The Oakmark Select Fund’s performance since the end of the second quarter has been dreadful. Not only has the market declined significantly, but our Fund has fared meaningfully worse. What is especially frustrating is that this decline has not been caused by an unusual number of reductions in the earnings or growth prospects of the businesses we own. One of the primary negatives has been fear in the home mortgage market. This has caused sharp declines in the stocks of mortgage originators, and our largest holding, Washington Mutual, has been hit hard, though not as hard as many in that business. We believe that Washington Mutual has taken on less risk in their loan portfolio than their peers have, as demonstrated by the strong credit ratings of their borrowers (FICO scores) and their lower loan-to-value ratios. Further, as a bank, Washington Mutual has much longer term funding than do pure mortgage originators, which means that they have more control over the decision to maintain their mortgage investments than do competitors that rely on short term borrowing. Because poorly funded competitors are exiting the business, this difficult period should end up enhancing Washington Mutual’s long term earnings potential.
Select Fund’s performance has also been hurt by most of our other holdings. Despite continued strong operating performance by businesses like McDonalds, Yum Brands (Taco Bell, KFC, Pizza Hut), Viacom (MTV, Nickelodeon, Comedy Central) and Limited Brands (Victoria's Secret, Bath and Body Works), their stock prices have fallen. We believe this divergence will be temporary, but we are also aware of how difficult this is for our investors, which is why I wanted to share this message reinforcing our approach to investing.
Oakmark’s investment philosophy is centered on the belief that in the long run, business performance and stock price performance converge. In the short run, however, stock price performance is controlled by supply and demand, which is strongly influenced by investor emotion. Those short-term disconnects create opportunity that we attempt to capitalize on. We buy businesses we believe are growing and well-managed, and we do so when we believe the company’s stock price does not reflect its real value. Then we wait. Over time, when price and value become consistent, we sell our stock and look for a new opportunity. The waiting part can be frustrating, especially at a time when our stock prices are moving in the wrong direction. But there are only two ways we can fail – we can fail if our analysis is wrong, and we can fail if we run out of patience.
Obviously, I can’t guarantee that our analysis today is right. And no doubt, we will prove to be too optimistic on some of our business value estimates. But I can assure you that the talent level and effort that goes into our analysis today is every bit as strong as it has been throughout our Fund’s history. I can also assure you that we won’t make the second mistake, running out of patience. Throughout our company’s 31-year history, we have used this same investment approach. We have previously endured times when other investors did not care about business value, and we have seen our patience rewarded. All of our investment professionals are committed to long-term value investing, and as frustrating as periods of underperformance are to us, we know they lead to opportunity.
Finally, I can assure you that we at Oakmark remain economically aligned with you, our shareholders. Personally, I don’t own stocks except through our funds. My largest investment is in The Oakmark Select Fund, and I have purchased more shares this quarter. The last few weeks have been as frustrating as any period I’ve experienced in my career. That frustration, however, will not cause us to abandon the discipline that has served us so well for so many years. We appreciate your patience and the confidence you have shown in our investment philosophy. Prices and values will eventually converge, and we believe that convergence will be positive for our results.
Bill Nygren
August 16, 2007
oaklx@oakmark.com
As of 6/30/07, The Oakmark Select Fund held the following equities as a percentage of the total net assets: Washington Mutual 13.88%; McDonald’s 6.30%; Yum Brands 8.43%; Viacom 4.19%; and Limited Brands 4.12%.
Portfolio holdings are subject to change and are not intended as recommendations of individual stocks.
Investing in value stocks presents the risk that value stocks may fall out of favor with investors and underperform growth stocks during given periods.
Because Select Fund is non-diversified, the performance of each holding will have a greater impact on the fund’s total return, and may make the fund’s returns more volatile than a more diversified fund.
The discussion of investments and investment strategy of the Funds (including current investment themes, the portfolio managers’ research and investment process, and portfolio characteristics) represents the investments of the Funds 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.
