Dear Shareholder
Nearly all major stock and bond indexes produced positive results during 2020 as markets recovered from the steep sell-off that resulted from the spread of the coronavirus. Extraordinary fiscal and monetary support from global governments and central banks helped spur the rebound, although the pandemic continued to pose significant public health and economic challenges as the year came to an end.
In the U.S., the large-cap Dow Jones Industrial Average and S&P 500 Index reached record highs, as did the technology-heavy Nasdaq Composite Index—a result that few would have predicted in late March after the benchmarks tumbled more than 30% as governments instituted lockdowns to try to halt the spread of the virus. Large-cap information technology and internet-related firms helped lead the rebound as they benefited from the work-from-home environment and an acceleration in demand for online services.
Within the S&P 500, the technology and consumer discretionary sectors were the top performers, and communication services and materials stocks also outperformed. Despite a late rally, the energy sector trailed with significant losses due to a plunge in oil prices.
Most equity markets outside the U.S. also performed well. Emerging markets outpaced developed markets, and Asian shares delivered strong results as China and other countries in the region proved relatively successful in containing the coronavirus.
Growth stocks significantly outpaced their value counterparts for the full year; however, value shares rallied late in the period. Positive vaccine news in November raised hopes for a return to normalcy in 2021 and boosted sectors that had been beaten down in the initial phases of the pandemic.
Within the fixed income universe, corporate bonds delivered strong results as the market easily absorbed a torrent of new issuance. After falling to record lows in March, intermediate- and longer-term Treasury yields ticked higher later in the year but remained very low by historical standards, a factor that encouraged investors to seek out riskier securities with higher return potential.
While investors had reason to cheer the market's recovery, the global economic outlook remained unclear as the year came to an end. Most notable on the positive side was the start of vaccine distributions, which provided hope that the pandemic was in its final phase. In addition, Congress passed a $900 billion coronavirus relief package, supplementing the $2.4 trillion allocated to address the crisis earlier in the year, and the Fed continued to pledge very accommodative monetary policies for the foreseeable future. Meanwhile, political uncertainty diminished with Joe Biden's victory in the U.S. presidential election and the completion of a Brexit trade deal between the UK and the European Union.
On the negative side, concerns about a resurgence in virus hospitalizations led to new lockdowns and business restrictions in many countries, which in turn appeared to threaten economic recoveries. In the U.S., after a strong recovery in the summer and fall, the pace of hiring slowed late in the year, and household spending declined in November for the first time since April.
It was a remarkable 12-month period in many ways, but as far as markets are concerned, I can recall no calendar year that so starkly displayed evidence of both fear and greed. Fear emerged during the March sell-off and again in April as oil futures briefly traded in negative territory. Greed surfaced later as some assets seemed to continue to rally without fundamental support. Bitcoin rocketed to a record high of $29,000 by year-end, and the amount of money raised by initial public offerings also climbed to historic levels. While valuations are still attractive in some areas of the market, other sectors appear to have already priced in a strong rebound in earnings and are trading at elevated levels.
There are both risks and potential rewards in this environment, and we believe strong fundamental analysis and skilled active security selection will remain critical components of investment success.
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 12 months?
The Equity Income Fund returned 1.32% for the 12-month period ended December 31, 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 varied slightly, reflecting their different fee structures. Past performance cannot guarantee future results.)
What factors influenced the fund's performance?
U.S. equity market performance in 2020 was unusually narrow, resulting in a large dispersion between value and growth stocks. This disparity was a headwind to fund performance for most of the year as low-valuation and high-yielding stocks significantly underperformed. During the fourth quarter, however, our performance rebounded notably as several of our long-term bets began to turn the corner and valuation as a factor was no longer a headwind.
Several financials names, including JPMorgan Chase (JPM, Financial), Wells Fargo (WFC, Financial), and U.S. Bancorp (USB, Financial), struggled as investors expressed concern over the state of the global economy and resulting credit risk caused by the coronavirus pandemic. On top of the broader macroeconomic headwinds that plagued financials for much of the year, Wells Fargo struggled amid idiosyncratic concerns about an 80% dividend cut, combined with a lack of progress on cost-cutting and the continuation of the Fed-mandated asset cap, which prevented the company from growing its loan book during the pandemic. While we expect additional rate and credit pressure going forward, we believe Wells Fargo has good long-term fundamentals and an attractive valuation. In our view, the bank is set up for an earnings and valuation rerate on the other side of the pandemic, particularly if it can satisfy regulators' consent orders and be able to grow its assets once more. Although most banks saw disappointing returns in 2020, there was a wide divergence in performance, as some banks were considered higher quality by the market and, therefore, better positioned to withstand the pandemic pressures. JPMorgan Chase and U.S. Bancorp were two such companies owned in the portfolio, so we took advantage of the relative strength by trimming JPMorgan Chase and eliminating U.S. Bancorp in favor of more attractive risk/reward stories elsewhere in our investment universe. (Please refer to the portfolio of investments for a complete list of holdings and the amount each represents in the portfolio.)
The energy sector also featured several detractors from performance. 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. The stock finished the year as a significant absolute and relative detractor, and we trimmed most of our position in recognition of the changing risk profile of the investment brought on by the pandemic. ExxonMobil (XOM, Financial) suffered from operational headwinds related to the coronavirus pandemic, which adversely impacted the company's near-term earnings power. However, our underweight in the name benefited relative returns for the year.
