Brian Rogers 2013 letter to investors
The equity market advanced sharply in 2013, providing excellent returns in both halves of the year with only minor setbacks along the way. Encouraging economic news, healthy gains in corporate earnings, and renewed investor interest in equities combined to create a favorable environment for stocks, with the S&P 500 Index generating a total return of 32.39%. Large-cap value stocks, with their relatively high dividend yields, participated fully in the rally. Investors seeking dividend income and appreciation fared far better than fixed income investors, who saw their investments struggle through most of the year. Concerns about likely changes in Federal Reserve policy triggered a rise in interest rates, which put pressure on longer-term Treasuries. The 10-year Treasury yield rose more than a full percentage point in 2013 and closed the year above 3%.
In this environment, the Equity Income Fund returned 13.70% in the second half, trailing the 16.31% return of the S&P 500 Index and slightly outperforming the 13.50% return of the Lipper Equity Income Funds Index. For the year, the fund returned 29.75%, lagging the 32.39% of the S&P while surpassing the Lipper Equity Income Funds Index’s 28.70% return. (Returns for the Advisor and R Class shares are also shown and reflect their different fee structures.)
As rising interest rates affected the bond market, several traditional high-dividend-yield sectors also came under pressure. Nevertheless, we were reasonably satisfied with your fund’s performance in 2013.
On December 11, 2013, your Board of Trustees declared a regular income dividend of $0.14 per share for the fourth quarter. The Board also declared a long-term capital gain distribution of $0.85 per share payable to shareholders of record that day. These distributions were paid on December 13, and you should already have received a check or statement reflecting them. The fourth-quarter income dividend of $0.14 per share brings total 2013 income dividends to $0.54 per share. (Distributions for the Advisor and R Class shares were different.)
In 2013, risk and cyclicality were in favor, and safety and stability were less profitable. On the positive side of the ledger, our investments in many large-capitalization cyclical companies, such as DuPont, 3M (MMM), Boeing (BA), Honeywell International (HON), Harris (HRS), and Illinois Tool Works (ITW), contributed to your fund’s strong performance. Media companies performed well, with Time Warner (TWC) and Walt Disney (DIS) generating very strong returns. The financials sector was also profitable, and we reaped solid returns from Bank of America, JPMorgan Chase, American Express, and Legg Mason. Other holdings performed very well on their own, absent generally strong support from their sectors. These included energy giant Hess, agricultural processor Archer-Daniels-Midland, pharmaceutical stalwart Bristol-Myers Squibb, and tech mainstay Microsoft. (Please refer to the fund’s portfolio of investments for a complete list of holdings and the amount each represents in the portfolio.)
Notwithstanding the strong year, some of our holdings in the energy, utilities, and telecommunication services sectors lagged the broad market. Several of our consumer staples investments, including Campbell Soup and McCormick, struggled to keep up with the overall market. Utilities stocks Duke Energy, Entergy, and Exelon and telecommunication services companies AT&T and Verizon were somewhat disappointing. Even in a powerful equity market advance, such as we experienced last year, rising interest rates tend to take a toll on these sectors. A couple of our positions, notably Petrobras and Quest Diagnostics, were hampered by company-specific issues.
The Major Portfolio Changes table highlights our investment activity over the last six and 12 months. In the last six months of the year, our largest purchases included Deere (DE), Stanley Black & Decker (SWK), GlaxoSmithKline (GSK), and Potash Corporation of Saskatchewan (POT). These companies share the common characteristics of attractive valuations, good dividend histories, strong financial positions, and a recent pattern of disappointing stock market returns. Identifying good companies selling at unusually attractive prices is the hallmark of what we do. Regarding our sales, most of them reflected decisions made in the second half about individual company valuations. As always, our sale of a security is a comment on its valuation and not a statement about the company’s quality. For example, 3M is an outstanding global corporation with a great track record. There comes a time, however, when a company’s stock price advances to the point where its valuation relative to the company’s equity is less compelling, in our opinion. We would say the same about Capital One Financial, Lockheed Martin, and SLM Corporation (Sallie Mae), which were among the stocks we eliminated in the second half of 2013.
We were somewhat surprised by the market’s strength in 2013, and we enter 2014 with a cautiously optimistic outlook. Following the excellent gain for the S&P 500, corporate earnings growing in the area of 6%, and an expansion in price/earnings multiples, stocks have become more expensive. Nevertheless, despite less appealing valuations, equity markets historically have generated reasonable returns in most years following strong years like 2013. Rarely have there been consecutive years with returns of 30% or more, but we would not be surprised to see continuing gains this year, although on a more modest scale. That said, a correction is likely at some point, as it has been some time since we’ve seen a significant market pullback.
We expect continued reasonable economic growth in 2014. We believe corporate earnings will grow at about the same rate as in 2013, and we believe companies will continue to buy back their shares and increase dividends in 2014. The question now is, how will investors react to a gradual change in Federal Reserve policy scheduled to begin in January? We expect to see some ongoing upward pressure on interest rates this year. However, while investors often worry that higher interest rates could undermine stocks, higher rates are usually a function of firmer economic conditions, which tend to be supportive of corporate earnings.
Our view is that this is not an environment in which investors should take undue risk. There are a few signs of “irrational exuberance,” to quote a former Fed chairman, and investors have exhibited some aggressive behavior in the initial public offering market. As we explore the range of investment choices in our search for portfolio holdings, we see fewer intriguing opportunities than in recent years. This makes us more cautious at the onset of the new year, but we remain optimistic about the fund’s prospects as we focus on our efforts to generate appealing long-term returns for our shareholders.
We appreciate your continued confidence in the Equity Income Fund. Respectfully submitted,
Brian C. Rogers
President of the fund and chairman of its Investment Advisory Committee
January 17, 2014
The committee chairman has day-to-day responsibility for managing the portfolio and works with committee members in developing and executing the fund’s investment program
The views and opinions in this report were current as of December 31, 2013. They are not guarantees of performance or investment results and should not be taken as investment advice. Investment decisions reflect a variety of factors, and the managers reserve the right to change their views about individual stocks, sectors, and the markets at any time. As a result, the views expressed should not be relied upon as a forecast of the fund’s future investment intent. The report is certified under the Sarbanes-Oxley Act, which requires mutual funds and other public companies to affirm that, to the best of their knowledge, the information in their financial reports is fairly and accurately stated in all material respects.