Oakmark Equity and Income Fund: Quarter Review
The June quarter in the securities’ markets proved to be a time of quiet advance. In fact, the quarter’s low volatility completely belied the many disruptive factors affecting international political conditions. As the quarter proceeded, market commentators returned again and again to this apparent contradiction. We also cannot explain why volatility, as well as trading activity, remains quiescent. Certainly central banks’ constant monetary stimulus has helped sustain securities prices. Worldwide economic activity has also shown moderate growth, although many of us remember other time periods when temperate economies have produced extreme market volatility (cf. the crash of 1987). One year ago we wrote that investors should “embrace volatility,” but we admit that it is difficult to identify volatility to embrace today.
The Equity and Income Fund returned 3% in the quarter, which contrasts to a 4% gain for the Lipper Balanced Funds Index, the Fund’s performance benchmark. For the first six months of 2014, the returns are 5% for both the Fund and the Lipper Balanced Funds Index. For the nine months of the Fund’s fiscal year the Fund has earned 12%, which compares to 11% for the Lipper Balanced Funds Index. The annualized compound rate of return since the Fund’s inception in 1995 is 11% while the corresponding return to the Lipper Balanced Funds Index is 7%.
The stocks that contributed most to the quarter’s return were National-Oilwell Varco, Inc. (NYSE:NOV), FedEx Corporation (NYSE:FDX), Baker Hughes Incorporated (NYSE:BHI), Dover Corp (NYSE:DOV) and General Motors Company (NYSE:GM). The largest detractors were Bank of America Corp (NYSE:BAC), TD Ameritrade Holding Corp. (NYSE:AMTD), Carter’s, Inc. (NYSE:CRI), Mastercard Inc (NYSE:MA) Class A and Knowles Corp (NYSE:KN). For the calendar six months Baker Hughes, General Dynamics Corporation (NYSE:GD), National Oilwell Varco, Foot Locker, Inc. (NYSE:FL) and Dover led the contributors while the significant detractors were General Motors, MasterCard, Scripps Networks Interactive, Inc. (NYSE:SNI), AFLAC Incorporated (NYSE:AFL) and Bank of America. Finally, for the fiscal year, the top contributors were Baker Hughes, FedEx, General Dynamics, Oracle Corporation (NYSE:ORCL) and Foot Locker while Quest Diagnostics (sold), Atlas Air Worldwide Holdings, Inc. (NASDAQ:AAWW), Carter’s, Rowan Companies PLC (NYSE:RDC) and Cenovus Energy Inc (NYSE:CVE) (sold) detracted. It is interesting to note the issues that repeat as contributors on the above lists (e.g., Baker Hughes), as well as those that show up in opposing groups, depending on the time period (e.g., General Motors). Experience teaches us to expect this sort of rotation within our portfolios.
Oakmark Equity and Income Fund: Asset Allocation/ Transaction Activity
Given the lack of volatility described above, it should surprise no one that our trading activity was modest in the quarter. As the stock market’s ascent continued, most Fund equity holdings participated in the advance, thereby carrying their share prices upward toward our sell targets. Typically, we reduce the size of a particular holding before it reaches its sell target so that we can buy a more attractively priced asset. Several issues presented us with this opportunity during the quarter. We also added two new holdings, Fidelity National Financial Class A and Reinsurance Group of America, and eliminated the Devon Energy position. The net effect of this activity was a slight reduction in the equity percentage of the portfolio. We modestly increased the fixed income allocation, but rest assured that the views we have previously expressed about the difficulties of investing in this sector remain acute.
With the sale of Devon Energy Corp (NYSE:DVN), the Fund now contains only one exploration and production company holding (Ultra Petroleum). For many years this sector has contributed substantially to Fund returns, so one may well ask, “What has changed to cause you to give up exposure to this industry?” The answer derives from the combination of new information with heightened valuations. Readers are no doubt familiar with the revolution in drilling technology that has resulted in substantial new North American oil production. Although the new drilling techniques have proven successful in meeting their early targets, the decline in production rates per oil well after one year has surpassed expectations. At the same time that we were observing this deterioration in productivity, the industry’s stocks were generally enjoying significant price increases. We took advantage of this price move to reduce our commitment. Ultra Petroleum, despite its name, is somewhat different from its industry peers in that its hydrocarbon production remains weighted to natural gas. Gas well productivity trends do not show the same deterioration at present. As well, we believe that natural gas itself is priced quite cheaply relative to oil.
