Oakmark Equity and Income Fund: Second Quarter 2011
June 30, 2011
“Optimism is the content of small men in high places”
F. Scott Fitzgerald
The Equity and Income Fund achieved a return of 1% for the quarter ended June 30, 2011, which matched the 1% return reported by Lipper for its Balanced Fund Index. For the 2011 calendar year to date, the Fund returned 6%, and the Lipper Balanced Fund Index returned 5%. The Equity and Income Fund also returned 8% compounded annually over the past 10 years versus 4% for the Lipper Balanced Fund Index for the same period. We are pleased that our absolute performance has improved across these respective periods of time.
We are also pleased that the Federal Reserve has ended its most recent program of quantitative easing. Equity investors will hopefully return their focus to business fundamentals (valuations and earnings) rather than committing themselves solely to an asset class tied to a benchmark. We remain less sanguine about the opportunities in fixed-income investments, where it appears that the continued suppression of interest rates by a number of central banks has enabled many unhealthy businesses to stay afloat. Stimulating the economy is indeed a laudable goal, but in many instances we believe these efforts have actually delayed a sustained recovery. Even though the Fund has met its goals of capital preservation and a real rate of return, we would be the first to admit that our way of getting there was not particularly pretty. If anything, our strategy followed the approach that “less is more.”
In that vein, the equity allocation at the end of the quarter crept up to 69.4% from 67.9% at the beginning of the quarter, due more to appreciation than any conscious effort to increase it. That said, this ratio is toward the high end of our historic commitment to equities, which reflects the absence of compelling opportunities in fixed-income investments, rather than any strong conviction that equities are significantly undervalued. For the most part, we like what we own, but we do not believe that stocks are especially cheap.
During the past quarter, we reduced the fixed-income component of the portfolio to 21.3%, and within that allocation, the duration dropped to 1.6 years. The balance of the Fund’s holdings is in cash reserves, mostly short-term U.S. and Canadian Treasury Bills and commercial paper. We have not been inclined to put new money into fixed-income securities because we have not felt that the reward would justify the risk. The Fund is currently positioned defensively in preparation for a rising interest rate environment, but our short-term returns will suffer if intermediate- and long-term interest rates undergo sustained increases. Consequently, volatility in the fixed-income portion of the portfolio has been dampened.
The strongest contributor to performance during the quarter was Nestlé, a diverse consumer-brand company with strong exposure to emerging and developed markets. Nestlé has survived and prospered in almost every market environment because of its skilled management team and strong balance sheet. The next strongest contributor to the Fund was UnitedHealth Group, which owns many businesses that we believe should prosper given the environment for healthcare service companies; it is also well-positioned to benefit from the new healthcare bill, assuming the bill survives the judicial challenges. The third strongest contributor was L3 Communications, a well-run defense business with a substantial presence in many “black budget” areas. Its management team is highly respected, and the company appears undervalued according to many private-market metrics. The next biggest contributor to performance during the quarter was Goodrich, an aerospace business with a strong replacement-part business in aircraft landing gear and brakes. Areas of Goodrich’s business reported much greater demand than expected due to an unanticipated pick-up in airline business. Another important Fund contributor was MasterCard, which gained value after the fee cap for debit cards turned out to be much less than expected. Diageo and Sara Lee, two consumer-brand companies, also added to returns. Diageo has received increasing recognition for its efforts in emerging markets. Sara Lee has a new management team that has generated confidence that it can extract more shareholder value from the company’s businesses than previously thought.
The worst contributor for the quarter was Walter Energy, a metallurgical-coal company whose value is often based on the strength of the Chinese economy rather than its own business sector. The next worst contributor was Concho Resources, an energy company whose share price declined after the U.S. announced it would tap into its strategic oil reserves (and a few short weeks later the price of oil has recovered back to its previous levels). Flowserve also dampened Fund performance as a result of its disappointing earnings announcement. The market’s reaction was stronger than usual because Flowserve is a relatively illiquid security. Closing out the list of the larger Fund detractors were Apache and Cenovus Energy, both energy companies with oil exposure. As with Concho, the market seemed concerned that oil prices would decline, but we believe all three companies will continue to generate cash with barrels of oil equivalent (BOE) prices above $80.
We added new positions in Carter’s Inc. and Quest Diagnostics. Carter’s is the largest maker of branded apparel for babies and children in the United States--a strong company that we made the mistake of exiting too early once before. Recently, Carter’s business has been hurt by increased raw-material costs, especially cotton, and its valuation suffered. We expect that it will in turn benefit when commodity prices decline. Quest Diagnostics is part of the near-oligopoly business that controls healthcare diagnostic testing, information and services in this country. Like many of its peers, Quest dispenses a substantial amount of cash and appears to be positioned to do well in almost any economic environment.
We sold our positions in Cisco and Walter Investments during the quarter. Cisco was our relatively recent foray into the technology space. Given that we try to manage the Fund as efficiently as possible from a tax perspective, we took the opportunity to realize a short-term taxable loss in the issue. Walter Investments, a spin-off from Walter Energy, was a mortgage real-estate investment trust and servicer that we previously owned when both it and Walter Energy were part of a much larger corporation, J.W. Walter. Walter Investments had been performing well, but after management made some capital-allocation decisions that we did not understand, we elected to sell and move on.
Inflation or Deflation?
