Dear Shareholder,
Major stock and bond indexes produced mixed results during 2021 as strong corporate earnings growth and a recovering economy contended with worries about inflation, new coronavirus variants, and less accommodative central banks. Most developed market stock benchmarks finished the year with positive returns, although gains slowed in the second half of the year, while fixed income returns faced headwinds from rising interest rates.
Large-cap U.S. growth stocks delivered the strongest returns, but solid results were common in many developed markets. However, emerging markets stock benchmarks struggled amid a significant equity market downturn in China.
The large-cap S&P 500 Index returned almost 29%, marking its third straight year of positive returns. Robust results were widespread across the benchmark—according to Bloomberg data, 2021 marked the first year that all of the S&P 500 sectors recorded double-digit gains. The energy sector, which was the worst performer in 2020, was the leader in 2021 amid a sharp increase in oil prices, and real estate stocks also rebounded from a down year as strong demand led to rising rents. Financial and information technology stocks also produced excellent returns and outperformed the broad market.
In the fixed income market, rising Treasury yields weighed on performance, but below investment-grade corporate bonds delivered solid results as they benefited from improving fundamentals and investor demand for higher-yielding securities. (Bond prices and yields move in opposite directions.)
A robust increase in corporate earnings growth appeared to be a significant performance driver during the year. According to FactSet, overall earnings for the S&P 500 rose 89% in the second quarter of 2021 versus the year before, the fastest pace since 2009, and while third-quarter earnings slowed, they continued to beat expectations at an impressive pace. Despite the significant rally in the S&P 500 during 2021, the index’s price/earnings ratio actually fell over that period as earnings rose faster than stock prices. Although economic growth showed signs of slowing at times, data remained generally positive through the end of the period. The unemployment rate, which started the year at 6.7%, fell to 3.9% by December, and job openings reached a record high.
However, optimism surrounding strong earnings and employment gains was tempered by inflation concerns. Prices surged as the release of pent-up demand and supply chain disruptions contributed to higher inflation around the globe. In the U.S., the 6.8% increase in the consumer price index for the 12-month period ended in November was the highest level since 1982, a factor that may have contributed to a decline in consumer sentiment late in the year.
Meanwhile, central banks began to move away from the extremely accommodative policies they instituted in response to the initial wave of the coronavirus. The Federal Reserve began trimming its purchases of Treasuries and agency mortgage-backed securities in November, and policymakers indicated that they could soon start raising short-term interest rates.
How markets respond to the normalization of monetary policy is an open question. While fading stimulus might pose some challenges for investors, I believe it could contribute to a return of price sensitivity in global markets, which bodes well for selective investors focused on fundamentals.
Elevated valuations, higher inflation, and the continuing struggle to control the pandemic also pose potential challenges for financial markets in 2022. However, on the positive side, household wealth gains, pent-up consumer demand, and a potential boom in capital expenditures could sustain growth even as monetary policy turns less supportive. In this environment, our investment teams will remain focused on using fundamental research to identify companies that can add value to your portfolio over the long term.
Thank you for your continued confidence in T. Rowe Price.
Sincerely,
Robert Sharps
President and CEO
FUND COMMENTARY
How did the fund perform in the past 12 months?
The Equity Income Fund returned 25.68% for the 12-month period ended December 31, 2021. The fund outperformed its benchmark, the Russell 1000 Value Index, as well as its peer group, the Lipper Equity Income Funds Index. (Returns for the Advisor, R, I, and Z Class shares varied slightly, reflecting their different fee structures. Past performance cannot guaranteefuture results.)
What factors influenced the fund’s performance?
The Equity Income Fund generated strong returns in 2021, with relative outperformance driven by both sector allocation and stock selection. Throughout the year, the portfolio benefited from our longterm focus and willingness
to lean into our idiosyncratic ideas and pockets of dislocation caused by the pandemic in 2020. Although the
portfolio outperformed its benchmark for the one-year period, it trailed the benchmark during the back half of the year, as the market showed a preference for more expensive, lower dividend-yielding names amid concerns over new coronavirus variants and monetary policy.
The portfolio’s financials sector names contributed to gains within the portfolio, particularly banks such as Wells Fargo (WFC, Financial), Fifth Third Bancorp (FITB, Financial), and Morgan Stanley (MS, Financial). Overall, the sector benefited from economic optimism, robust capital market activity, and a healthy consumer aided by fiscal stimulus. Certain insurance names also performed well, such as American International Group.
Amid a strong industry backdrop, American International Group (AIG, Financial) ended the period higher, buoyed by strength in property and casualty insurance pricing along with the company having a significant amount of cash available to be deployed into buybacks and dividends. (Please refer to the portfolio of investments for a complete list of holdings and the amount each represents in the portfolio.)