As noted above, we initiated a position in Fidelity National Financial Inc (NYSE:FNF), the largest and most profitable title insurance company in the U.S. Title insurance is a fairly concentrated market with the top four industry players controlling approximately 90% of the market. The industry benefits from several factors: lenders require title insurance in order to make mortgages, customer sensitivity to the price of title insurance is low and the industry has high barriers to entry. FNF management has focused on cost reduction in the core business and has broadened the company’s operations so that it combines title insurance, mortgage servicing and mortgage technology in a unique package. Finally, the company has a portfolio of non-core assets that is being spun out to FNF shareholders today.
Our second new purchase was Reinsurance Group of America Inc (NYSE:RGA), one of the largest life reinsurance companies. In this business, RGA reinsures life policies which have been ceded from traditional life companies. RGA has been in this business for over three decades and has collected a vast amount of mortality data, which has led to consistently good underwriting results. Not only has RGA benefited from positive underwriting, but also the whole life reinsurance industry has been aided by increasing life expectancy, which has exceeded actuarial expectations for over two decades. This favorable environment has allowed RGA to earn what we believe are solid returns and increase book value around 10% annually for the last decade. Based on current mortality tables, we believe that RGA’s liabilities are overstated and RGA is currently valued well under economic book value. Over time, we believe this hidden book value will flow into earnings. As we have noted in recent reports, it is difficult to identify dominant investment opportunities, but we continue the search and we believe that FNF and RGA meet our high demands for new ideas.
Oakmark Equity and Income Fund: Questions/Answers
We will close this report with a review of some questions that investors have posed to us. These are not arrayed in any particular order.
Q: What is the current percentage of non-U.S. investments in the Fund?
A: We have invested approximately 10% of the Fund in non-U.S. assets, almost entirely in the form of liquid European stocks. The Fund’s prospectus permits us to invest as much as 35% of the Fund in non-U.S. assets. The Fund’s international percentage has been higher in the past, particularly when we identified attractive opportunities in sovereign debt. We do not target this allocation – rather, we always go wherever our understanding of value takes us.
Q: Do the managers of the Fund make determinations as to how much to invest in individual industries?
A: Although the Fund prospectus defines diversification guidelines, we do not intentionally invest the Fund from that level. We build the portfolio from the bottom up but regularly review the Fund’s diversification to ensure that the limitations are enforced.
Q: What is the Fund’s investable equity universe?
A: The Fund is all-cap, meaning that we search for value in all shapes and sizes. As noted above, we have a hard limit concerning investment in non-U.S. domiciled assets. We look for value opportunities wherever they may be found, but within the limitations of the prospectus.
Q: Early in the Fund’s life the fixed income segment was primarily invested in U.S. Treasury notes. Why have you now reduced this position to minimal levels?
A: When we incepted the Fund in 1995, intermediate-term U.S. Treasury notes offered the combination of 6% yields and unmatched liquidity. Today such notes still have the liquidity, but they yield less than 2%. At these levels we believe that such notes offer too much risk for the potential reward.
Q: Why do you sometimes speak of two different turnover rates (measures of trading activity) for the Fund?
A: Our equity investing methodology is based on the premise that over the long term, price and value will come together periodically. Our typical holding period for an individual stock falls in the range of 3-5 years, which implies annual turnover rates of 20-33%. With U.S. Treasury notes, however, their homogeneity and minimal trading costs cause us to think differently. In the past we have traded more actively in U.S. Treasury notes in order either to change the portfolio’s duration or to capture losses, when available. This can lead to the situation where the total portfolio turnover rate looks high relative to what one expects of our equity investing philosophy. In the current interest rate environment, our opportunities to trade U.S. Treasury notes have been curtailed, with the result that equity turnover rates and total Fund turnover rates are collapsing together.
Q: You mentioned “capture losses” in the question above. Why would you want to do this?
A: The Fund’s owners are a mix of tax-exempt and taxable investors. We work to make the Fund as tax-efficient as possible for our taxable shareholders, but never at the cost of limiting total return.
Of course, we receive many other questions, some of which we attempt to answer through these reports. As always, we thank our fellow shareholders for investing in the Equity and Income Fund and welcome your future questions.
Clyde S. McGregor, CFA
M. Colin Hudson, CFA
Matthew A. Logan, CFA
Edward J. Wojciechowski, CFA
Oakmark Equity and Income Fund: Second Quarter 2014 by Oakmark.com