Oakmark Equity and Income Fund letter for the third quarter 2014
Oakmark Equity and Income Fund: The “Inactive” Active Manager
A recent article in the Financial Analysts Journal caused quite a stir in the investment world. In the article1, Charles Ellis, a longtime and well-respected investment consultant, argues that “the increasing efficiency of modern stock markets makes it harder to match them and much harder to beat them—particularly after covering costs and fees.” Ellis’s conclusion is that “active” investment management (as opposed to “passive” management that simply replicates the results of benchmarks) is “no longer a game worth playing.”
A key tenet of our investment process at Oakmark is our active investment style, so it was with great interest that we read Mr. Ellis’s article. We agree that active management has become more competitive over the years as “increasing numbers of highly talented young investment professionals have entered the competition” and “[t]hey have more-advanced training than their predecessors, better analytical tools, and faster access to more information.” Yet we remain as comfortable as ever that our style of active management will continue to produce competitive returns over the long run. The key is to be inactive.
Seth Klarman: Investors Can No Longer Rely On Mean Reversion
"For most of the last century," Seth Klarman noted in his second-quarter letter to Baupost's investors, "a reasonable approach to assessing a company's future prospects was to expect mean reversion." He went on to explain that fluctuations in business performance were largely cyclical, and investors could profit from this buying low and selling high. Also Read More
By inactive, we don’t mean we will passively mirror a benchmark. Instead, inactive refers to our low turnover approach to investing, which is a critical element of our active management strategy. It’s not that low turnover is inherently good. In fact, we love high turnover when it’s because a security has quickly reached our sell target. But we know the world generally doesn’t work that way. So, we buy a stock with the expectation of holding it for three to five years. That long-term perspective allows us to take advantage of investors with shorter time horizons, many of whom measure the success of an investment in three to five quarters. With such a myopic view, these investors tend to avoid stocks they may find cheap but that they don’t expect to perform well within their narrow windows.
At Oakmark, we gladly buy attractively-priced stocks, even when we don’t have the foggiest idea as to when they may trade at our estimate of intrinsic value. We are comfortable doing so because even though we may not know when a given stock will hit our sell target, we are confident that over the long-term a meaningful percentage of our stocks will do so.
Of course, expecting at the outset to hold a stock for three to five years isn’t enough to actually carry that out. Many long-term investors turn into short-term investors at the first sight of trouble. The ability to execute a truly long-term strategy is often attributed to patience. Defined by the Oxford Dictionary as “the capacity to accept or tolerate delay, trouble, or suffering without getting angry or upset,” patience plays a part.
But if you follow a value-based approach like we do at Oakmark, where we are always in search of the most attractively-valued securities, it’s not just patience that keeps us invested in a security. Impatience wouldn’t result in a different assessment of a company’s worth. Rather, to execute a long-term approach successfully, you need the ability to withstand long periods of doubt that arise when the stock—and seemingly the rest of the investment world—go against you and make you question your thesis. To remain invested, you must have conviction in your thesis, which can only come from rigorous and continuous fundamental research.
Our inactivity belies all of the work we do to arrive at our investment opinions. While the composition of the Oakmark Equity and Income Fund may change little from quarter to quarter and even year to year, our research teams – the lifeblood of our firm – are constantly working to find new investments and maintain coverage of our existing ones. To do so, each year they look at hundreds of companies (and formally recommend dozens to the investment committees), have more than a thousand meetings and discussions with management teams, and also consult countless other knowledgeable sources, such as customers, suppliers and former employees to supplement their analysis. This active research effort gives us the confidence to remain so inactive in our portfolio management, and, therefore, to fully exploit our time horizon edge.
Oakmark: Quarter Review
Despite more than usual market worries about geopolitical events, the S&P 500 managed a small advance of 1% in the quarter. The Equity and Income Fund declined 2% in the quarter, which slightly trailed the Fund’s performance benchmark, the Lipper Balanced Fund Index, which declined 1% in the quarter. For the Fund’s fiscal year ended September 30, results were up 10.4%, compared to 10.5% for the Lipper index. The annualized compound rate of return since the Fund’s inception in 1995 is 11% versus 7% for the Lipper Balanced Funds index.
