Oakmark Equity and Income Fund: Fourth Quarter 2011
December 31, 2011
Reversing much of the previous quarter’s decline, the U.S. equity market rebounded vigorously in the fourth calendar quarter. This rally enabled the Equity and Income Fund to return 9% in the period, which compares to the 7% that Lipper reported for its Balanced Fund Index. The annualized compound rate of return since the Fund’s inception in 1995 is 11%, while the corresponding return for the Lipper index is 6%.
For the past 12 months, the Fund returned 1%, virtually the same as the Lipper Balanced Fund Index. Oddly, in a year that was perceived as unusually volatile, the outcome for U.S. equity indices in 2011 was tepid. For instance, the 2011 S&P 500 total return was 2%, while unweighted market indices, such as the Value Line Composite, or small-cap indices, such as the Russell 2000, showed losses. Of course, as noted in the reports for several of the internationally oriented Oakmark Funds, the year was far more difficult in almost all markets outside the U.S.
One characteristic of the 2011 stock market was a plethora of what Birinyi Associates calls “one-way days.” We have previously written about increasing levels of correlation among stocks, and a one-way day is a simple measure of this correlation. In a one-way day, more than 90% of the stocks in the S&P 500 move together, either to the upside or to the downside. Although that might not sound so unusual, such days have historically been quite rare since the entire stock market has been so broadly diversified. The fact that Birinyi measured 69 one-way days in 2011 is significant. It seems especially strange that this increased daily correlation would help to produce a market outcome that was relatively flat for the year.
As we have written many times, we believe short-term volatility is the friend of value investors because it creates opportunities for greater-than-normal mispricing. We become particularly interested when all stocks move together. As value investors, we believe that our analysis of a company adds great insight into understanding what a business is worth. The worst outcome for us is to purchase shares in a company from an investor whose understanding of the value of this particular business is superior to ours. In contrast, when stocks are trading as a class rather than on their individual merits, our insights should afford us the possibility for superior outcomes.
Last quarter we wrote about several instances of how acquisition activity benefited the Fund in what was overall a dreadful period. In the recent strongly positive quarter, however, none of the Fund's holdings announced agreements to be acquired. Leading contributors to the Fund’s return included Philip Morris International, Flowserve, Rockwell Automation, General Dynamics and Varian Medical Systems. The largest detractors were Hospira, Boston Scientific, CR Bard, Xylem and PerkinElmer, of which the latter was sold during the period. The detractors have a strong tilt to medical and/or scientific industries, while the contributors have an industrial bent. Hospira was also the Fund’s largest detractor for the calendar year, as the company struggles with an FDA investigation of its manufacturing processes. Other 12-month detractors include Walter Energy, Apache, Boston Scientific and PartnerRe (sold during the December quarter). Contributors to the year’s return were Goodrich (sold after the takeover announcement), United Health Group, TJX, Philip Morris International and MasterCard Class A.
The Fund’s experience with Walter Energy has truly been stunning. In a little more than three years, the share price moved from $10 to a high of $141, and then it dropped to its current $60 level. Although this metallurgical coal company has suffered both from unexpected management changes and production shortfalls at its mines in 2011, today’s valuation of the stock, in our opinion, absurdly undervalues the company’s assets. Walter’s stock has experienced bouts of great volatility when stories of alleged takeover negotiations have been published in the financial press. We admit that we cannot predict such an outcome, but we do envision a future in which Walter’s share price better reflects the company’s intrinsic value.
We changed the overall shape of the Fund’s portfolio only modestly in the quarter. Some of this was simply because of the strong return for stocks. The equity allocation remained flat at 66%. We added to the Fund’s fixed-income holdings, but the percentage allocation fell because of modest price changes while equity prices were rising. We slightly increased the duration of the fixed-income portfolio to 1.7 years. To repeat ourselves once again, we believe that high-quality bonds are priced as though inflation will never again be a problem and offer little in the way of risk-adjusted value to investors. We did make what is, for us, an unusual fixed-income purchase – a bond issued in connection with the takeover of Kinetic Concepts, a company that we previously owned in the Fund. We normally abhor new issue corporates, but this offering came at a time when markets were weak and when we perceived opportunity.
Our only new equity purchase was EnCana, a name that we sold out of the Fund at much higher prices in December 2010. EnCana is one of North America’s largest producers of natural gas, a commodity now in oversupply because of the industry’s successful exploitation of shale. Other continents, however, pay much higher prices for natural gas, and we expect a robust export market to develop. In the meantime, we believe EnCana is very well-managed and the stock pays a rich dividend.
Our sales during the quarter were CME Group, Exelis, Goodrich, ITT, Kinetic Concepts, Mentor Graphics, PartnerRe and PerkinElmer. ITT fragmented into three parts during the quarter, and we retained only Xylem while selling Exelis and the piece of the business that retained the ITT name. PerkinElmer announced an expensive acquisition, which caused us to rethink our holding. We sold Goodrich and Kinetic Concepts because their acquisition announcements took the stocks to our estimate of intrinsic value. PartnerRe has a new management team that articulated a significant change in how the company will underwrite insurance, and we chose to move on. We sold CME Group in order to harvest tax losses. Mentor Graphics ended up at our sell target. We concluded that the company’s ability to grow its per-share value was insufficient to warrant continued ownership.
