Dear Shareholder
Financial markets recorded widely mixed results during the first half of 2020 as the spread of the coronavirus disrupted global economies. Although stocks and bonds experienced extraordinary volatility, historic levels of fiscal and monetary stimulus helped mitigate the losses.
Market sentiment was positive as we entered the year, and the S&P 500 Index advanced to a record high on February 19. However, stocks began falling as the coronavirus spread in Italy and other countries outside China. The major indexes continued their slide as cases mounted in the U.S. and New York City became the epicenter of the pandemic. Governments throughout the world issued stay-at-home orders to contain the virus, and some sectors, such as travel, restaurants, and shopping malls, nearly came to a halt.
According to the National Bureau of Economic Research, a recession officially began in February, ending the longest expansion in U.S. history. Over 22 million Americans lost their jobs in March and April, and many measures of economic activity, including retail sales and industrial production, experienced record-setting declines. By March 23, the S&P 500 Index had fallen by about a third from the start of the year.
In response to the rapid economic contraction, global central banks took bold accommodative steps, and many governments around the world passed emergency spending packages. The Federal Reserve cut its short-term lending rate to near zero and began massive purchases of government and corporate bonds to stimulate the economy and supply liquidity in the fixed income market.
The federal government also provided trillions of dollars in fiscal help in the form of direct payments to many Americans, expanded unemployment insurance, and subsidies to sectors such as transportation and health care that had been directly impacted by the pandemic. As lockdowns eased late in the period, there were signs of economic recovery, especially in stronger-than-expected payroll data, but surges in new virus cases in some states remained a concern.
Boosted by the stimulus and indications that the economy was mending faster than many expected, nearly all sectors recouped some of their losses by the end of June, and some segments were back in positive territory. For the six-month period, the tech-heavy Nasdaq Composite Index reached record highs and easily outperformed other benchmarks as the pandemic appeared to accelerate trends in retail, social media, and content streaming that benefited the large technology platforms. Large- and mid-cap growth stocks also produced positive returns and outperformed small-caps and value shares, which lost ground.
The S&P 500 Index finished the period with modest losses overall. Within the benchmark, tech and consumer discretionary stocks rallied, but energy shares were down more than 35% (including dividends) amid tumbling oil prices, and the financials sector struggled in a low-yield environment. Non-U.S. equity markets were generally negative and lagged the U.S. benchmarks.
In the fixed income universe, Treasuries were the top performers as yields dropped to record lows during the period, and other U.S. investment-grade bonds were also generally positive. High yield and emerging markets bonds were particularly hard hit during the market sell-off in March, but the sectors staged a strong recovery as investors sought out higher-yielding securities. Emerging markets debt denominated in U.S. dollars outperformed local currency issues, as weakness in certain currencies weighed on local bond performance in U.S. dollar terms.
As we enter the second half of the year, we expect markets to remain volatile. The scale of the stimulus and the potential for medical breakthroughs create the potential for stocks to move higher, but much depends on the course of the virus. Rising tensions between the U.S. and China, social unrest, and the U.S. elections in November could also drive market performance.
Our investment teams will be carefully monitoring these developments, and I believe that our disciplined fundamental research and strategic investing approach will continue to serve our shareholders well in this uncertain environment.
Thank you for your continued confidence in T. Rowe Price.
Sincerely,
Robert Sharps
Group Chief Investment Officer
Management's Discussion of Fund Performance
INVESTMENT OBJECTIVE
The fund seeks a high level of dividend income and long-term capital growth primarily through investments in stocks.
FUND COMMENTARY
How did the fund perform in the past six months?
The Equity Income Fund returned -18.78% for the six months ended June 30, 2020. The fund underperformed the Russell 1000 Value Index as well as its peer group, the Lipper Equity Income Funds Index. (Returns for the Advisor, R, and I Class shares reflect different fee structures. Past performance cannot guarantee future results.)
What factors influenced the fund's performance?
Dramatic uncertainty caused by the coronavirus pandemic has caused investors to shrink their time horizon and reduce their risk appetite. As a result, several names in the portfolio that we continue to believe are meaningfully undervalued over the long term posted disappointing returns during the first half of the year. Several financials names, notably market bellwethers Wells Fargo (WFC, Financial) and JPMorgan Chase (JPM, Financial), were pressured as investors expressed concern over the state of the global economy and resulting credit risk amid the pandemic. In industrials and business services, GE (GE, Financial) shares underperformed as investors remained concerned with the industrial conglomerate's liquidity and its exposure to aviation. Although the company may face short-term headwinds caused by the coronavirus pandemic, we remain confident in GE's leadership team and its ability to navigate this environment. We continue to believe GE has ample liquidity for the current environment and that the company is trading below its sum-of-the-parts valuation. Additionally, shares of Boeing (BA, Financial) suffered during the first quarter due to the prospect of a prolonged period of suppressed air travel caused by the coronavirus pandemic. (Please refer to the portfolio of investments for a complete list of holdings and the amount each represents in the portfolio.)
