HIGHLIGHTS
- The Equity Income Fund outperformed both the Russell 1000 Value Index and the Lipper Equity Income Funds Index for the six months ended June 30, 2022.
- Within the fund, absolute contributors were concentrated within sectors that benefited from rising commodity and energy costs and the flight to more defensive stocks against a background of geopolitical turmoil. Top detractors were focused in sectors that struggled amid the uncertainty associated with an inflationary environment.
- Changes in sector allocation were the result of our bottom-up stock selection. During the first half of the year, we focused on fading cyclicality within the portfolio and invested in names with idiosyncratic returns drivers and companies we liked long term that faced near-term stress.
- Going forward, our aim is to create a portfolio that is balanced for a variety of market settings, investing in ideas where the risk/reward ratio is particularly attractive while being cognizant of our beta. As always, our focus remains on investing in higher-quality companies where there is a confluence of compelling valuations, attractive long-term fundamentals, and strong dividend yields.
Dear Shareholder
Major stock and bond indexes produced sharply negative results during the first half of 2022 as investors contended with persistently high inflation, tightening financial conditions, and slowing growth.
After reaching an all-time high on January 3, the S&P 500 Index finished the period down about 20%, the worst first half of a calendar year for the index since 1970. Double-digit losses were common in equity markets around the globe, and bond investors also faced a historically tough environment amid a sharp rise in interest rates.
Value shares outperformed growth stocks as equity investors turned risk averse and rising rates put downward pressure on growth stock valuations. Emerging markets stocks held up somewhat better than shares in developed markets due to the strong performance of some oil-exporting countries. Meanwhile, the U.S. dollar strengthened during the period, which weighed on returns for U.S. investors in international securities.
Within the S&P 500, energy was the only bright spot, gaining more than 30% as oil prices jumped in response to Russia’s invasion of Ukraine and the ensuing commodity supply crunch. Typically defensive shares, such as utilities, consumer staples, and health care, finished in negative territory but held up relatively well. The consumer discretionary, communication services, and information technology sectors were the weakest performers. Shares of some major retailers fell sharply following earnings misses driven in part by overstocked inventories.
Inflation remained the leading concern for investors throughout the period. Despite hopes in 2021 that the problem was transitory, and later expectations that inflation would peak in the spring, headline consumer prices continued to grind higher throughout the first half of 2022. The war in Ukraine exacerbated already existing supply chain problems, and other factors, such as the impact of the fiscal and monetary stimulus enacted during the pandemic and strong consumer demand, also pushed prices higher. The May consumer price index report (the last to be issued during our reporting period) showed prices increasing 8.6% over the 12-month period, the largest jump since late 1981.
In response, the Federal Reserve, which at the end of 2021 had forecast that only three 25-basis-point (0.25 percentage point) rate hikes would be necessary in all of 2022, rapidly shifted in a hawkish direction and executed three rate increases in the first six months of the year. The policy moves included hikes of 25, 50, and 75 basis points—the largest single increase since 1994—increasing the central bank’s short-term lending benchmark from near zero to a target range of 1.50% to 1.75% by the end of June. In addition, the Fed ended the purchases of Treasuries and agency mortgage-backed securities that it had begun to support the economy early in the pandemic and started reducing its balance sheet in June.
Longer-term bond yields also increased considerably as the Fed tightened monetary policy, with the yield on the benchmark 10-year U.S. Treasury note reaching 3.49% on June 14, its highest level in more than a decade. (Bond prices and yields move in opposite directions.) Higher mortgage rates led to signs of cooling in the housing market.
The economy continued to add jobs during the period, and other indicators pointed to a slowing but still expanding economy. However, the University of Michigan consumer sentiment index dropped in June to its lowest level since records began in 1978 as higher inflation expectations undermined confidence.
Looking ahead, investors are likely to remain focused on whether the Fed can tame inflation without sending the economy into recession, a backdrop that could produce continued volatility. We believe this environment makes skilled active management a critical tool for identifying risks and opportunities, and our investment teams will continue to use 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
CEO and President
FUND COMMENTARY
How did the fund perform in the past six months?
The Equity Income Fund returned -8.38% for the six-month period ended June 30, 2022. 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 guarantee future results.)
What factors influenced the fund’s performance?
In the worst first half of a calendar year for the S&P 500 Index since 1970, investors shunned riskier assets in response to Russia’s invasion of Ukraine, elevated inflation exacerbated by rising commodity prices, and Federal Reserve interest rate increases. Investors were also concerned about inflation’s impact on consumer spending and corporate profits, particularly as some high-profile companies and major retailers disappointed with their financial results or projections.
The Equity Income Fund outpaced its benchmark, with relative outperformance driven by both stock selection and sector allocation. Given steps taken during the worst portions of the pandemic, the portfolio was well positioned for an environment of higher interest rates and commodity prices. This positioning, combined with our valuation discipline, was a large tailwind to performance during the first half of 2022, as most of the pain in the equity market came from companies in the higher end of the valuation distribution.