Select names in the information technology sector also delivered strong performance over the period. Applied Materials (AMAT, Financial) rose as shares continued to benefit from cyclical strength within the industry and robust semiconductor demand over the year. Microsoft (MSFT, Financial) was buoyed by impressive earnings results, including strong revenue growth within its cloud computing and productivity and business processes segments. Midway through the year, shares also benefited from accelerated corporate spending on enterprise technology services. Longtime holding Qualcomm (QCOM, Financial) also contributed despite choppy performance over the year. Recently, the company has been taking market share in the Android ecosystem and broadening into the non-handset business. Shares of Qualcomm gained particularly during the fourth quarter when increased semiconductor chip supply drove robust reported financials, and the company raised its forward guidance.
Elsewhere in the portfolio, shares of low-cost nitrogen producer CF Industries (CF, Financial) advanced early in the period after an earnings report showed the company had executed well in an uncertain environment driven by unfavorable weather. The company was also able to reduce operating rates while selling excess gas back into the market. Later in the year, CF Industries benefited from higher nitrogen prices due to reduced operating rates in Europe and Asia as well as increased nitrogen fertilizer demand. While we continue to appreciate the company’s position as a low-cost nitrogen producer and its free cash flow generation, we moderated our position size amid the cyclically peaking backdrop.
Some of the portfolio’s greatest absolute detractors came from the health care sector. Medical device company Medtronic (MDT, Financial) fell on investor uncertainty about the potential strength of the clinical trial data for its renal denervation system and as regulators flagged concerns in its diabetes business. Additionally, Zimmer Biomet Holdings (ZBH, Financial) underperformed during the period, as the rise of the delta and omicron variants of the coronavirus prolonged the uncertainty around a return to normalcy for elective procedures.
Compared with the benchmark, stock selection in financials contributed the most value to relative performance. Conversely, stock selection in consumer discretionary detracted the most from relative results.
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 purchases over the 12-month period hailed from a wide variety of sectors.
In health care, we initiated a position mid-period in managed health care and insurance company Cigna (CI, Financial) following relative weakness in the name. We continued to add to Cigna, as we believe the company has an attractive valuation and should benefit from an improved managed care environment over time. We also added to cloud computing and virtualization technology company Citrix Systems (CTXS, Financial). The company delivered negative total returns for the year as reported financials missed revenue and included lower-than-expected guidance.
We are cognizant of the potential headwinds that Citrix Systems may experience as it transitions to a subscription-based business, but we remain encouraged by the company’s competitive positioning and believe the market underappreciates the margin impact this transition will ultimately have.
Notable sales were also spread out among several areas of the market. Our largest equity sale was global investment bank Morgan Stanley, which we reduced significantly by year-end. We continue to appreciate Morgan Stanley and believe its business model transformation holds value, but we sold into relative strength to take advantage of other opportunities with more compelling valuations. In financials, we also moderated our positions in PNC Financial Services Group (PNC, Financial) and State Street (STT, Financial) on relative strong performance. Elsewhere in the portfolio, we pared shares of specialty chemical conglomerate DuPont de Nemours (DD, Financial). We remain appreciative that the company is positioning itself as a leader in electronic materials and industrial technology but reduced our position to invest in higher-conviction ideas.
The portfolio’s largest sector allocation is in financials. We remain overweight relative to the benchmark, and we increased our absolute exposure during the period. The portfolio’s second-largest sector allocation is in health care, where our absolute exposure also increased. Still, our underweight to the benchmark increased as a result of the reconstitution of the benchmark index that took place in June. Industrials and business services, our third-largest sector allocation, is underweight the benchmark, but our underweight decreased over the period. We also decreased our absolute exposure to the sector.
What is portfolio management’s outlook?
Market concerns surrounding COVID-19 were met with an aggressive and coordinated fiscal and monetary policy response. Moving forward, all eyes remain on the trajectory of both the virus and monetary policy. Given this duality, we expect a choppy market throughout 2022 with a focus on potential missteps by the Federal Reserve. While fundamentals are strong, the equity market is relatively expensive, particularly on the growth side. However, low bond yields mean that there are few alternatives to equities.
Although markets are showing isolated signs of exuberance, the economic backdrop seems reasonable. For markets to continue their ascent, they will need to climb a wall of worry consisting of pandemic dynamics, inflation, and labor shortages. The intensity of each concern will likely have a strong bearing on equity market returns in 2022. Amid this backdrop, we remain consistent in our style with a focus on valuation, fundamentals, dividend yield, and a long-term orientation.
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.
