Oakmark Equity and Income Fund: First Quarter 2016
March 31, 2016
Rocky Markets, Steady Strategy
The S&P 500 gained 1% this quarter, a modest increase by historical standards but one few are complaining about given the unusually rough start to the year. Within the first four trading days, the index was down 5% and 2016 took the award for worst-ever start to a year. And it only got worse. By the middle of February, the market had fallen by nearly 11%, driven by fears of a slowing global economy, especially relating to China. If this all sounds familiar, it’s because nearly the same thing happened in August 2015: The market plunged 11% due to broadly similar concerns.
We are pleased that the market’s rebound throughout the second half of the quarter lifted the Fund to a 1% return for the quarter, and also that the market’s earlier decline allowed us to establish positions in four companies at prices that were on average 23% lower than at the start of the year. Investors’ occasional manifestations of fear—and greed—often provide us with unusually good opportunities to carry out our disciplined, value-based investment strategy. Typically, that means that we venture toward whatever is out of favor and away from what is in favor. So while the world was fretting about a potential U.S. recession earlier this year, we added four economically sensitive businesses to the portfolio: Citigroup, Comerica, State Street and Jones Lang LaSalle.
It is fair to wonder how economically sensitive businesses fit into a conservative balanced fund. We believe two factors can transform volatile businesses into conservative investments. The first is price. If purchased at a low enough price in relation to estimated value, a cyclical business—like any other—can offer a margin of safety large enough to cushion the investment from many unforeseen negative developments. The second is time. While in the short term the economy—and therefore the earnings of economically sensitive businesses—might be unpredictable, over the long term growth can be more predictable (and so too are the earnings of economically sensitive businesses). The combination of buying at a sufficient discount to value and having a long time horizon—key elements of our overall investment strategy—makes us comfortable investing in businesses that may have volatile year-to-year results.
The fixed income market also presented us with compelling opportunities this quarter. A broad flight to safety caused corporate credit spreads to briefly widen to levels not seen since the financial crisis, which gave us the opportunity to increase our corporate bond portfolio by over 20% during the quarter. We will continue to look for attractive opportunities to increase our fixed income portfolio, but will proceed cautiously as corporate credit spreads need to be wide enough to compensate us for the rise in treasury yields we expect over time.
Though it may be de rigueur for investment managers to proffer macroeconomic prognostications, we neither claim to know, nor do we make an effort to know, how the economy will perform this year or next. But we have great confidence that over the long run, the economy will continue to grow and thus serve as a tailwind to the companies in the Fund. As Warren Buffett said, since 1776 it has never paid to bet against the U.S. And that generally applies to the global economy as well. Inevitably, however, there will be periods when growth slows and even reverses. Such times aren’t pleasant, but they don’t change our confidence in the ultimate direction of the economy. Seven years ago, this long-term perspective enabled us to confidently execute our investment strategy during the worst economic crisis of our lifetimes, and it continues to serve us well today.
The Equity and Income Fund returned 1% in the quarter, which was in line with the Lipper Balanced Fund Index, the Fund’s performance benchmark. For the trailing year, the Fund had a loss of 5% versus a loss of 1% for the Lipper Index. Since the Fund’s inception in 1995, the annualized compound rate of return is 10%, compared to the Lipper Index return of 7% over the same time period.
Oracle, Philip Morris International, Glencore, Kate Spade and CVS Health led the list of contributors for the quarter. The largest detractors were Bank of America, General Motors, Borg Warner, Goldman Sachs and TD Ameritrade. Financials in general had a difficult quarter, but we remain confident that these stocks are undervalued.
As mentioned above, we added four companies to the portfolio. While three of these businesses are banks, each faces different market concerns: emerging market exposure for Citigroup, energy lending for Comerica, and interest rate and market sensitivity for State Street. The fourth addition, commercial real estate services provider Jones Lang LaSalle, is outside of the banking industry, but is also economically sensitive. A summary of each addition is provided below:
Citigroup: We believe that universal banks are significantly undervalued relative to their normalized earnings power. Citigroup’s global franchise gives it a unique advantage as the company has more than twice as many country banking licenses and direct local payment network connections as its closest competitor. This unique global reach is an attractive asset that is virtually impossible to replicate in today’s regulatory environment, and we believe it makes Citigroup one of the only viable choices for multinational corporations looking for a consolidated banking relationship. We calculate that Citi has meaningful excess capital, which—combined with its significant deferred tax assets—should give its management team various options to increase shareholder value.