Within the portfolio, health care sector names contributed to gains, particularly AbbVie (ABBV, Financial) in pharmaceuticals as well as managed care companies Elevance Health (ELV, Financial) (formerly Anthem) and Cigna (CI, Financial). Overall, the sector benefited from the appeal of its defensive nature due to comparatively reduced sensitivity to macroeconomic pressures. AbbVie performed particularly well following the Food and Drug Administration approval of its drugs Rinvoq and Skyrizi, which should help balance sales deficits from Humira’s loss of exclusivity in 2023. (Please refer to the portfolio of investments for a complete list of holdings and the amount each represents in the portfolio.)
Certain financial names, notably in the insurance industry, also added value over the period. Conglomerate Loews (L, Financial) outperformed the sector for the first half. The company’s value is largely attributable to its majority ownership in U.S. commercial property and casualty (P&C) insurance company CNA Financial (CNA, Financial), which has continued to benefit from a strong pricing environment for P&C insurers. CNA Financial also reported strong earnings in both quarters, which contributed to higher underwriting income. MetLife’s (MET) recent operational results boosted positive sentiment toward the stock, and Chubb (CB, Financial) also benefited from the ongoing P&C upcycle.
Elsewhere in the portfolio, shares of low-cost nitrogen producer CF Industries (CF, Financial) profited from surging natural gas prices and fertilizer prices, which proved to be tailwinds for most of the period. Russia’s invasion of Ukraine caused natural gas prices to rise even further and created a disruption to global fertilizer supplies, which further propelled the stock. Defense contractor L3Harris Technologies (LHX, Financial), generally hedged against inflation and recession, benefited from improved Department of Defense budgets and increased international defense spending.
The portfolio’s greatest absolute detractors hailed from a variety of sectors. Global multi-industrial company GE (GE, Financial) underperformed as its renewables segment and aviation segment contended with inflationary pressures and supply chain pressures, respectively. These temporary concerns have depressed valuation, thereby creating an attractive risk/reward ratio. We believe plans to begin to separate the conglomerate next year will highlight the value of the businesses within GE. Walt Disney (DIS, Financial) shares suffered from investor concerns about the ability of the company to meet the aggressive growth targets of its Disney+ streaming platform.
Compared with the benchmark, stock selection in health care contributed the most value to relative performance. Conversely, stock selection in communication services detracted the most from relative results, although our underweight position to the sector moderated losses.
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 six-month period were from varied sectors. In communication services, we initiated a position in Meta Platforms (META, Financial) late in the period following a significant correction in the stock. While questions remain about the company’s core business and its plans to invest significantly in research and development over the next few years, the sizable correction has created an attractive valuation and a reasonably good risk/reward profile from current levels. We also added to our position in News Corp. (NWSA, Financial). While we remain cognizant of the headwinds that the company faces, we appreciate its collection of high-quality assets with durable growth profiles. Further, we believe that shares are trading at a considerable discount to a sum-of-the-parts valuation. In financials, we added to our position in life insurance company Equitable Holdings (EQH, Financial) due to its compelling valuation. In our view, the company’s earnings are poised to benefit from operational earnings growth, share buybacks, and dividends. We also purchased shares of consumer staples name Conagra Brands (CAG, Financial), as we value the stock’s defensive nature and its growth potential within the frozen foods space.
Notable sales were also spread out among several areas of the market. Our largest equity sale was chicken, beef, and pork producer and processor Tyson Foods (TSN, Financial). We continue to appreciate the name but are concerned that increased feed costs will impact margins, particularly in chicken and beef. In financials, we moderated our positions in MetLife (MET), Wells Fargo (WFC), and Fifth Third Bancorp (FITB), all of which have been strong contributors in recent periods. Elsewhere in the portfolio, we exited our position in UnitedHealth Group (UNH) given its premium valuation and took profit from Elevance Health and Cigna by paring shares.
The portfolio’s largest sector allocation is in financials. We remain overweight relative to the benchmark, but we decreased our absolute exposure during the period. The portfolio’s second-largest sector allocation is in health care, where our absolute exposure increased. Utilities, our third-largest sector allocation, is significantly overweight the benchmark, and this overweight increased on an absolute and relative basis over the period. Please note that weighting versus the benchmark also changed as a result of the reconstitution of the benchmark index that took place in June.
What is portfolio management’s outlook?
We believe the cone of uncertainty is abnormally wide now, with potential outcomes dependent on events outside of our control. Additionally, the Russian invasion of Ukraine has structurally increased geopolitical risk while exacerbating already high inflationary pressures, contributing to the market pricing in higher odds of a recession.
Given this view, we have been focusing on creating a portfolio that is balanced for a variety of market settings. We used weakness in select names to take advantage of opportunities in the market where the risk/reward ratio was particularly attractive while being cognizant of our beta. Our focus remains on investing in higher-quality companies where there is a confluence of compelling valuations, attractive long-term fundamentals, and strong dividend yields.
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.
