Commentary

U.S. Equity Strategy

June 30, 2021

THE MARKET ENVIRONMENT

Vaccination rates increased, pandemic-related restrictions were lifted and businesses increasingly reopened throughout the second quarter. Moody’s Analytics’ Back-to-Normal Index climbed to 94%, indicating that the U.S. economy was nearing its pre-pandemic levels last seen in early March 2020. Consumers shifted spending during the quarter toward services, such as travel and eating out, as they unleashed pent-up demand.

During the quarter, the U.S. stock markets started to digest uncertainty in interest rates as well as inflation and monetary policy. Inflation readings from the Labor Department showed that core inflation rose at the fastest pace since 1992, up 3.8% in May versus a year earlier. In addition, supply chain bottlenecks emerged as truck utilization was near capacity and critical materials, including semiconductors, were in short supply. After a number of Fed policymakers predicted two 0.25 point increases in 2023, the market interpreted this as the beginning of a shift in tone from super-dovish to a hint of hawkish. However, Chairman Jerome Powell’s testimony to Congress reassured investors that the Fed will not rush to tighten monetary policy, which has been accommodative since the spring of 2020.

After passing the American Rescue Plan earlier in the year, the Biden administration pursued its second leg of the Build Back Better program—the American Jobs Plan. At the end of June, the $1 trillion bipartisan initiative, which is focused on infrastructure spending, appeared on track for passage by Congress.

Ultimately, the S&P 500 Index posted its second-best first-half gain in more than 20 years and recorded its fifth straight quarterly gain. Despite the upward momentum, some volatility persisted as value stocks rallied on days with higher interest rates, while growth rallied when interest rates dipped. We believe a lift in yields at the beginning of a recovery reflects a positive inflection in the potential real growth of an economy and prices that are relatively well-anchored. Even as rates return to more normal levels, we think they can continue to support healthy markets. In our view, any associated rise in volatility will be a source of opportunity for long-term value investors like ourselves.

THE PORTFOLIO

Top Performers:
Alphabet’s results continue to positively surprise the market as the company’s first-quarter total revenue, operating income and earnings per share outpaced expectations by 7%, 39% and 67%, respectively. From our perspective, Alphabet’s results were impressive and again exhibited faster than expected revenue growth across the board with total revenue that advanced 34% from the prior year. In addition, the adjusted operating margin (excluding “other bets” activity) expanded by 820 basis points. By segment, search revenue grew 30%, YouTube advertising revenue rose 49% and cloud revenue increased 46%. Furthermore, margin trends improved across all segments as underlying operational expenses appear progressively well controlled relative to history. Management repurchased $11.4 billion worth of shares in the quarter and authorized an additional $50 billion to buy back Class C shares. Based on this solid fundamental performance and share repurchases, we raised some of our near-term valuation metrics.

First-quarter earnings from Equifax included revenue and earnings per share that exceeded market expectations. We saw results as strong with organic revenue growth of more than 20% and an earnings per share increase of 37%, despite significant investments and redundant costs associated with the migration to cloud computing. Although these costs negatively impacted margins by about 300 basis points, the company still achieved a 250 basis point adjusted earnings margin expansion to 35.6%. Equifax appears to be taking market share both within mortgage verticals and increasingly with the non-mortgage business. Impressively, management raised its full-year guidance for revenue and earnings per share by 5% and 9%, respectively, even while reducing its mortgage inquiry expectations for the full year. In our view, this is a bullish signal and implies that the non-mortgage end markets are expected to have a strong recovery following years of sluggish growth.

Facebook’s first-quarter earnings report included revenue that surpassed market expectations by about $2 billion (roughly 10%), while earnings per share of $3.30 rose 94% from a year ago and were materially better than market forecasts for $2.35. Total revenue grew 48% year-over-year, driven by a 30% increase in the average price per advertisement, while the operating margin expanded 1,000 basis points to 43%. Facebook’s strengthening performance stemmed from ecommerce advertising, which management says is now the company’s largest and fastest growing advertising vertical. In addition, accelerating Oculus sales led to a revenue advance of nearly 150% in the “other revenue” segment. CEO Mark Zuckerberg noted his enthusiasm for augmented reality/virtual reality development over the long run. Furthermore, the company anticipates strong second-quarter revenue growth at a rate that meets or is “modestly above” first-quarter levels. Lastly, late in the quarter, a federal court dismissed the Federal Trade Commission’s antitrust complaint against Facebook concerning its purchases of Instagram and WhatsApp. While we acknowledge that future litigation may follow, we are pleased that this complaint was terminated.

