Dear Shareholder
Stocks posted strong gains in 2019 as most major U.S. indexes hit record highs in a broad-based rally that more than offset 2018’s losses. Large- and mid-cap growth stocks were the strongest performers, with the S&P 500 and Nasdaq benchmarks recording their best year since 2013. U.S. shares outpaced their global counterparts, although most non-U.S. indexes also finished with solid double-digit gains.
Technology shares performed best within the S&P 500, helped by strong gains from industry giants Apple and Microsoft, and financial stocks also outperformed the broader market. Fixed income securities produced solid gains during the period as well—with corporate bonds leading the way—as longer-term Treasury yields fell to historic lows in late summer before partially rebounding.
In a sign that public markets have retained discipline, investors expressed skepticism about certain private-equity valuation levels when compared with their prospects for financial profitability. Relatively few initial public offerings (IPOs) saw their prices appreciate during the year, and one high-profile IPO candidate (WeWork) decided to withdraw its offering altogether after its valuation was dramatically reduced in the weeks before its proposed IPO.
Although the year opened with concerns that an escalating U.S.-China trade dispute could lead to a recession, global central banks played a key role in supporting markets. Fed policymakers delivered quarter-percentage-point rate cuts in July, September, and October and took steps to maintain liquidity in short-term lending markets. Other central banks also acted to address flagging growth, including the European Central Bank, which lowered its benchmark deposit rate deeper into negative territory and announced that it was restarting its quantitative easing program.
The pivot to a more accommodative monetary policy was a marked change from 2018, when the Fed raised rates four times, and appeared to be successful in reenergizing the economy. After contracting earlier in 2019, key U.S. manufacturing indicators showed signs of stabilizing by year-end, and the labor market remained strong, with solid payroll gains and an unemployment rate hovering near a 50-year low. With this more encouraging economic backdrop, it was not a surprise that in December Fed officials seemed satisfied that monetary policy was properly positioned to support continued growth and forecast no additional rate moves in 2020.
Besides central bank policy, investors also closely followed developments in the U.S.-China trade dispute. Stocks stumbled in May and August after the U.S. announced new tariffs on some Chinese imports and China retaliated with new tariffs of its own. However, investors generally took an optimistic view of trade negotiations, which limited the trade war’s toll on markets, and in December the two countries announced a “phase one” agreement to reduce some existing tariffs and cancel the imposition of new ones.
With monetary policy worldwide largely committed to ensuring market liquidity and some global economic indicators showing signs of improvement, there are reasons to be optimistic in 2020. However, we caution investors not to expect the outsized gains of the past year. If the post-World War II era is to be a guide, the S&P 500 has on average generated mid-single-digit returns in the fourth year of a presidential cycle.
Further market advances will likely hinge on a resumption in earnings growth, which stalled in 2019, and there is no shortage of global risks in the year ahead. Unresolved trade issues, tensions in the Middle East, and policy debates on taxes, health care, and wealth disparity leading up to the U.S. presidential election all have the potential to cause market volatility.
In addition to these risks, T. Rowe Price analysts will be closely following how disruptive forces such as innovation, technological change, and automation could impact a growing number of global industries. In an uncertain environment, with a wide dispersion of returns possible, we believe that in-depth fundamental research that integrates environmental, social, and governance considerations will be critical to successfully assess opportunities and risks. I am confident our strategic investing approach will continue to serve our shareholders well.
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 26.58% for the 12 months ended December 31, 2019. The fund performed in line with the Russell 1000 Value Index and outperformed 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?
Absolute contributors were spread throughout several sectors. In financials, shares of JPMorgan Chase (JPM, Financial) outperformed as the global bank continued its trend of rising profitability fueled largely by stronger-than-expected net interest income. Improved sentiment for big banks amid rising market optimism also boosted shares late in the period. In the information technology sector, shares of Qualcomm (QCOM, Financial) finished higher as a result of the chip manufacturer reaching a multibillion-dollar settlement with Apple in the second quarter, followed by stronger-than-expected revenues later in the year, as Mobile Station Modem chip shipments exceeded expectations. Microsoft (MSFT, Financial) continued to generate strong growth within cloud computing through its Intelligent Cloud, which includes Azure, on-premises, and professional service offerings. Investors also reacted positively to the software giant’s $10 billion Pentagon cloud contract win late in the period. (Please refer to the portfolio of investments for a complete list of holdings and the amount each represents in the portfolio.)