Additionally, several names within energy detracted from absolute results but aided in performance relative to the benchmark. Global exploration and production company Occidental Petroleum (OXY, Financial) fell sharply in March as the company was forced to slash its spending projections in the wake of the Saudi-Russian oil market share battle, which sent crude prices lower. Positions in Total (XPAR:FP, Financial) and ExxonMobil (XOM, Financial) also lowered absolute returns. Elsewhere in the portfolio, shares of Tyson Foods (TSN, Financial) fell due to input cost inflation and broader market uncertainty stemming from the coronavirus outbreak, which has hampered exports to China and shifted demand to residential use from food services. Industrywide price-fixing allegations also pressured shares of chicken companies later in the period.
Contributors were spread out among several sectors. In information technology, shares of Microsoft (MSFT, Financial) held their value despite the broader coronavirus-instigated sell-off in equities. Shares then rose later in the period following a strong quarterly earnings report highlighted by robust growth within the software giant's Intelligent Cloud segment. Investors appeared to prioritize Microsoft's solid fundamentals, defensible business model, and attractive growth potential. Select health care firms added value as well. Biopharmaceutical company AbbVie (ABBV, Financial) rebounded strongly off the market bottom due to solid operational results and the closure of the company's acquisition of Allergan in May while Gilead Sciences (GILD, Financial) outperformed due to high hopes surrounding the company's remdesivir drug and its potential application as a COVID-19 (the disease caused by the coronavirus) treatment. Meanwhile, oil field services company Halliburton (HAL), which we added to the portfolio during the depth of concerns over crude oil fundamentals, rose during the second quarter in conjunction with crude oil prices. Kimberly-Clark (KMB) benefited from a surge in demand for tissue products.
Compared with the benchmark, stock selection in industrials and business services detracted the most from relative performance. Conversely, security choices in information technology added the most value relative to the benchmark.
How is the fund positioned?
The Equity Income Fund seeks to buy well-established, large-cap companies that have a strong record of paying dividends and appear to be undervalued by the market. The fund's holdings tend to be solid, higher-quality companies going through a period of controversy or stress, reflecting our dual focus on valuation and dividend yield. Each position is the product of careful stock picking based on the fundamental research generated by T. Rowe Price's team of equity analysts, as opposed to selection based on broader market or macroeconomic trends.
Our exposure to financials, the fund's largest sector, declined in absolute terms but rose relative to the benchmark primarily due to the annual reconstitution of the Russell style benchmarks. We sold shares of certain firms that we believe are trading at a relative valuation premium, including JPMorgan Chase and U.S. Bancorp (USB), in order to buy shares of companies that had fallen to attractive levels. For example, we purchased shares of Loews (L) on weakness. The conglomerate's earnings have been under pressure due to severe operational challenges related to the coronavirus pandemic. However, we are encouraged by the company's resilient balance sheet and solid cash position. We also added to our position in American International Group (AIG) on weakness as investors appeared to price in the possibility of pandemic-related underwriting losses for property and casualty insurers, which we view as unlikely.
The fund's second-largest sector allocation is health care, and we increased our exposure in both absolute and relative terms. We bought shares of certain firms, notably Becton, Dickinson & Company (BDX), that have exposure to the COVID-19 testing market. We also bought shares of AbbVie on weakness ahead of its acquisition of Allergan, which we believe should add value through a more diversified revenue model. Conversely, we sold shares of Johnson & Johnson (JNJ), as we are concerned that hospitals may take longer than anticipated to pass peak coronavirus admissions and repurpose facilities back toward elective procedures.
Other notable equity subtractions include Verizon Communications (VZ), Microsoft, and Dow (DOW), all of which we sold on relative strength. We bought shares of DuPont de Nemours (DD), as we believe the market is discounting the value of its specialized chemical assets. We also initiated a position in Enbridge (ENB), the largest gas and oil pipeline company in North America, on weakness. The stock underperformed as concerns about sustained low demand for fuel amid the coronavirus pandemic buffeted the broader energy sector. We are confident in the company's resilient revenue model and high-quality asset base.
What is portfolio management's outlook?
The current environment is without precedent, as the crisis facing the economy is not a result of excesses in the system or failed policy. It is, rather, a medical crisis and therefore requires a medical solution. At the same time, the Federal Reserve has indicated a willingness to use all tools at its disposal to support the economy, and the federal government has passed sweeping fiscal policy stimulus.
Aided by this support, the market has begun to look past the pandemic, pricing in continued improvement in both economic data and COVID-19 cases and abandoning many of the worst-case scenarios that now seem less likely. Despite recent optimism, we believe a clear market outlook is challenging from these levels and expect the market will continue to be headline-driven until there is a clear path to a medical solution to the pandemic.
We are, therefore, focused on finding companies that have the financial strength to make it through a wide range of environments and that offer the best balance of quality and valuation appeal. Given the uncertainty, investors' time horizon has shrunk, so we see opportunities by extending the time horizon to identify investment candidates that look attractive under a "normalized" environment.
Though they have rebounded, markets remain bifurcated, and we continue to see attractive valuation disparities in the market. While we seek to remain balanced, we will take opportunities to lean into cyclical names with attractive valuations while maintaining a keen focus on balance sheet strength. By adhering to our investment approach and valuation discipline, we believe we will be able to take advantage of this uncertainty and make attractive long-term investments for our clients.
The views expressed reflect the opinions of T. Rowe Price as of the date of this report and are subject to change based on changes in market, economic, or other conditions. These views are not intended to be a forecast of future events and are no guarantee of future results.
