Oakmark Select Fund: Third Quarter 2012
September 30, 2012
For the quarter, the Oakmark Select Fund gained 6%, consistent with the 6% gain in the S&P 500. Good gains in our media and financial stocks – Liberty Interactive, Di scovery, Time Warner, Comcast, JP Morgan and Bank of America, all up more than 10% – helped produce our good return. Two losers – Intel and Dell, off 14% and 21%, respectively – offset some of that gain. Because both businesses are performing close to our expectations, we continue to hold both stocks.
Looking at the fiscal-year results, Oakmark Select achieved a very good absolute return of 27%, just short of the S&P 500’s 30% gain. Good stock selection and a heavy weighting in consumer discretionary – primarily media companies – helped our performance. Our top contributors were Discovery (up 59%), Comcast (72%), eBay (63%) Liberty Interactive (40%) and Time Warner (48%). We have trimmed the Discovery and Comcast holdings and, as discussed below, sold eBay and Time Warner.
On the negative side, two stocks suffered meaningful losses: Dell and Newfield Exploration. We’ve written about their issues before, but in short, Dell is really two businesses – a declining PC business and growing non-PC businesses. We believe the non-PC businesses, which now account for most of Dell’s income, should be getting more investor attention. Newfield is an energy company whose main revenue stream is transitioning from natural gas to oil. Investors, however, seem to be more focused on the declining gas production than on the growing oil revenues. When a company has one growing business and one shrinking business, we find investors often behave like the Winnie the Pooh character Eeyore in always seeing the glass as half-empty.
During the fiscal year, we eliminated four positions from the Fund. That should be considered a typical number, given that the Fund holds about 20 stocks and averages about a five-year holding period. The stocks we sold were Bristol Myers, eBay, H&R Block and Time Warner. With the exception of Block, the sales were the result of stocks having performed so well that new opportunities forced them out of the portfolio. As stated in the quarterly report when we sold Block, despite having made money on it, business fundamentals were not unfolding as we had anticipated, and we lost confidence in management’s ability to remedy things.
Replacing those positions, we added AIG Corp, Bank of America, BMC Software and TRW. It should come as no surprise that, as investors were paying a larger premium for safety, our purchases were generally riskier businesses than our sales. AIG and Bank of America were both new in the past quarter. Their stories are quite similar: Financial businesses at the eye of the storm in 2008, now selling for less than half of book value, with management targeting a double-digit return on equity within three years and with a commitment to return capital to shareholders through share repurchases and dividends.
Some of the bears on these stocks are concerned that top-line growth might be very difficult to come by. Let’s assume they are right and that AIG earns 7% on its equity in 2014 (EPS of about $5.25 per share). Further, let’s assume that, by the end of next year, AIG is deemed to have sufficient capital such that future earnings are entirely excess capital. That would mean that AIG, selling at half of book value, would generate enough cash to repurchase 14% of its shares annually. If it had flat net income, it would produce a 16% annual growth rate in EPS.
Bank of America has a similar story, except that its dividends are expected to be an important part of its return. Again assuming a 7% ROE in 2014 (EPS of about $1.50 per share) but with a 30% payout ratio, Bank of America would be paying a dividend of 5% on the current stock price and repurchasing about 10% of its shares annually. As with our other financials, we aren’t arguing that AIG and Bank of America are the world’s greatest businesses, but rather that a price of only 50% of book value is a bargain purchase price.
As we begin our new fiscal year, we continue to believe equities are the most attractively priced asset class and that, within equities, the stocks investors mistakenly view as safe are generally the least attractive. Usually stocks get more popular after they go up and vice-versa. Despite the S&P returning 30% in the past year, we see no signs of investors being more positive on equities or more willing to take on risk. Mutual fund flows continue to strongly favor fixed income, an asset class we believe is overvalued and, at these price levels, mistakenly viewed as safe. In fact, CNBC reported last month that at fund industry giant Fidelity, long known for its equity funds, assets invested in its bond funds now exceed assets in its equity funds. We view investors’ lack of interest in equities as another positive.
Thank you for your support.
William C. Nygren, CFA
Henry R. Berghoef, CFA
As of 9/30/12 Liberty Interactive Corp. represented 4.8%, Discovery Communications, Inc. 8.5%, Time Warner, Inc. 0%, Comcast Corp. 4.9%, JPMorgan Chase & Co. 5.3%, Bank of America Corp. 5.0%, Intel Corp. 4.1%, Dell, Inc. 2.9%, eBay, Inc. 0%, Newfield Exploration Co. 4.9%, Bristol-Myers Squibb Co. 0%, H&R Block, Inc. 0%, American International Group, Inc. 4.0%, BMC Software, Inc. 4.1%, and TRW Automotive Holdings Corp. 5.0%, of the Oakmark Select Fund's total net assets. Portfolio holdings are subject to change without notice and are not intended as recommendations of individual stocks.
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.
EPS refers to Earnings Per Share and is calculated by dividing total earnings by the number of shares outstanding.
Because the Oakmark Select Fund is non-diversified, the performance of each holding will have a greater impact on the Fund's total return, and may make the Fund's returns more volatile than a more diversified fund.
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.