In terms of the fiscal year that ended on September 30, the Fund earned 1% and the Lipper Balanced Fund Index earned 2%. Retailer TJX had the largest positive effect on the Fund’s fiscal-year return followed by Goodrich, Avon Products, Costco and Hospira. The most significant detractors were Medtronic and ITT (both sold in the March quarter), along with Mohawk Industries. The annualized compound rate of return since the Fund’s inception nearly 14 years ago is 11%, over which time the Lipper Balanced Fund Index return is 6%.

Environmental Change
“The accuracy of an economic vision is not always commensurate with the analytical ability of those who hold it. Pessimistic visions about almost anything always strike the public as more erudite than optimistic ones.” -- Joseph Schumpeter

One year ago, the pessimistic vision held sway around the world as weaknesses in the financial system were exposed. Some authorities have asserted that the economic world came close to seizing up last fall. Writing one year later, we know that the stock market hit its nadir in early March and has since rocketed upward. It appears to us that the value compression that developed in the bear market was both excessive and unsustainable, helping to make the rebound of the past six months more explicable.

We believe the re-emergence of mergers and acquisitions activity during the recent quarter is one indication that the economy may be returning to something approaching normal. The Equity and Income Fund contained one beneficiary of such activity: Varian Inc. In July, former Fund holding Agilent agreed to purchase Varian for $52 in cash. Although the offer price was well below the stock’s all-time high price, it was more than twice Varian’s March share price. We are sorry to lose such an interesting company from the Fund, but are pleased to see that an intelligent management team endorses one of our value judgments. As value investors, we expect our portfolios to benefit occasionally from merger and acquisition activity. In fact, the absence of acquisitions in the Fund could indicate poor price discipline or style drift on our part. We are gratified to have two cash buyouts in the Fund this year: UST and Varian.

On a related note, during last November’s tumultuous times, we observed that Chesapeake Energy had completed two sales of natural gas production properties. These sales were to respected purchasers and at prices that validated our methodology for valuing companies in that industry. We have consistently argued that the prices of oil and gas properties are far more stable than the prices of the commodities they produce, and we believe that Chesapeake’s distress sales support our case.

Transaction Activity
The portfolio grew by five equity holdings in the quarter, as we initiated positions in seven companies while eliminating two. As usual, the only thing that the new holdings have in common is what we believe to be their attractive valuation. The companies range from relatively small (Diebold) to very large (Cisco Systems, at one time the highest market capitalization company in the world). A few of the new issues allowed us to purchase the position sizes that we desired, while others’ share prices quickly rose out of our buy range. Shareholders periodically ask why we put up with the “clutter” in the portfolio that emerges from the application of our price discipline. Our response is that we can put up with almost anything if it adds to shareholder value and complies with the Fund’s prospectus limits. One example is the spinoff from Walter Energy, named Walter Investment Management Corp. Soon after the spinoff the new concern’s price dropped to a point where the Fund’s position was equal to merely 0.05% of the Fund. Had we chosen simply to eliminate this “clutter” at that moment, the Fund would have missed out on the subsequent price rebound, at current prices worth roughly $11 million in incremental value. “Profitable clutter” we say.

Touching on the new names alphabetically, Broadridge Financial provides the financial industry with outsourcing services. Formerly part of Automatic Data Processing, Broadridge supplies investor communications solutions (proxy distribution and processing), as well as securities processing and clearing services. Another—and perhaps better known—new holding is Cisco Systems, which develops and markets data networking equipment, such as routers and switches. Cisco’s high profitability gives the company a powerful balance sheet with plentiful net cash. The aforementioned Diebold is primarily a manufacturer and servicer of automated teller machines (ATMs). The fourth new purchase, L-3 Communications Holdings, is the first position in the Fund’s history that has a number in its name. The company provides military communications equipment—a product line that should benefit from the continued need for intelligence and reconnaissance activity. Next, Precision Castparts manufactures complex metal components for aerospace and industrial gas turbines. Former Fund holding Rockwell Automation returned to the portfolio. We have always appreciated the company’s market position and shareholder orientation, and we are pleased to resume an ownership position. U.K.-based Unilever adds to the Fund’s international exposures, especially given the company’s strong presence throughout developing and emerging markets. We are also attracted to the evolution of the company’s management structure. Finally, we eliminated two holdings in the quarter: Dish Network and Washington Post.

