I wish I had better news to report, but The Oakmark Select Fund’s investment losses have continued since I last corresponded with you in September. Given this weak performance, I thought that reviewing why we own what we own might be helpful since many of you use year end as a time to re-evaluate your investments. I’d like to address our holdings by categorizing them into four groups. Be aware that new information could cause us to quickly change our opinion on any stock. (Holdings are as of September 30, because we only report changes quarterly.)
First, there are four stocks in the portfolio that I would no longer buy at today’s prices: Discovery Holdings, Dun & Bradstreet, McDonalds and Yum Brands. We have profited greatly from these holdings. They are great businesses, our value estimates have increased more than we projected, but the stocks have increased even more. These stocks now trade much closer to our sell targets than our buy targets. We would sell these stocks if their sell targets were exceeded or if we need to make room for other stocks that become more attractive.
Next, the largest category of our holdings is the companies that have been growing about as we expected — some a little better, some a little worse — and in our judgment still warrant purchase. That list includes Bristol-Myers, Dell, IMS International, Intel, JPMorgan, Liberty Interactive, Viacom, Western Union and Xerox. We expect that over the coming year, some of these will move to the first group and — through good stock price performance — will reach their sell targets.
The third category includes three stocks that went up significantly after we bought them, then had fundamental disappointments, and now are undergoing change: H&R Block, Limited Brands and Time Warner. H&R Block has new directors (whom we helped vote into office), is searching for a new CEO, and is exiting a disastrous mortgage business. Limited Brands has sold their unprofitable Express division and can now focus on their leading specialty chains, Victoria’s Secret and Bath & Body Works. Time Warner will also be under the leadership of a new CEO who will examine ways to increase the value of their AOL and cable divisions. In hindsight, we missed an opportunity to sell these stocks at higher prices. However, these companies are addressing their problems and current valuations look too attractive to sell them now.
The fourth category includes three stocks for which we clearly overestimated business value, and now have meaningful losses compared to our cost. They are Home Depot, Pulte Homes and Sprint. We continue to believe that the intrinsic value of each of these stocks exceeds its current price. However, we need to consider that we may be able to increase the Fund’s after-tax return by tax trading — or swapping into equally undervalued stocks that we don’t yet own. Our stocks in this category, as well as the strong performers in the first category, are the most likely holdings for near-term sale.
The fourth category also includes our largest holding, Washington Mutual. WaMu has been our most costly error. It has become clear that a higher percentage of WaMu’s mortgages are impaired than we had initially believed, and with an unprecedented decline in home values, this company has become much riskier than we had anticipated. Given what we know today, we should have sold WaMu stock some time ago when its price was higher. It would be cathartic to just sell WaMu now. However, I continue to believe the stock has a very attractive risk-return profile. WaMu's deposit franchise remains strong, and I find it highly unlikely that potential loan losses will overwhelm the company’s franchise value. Whenever we own a stock that declines sharply we ask ourselves the question: if we didn’t already own this would we buy it now? I’m confident that the answer for WaMu is a resounding “yes.”
At the beginning of 2007 WaMu accounted for 15% of the Fund’s assets. Despite buying a few more shares, its current weighting is just over half of that, and today it is no longer our largest position. This year, WaMu’s stock price decline has far exceeded the decline in our intrinsic value estimate. Because of that, our return expectations have increased and remain substantially higher than what we expect for our other holdings. However, because WaMu’s risk level is now much higher than what we originally estimated, I don’t believe it is appropriate to restore our prior weighting.
When we were out of sync in 2000, we believed our stocks were very attractive despite the market appearing overvalued. By 2003, stocks looked far more attractive to us than other asset classes, but compression of valuations lessened the value we could expect to add from stock selection. Now, after divergent performance in a generally strong market, we believe that selected companies are selling at unusually large discounts to their value. Therefore, we believe that the opportunity to add value via stock selection is again above normal.
Some holdings we had initially assessed as cheap are now even cheaper, which has hurt our recent performance. However, this also creates a bigger opportunity if those stocks recover. My confidence in our investment process and the team that implements that process leads me to believe that we will look back on today as an unusually attractive buying opportunity. That’s why I’ve again increased my personal investment in the Fund and would encourage you to consider doing the same.
Best Wishes,
Bill Nygren
December 18, 2007
oaklx@oakmark. com
As of 9/30/07, The Oakmark Select Fund held the following equities as a percentage of the total net assets: Discovery Holding Company 5.63%; The Dun & Bradstreet Corporation 2.60%; McDonald’s Corporation 6.82%; Yum! Brands, Inc. 8.11%; Bristol-Myers Squibb Company 4.04%; Dell Inc. 3.51%; IMS Health Incorporated 4.46%; Intel Corporation 4.19%; JPMorgan Chase & Co. 3.75%; Liberty Media Holding Corporation - Interactive 4.15%; Viacom, Inc. 4.14%; Western Union Company 3.29%; Xerox Corporation 3.94%; H&R Block, Inc. 6.21%; Limited Brands, Inc. 3.91%; Time Warner Inc. 4.65%; The Home Depot, Inc. 2.75%; Pulte Homes, Inc. 2.90%; Sprint Nextel Corporation 3.50%; and Washington Mutual, Inc. 13.11%.
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.