Comerica: Comerica is a well-capitalized, middle-market regional bank focused primarily on commercial lending activities. The bank’s most distinguishing characteristics are its especially asset-sensitive balance sheet and its low cost deposit base, which we believe will give it pronounced earnings leverage should interest rates eventually rise as we expect. Comerica’s exposure to Texas—and by extension, the energy market—has weighed heavily on the company’s share price. We have confidence that any credit losses here will be manageable given that only a small portion of the company’s overall loan portfolio consists of energy exposure. Plus, the management team has a strong underwriting track record. Trading at a meaningful discount to tangible book value, peer valuations and our assessment of private market value, we believe Comerica is an attractive investment opportunity.
State Street: State Street is one of the world’s largest trust banks and asset managers. As a trust bank, the company provides critical back office services to owners of financial assets for which it receives fees. In the process of providing these services, State Street also holds client deposits, which it invests. The resulting spread income significantly drives State Street’s earnings. We believe State Street will continue to grow with global financial assets and along the way is returning the vast majority of its earnings to shareholders in the form of dividends and share buybacks. We believe State Street’s current valuation is too low for this high-return, growing business.
Jones Lang LaSalle: Jones Lang LaSalle is one of the world's largest commercial real estate services providers. Its scale, along with its product breadth, allows the company to provide differentiated services to large corporate customers, which are increasingly outsourcing real estate management needs. Smaller competitors have difficulty matching this value proposition, giving Jones Lang LaSalle increased market share in what remains a fragmented industry. While commercial real estate markets are inevitably cyclical, an increasing percentage of its revenue comes from recurring sources, and this should dampen the impact of cyclical market swings. We believe we are buying this high-quality, quickly growing franchise at a discount.
The Fund exited eight positions in the quarter. Broadridge and Bruker were both long-tenured holdings with results that validated our investment cases. We thank the management teams of both companies for their contribution to the Fund’s success. Another company we exited that contributed to Fund returns was Precision Castparts, which was acquired by Berkshire Hathaway. As mentioned in the past, we seek to minimize taxable events by swapping holdings from loss positions into other holdings that offer similar exposures. This is the approach we took in selling Oceaneering, Rowan, Southern Copper and T. Rowe Price. The final elimination was Knowles, which was a small position received as a spin off from Dover and did not play out as we expected.
As always, we thank our shareholders for entrusting their assets to the Fund and welcome your questions and comments.
Clyde S. McGregor, CFA
M. Colin Hudson, CFA
Matthew A. Logan, CFA
Edward J. Wojciechowski, CFA
The holdings mentioned above comprise the following percentages of the Oakmark Equity and Income Fund’s total net assets as of 03/31/16: Citigroup, Inc. 0.5%, Comerica Bank 0.5%, State Street Corp 0.5%, Jones Lang LaSalle Inc. 0.3%, Oracle Corp. 4.0%, Philip Morris International, Inc. 2.1%, Glencore PLC 0.9%, Kate Spade & Co. 0.8%, CVS Health Corp. 3.0%, Bank of America Corp. 3.8%, General Motors Co. 4.3%, BorgWarner, Inc. 1.7%, The Goldman Sachs Group, Inc. 1.4%, TD Ameritrade Holding Corp. 1.8%, Broadridge Financial Solutions, Inc. 0%, Bruker Corp. 0%, Precision Castparts Corp. 0%, Berkshire Hathaway Inc. 0%, Oceaneering International, Inc. 0%, Rowan Cos. PLC 0%, Southern Copper Corp. 0%, T Rowe Price Group, Inc. 0%, Knowles Corp. 0%, and Dover Corp. 2.4%. Portfolio holdings are subject to change without notice and are not intended as recommendations of individual stocks.
Click here to access the full list of holdings for The Oakmark Equity and Income Fund as of the most recent quarter-end.
The S&P 500 Total Return Index is a market capitalization-weighted index of 500 large-capitalization stocks commonly used to represent the U.S. equity market. All returns reflect reinvested dividends and capital gains distributions. This index is unmanaged and investors cannot invest directly in this index.
The Lipper Balanced Funds 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 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.