 2019
September 30, 2019
As part of our management process, we maintain a certain level of short-term reserves—or what we call “frictional cash”— to handle security purchases and/or investor redemptions. On each business day, our fund accounting group informs our team of fixed income traders how much frictional cash is available for very short-term investments. Our traders scan the short-term investment market to identify attractive opportunities and then transact to ensure that all of the Fund’s cash is working. We typically use this frictional cash to invest in top-rated commercial paper issuers, overnight discount notes with federal agencies and repurchase agreements with our custodial banks.
These overnight repurchase agreements—referred to as the “repo” market for short—are central to the financial industry’s daily cash management. Banks, hedge funds and other institutions that carry inventories of fixed income investments often fund their business activities via short-term loans, and they use their inventory as collateral. Money market funds are major investors in these short-term loans and other long-only investors, like the Equity and Income Fund, participate as well.
Usually, the rate of interest paid for repurchase agreement loans is similar to the target rate that the Federal Reserve sets for federal funds. On the morning of September 16, however, the repo market interest rate suddenly surged higher to more than twice the level of the previous day. Although the number of trades transacted at abnormal levels was not large, the occurrence unnerved some investors because the last time this happened was in 2007 before the global financial crisis became evident. As Bloomberg financial columnist John Authers wrote, “It’s a rule of thumb that if you’re even talking about such geeky fare as…overnight repurchase agreements, then something has already gone wrong…It doesn’t necessarily follow, however, that we’re doomed to stage a full-volume repeat of the financial disasters of 2007-2008. The causes are different.”1
We agree that this year’s disturbance was more technical than it was a harbinger of serious market distress. In 2007, the problem with the repo market occurred because financial institutions began to distrust the safety of the collateral being offered. Much of that collateral was in the form of mortgage-backed securities that were ostensibly AAA but, in fact, did not deserve that rating. In 2019, we are unaware of collateral safety issues. As well, the banking industry itself has significantly increased its capital ratios over the past 12 years. Instead, the problem seems to have arisen due to a confluence of normal market events that, when taken together, removed reserves from the market. These include massive quarterly corporate tax payments, settlement of the sale of a large new issue Treasury note and the Fed’s gradual reduction in the size of its own balance sheet. As these factors persisted, the Fed Funds rate itself hit—and then even exceeded—the Fed’s target rate. That definitely caught the Fed’s attention because it did not want to be seen to be losing control of short-term rates. The Fed subsequently responded by injecting reserves into the market. Although this response might have been a little late, it was effective in bringing short-term interest rates back into the desired range.
The repo market is sometimes referred to as part of the plumbing inside the financial system. In 2007, the fact that the entire system had become clogged with bad securities became evident in that market first. Although we believe today’s conditions are very different (and better), we remain vigilant. All three of your Fund’s managers have mine experience—in fact, one of us is a degreed geologist—and we know why miners used to keep canaries in coal mines.
Quarter and Fiscal Year Review
The Equity and Income Fund returned 0.2% in the quarter, which compares to 1.3% for the Lipper Balanced Fund Index, the Fund’s performance benchmark. For the nine months of the calendar year, the Fund returned 12.7%, compared to 13.6% for the Lipper. And, for the 12 months ended September 30 (the Fund’s fiscal year), Equity and Income earned 2.3%, which compares to 4.9% for the Lipper Balanced Fund Index. The annualized compound rate of return since inception in 1995 is 9.7%, while the corresponding return to the Lipper Index is 6.9%.
CVS Health, Alphabet, Nestlé, Ally Financial and Mastercard provided the largest contribution to portfolio return in the quarter. The most significant detractors were Lear, BorgWarner, UnitedHealth Group, American Airlines and Diamondback Energy. Lear and BorgWarner are both automobile parts suppliers. Although the U.S. auto market remains solid, in our opinion, China has experienced declining sales and tariffs, threats of more tariffs, and recession angst have depressed automotive equities. Contributors for the calendar year to date were Mastercard, Nestlé, Bank of America, TE Connectivity and General Motors. Foot Locker, Regeneron, National Oilwell Varco, UnitedHealth Group and Glencore were the leading detractors for the nine months. Finally, for the Fund’s fiscal year, the largest contributors were Nestlé, General Motors, Mastercard, Ally Financial and Charter Communications. The stocks that detracted most were National Oilwell Varco, CVS Health, UnitedHealth Group, Glencore and Regeneron. The appearance of health care names on the various detractor lists is somewhat unusual and most likely reflects the political environment.