Elsewhere in the portfolio, investors reacted positively to news that Southern Company’s (SO, Financial) Vogtle nuclear power project is progressing and were drawn to the sector’s durable earnings profile during several periods of market volatility during the year. Shares of Tyson Foods (TSN, Financial) continued to benefit from the ongoing effects of African swine fever, causing global protein prices to rise in the wake of the outbreak, and the reopening of the Chinese market to U.S. poultry sales later in the year. TC Energy (TRP, Financial), a utility-like infrastructure company that also operates an irreplaceable natural gas pipeline in the U.S., was a significant contributor. Shares finished higher over the year after a series of successful asset sales have, in our view, positioned the company to transition into a self-funding business.
Detractors hailed from several sectors. Share prices of global energy exploration and production company Occidental Petroleum (OXY, Financial) fell as the firm pursued a debt-fueled takeover of Anadarko Petroleum. The market balked not only at the valuation and strategic rationale for the deal, but also at the way Occidental Petroleum financed the transaction seemingly to avoid a shareholder vote. Shares of DuPont de Nemours (DD, Financial) traded lower as a result of concerns over the company’s ultimate liability to remediate chemical contamination in water systems surrounding some of its plants and slowing demand in its end markets. Pfizer (PFE, Financial) shares suffered following the company’s decision to spin off Upjohn, its off-patent drug business, into a standalone firm, which will subsequently merge with Mylan. Shares of PG&E (PCG, Financial) declined due to concerns that the utility could face significant liability claims amid massive wildfires in California. We eliminated our position due to concerns regarding the company’s future profitability.
Compared with the benchmark, stock selection in the consumer staples and information technology sectors added the most to performance. On the other hand, stock selection in communication services and materials detracted the most from relative returns.
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.
Given our cautious outlook, we are positioned neutrally relative to our benchmark in terms of companies tied to the economic cycle. Our exposure to financials, the fund’s largest sector, reflects much of our cyclical positions and remained broadly unchanged in absolute terms but declined relative to the benchmark as we trimmed holdings that performed well over the year. We reduced our positions in JPMorgan Chase and Citigroup (C, Financial) after strong performance. We eliminated our stake in Ameriprise Financial (AMP, Financial) due to our concerns with the stock’s risk-adjusted upside in light of recent share price appreciation. We increased our position in Wells Fargo (WFC, Financial), our top holding at period-end. Despite the onslaught of reputational and regulatory problems stemming from a fake customer accounts scandal in 2016, we believe Wells Fargo has good long-term fundamentals and has made progress in addressing past issues in its sales culture. We also like the bank’s expense discipline.
Our allocation to health care, the second-largest allocation, declined in absolute terms but rose relative to the benchmark. We eliminated our holdings in Merck (MRK) midway through the period after a strong run and bought a stake in AbbVie (ABBV) in the wake of its announced acquisition of Allergan (AGN), a deal that we believe provides the company with several new durable revenue streams. Before its deal with AbbVie was announced, we also initiated a position in Allergan early in the period and increased our stake in the runup to the deal announcement.
Other notable equity subtractions include Microsoft, Johnson Controls International (JCI), and Hess (HES), all of which we trimmed on strength. In utilities, we took advantage of share price appreciation to exit our position in Duke Energy (DUK). We are wary of the company’s elevated debt load, ongoing legal troubles regarding its Atlantic Coast Pipeline, and worsening risk/reward profile relative to its peers. We added to our stake in GE (GE). Though we acknowledge prior management’s missteps and the remaining challenges GE faces, we remain confident in the current leadership team. We also like the company’s attractive valuation and its progress on its turnaround efforts. While its power business continues to struggle, we believe the current management team will be successful in de-risking its balance sheet and turning around struggling businesses.
What is portfolio management’s outlook?
U.S. stocks surged in 2019, with several major indexes hitting all-time highs in the second half of the year. The Federal Reserve’s decision to keep rates steady in the first half of the year and then reduce them three times starting in July was a major driver of market performance. Trade discussions between the U.S. and China also drove market sentiment. Speculation arose numerous times during the year that the two countries were “close” to reaching an agreement, though occasional tensions seemed to reduce its likelihood. A preliminary “phase one” trade deal was not officially struck until December.
Hard economic data remain weak, but economic indicators appear to be bottoming. Moreover, the Federal Reserve’s accommodative monetary policy and a warming in U.S.-China trade relations have improved investor sentiment.
Given the strength of the market over the past year, we believe investors may be too complacent; caution is warranted. While a strong consumer and more accommodative monetary policy provide support, we believe political, regulatory, and geopolitical risks are likely to be elevated in 2020. Given this backdrop, we expect positive but muted returns for the equity market in 2020 coupled with the potential for more extreme outcomes.
Share price appreciation in recent periods has made pockets of attractive investment opportunities tougher to come by. Despite this challenging environment, we have identified attractively valued investment opportunities through bottom-up, fundamental analysis and continue to maintain a disciplined, longer-term approach while also taking advantage of volatility to selectively add shares of high-quality companies.
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.