Readers of these letters over the past several years might be forgiven for wondering if these letters are written by two schizophrenic portfolio managers, especially when it comes to our prognostications about inflation or deflation. In our defense, the bond market has behaved similarly. During one quarter, interest rates and bond prices seem to indicate that we are on the cusp of a sustained period of inflation--perhaps even hyperinflation-- as a result of excessive government spending. A quarter later, interest rate pressures subside and one sees signs of a Japan-like deflation in virtually every economic signal. We have recently come to the conclusion that we are in for a period of having to deal with both at the same time.
Some years ago, before the current fashion of lamenting the U.S.’s debt situation began, we heard concerns that U.S. citizens would face declining standards of living for the first time in generations. We were somewhat skeptical: regardless of political disagreements, this country has always at least muddled through. We concede now that those comments were arguably wiser than we initially thought. Clearly, inflation, as reported by the government’s CPI numbers, has been understated for some time. Yet, today, with gasoline around $4 a gallon, just the expense of going to work and running errands is consuming a good part of household income.
The other part of the equation, of course, is food. Again, one need only enter a supermarket and look at the costs of butter, margarine, chicken, bread and the other necessities of preparing a weekly menu to know that the expense of eating has also gone up substantially. With these two components of the average American’s budget increasing, there is not much left for discretionary spending. This explains why dry cleaners find their business down; auto dealers find that servicing is being pushed out to the limits of recommendations; and all the other little things that make up a household’s annual budget are being examined and chopped.
“Wait a minute,” you say. “What about savings? Can’t Americans dip into savings to continue to maintain their standard of living?” We recently had the occasion to look at the returns that one could obtain in the Chicago area from a one-year certificate of deposit today and what one could obtain in the past. Five years ago, the rate of interest on a one-year certificate was 4.85% simple interest, so a saver with a $100,000 certificate would receive $4,850 in interest annually, or roughly $404 a month, to supplement monthly income. Recently, that same one-year certificate renewed at a rate of 0.50% simple interest. Thus, our saver will receive only $500 a year in simple interest, or $41 a month. Therefore, the certificate-holder must now decide whether to fill up the gas tank less often, to eat less or less well, or to tap into the principal amount of the certificate. We suspect that, when the downturn began, many people believed that prosperity would have returned by now, so short-term tapping into the principal might have seemed acceptable. We now think that there is no short-time return to economic prosperity on the horizon, so caution is in order. Toward that end, the Fund is focused now more than ever on generating an absolute positive total return for its investors, hopefully enabling them to supplement their other sources of income.
We have watched the ongoing drama of the potential sovereign-debt defaults in Greece, Ireland, Italy, Portugal and Spain. With wailing and the gnashing of teeth, the central bankers in Europe have expended considerable effort trying to find solutions that will allow for more loans to be made to these countries, probably at higher rates of interest than the ones that they can’t presently pay, all to help keep banks in France, Germany and the United Kingdom from having to write off all of their investments in and loans to these countries. In contrast, Iceland, which is not part of the euro bloc, defaulted on its debt and proceeded to wipe out the bond and equity holders of its banks that had gotten the country into that mess. Today, Iceland can borrow at lower rates than Greece can, and its economy appears to be on the mend. Is there a lesson in this, for both Europe and the United States? The other point we would note, given a propensity on the part of many Americans to be ignorant of history, other than current events, is this: in all of these countries, but especially in both Greece and Italy, there perhaps remains a deep-seated aversion to taking direction from the Germans.
Shifting Tectonic Plates
We are relatively comfortable with our current portfolio positions, which is not to say that we are feeling complacent. If anything, we spend more time looking for unappreciated investment opportunities. We are willing to cap the Fund’s upside potential if we can limit its downside risks. However, that is not easy in today’s market environment because many aspects of the investment world are not behaving as they normally do. For example, income, either dividend or coupon, is currently overvalued and hence overpriced. Accordingly, we see little value in most fixed income investment choices today, even though we are actively searching for inefficiencies in this sector. Likewise, although we prefer equities, we do not believe there is enough fear and loathing in that sector to indicate the start of a new bull market. Hence, our default position is, to a certain extent, cash and cash equivalents, which we think may actually be slightly undervalued. We also wonder if too many domestic companies that are overly sensitive to Wall Street criticism have overcompensated in recent years. These companies use a capital-allocation model that prizes share repurchases and dividends over reinvesting in business for growth. Repeated over and over, on the macro level, this allows one insight into the current and continuing weakness of job creation and economic growth. We recognize this is a somewhat out-of-sync comment, but we have warned you that we will often be out of sync. We are not fond of the cheery consensus, and we are too old and scarred to be eternal investment optimists, especially with other peoples’ money. Our focus remains the long term and, ideally, the sustainable long term. We still come to work, eager to find the compelling value opportunities. We will write to you again at the end of the next quarter concerning our efforts in that regard.
Clyde S. McGregor, CFA
Edward A. Studzinski, CFA
The Oakmark Equity and Income Fund closed to certain new investors as of 5/13/10.
As of 6/30/11, Nestlé SA - ADR represented 3.3%, UnitedHealth Group, Inc. 2.5%, L-3 Communications Holdings, Inc. 2.3%, Goodrich Corp. 2.0%, Mastercard, Inc., Class A 1.2%, Diageo PLC – ADR 2.7%, Sara Lee Corp. 2.3%, Walter Energy, Inc. 1.7%, Concho Resources Inc. 1.5%, Flowserve Corp. 1.2%, Apache Corp. 2.7%, Cenovus Energy, Inc. 3.9%, Carter's Inc. 0.2%, Quest Diagnostics Inc. 0.8%, Cisco Systems, Inc. 0%, and Walter Investment Management 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.
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.