We maintained a steady asset allocation for the Fund. During the quarter, interest rates suddenly began to move higher, which gave us hope for better opportunities in fixed income, but this proved to be short lived. Since rates have returned to unattractive levels, we have allowed the fixed income duration to attrite. We recognize that with negative interest rates in much of the developed world, it is difficult for U.S. rates to increase meaningfully, but just because U.S. bonds are priced better than foreign bonds does not make them intrinsically attractive. We will continue to maintain a defensive fixed income posture until bonds become more competitive with equities for portfolio space.
During the quarter, the Fund added two new positions, Agilent Technologies and Southwest Airlines. Agilent Technologies sells analytical instruments that are primarily used by research scientists and quality control labs. Agilent’s portfolio has transformed dramatically since being spun off from Hewlett Packard in 1999 as the company pared back cyclical business lines in semiconductors, electronic measurement and communications. Today, we are left with a pure-play that is focused on life science and diagnostics. The majority of sales now come from recurring sources, such as consumables, software and service, which are more profitable and less volatile than capital equipment orders. Since slimming down, Agilent’s management has delivered consistent share gains, robust organic growth and solid margin expansion. We believe the market doesn’t fully appreciate the portfolio transformation that has taken place and still perceives the business as cyclical. Agilent trades at a significant discount to its closest peers and historical private market transactions. When fears about slowing industrial production and exposure to China drove Agilent’s stock price down significantly, we were able to invest in this above-average business at a reasonable price.
Southwest is the largest and most profitable airline in the U.S. A member of Fortune’s list of the “World’s Most Admired Companies” every year for a quarter of a century, Southwest has 23% domestic market share and a track record of profitability that spans 46 consecutive years. The company generates above-average operating profit margins, enabled by its low-cost model compared to the network carriers. And its superior brand loyalty among customers stems from its reputation for good service, efficient operations and no nickel-and-diming on fees. The company maintains a strong balance sheet and returns its free cash flow to shareholders through significant share repurchases and dividends. We believe that the consolidation of the airline industry over the past two decades should lead to meaningfully better returns for the industry. The recent turbulence caused by the grounding of the Boeing 737 MAX aircraft, among other short-term issues, enabled us to buy Southwest shares at only a mid-single-digit multiple of normal operating income and at a large discount to our estimate of intrinsic value.
The Fund did not exit any holdings during the quarter.
We thank our shareholders for entrusting their assets to the Fund. We welcome your questions and comments.
Clyde S. McGregor, CFA
M. Colin Hudson, CFA
Edward J. Wojciechowski, CFA
1Authers, John. "Markets Are Starting to Play a Haunting Tune," Bloomberg, September 17, 2019
The securities mentioned above comprise the following percentages of the Oakmark Equity and Income Fund’s total net assets as of 09/30/19: Agilent Technologies 0.6%, Ally Financial 2.0%, Alphabet Cl C 2.8%, American Airlines Group 0.7%, Bank of America 5.0%, BorgWarner 1.8%, Charter Communications Cl A 2.0%, CVS Health 2.6%, Diamondback Energy 0.8%, Foot Locker 1.3%, General Motors 5.0%, Glencore 0.9%, Hewlett-Packerd 0%, Lear 1.4%, Mastercard Cl A 3.3%, National Oilwell Varco 0.6%, Nestle ADR 2.9%, Regeneron Pharmaceuticals 0.5%, Southwest Airlines 0.2%, TE Connectivity 4.4% and UnitedHealth Group 1.3%. 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 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 09/30/2019 unless otherwise specified.