Concentrated Strategy

September 2019

Recession – a word that strikes fear in the hearts of economists and investors alike – became a frequent topic of conversation in the third quarter. Alarm arose when the 2-year and 10-year Treasury yields inverted, which many fear signals a weakening economy. While economic pundits argue that the yield activity alone does not point to a downturn, the last five 2-10 inversions eventually led to recessions.

The curve inversion came amid a cascade of discouraging economic news. The U.S. economy grew only 2% (annualized) in the second quarter, which was far lower than the 3%-plus growth rates realized over the past year. Manufacturing activity shrank in August for the first time since August 2016. Also in that month, job growth fell short of expectations with downward revisions of July and June data as well. Consumer confidence declined to a three-month low level in September, prompted by unrelenting anxiety over trade wars, and the Federal Reserve decided to cut key interest rates in both July and September. Fed Chairman Jerome Powell stated that while the economy remained strong and unemployment low, “there are risks to this positive outlook.” 

In a surprising move, the Business Roundtable (a consortium of chief executives from the country’s top businesses, including Apple, IBM and JPMorgan Chase) released a “statement on the purpose of a corporation” that outlined a fresh perspective for the role of a company. The declaration counters the prevailing Milton Friedman-based economic view that the only job of a business is to make money for shareholders. Instead, the statement promises to consider the interests of all stakeholders, including customers, employees, suppliers and communities, and was endorsed by 181 of 193 Roundtable members. Some CEOs intimated that the philosophical shift stemmed from an increased public focus on corporate responsibility.  

Looking forward, we acknowledge that there are several factors that will influence both the economy and markets. While not a welcomed event, we know that a recession is a natural part of a market cycle. That is why, when considering whether a company is a suitable investment, we look for a durable revenue stream that can withstand periods of slow macroeconomic growth. We also scrutinize management teams and look for those that recognize the role of all stakeholders alongside shareholders in building successful businesses. We think this approach can work to strengthen company fundamentals and provide greater shareholder rewards in the long term. 


Top Performers:
Alphabet delivered strong second-quarter earnings results as revenue growth accelerated. Total revenue reached $38.94 billion, which bested analysts’ estimates for $38.15 billion in total revenues. Earnings per share ($14.21 vs. $11.10) also exceeded market expectations. Furthermore, the company’s operating margin of 24% was more robust than consensus expectations of 22.5%, and we found this achievement reassuring given CFO Ruth Porat’s recent comments about the possibility for increased sales and marketing expenses in the second quarter. Management also announced a new $25 billion share repurchase program with no expiration date, which added to our confidence in the team’s commitment to building shareholder value. In addition, we attended the company’s annual investor day where members of the executive team gave updates on several initiatives. Alphabet believes cloud computing provides significant growth potential and is on pace to deliver $8 billion in annual revenue. Notably, Thomas Kurian, CEO of Google’s cloud operations, predicts revenues can exceed $10 billion annually. 

Agilent Technologies delivered solid fiscal third-quarter earnings results, in our view, as exhibited by growth in organic sales (+6%), adjusted earnings (+10%) and adjusted earnings per share (+13%) along with double-digit growth in recurring revenues, despite flat instrument sales. These results provide affirmation in our belief that the company is now a more resilient business that is less dependent on large capital equipment orders. Margins also expanded 90 basis points year-over-year, benefitting from a positive business mix shift. In addition, management increased its outlook for 2019 sales and earnings per share, while Agilent repurchased about 2.5% of its share base in the quarter. 

Moody’s second-quarter earnings report was solid, in our view, despite a tough issuance backdrop. Earnings per share ex-items ($2.07 vs. $2.00) and revenue ($1.21 billion vs. $1.20 billion) were both in excess of the market outlook. We think the ratings segment performed particularly well as revenue declined only 2% year-over-year, despite a 14% decline in global debt issuance volumes. As a consequence of these satisfying results, management increased its full-year earnings per share guidance range from $7.85-8.10 to $7.95-8.15 ex-items. The company appointed Robert Fauber, current president of Moody’s Investors Service (MIS), as its new COO, effective November 1. Michael West will take over as president of MIS, while Stephen Tulenko will replace Mark Almeida as president of Moody’s Analytics. West (current head of MIS Ratings and Research) and Tulenko (current executive director of Moody’s Enterprise Risk Solutions) have both been with the company for more than 20 years. We find that Moody’s financial performance this year provides an excellent reminder of our investment case. The company’s competitive position and business model allow it to generate revenue growth and margin improvement, despite a tough backdrop for its end market. Moody’s long runway for growth from both pricing power and the durability of the business makes this an attractive investment opportunity, in our view.

Bottom Performers:
Netflix delivered weak second-quarter results, in our view. New subscribers for the quarter (+2.7 million) fell short of guidance for 5 million new subscribers. However, revenue growth accelerated from 22.2% in the first quarter to 26% in the second quarter and earnings margins expanded 252 basis points to a record 14.3%. Management reiterated guidance, including expectations for 7 million net additions in the third quarter and further revenue growth acceleration to 31%, with an additional 390 basis points of margin expansion. In August, news reports revealed that Netflix will pay between $200-300 million for HBO’s “Game of Thrones” series creators David Benioff and D.B. Weiss to develop exclusive streaming content. The company beat out competitor Amazon for acquiring the talent. In September, The Wall Street Journal reported that Netflix entered into an agreement to purchase the five-year rights to “Seinfeld” for about $500 million. Later in the month, data suggesting the company’s international subscriber growth was slowing spooked investors. We like that Netflix’s significant spending on programming requires little incremental investment as new users subscribe and we think superior content provides a formidable barrier to entry. We believe that Netflix is a solid investment that should reward shareholders into the future. 

Lear preannounced its second-quarter earnings results and also trimmed full-year earnings guidance by 15% in July, which proved disappointing to investors. In our estimation, the seating segment performed well, with margins up 60 basis points quarter-over-quarter. However, e-systems revenues are projected to decline 5%. We met with management later in the third quarter to discuss both the seating and e-systems segments. Overall, the team’s confidence in seating is exceptionally strong and CEO Ray Scott is optimistic that new talent in e-systems will turn the segment around. Seating recently underwent a series of major model changes over the past few quarters without missing a beat and its dollar market share grew from 17% in 2013 to 23% today. The team is confident the company is on the cutting edge of seating design for both electric and shareable vehicles and believes that 28% dollar market share is achievable over the next five years. We continue to believe Lear is significantly undervalued relative to its normalized earnings power. 

Along with other exploration and production companies, Centennial Resource Development’s share price came under pressure in the third quarter. The company was also adversely impacted by multiple negative analysts’ notes downgrading the company. However, Centennial’s second-quarter earnings report beat consensus production estimates by 6% and also beat the market’s expectations for adjusted earnings ($170 million vs. $155 million). Management increased production guidance for 2019 by 8%, while lowering guidance for operating expenditures (-12%) and general and administrative costs (-16%). The company also called out well production activity as now showing a 10% improvement over 2018. Drilling time has gone down 15% year-over-year, completion time has come down 25% year-over-year and total capital efficiency improved 5% year-over-year. Despite some challenges in the short term, we like that Centennial has already managed to optimize its wells in the Permian Basin beyond what previous operators were able to achieve. We believe that as the company pinpoints new target zones and fine-tunes well designs for its acres, it is advantageously positioned to build upon its early successes into the future.

During the quarter, we initiated a position in Agilent Technologies and sold General Electric from the portfolio. 

Past performance is no guarantee of future results.


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