The views and opinions in this report were current as of December 31, 2014. They are not guarantees of performance or investment results and should not be taken as investment advice. Investment decisions reflect a variety of factors, and the managers reserve the right to change their views about individual stocks, sectors, and the markets at any time. As a result, the views expressed should not be relied upon as a forecast of the fund’s future investment intent. The report is certified under the Sarbanes-Oxley Act, which requires mutual funds and other public companies to affirm that, to the best of their knowledge, the information in their financial reports is fairly and accurately stated in all material respects.
REPORTS ON THE WEB Sign up for our E-mail Program, and you can begin to receive updated fund reports and prospectuses online rather than through the mail. Log in to your account at troweprice.com for more information.
Fellow Shareholders The U.S. stock market enjoyed a solid year as corporate earnings grew at a healthy pace. Given the number of geopolitical hotspots and slower rates of economic growth around the world, the U.S. market also benefited from a flight to quality as global investors sought out the relative safety of U.S. investments. This was particularly noticeable in the fixed income market, as long-maturity Treasury securities generated powerful returns.
As shown in the Performance Comparison table, the Equity Income Fund returned 1.28% and 7.49% for the 6- and 12-month periods ended December 31, 2014, respectively, lagging the S&P 500 Index and the Lipper Equity Income Funds Index in both periods. (Returns for the Advisor and R Class shares are also shown and reflect their different fee structures.) We were disappointed with the fund’s results this year, which were held back by the weak performances of a number of our larger positions. Many of these companies posted positive returns but still trailed the strong advance of the S&P 500.
Dividend Distribution
On December 10, 2014, your fund declared a fourth-quarter net income dividend of $0.17 per share, payable to shareholders of record on December 12. You should already have received your check or statement reflecting this distribution. The December dividend brings
your total dividends in 2014 to $0.66 per share. In addition, on December 12, your Board declared a long-term capital gain distribution of $1.78 per share, reflecting the gains realized on investments sold in 2014. (Distributions for the Advisor and R Class shares were different.)
Portfolio Review
Unfortunately, 2014 marked a period in which our stock selection was simply disappointing. We were particularly hurt by several of our larger holdings in the energy sector, almost all of which declined in price as the price of oil dropped dramatically in the fall. These included Chevron (CVX, Financial), ExxonMobil (XOM, Financial), and Apache (APA, Financial)—all solid companies that could not withstand the impact of the generally weak sector. (Please refer to the fund’s portfolio of investments for a complete list of holdings and the amount each represents in the portfolio.)
In addition, several positions that had performed well for us over the long term, such as Boeing (BA, Financial), Emerson Electric (EMR, Financial), and Eaton, all lost value during the year. Our traditional holdings of higher-yielding telecom services companies, including AT&T (T, Financial) and Verizon (VZ, Financial), suffered as well. Other portfolio positions—American Express (AXP, Financial) and Honeywell International (HON, Financial) among them—generated positive returns but failed to match the 13.69% return of the broad market, as measured by the S&P 500 Index.
The big surprise of the year was the utilities sector, which outperformed other areas of the market as yield-starved investors continued to search for income-producing securities. Fortunately, we held several major utilities stocks among our top holdings, including Duke Energy (DUK, Financial) and Entergy (ETR, Financial), which contributed nicely to performance.
Other winners in the portfolio were materials companies DuPont, MeadWestvaco, and International Paper; media giants Walt Disney and Time Warner; and technology stocks Microsoft, Apple, and Corning.
As shown in the Major Portfolio Changes table, we eliminated several positions that had performed very well and contributed to the fund’s performance over the long term. Stocks we eliminated were United Continental, Legg Mason, Petrobras, Allstate, and Norfolk Southern. We reduced our investment in Apple, as the stock has rebounded sharply and reached a level that no longer strikes us as attractive.
During the year, we initiated positions in MetLife, Qualcomm, IBM, and Rayonier and added to Loews and Mattel. Their share price valuations were appealing, and the companies either pay relatively high dividends or repurchase their own stocks in the marketplace—some of them employing a combination of the two.
Outlook
The U.S. economy continues to grow at a reasonably healthy pace. The housing sector is recovering, and job growth has resulted in the unemployment rate dropping to 5.6%. Business confidence is relatively high. The Federal Reserve has been deliberating about when it will begin to raise short-term interest rates. Other economies around the world, such as Japan and the eurozone, appear to be facing more headwinds. Growth has been slowing in China and other large developing economies. An important question for 2015 is to what extent lower rates of growth elsewhere will affect the revenue and earnings growth of U.S. companies.
We would not be surprised to see more volatility in 2015 than we experienced last year. We are also somewhat wary of U.S. stock valuations, with the S&P 500 price/earnings ratio standing at 16.8 times projected earnings for the next 12 months at the end of 2014. We recognize that stock prices have advanced steadily since early 2009, when stocks hit bottom in the aftermath of the global financial crisis. We have often used the phrase “cautiously optimistic” to describe our outlook for equities. As we enter 2015, we find ourselves a bit more cautious and a little less optimistic. We believe this will be a challenging year, as it has become increasingly difficult to find attractively valued investment opportunities.
Finally, you may recall that we announced in June that John Linehan will succeed me as portfolio manager of the fund this coming November. Consequently, this is my last Equity Income Fund annual report to you. When we introduced the fund in 1985, I never expected to manage it for 30 years, and it has been an honor to oversee your investments over the decades. Passing the baton is easy when you know the recipient will do a great job in the future. John and I will be working closely in 2015 to ensure a seamless transition.
As always, we will continue to do our best to identify sound investments on your behalf.
Respectfully submitted,
Brian C. Rogers
President of the fund and chairman of its Investment Advisory Committee
January 19, 2015
The committee chairman has day-to-day responsibility for managing the portfolio and works with committee members in developing and executing the fund’s investment program.