Bottom Performers:
Thor Industries reported fiscal third-quarter results that included revenue of $3.46 billion and earnings per share of $3.29, which were better than market forecasts by 14% and 41%, respectively. Furthermore, the company’s consolidated recreational vehicle order backlog increased 32% to $14.32 billion from $10.81 billion at the end of the second quarter, which we think bodes well for future positive performance. Consumer demand remains robust at the retail level, and inventory positions remain historically low at the dealer level. CEO Bob Martin commented that he sees “no signs of demand slowing even as the economy recovers from the pandemic.” Martin further remarked that this favorable scenario is not limited to the U.S. as he sees “lots of runway” for both organic and inorganic expansion in Europe. Despite these solid results and positive trends, the share price of Thor Industries fell for the quarter, possibly due to investor profit taking. Even though Fiserv’s first-quarter earnings disappointed investors, we saw results as respectable considering the challenging operating environment. Results were largely in line with our estimates, and total revenue and earnings per share surpassed market expectations. More importantly, organic revenue grew 4% from the prior year, earnings rose 15% and earnings per share advanced 18%. In merchant acquiring, organic growth amounted to 8% and margins improved 650 basis points, while gross payment volume in Clover (cloud-based point of sale product) grew 36%, ecommerce transactions grew 24% and the company won a record number of new customers during the period. In addition, we were pleased that Fiserv executed $612 million worth of share repurchases in the quarter (or about 0.8% of it share base). Despite this solid performance, the share price of Fiserv fell for the quarter as a market analyst downgraded the company, stating that valuations may contract from slowing organic revenue growth in the merchant segment. We possess an opposing view and our investment thesis for the company remains intact.

Although CDK Global’s fiscal third-quarter revenue exceeded market forecasts, adjusted earnings fell about 2% below projections and earnings per share missed expectations by 43%. However, the company continues to make progress on most key performance indicators, with dealer sites realizing the ninth consecutive quarter of growth. We like that revenue per site is rising as the company continues to drive penetration of products, such as the service application and its customer relationship management offering. We think there remains sufficient opportunity for further advancement owing to cross-selling efforts. Moreover, although a recent accounting change and amortization of Covid-19-related customer discounts weighed on the year-over-year earnings growth rate, we believe these negative effects should dissipate in the next few quarters. Importantly, management committed to generating mid-single-digit organic revenue growth next year as measured by dealer sites and revenue per site. CDK also announced plans to execute $200-$250 million in share repurchases by the end of 2022. In our view, the company is a growing, high-margin and mission-critical software business, and our investment thesis remains intact.

There were no new purchases during the quarter and we eliminated Oracle from the portfolio.

Past performance is no guarantee of future results.

The S&P 500 Total Return Index is a float-adjusted, capitalization-weighted index of 500 U.S. large-capitalization stocks representing all major industries. It is a widely recognized index of broad, U.S. equity market performance. Returns reflect the reinvestment of dividends. This index is unmanaged and investors cannot invest directly in this index.

The Russell 1000® Value Index measures the performance of the large-cap value segment of the U.S. equity universe. It includes those Russell 1000® companies with lower price-to-book ratios and lower expected growth values. This index is unmanaged and investors cannot invest directly in this index.

The specific securities identified and described in this report do not represent all the securities purchased, sold, or recommended to advisory clients. There is no assurance that any securities discussed herein will remain in an account’s portfolio at the time one receives this report or that securities sold have not been repurchased. It should not be assumed that any of the securities, transactions, or holdings discussed herein were or will prove to be profitable. Holdings are representative of Harris Associates L.P.’s U.S. Equity composite as of 06/30/21.

Certain comments herein are based on current expectations and are considered “forward-looking statements”. These forward looking statements reflect assumptions and analyses made by the portfolio managers and Harris Associates L.P. based on their experience and perception of historical trends, current conditions, expected future developments, and other factors they believe are relevant. Actual future results are subject to a number of investment and other risks and may prove to be different from expectations. Readers are cautioned not to place undue reliance on the forward-looking statements.

The information, data, analyses, and opinions presented herein (including current investment themes, the portfolio managers’ research and investment process, and portfolio characteristics) are for informational purposes only and represent the investments and views of the portfolio managers and Harris Associates L.P. as of the date written and are subject to change without notice. This content is not a recommendation of or an offer to buy or sell a security and is not warranted to be correct, complete or accurate.