The Trouble with Bonds
“Bonds: Why Bother?” writes well-known investor Robert Arnott in a now famous article in the April edition of the Journal of Indexes. The article’s title is deceptive because Arnott actually argues that investors’ faith in equities is misplaced. Arnott seeks to deflate the arguments that 1) stocks earn superior returns to long-term bonds and 2) stocks always rebound strongly from periods of under-performance so that true long-term investors will enjoy higher returns in equities with little additional risk. Demonstrating his case with a powerful, albeit extreme, example, Arnott calculates that for the 40-year period ending February 2009, investors in 20-year U.S. Treasury bonds earned marginally higher returns than stock index fund investors. (Of course, index funds did not actually exist in 1969.) Arnott also notes that “it’s hard to construct a scenario that delivers a 5 percent risk premium for stocks, relative to Treasury bonds, except from the troughs of a deep depression…”

History will finally decide whether we are emerging from a depression trough, but whatever happened, it was certainly deep and depressing. Economic indicators are currently quite conflicted, and the unparalleled extent of governmental intervention makes forecasting hazardous. But with Treasury bond yields at their current levels it is hard to envision a long-term outlook in which equity returns do not outdistance bonds. In recent years we have written voluminously about the Fund’s fixed income component and our struggles to balance risk, reward and liquidity. As noted early in this report, we have reduced the Fund’s holdings of inflation-indexed bonds because we found them to be expensive relative to standard-issue Treasurys given the low inflation environment that we expect to prevail for some time. Inflation may simply be a monetary phenomenon, and worldwide monetary authorities are working diligently to expand the money supply. Nevertheless, it is hard to ignite inflation in an environment of declining unit labor costs. In the future when employment figures improve and unit labor costs rise, we expect the Fund’s fixed income segment to look quite different than it does today.

Once again, we thank you for being our shareholders and invite your questions and comments.

Clyde S. McGregor, CFA
Portfolio Manager
oakbx@oakmark.com

Edward A. Studzinski, CFA
Portfolio Manager
oakbx@oakmark.com

 

As of 9/30/09, Avon Products, Inc. represented 3.4% of The Oakmark Equity and Income Fund’s total net assets, Apache Corp. 2.4%, Walter Energy, Inc. 1.2%, Costco Wholesale Corp. 2.3%, EnCana Corp. 3.1%, Alliant Techsystems, Inc. 0.6%, Laboratory Corp. of America Holdings 2.0%, Broadridge Financial Solutions, Inc. 0.3%, The TJX Cos., Inc. 2.1%, Goodrich Corp. 1.5%, Hospira, Inc. 2.2%, Medtronic, Inc. 0%, ITT Corp. 0%, Mohawk Industries, Inc. 0.7%, Varian Inc. 0.2%, Agilent Technologies Inc. 0%, UST Inc. 0%, Chesapeake Energy Corp. 0%, Diebold, Inc. 0.2%, Cisco Systems, Inc. 0.6%, Walter Energy, Inc. 1.2%, Walter Investment Management Corp. W/I 0.1%, L-3 Communications Holdings, Inc. 1.5%, Precision Castparts Corp. 0.3%, Unilever NV – ADR 0.3%, Unilever PLC – ADR 0.4%, Rockwell Automation, Inc. 0.3%, EchoStar Corp. 0%, and The Washington Post Co., Class B 0%. Portfolio holdings are subject to change without notice and are not intended as recommendations of individual stocks.

The Lipper Balanced Fund Index is comprised of 30 balanced funds. This index is unmanaged and investors cannot actually make investments in this index.

“Bonds: Why Bother?” Robert Arnott, Journal of Indexes, April 20, 2009.

Investing in value stocks presents the risk that value stocks may fall out of favor with investors and underperform growth stocks during given periods.

Equity and Income invests in medium- and lower-quality debt securities that have higher yield potential but present greater investment and credit risk than higher-quality securities, which may result in greater share price volatility. An economic downturn could severely disrupt the market in medium or lower grade debt securities and adversely affect the value of outstanding bonds and the ability of the issuers to repay principal and interest.

The discussion of the Funds’ investments and investment strategy (including current investment themes, the portfolio managers' research and investment process, and portfolio characteristics) represents the Funds’ investments and the views of the portfolio managers and Harris Associates L.P., the Funds' investment adviser, at the time of this letter, and are subject to change without notice.