Oakmark Equity & Income Fund

Clyde McGregor, the fund manager of the Oakmark Equity Income Fund, recently held a conference call covering the period ending March 31, 2012. Below we summarized what we thought were some of his key points.

McGregor invests in companies that he believes trade at a substantial discount to what he considers to be their true business value (which is the approach employed by all the investment professionals at Harris Associates, the fund’s investment manager).  Every stock purchase is viewed as buying a piece of a business, not just a stock certificate.  Also, having a smaller, more focused portfolio of stocks (15-60, for example, rather than 100-150) allows the manager’s best ideas to have a meaningful impact on investment performance.

The Equity and Income Fund has assets under management (AUM) of about $20 billion. It is a low cost fund with an annual management fee of 0.67%. Morningstar calculates that the average fund in the category has an expense ratio of 0.77%. The fund currently holds 53 equities.  Its asset allocation is about 70% stocks and 30% bonds; representing the highest equity weighting the fund attains.

The Equity and Income Fund is an all-cap fund on the stock side with the 21 person research staff going wherever value takes them. The highest market cap stock in the fund is about $207 billion and the lowest $306 million. During this quarter, the median market cap of the fund reached a new high of $9 billion.  At quarter’s end 62% of the portfolio was invested in large cap stocks with 14% of the equities being international.

The fixed income or bond portion of the fund is composed of 13% US Treasuries, 9% non-US sovereign debt, 7% in Treasury Inflation Protected Securities (TIPS), 1% in corporate bonds and just a sliver of agency debt.  The duration of the fixed income portfolio is a short 1.65 years.  (Duration measures sensitivity to interest rates.  Technically, if interest rates were to rise by 1%, the value of the fund’s bond holdings should decline by 1.65 %.)  They have kept duration short for some time now.

The fund was up 8% for the quarter ending March 31 about even with its peer group. The fund was underweighted in a few stronger market segments - financials and technology – but benefitted from good stock selection in names like United Health, Diageo, Texas Instruments and TJX.  

The fund added 8 new equity names to the portfolio while selling 4; they sold 3M, Sara Lee, L3, and Tractor Supply.  The eight new additions during the quarter were: Ebay, Illinois Tool Works, Parker Hannifin, Republic, Staples, Ameritrade, Lear, and Northrop Grumman. Unfortunately the buying window on a number of these stocks was very small so the fund was unable to build very large positions.  This also had the effect of lowering the turnover of the fund to 30% (turnover for the average fund in this category is above 60%).

One fund holding, Pentair, is going to merge with a division of Tyco international. Pentair is going to be the name of the combined firm while Tyco shareholders will own a majority of the new company’s shares.

McGregor noted he has been trying to add income to the portfolio without overpaying for it, which he stated has been difficult because “income is overpriced today,” a distortion he believes is created by the Federal Reserve.  He also mentioned that he does not find a lot of value in Real Estate Investment Trusts (REITs) or Master Limited Partnerships ( MLPs)two sectors that yield-focused investors have long found attractive given that their unique tax structure which has led to higher distributions.

In the current environment with extremely low interest rates (that are likely to rise) and companies at average valuations (as measured by PE ratios), McGregor expects that equities will likely not advance much going forward.  He did point out that today American business and industry is managed much better than the recent past with technology helping managers run their businesses more effectively resulting in greater profitability than in the past.  This could be more supportive of valuations expanding.

While the fund has had a 10.94% average annual return since inception, McGregor thinks it more realistic to expect mid to single digit compound rate of returns going forward. While he will work very hard to maintain that 10% return going forward it would require a substantial return from stocks given low bond yields.  For the reasons given above he expects that to be unlikely.

We continue to like the Oakmark Equity & Income Fund.  The fund’s research-driven, consistent pursuit of the best values in United States and overseas equity markets coupled with a protective high-quality bond portfolio has generated solid returns with much less volatility than an all stock portfolio. We think the fund is a relatively conservative way to get stock exposure. We view the fund as an attractive investment option for retirement plans and a core fund for many of our clients with smaller account balances.

Returns through 3/31/2012

	YTD	1 Year	3 Years	5 Years	Since Inception*
Equity and Income	7.91%	3.74%	14.89%	5.32%	10.59%
Lipper Balanced Index	7.88%	4.60%	16.79%	3.04%	6.62%

Sources are Morningstar and Oakmark

* Inception is 11/1/1995

Assistance on this post was provided by Grace Guo

(Harvest Financial Partners owns the Oakmark Equity & Income fund in client portfolios and uses it as a default investment option in a number of retirement plans where Harvest is the investment advisor.  The authors own it and other Oakmark Fund in their personal portfolios.  Positions may change at any time)