U.S. Equity Strategy

September 2019

THE MARKET ENVIRONMENT
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. 

THE PORTFOLIO
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.  

Apple reported fiscal third-quarter total net revenue and earnings per share that surpassed market projections and reinforced our view that innovation continues to thrive at the company. Net revenues accelerated most in the wearables, home and accessories segment, which advanced 48% and far outpaced market forecasts. Revenues also rose in the Mac and iPad segments by about 11% and 8%, respectively. Importantly, the higher-margin services segment realized a revenue increase of 13% and reached a record level of nearly $11.5 billion. In addition, even though iPhone revenues fell by roughly 12%, sales showed good signs of improvement, especially in China, in our view. Furthermore, the company announced an agreement to purchase Intel’s smartphone modem business. Although the deal is relatively small (using $1 billion of the company’s $212 billion available cash), it gives Apple more control over product development and costs as it moves toward the important 2020 launch of 5G phones. Later in the quarter, the company introduced its new iPhone 11, which included a lower price point on the entry-level version of the phone. Apple also announced the launch of Apple TV+ on November 1. 

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.

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. 

DXC Technology reported fiscal first-quarter revenue of $4.98 billion and earnings per share of $1.74, which both surpassed market targets. However, adjusted earnings fell short of market forecasts by nearly 5% and management reduced full-year guidance for revenue (by about 2.5% or $500 million) and earnings per share (by 9% or $0.75 per share), which triggered a significant share price decline in August. Management cited that the revisions came from a faster than expected acceleration of client migrations from legacy business offerings toward cloud environments and negative currency effects. However, the company continued to build momentum in its digital business, which realized revenue growth of 35% and order pipeline growth of 80% as clients put resources toward a digital transformation or modernization efforts and shifted away from spending on legacy application maintenance and infrastructure outsourcing. After the earnings release, we spoke with CEO Mike Lawrie who stated that he believes the sharp decline in legacy business revenues is only a short-term challenge and expects most clients will utilize a hybrid of legacy offerings mixed with cloud solutions, which would cause legacy business revenues to stabilize. Lawrie announced later in the third quarter that he would step down from the CEO role, but remain on as chairman. Lawrie’s replacement Mike Salvino was the former CEO of Accenture Operations, which is a business with direct parallels to DXC. While we are still evaluating the management change, we recently spoke with new CEO Salvino and came away with a positive impression of his capabilities to grow the business. 

Second-quarter revenue from Concho Resources met market expectations, while earnings per share fell short of projections. In our view, the company’s results were weak partly owing to disappointing results from its “Dominator” spacing test, which is an ambitious 23-well pad in the Delaware Basin intended to test the upper boundary of wells per section. Although the wells showed respectable initial production rates, output quickly eroded as pressure depleted, very similar to what we have seen at other exploration and production companies that have tested the limits on well spacing. In addition, Concho lowered activity levels for the second half of the year, mostly by reducing rigs and pushing well completions into 2020 to meet its full-year capital budget guidance of $2.8-$3.0 billion. This approach demonstrates to us that the company’s management team is serious about capital discipline, which is an attribute that we look upon favorably. However, management lowered the outlook for third-quarter oil production, which we and the market found concerning. We spoke with CEO Tim Leach and President Jack Harper who attributed the adjusted production guidance to the failed spacing test and timing issues related to drilled but uncompleted wells. Based on our discussions, we believe Concho can work past near-term issues and its output in 2020 can significantly outperform current-year production.

During the quarter, we initiated positions in Agilent Technologies, CDK Global and Humana. We eliminated Bank of New York Mellon and CarMax from the portfolio. 

 
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