Retirement of Edward A. Studzinski
As noted in the President’s report and previously disclosed through a press release, my partner and co-manager, Edward Studzinski, announced his retirement in December. As it happened, Ed joined Harris Associates almost immediately after we began the Equity and Income Fund in 1995. His particular talents were well-suited to what was then called the Oakmark Balanced Fund, so we quickly began what has turned out to be a 16-year collaboration. In 2000, Harris Associates decided to make an official designation of co-managers for each Fund, and Ed was the obvious choice for Equity and Income.
Ed’s decision to retire has catalyzed a pronounced change in the content of the communications that we receive from our shareholders. Before his announcement, we were occasionally asked about our succession plans for the management of the Fund, given that both of us can generously be described as “mature.” Now the questions basically reduce to: “How can you manage without Ed?” and “What is the management plan from here?” The basic answer to both questions is that I remain portfolio manager for the Fund, and we have chosen a group of investment professionals to serve as an advisory committee to me while we consider how best to structure the Fund’s management team for the future.
Harris Associates is blessed with a deep pool of talented investors, and mentoring and developing the younger cohort is an important part of the job for those of us who are more senior. I look forward to the opportunity to work even more closely with those who will replace Ed and eventually me in this role. This does not, however, mean to imply that Ed will not be missed. Ed’s contributions to the success of the Fund over its life in total and for the past 10½ years as co-manager in particular are legion. Since Ed began as co-manager, Equity & Income Fund has returned 9% per year. Over the same period, the Lipper Balanced Fund Index has returned 3% and the S&P 500 less than 1%. Some referred to the previous decade as the “lost decade” for investors. Ed helped to make sure that Equity & Income Fund shareholders did not see that time as “lost.” I am sure that many of our long-term shareholders will miss Ed’s interesting and thoughtful shareholder letters, which had been published on the January/July cycle.
In his life, Ed has been a Navy captain, a lawyer, the chief investment officer for a trust company and, most recently, my partner at Harris Associates. He now moves into a new stage of his life. I hope that he finds retirement to offer suitable challenges and inspiration. Ed, for myself and all of our shareholders in the Oakmark Equity and Income Fund, I express our admiration for what you have accomplished and extend to you our deepest gratitude.
Clyde S. McGregor, CFA
The Oakmark Equity and Income Fund closed to certain new investors as of 5/13/10.
As of 12/31/11, Philip Morris International, Inc. represented 2.6%, Flowserve Corp. 1.9%, Rockwell Automation, Inc. 1.9%, General Dynamics Corp. 2.9%, Varian Medical Systems, Inc. 2.0%, Hospira, Inc. 1.4%, Boston Scientific Corp. 1.2%, CR Bard, Inc. 1.3%, Xylem, Inc. 0.1%, PerkinElmer, Inc. 0%, Walter Energy, Inc. 1.3%, Apache Corp. 2.4%, PartnerRe, Ltd. 0%, Goodrich Corp. 0%, UnitedHealth Group, Inc. 3.1%, The TJX Cos., Inc. 2.1%, Mastercard, Inc., Class A 1.7%, Kinetic Concepts, Inc. 0%, Encana Corp. 0.9%, CME Group, Inc., Class A 0%, Exelis, Inc. 0%, ITT Corp. 0%, and Mentor Graphics Corp. 0% of the Oakmark Equity and Income Fund’s total net assets.
Portfolio holdings are subject to change without notice and are not intended as recommendations of individual stocks.
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 S&P 500 Index is a broad market-weighted average of U.S. blue-chip companies. This index is unmanaged and investors cannot actually make investments in this index.
The Value Line Composite Index is composed of all of the companies that are included in the Value Line Investment Survey. This market benchmark assumes equally weighted positions in every stock covered in The Value Line Investment Survey. That is, it is assumed that an equal dollar amount is invested in each and every stock. The returns from doing so are averaged geometrically every day across all the stocks in The Survey and, consequently, this index is frequently referred to as the Value Line (Geometric) Average (VLG). The VLG was intended to provide a rough approximation of how the median stock in the Value Line universe performed. This index is unmanaged and investors cannot actually make investments in this index.
The Russell 2000 Index measures the performance of the small-cap segment of the U.S. equity universe. The Russell 2000 Index is a subset of the Russell 3000® Index representing approximately 10% of the total market capitalization of that index. It includes approximately 2000 of the smallest securities based on a combination of their market cap and current index membership. This index is unmanaged and investors cannot invest directly in this index.
Birinyi Associates is a money management and research firm.
Equity and Income 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 discussion of the Funds’ investments and investment strategy (including current investment themes, the portfolio managers' research and investment process, and portfolio characteristics) represents the Funds’ investments and the views of the portfolio managers and Harris Associates L.P., the Funds' investment adviser, at the time of this letter, and are subject to change without notice.