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T. Rowe Price Equity Income Fund Semi-Annual Letter 2019

Dear Shareholder

Markets overcame a bout of volatility in May and recorded exceptional returns in the six months ended June 30, 2019. The large-cap S&P 500 Index reached record highs and notched its best start to a year in over two decades. Overseas equity markets were also strong, while bond prices rose as longer-term interest rates fell to their lowest levels since late 2016.


Markets rebounded to start the year, as many of the worries behind the sell-off in late 2018 receded. Investors seemed most relieved by a dovish pivot in monetary policy. The S&P 500 scored its best daily gain for the period on January 4, after Federal Reserve Chair Jerome Powell pledged that the central bank would respond with all the tools at its disposal to counteract an economic downturn or financial turmoil. The Fed soon paused and kept rates steady following a series of quarterly hikes stretching back to late 2017.

Investors also seemed comforted by progress in U.S.-China trade relations. In March, President Donald Trump postponed a threatened tariff increase on Chinese goods and remarked that the two sides were "getting very close" to a deal. Encouraging statements continued to flow from the White House, and speculation grew that Chinese President Xi Jinping would soon visit Washington to sign an agreement.

Hopes for a deal were dashed in early May, however, sending stocks sharply lower. With negotiations at a standstill, on May 10, the administration increased the tariff rate to 25% from 10% on $200 billion in Chinese goods, as the president had long threatened. China soon retaliated with its own tariffs. A technological "cold war" also seemed to be developing, with both sides taking measures to cut off the other's access to key components and raw materials. Stocks fell sharply in response, and the small- and mid-cap indexes moved back into correction territory, or down more than 10% from the highs they established late in the previous summer.

Another turn in trade policy in June helped stocks recover their losses. The White House abandoned an earlier threat to put tariffs on Mexican imports in response to immigration issues, and President Trump again softened his stance on China. Markets were closed on the final weekend of the month, when the president announced that he and President Xi had agreed to resume trade negotiations and arranged a truce that would at least temporarily prevent the imposition of further tariffs.

An even bigger factor in the June rebound appeared to be growing confidence that the Fed would cut interest rates rather than merely keep them steady. Fed Chair Powell pledged that policymakers were paying close attention to the impact of trade tensions on the economy and would "act as appropriate to sustain the expansion." Policymakers also dropped references to being "patient" in adjusting monetary policy. By the end of the month, futures markets were pricing in 75 basis points (0.75 percentage point) of cuts in the second half of the year, with a reasonable chance of more to come in 2020.

The dovish shift in Fed policy has been driven by accumulating evidence of slowing global growth. Rising trade barriers have taken a heavy toll on the global manufacturing sector, and business investment has pulled back as managers confront additional sources of uncertainty, such as the possibility of a disorderly Brexit this October. As a result, corporate earnings growth has stalled in the U.S. and turned negative in other major markets. On the positive side, consumers remain in much better shape, particularly domestically.

We see little evidence to suggest a recession is on the horizon. Indeed, with markets at all-time highs, investors seem willing to bet that this decade-long economic recovery still has legs. We will keep a close eye on developments and rely on our careful fundamental research to avoid pitfalls; 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,

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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 six months?

The Equity Income Fund returned 15.75% for the six months ended June 30, 2019. The fund underperformed the Russell 1000 Value Index and performed in line with its peer group, the Lipper Equity Income Funds Index. Returns for the Advisor, R, and I Class shares varied slightly due to different fee structures. (Past performance cannot guarantee future results.)

What factors influenced the fund's performance?

Information technology stocks comprised many of the fund's best performers as the sector rebounded from a sizable selloff in the last quarter of 2018. Qualcomm was the fund's top contributor after the mobile phone chipmaker reached a settlement with Apple in a long-running legal dispute over patent royalties, pushing up the company's shares to their highest levels since 2014 at the end of June. Software company Microsoft and network equipment maker Cisco Systems also ranked among the fund's leading contributors. In the consumer staples sector, Tyson Foods helped returns as fundamentals in the chicken market improved and an outbreak of African swine fever across Asia last year led to expectations for higher U.S. protein prices. Among financials, American International Group contributed to performance after the insurer reported better-than-expected earnings in May after six quarters of earnings misses, aided by a long-awaited turnaround in its core property-casualty business. (Please refer to the portfolio of investments for a complete list of holdings and the amount each represents in the portfolio.)