Oakmark’s largest contributors
The largest contributors to the quarter’s returns were Bank of America Corp (NYSE:BAC), Foot Locker, Inc. (NYSE:FL), Union Pacific Corporation (NYSE:UNP), General Dynamics Corporation (NYSE:GD) and UnitedHealth Group Inc. (NYSE:UNH). The largest detractors for the quarter were General Motors Company (NYSE:GM), BorgWarner Inc. (NYSE:BWA), Dover Corp (NYSE:DOV), TE Connectivity Ltd (NYSE:TEL) and Baker Hughes Incorporated (NYSE:BHI). For the fiscal year, the largest contributors were General Dynamics, Baker Hughes, Foot Locker, FedEx and CVS Health. The biggest detractors were General Motors, Quest Diagnostics Inc (NYSE:DGX), Diageo plc (ADR) (NYSE:DEO), Glencore PLC (LON:GLEN) and Rowan Companies PLC (NYSE:RDC). Although we are never happy when stocks lose value, the small losses on these five stocks were completely offset by the gain in any of the five biggest winners.
Oakmark: Transaction Activity
During the quarter, the Fund’s equity allocation continued to decline, ending the quarter at 64%, compared to 65% last quarter and 73% at the beginning of the last fiscal year. The gradual decline in the Fund’s equity weighting reflects the upward move in the equity market, which has made stocks less attractive on a risk-adjusted basis. We continue to find the overall fixed income market to be unappealing, though we have found some individual issues that meet our value criteria.
Oakmark adds Glencore and Goldman Sachs
We added two new stock positions during the quarter: Glencore PLC (LON:GLEN) and Goldman Sachs Group Inc (NYSE:GS). Glencore was formed 40 years ago as a physical commodities trader (that is, the company buys and sells vessel-loads of coal, for example, instead of “paper trading” futures and forward contracts). Over the years, Glencore’s value-focused management team has grown the company into one of the largest miners in the world. After decades of being run as private company, Glencore went public in May 2011 at a price of $8.57. Like many companies in the mining sector, Glencore’s shares have fallen over the past few years as commodities prices have weakened, due to a glut of new supply. At the current price of $5.56, we believe the market has overly discounted the effects of the lower commodity price environment, giving us an opportunity to buy Glencore at a compelling discount to our estimate of intrinsic value. After giving the company credit for the expected ramp-up in production from large current investments, the company is trading at less than nine times earnings – too low considering that approximately a quarter of those earnings come from the very high return trading segment and the rest comes from long-lived and well run mining assets. In addition, we believe Glencore is managed by a smart and highly incentivized team (the senior leaders own billions of dollars of stock while often earning only nominal salaries). For all of these reasons, we find Glencore to be an attractive addition to the Fund.
Founded in 1869, Goldman Sachs is a leading global investment banking, securities and investment management firm that provides a wide range of financial services to a substantial and diversified client base. Large financial institutions are still viewed skeptically by investors who fear regulation and litigation will impair profits indefinitely. Goldman is further suffering from a severe slow-down in trading that will dampen profits for the second straight year in the company’s largest business segment. We believe that Goldman’s franchise remains strong, and despite the current cyclical lull in trading, returns are still well above the cost of capital. We trust that over time, Goldman’s management team will improve returns while continuing to allocate capital effectively. Trading near tangible book value, Goldman offers an attractive price for a business that earns a significant amount of revenue from high return asset management and underwriting and advisory services.
During the quarter, we sold small positions in Rowan and Now Inc., which was a spin-off from National Oilwell Varco.
Clyde S. McGregor, CFA
M. Colin Hudson, CFA
Matthew A. Logan, CFA
Edward J. Wojciechowski, CFA