Khanchit Khirisutchalual
Oakmark Equity and Income Fund – Investor Class
Average Annual Total Returns 06/30/22
Since Inception 11/01/95 9.38%
10-year 7.51%
5-year 5.74%
1-year -11.96%
3-month -12.06%
Gross Expense Ratio: 0.86%
Net Expense Ratio: 0.84%
Expense ratios are based on estimated amounts for the current fiscal year; actual expenses may vary.
The net expense ratio reflects a contractual advisory fee waiver agreement through January 27, 2023.
Past performance is no guarantee of future results. The performance data quoted represents past performance. Current performance may be lower or higher than the performance data quoted. The investment return and principal value vary so that an investor’s shares when redeemed may be worth more or less than the original cost. To obtain the most recent month-end performance data, view it here.
It’s been a difficult quarter and first half of the calendar year for almost all financial assets. The S&P 500 Index’s performance to start the year was the worst since 1970. The bond market was dreadful as well: The Corporate Grade Bond Index had its worst start since its inception in 1976. Riskier assets suffered worse yet. Special purpose acquisition company and cryptocurrencies indexes have fallen over 60% year to date. The triggering event for these selloffs was the continued rise in the Consumer Price Index to over 8.5% in May and the Federal Reserve signaling that getting inflation back to 2% is its primary focus.
This spike in inflation is something that the United States has not experienced since the early 1980s when inflation topped out at nearly 14%. In response, then-Chairman Paul Volcker increased the federal funds rate to a peak of 20% in 1981. This dramatic response reduced inflation to below 3% by 1983. While every bout of inflation has different causes and durations, current Chairman Jerome Powell has made it clear that he intends to tame inflation, even if this drives the economy into a recession. So far in 2022, the Federal Reserve has increased the federal funds rate three times, and the last increase of 75 basis points in June was the largest increase since 1994. The Federal Reserve expects the federal funds rate to end 2022 at 3.25%. Whether these increases will tame inflation is up for debate, but early signs indicate that they are having an impact on financial markets, at least. The amount of absolute wealth destruction so far in 2022 for both the bond and equity markets is the greatest on record.
Investors’ reaction to this spike in inflation and the subsequent federal funds rate increase is noteworthy. Historically, when the stock market enters a bear market, Treasury securities rally. During the past four bear markets, Treasurys provided a positive return, and during the Covid-19 bear market, they increased over 100%, annualized. As we noted, though, this time is different. Both stock and bond markets have had one of their worst starts ever to a year. As a result, some market pundits are questioning the relevancy of balanced funds (typically 60% equity/40% fixed income) and target-date funds. If bonds are not going to provide downside protection, why give up the upside of a 100% equity portfolio?
We believe that balanced funds are just as relevant today as they have ever been. One of the main attributes of balanced funds is that they are typically less volatile than equity funds. This reduced volatility may allow investors not to panic at the bottom and sell before the inevitable rally. Indeed, the fixed income component of these funds today has not provided nearly as much downside protection as it has in the past, but it has still provided some. Also, the poor start of the year for fixed income is one of the very reasons to be more optimistic about balanced funds going forward. As we have commented in past letters, interest rates were at such a low level that it was hard to be optimistic about general market fixed income returns. Given the increase in rates and the widening of credit spreads so far this year, the Barclay’s U.S. Aggregate Bond Index now yields nearly 4%, which provides a much more appealing current yield than existed for most of the prior decade.
Target-date funds are a special type of balanced fund in which the ratio between equity and fixed income holdings is changed by a predetermined path as the investor gets closer to retirement. A target-date fund’s equity allocation is typically more diversified than a traditional balanced fund’s, and it includes a higher weighting toward international stocks. Target-date funds have grown rapidly and now comprise over 40% of 401(K) assets. Yet, research by Bank of America in June 2022 found that if an employee entered the workforce in March 1994, the relevant target-date fund trailed a 60%/40% balanced fund by 116% through May 2022. The target-date fund’s higher weighting toward international stocks hurt their returns as did their gradual shift from stocks to bonds. The target-date fund behaved as it was supposed to do, but its predetermined equity mix and glide path toward increased fixed income weightings were inferior to the static weighting of a 60%/40% fund.
We believe that the Oakmark Equity and Income Fund has important advantages compared to general balanced funds and target-date funds. It has a flexible mandate that allows us to adapt the portfolio for various market conditions. Not only can we vary the Fund’s asset allocation, but we can also change the composition of the equity and fixed income portfolio. When equities are especially attractive versus fixed income, we can increase the equity weighting to 75% of the portfolio. If we find equities unappealing, we can take the weight down to 40%. Typically, we will remain close to a 60% equity/40% fixed income weighting, but the ability to shift allocations for various market conditions has been a big benefit to the Fund over its history.
We can also change the nature of the Fund by changing the composition of the equity and fixed income holdings. The Fund can invest across the market capitalization spectrum and in domestic and internationally domiciled stocks. We go where we find value. Currently, the valuation of small-/mid-cap stocks looks especially appealing. On the bond side, the portfolio does not have a targeted duration. With interest rates so low, we have intentionally kept the fixed income duration at low levels. As rates have increased, we have gradually increased the duration of the portfolio.