Elsewhere in the portfolio, shares of Tyson Foods (TSN, Financial) declined early in the period due to input cost inflation and broader market uncertainty stemming from the coronavirus pandemic, which hampered exports to China and shifted demand to residential use from food services. Industrywide price-fixing allegations also pressured shares of chicken companies during the period. We are optimistic that improving chicken fundamentals will drive the stock higher over the near term. Shares of Boeing (BA, Financial) suffered amid delays in the 737 MAX recertification process and pressure on air travel from coronavirus fears. While we continue to find Boeing shares attractive, we are cognizant of the uncertain near-term recovery path of global air travel post-pandemic and, therefore, largely kept our position flat in the name throughout the year.
Some of the portfolio's largest absolute contributors came from the information technology sector. Shares of Qualcomm (QCOM, Financial) rebounded from the first-quarter sell-off, rising considerably for the one-year period due to the company's strong position in 5G cellular technology. During the period, the company was able to resolve all its remaining licensing disputes, thereby stabilizing that business and leaving investors to focus on its earnings growth runway as 5G devices proliferate. Shares of Microsoft (MSFT, Financial) rose as the company reported robust growth within its Intelligent Cloud segment. Investors appeared to prioritize Microsoft's solid fundamentals, defensible business model, and attractive growth potential. We trimmed both positions throughout the year on strength.
Other notable contributors included UPS (UPS, Financial), which rose following its second-quarter earnings release featuring stronger-than-expected consumer demand. Though we trimmed our position following the earnings beat, we are optimistic that the company's efforts to address the profitability of its domestic package business and revamp its pricing program are paying off. Additionally, shares of leading global investment bank Morgan Stanley (MS, Financial) gained late in the period, driven by the company's resilient operating performance during the pandemic and positive market sentiment concerning the development and distribution of several COVID-19 vaccines. Investors also appeared pleased after the bank authorized a multibillion-dollar stock repurchase plan for 2021 following positive stress test results.
Compared with the benchmark, stock selection in health care 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 top sales during the year hailed from a wide variety of sectors. In communication services, we sold shares of Verizon Communications (VZ, Financial). In our view, the stock trades at an elevated relative valuation given the rise of competition in the 5G space and the possibility that Verizon Communications loses market share over time. We are also cognizant of the significant amount of capital investment needed to maintain its leading 5G network, thereby pressuring returns. In health care, we sold shares of Johnson & Johnson (JNJ), which held up well during the early part of the coronavirus pandemic. At the time, we were concerned that hospitals would take longer than anticipated to pass peak coronavirus admissions and repurpose facilities back toward elective procedures, a thesis that came to fruition. Our selling tapered off as the year progressed and the thesis played out. In energy, we trimmed our stake in TC Energy (TRP, Financial), a utility-like infrastructure company that owns natural gas pipelines within the U.S. and was a strong performer during the year relative to other energy stocks. We used some of the sale proceeds to purchase utilities that, in our view, offer a similar growth profile at a more compelling relative valuation.
Notable purchases were also spread out among several areas of the market. Our largest equity purchase was DuPont de Nemours (DD), to which we added heavily early in the year due to our view that the market was overly discounting the value of its specialized chemical assets. In the consumer discretionary sector, we initiated a stake in Volkswagen (XTER:VOW3) midway through the period and added to our position through the remainder of the year. We are optimistic about the German automaker's ability to make the transition to the new age of electric vehicles given its internal buy-in and heavy investment. In energy, we initiated a position in EOG Resources (EOG) early in the year amid a sell-off in energy names. We took advantage of further weakness late in the year to bolster our position. In our view, the company is a pack leader in onshore discovery and execution. We like EOG Resources' best-in-class management team and technical sophistication, and we are optimistic that the company will benefit from an eventual stabilization in oil prices.
The portfolio's largest sector allocation is in financials, and we remain overweight relative to the benchmark. Although we decreased our absolute exposure to the sector during the year, our relative overweight increased due in part to the reconstitution of the benchmark index that took place during the period. The portfolio's second- and third-largest sector allocations to health care and industrials and business services, respectively, decreased in both absolute and relative terms during the year. Both sectors are now underweight relative to the benchmark. As the year progressed, we reallocated funds to certain sectors that we believe have been underappreciated by the market and, thus, offer compelling valuations.
What is portfolio management's outlook?
The market closely followed COVID-19 headlines during 2020, tied to both vaccine news and stimulus measures. Over the year, rapid stimulus measures pushed federal debt to record levels and deficits to levels not seen since World War II. We also saw divergence in the market, as investors bid up stocks poised to benefit in the short term from COVID-19 and left behind those seen to be negatively impacted by the pandemic. The market also showed resilience as consumer spending and business confidence rebounded quickly, and a vaccine was brought to market in under a year.
Given market performance in 2020, we are beginning to see signs of exuberance, with narrow leadership, high index concentration, and increased special purpose acquisition company and initial public offering activity. Considering this, we believe 2021 will present a stock pickers' market, where more tempered returns may remind investors of the importance of dividends. Additionally, in the event of an economic recovery, this may be an environment where we could see inflation, as consumers and businesses have capital to deploy while household net worth is at an all-time high. Ultimately, there may be a recoupling between the market and the economy, which might benefit areas of the market that were left behind over the course of 2020.
Heading into 2021, we remain 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. By adhering to our investment approach and valuation discipline, we believe we will be able to take advantage of market opportunities 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.