Detractors were concentrated in health care, the biggest laggard year-to-date, as political pressure to contain drug and other health care costs raised fears of government intervention. Company-specific events also weighed on our health care holdings: CVS Health held back returns after the pharmacy chain gave a downbeat financial forecast in February due to weakness in its pharmacy benefit management and long-term care businesses. Bristol-Myers Squibb hurt performance after the drugmaker unexpectedly announced that it would divest a psoriasis treatment to address regulatory concerns related to its planned acquisition of Celgene. Other detractors hailed from various sectors: State Street hurt returns after the custody bank warned of a tougher operating environment due to the flattening U.S. Treasury yield curve, sending its shares to a nearly three-year low by period-end. Occidental Petroleum (NYSE:OXY) detracted from performance as the market reacted negatively to the company's controversial $38 billion takeover of Anadarko Petroleum, which angered major shareholders after Occidental's board pushed through the deal without a shareholder vote. Occidental was the biggest detractor in the first half, and its shares fell to their lowest level in more than a decade at the end of June.

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 exposure to financials, the fund's largest sector allocation, remained broadly unchanged as we trimmed holdings that performed well over the year's first half and bought names whose valuations had fallen to attractive levels. We reduced our position in JPMorgan Chase after strong performance and in regional bank KeyCorp due to its relatively high credit exposure. We increased our position in Wells Fargo (NYSE:WFC), 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 that Wells Fargo's stock price reflects much of the bad news surrounding the company and that it offers the most attractive risk/reward opportunity among U.S. large-cap banks.

Our exposure to health care, the second-largest allocation, declined. We reduced our holdings in Merck after a strong run and increased our positions in CVS Health and Bristol-Myers Squibb after share price weakness in both companies left their risk/reward profiles more attractive. Industrials and business services accounted for the third-largest sector allocation but our largest overweight versus the benchmark. Our exposure to industrials and business services increased slightly, reflecting the sector's broad gains and a few key purchases. We added to our position in conglomerate GE (NYSE:GE), which has sustained many problems across its businesses over the past two years but lately made tangible progress in addressing balance sheet concerns and turning itself around under a new chief executive.

Other names we bought that are experiencing near-term controversy included Qualcomm (NASDAQ:QCOM), which remains under a legal cloud after a federal judge ruled in May that the company violated U.S. antitrust laws. Despite the company's legal headwinds, we think that the market has underappreciated Qualcomm's earnings growth potential and continue to like the stock over the long term. We added to our position in timberland owner Weyerhaeuser (NYSE:WY), whose shares lost more than a third of their value in 2018 amid a glut in domestic lumber supply spurred by a cooling housing market and the trade dispute with China. Weyerhaeuser generates strong cash flow and pays a hefty dividend yield, however, and we took advantage of its weakness to increase our position. In the materials sector, we added to Dow (NYSE:DOW), the commodity chemicals company that recently completed its spinoff from conglomerate DowDuPont. Although Dow operates in a cyclical industry that is levered to global demand, the company benefits from having a strong balance sheet, an above-market dividend yield, and a management team focused on cost-cutting and prudent capital allocation. We think that Dow's internal discipline helps offset the unpredictable nature of its business.

What is portfolio management's outlook?

The S&P 500 Index recorded its best first-half performance since 1997 after the Federal Reserve signaled in June its willingness to cut interest rates if the economic outlook doesn't improve. While the Fed's unexpectedly dovish turn makes us uneasy because it raises the possibility that the central bank capitulated to presidential pressure to keep rates low, we interpret its latest decision as a sign that it will serve as a corrective mechanism if U.S.-China trade talks founder and end up slowing the economy's momentum. As we stated in our year-end 2018 letter in December, the trade rift with China remains a major source of investor anxiety and a growing threat to confidence and spending for consumers and businesses the longer it drags on. Despite the temporary detente struck at the G-20 summit in June, the U.S. and China harbor deep differences on intellectual property theft, technology transfer, China's industrial policy, and other issues that defy a quick or easy resolution. We anticipate that trade tensions with China and other geopolitical flareups will spur heightened volatility in the coming months, particularly if evidence grows that the latest tariff hikes are hurting consumer spending or corporate earnings.

Valuations appear mildly expensive following the first half runup, but we are still finding companies that offer good value on an absolute and relative basis. Though we realize that periods of high volatility can be unsettling, they lead to the best buying opportunities for long-term investors since they allow us to buy and sell companies at more attractive prices. Our disciplined investment approach, attention to valuation, and in-depth knowledge of our holdings accumulated by T. Rowe Price's equity research team have served us well in uncertain environments over many years. We are confident that these qualities will allow us to navigate what we believe will be a turbulent market environment for the rest of 2019.

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.

This article first appeared on GuruFocus.