This flexibility has served the Fund well throughout its history. By taking concentrated positions in areas that we find the most attractive given the current market opportunities, we have produced results that have exceeded the Lipper Balanced Fund Index. With interest rates and inflation increasing and the economy likely headed for a recession, it feels like a lousy time to invest. As Bill Nygren pointed out in his market commentary, this is not necessarily the case. We are excited about the investment opportunities we are finding in both the equity and fixed income market.
Quarter and Calendar-Year Review
The Oakmark Equity and Income Fund declined 12.1% in the second quarter, compared to a 10.8% decline for the Lipper Balanced Fund Index. For the first two quarters of 2022, the Fund is down 15.3%, compared to a 15.3% decline for the Lipper Balanced Fund Index. Since its inception in 1995, the Fund’s compounded annual rate of return is 9.4%, while the Lipper Balanced Fund Index’s return is 6.7%. For the most part, the biggest detractors for the Fund were economically sensitive and financial stock holdings. Even though these companies’ business fundamentals are quite strong, investors are clearly worried that they are in jeopardy. Although the economy certainly could enter a recession, we believe that the current valuations of these high-quality companies make them very attractive stocks for any investor whose time horizon is longer than a quarter or two.
The largest contributors to the portfolio’s return in the quarter were Philip Morris (PM), Reinsurance Group of America (RGA), Arconic (ARNC), Constellation Brands (STZ) and ABM Industries (ABM).
The largest detractors were General Motors (GM), Bank of America (BAC), Ally Financial (ALLY), HCA Healthcare (HCA) and Alphabet (GOOG, GOOGL).
Contributors for the year were PDC Energy (PDCE), Philip Morris, Reinsurance Group of America, General Dynamics (GD) and Diamondback Energy (FANG).
The largest detractors were HCA Healthcare, TE Connectivity (TEL), Ally Financial, Alphabet and General Motors.
HCA Healthcare stands out on the detractor list as it seems like this should be a good holding for the current market conditions. HCA’s business fundamentals are suffering due to short-term inflation pressures on staffing costs. We believe that HCA will be able to offset these pressures through pricing and efficiency actions and that the stock is significantly undervalued.
Transactions
We added two new positions, ABM Industries and ConocoPhillips (COP), in the quarter.
ABM is a leading provider of integrated facility services. The company’s 100,000+ employees perform janitorial, parking and maintenance services to every type of commercial building. ABM earns most of its revenue through multiyear contracts, and its client retention rates are consistently in the low- to mid-90% range. This makes for dependable cash flow generation, and the management team, led by CEO Scott Salmirs, strikes a good balance between reinvesting in technology-driven efficiency improvements and returning excess cash to shareholders. (ABM has paid a continuous quarterly dividend for the past 56 years.) The stock trades at about the same price as it did five years ago, even though significant margin improvements have pushed its earnings per share by approximately 85% since then. Wage inflation is a primary concern today for any labor-intensive business. In this case, though, the effect is mitigated by the fact that roughly two-thirds of the company’s direct labor is represented by collective bargaining agreements, in which wage increases are largely locked in for the next two to three years. The stock trades for approximately 12x this year’s projected earnings per share, a roughly 30% discount to the broader market. We find this to be an attractive price for a stable and well-managed business with a healthy balance sheet that tends to grow at about the same rate as the overall economy over time.
We believe Conoco is one of the highest quality independent oil producers in the industry today. The company has decades of low-cost drilling inventory in attractive oil basins, minimal leverage and industry-leading returns on invested capital. Conoco management has built this enviable competitive position through years of shrewd capital allocation and efficient operations. This includes a history of accretive divestitures and opportunistic acquisitions, including recent astute acquisitions of low-cost Permian assets at bargain prices and subsequent divestitures of non-core acreage. We believe this value-focused approach to both acquisitions and divestitures is rare in oil and gas and we are pleased to invest alongside these astute stewards of capital. The shares are priced at a greater than 20% free cash flow yield at current commodity prices and at a discount to peers on most earnings metrics. We are excited about the opportunity to purchase this industry leader at a discounted valuation.
We eliminated six positions during the quarter: CVS Healthcare (CVS), Constellation Brands, Diamondback Energy, General Dynamics, Humana (HUM) and Netflix (NFLX).
CVS, Constellation, General Dynamics and Humana were all successful investments that had performed relatively well recently as they all are viewed as safe havens. Although we still believe that all four stocks are undervalued, we believe that many of the more cyclical names in the portfolio are much more attractive. We sold Netflix to utilize the tax loss and reinvested the proceeds into other stocks we believe are equally undervalued. We sold Diamondback to buy ConocoPhillips, which we believe is more attractive.
We would like to thank our fellow shareholders for their investment in the Fund and welcome any questions or comments.
Clyde S. McGregor, CFA, Portfolio Manager
M. Colin Hudson, CFA, Portfolio Manager
Adam D. Abbas, Portfolio Manager
Editor’s Note: The summary bullets for this article were chosen by Seeking Alpha editors.
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