THE OAKMARK BALANCED FUND

Report from Clyde S. McGregor, Portfolio Manager

In my last quarterly letter I described how corporate takeovers and mergers inform our equity analysis process. I also noted that “our portfolios do occasionally experience such pleasant surprises.” Well, the recently concluded quarter was your Fund’s time to be pleasantly surprised. One might have expected that it would be the Fund’s smallest companies which would attract offers. Instead McDonnell Douglas and First USA, two of the largest capitalization equity issues in the Fund, were the lucky beneficiaries.

Both merger announcements produced significant increases in the target company’s stock price, adding to what had already been strong results in each case. Consistent with our perception that stocks generally are highly valued today, both acquirers will issue stock to make their purchase rather than pay with cash. We believe, however, that both of the combined concerns offer interesting possibilities as investments.

The Boeing/McDonnell Douglas merger looks to be a great match that resolves important issues. Both companies have a manufacturing capacity problem in commercial jets: Boeing has too little, and McDonnell Douglas too much. As well, Boeing will need McDonnell Douglas’ help if it is to win the Joint Strike Fighter competition with Lockheed Martin. My father-in-law, formerly a Boeing engineer, had been wondering what we could see that was attractive about McDonnell Douglas. Now he knows. We believe that the combined company will be a powerful competitor in all areas of the aerospace industry.

Banc One/First USA also looks to be a merger with enormous potential. Together they will have the third largest share in credit cards, a business where economies of scale are all-important. Cost savings look to be in the hundreds of millions of dollars. The merger will probably increase Banc One’s earnings growth rate while diversifying First USA’s vulnerability to trends in consumer lending.

Fire and Ice

The stock market’s strength over the last two years has been founded on an unusual combination of low inflation, moderate economic growth, and strong increases in corporate profits. It is unlikely that the economy can maintain this happy medium indefinitely, and economists/strategists continually speculate as to which direction the economy will take when it breaks out. One economist (Ed Hyman of International Strategy and Investment) has described the two possible outcomes as “fire and ice.”

Forced to choose between an outlook of fire (accelerating economic growth and inflation) or ice (sluggish to negative growth), I lean towards ice. Indicators of deflation continue to proliferate such as the recent drop in the price of gold, the big sell-off in the Japanese stock market, disappointing US retail sales for Christmas, and the rise in the value of the dollar. It is not our forecast that the current “Goldilocks” economy will change soon, but should it move toward ice, bonds would benefit and corporate profits would be at much greater risk.

Fixed Income Strategy and Tactics

In the first five quarters of the Fund’s life I have typically invested 25-30% of the Fund’s assets in Treasury And Agency notes and 10-15% in corporate bonds and preferred stocks which are below investment grade. At Harris Associates we believe that this “quality barbell” provides the best value to the Fund in today’s environment. We did not always have this point of view, but it has been more than ten years since our portfolios held investment grade corporate debt securities.

In the mid-1980’s we began to understand the effect that financial engineering could have on high grade bonds. At that time leveraged buyouts and other forms of corporate restructuring became everyday occurrences. Many transactions were completed at the expense of bondholders who discovered that unexpected corporate events could instantaneously transform their investment grade debt into low grade.

We believe that we reduce the riskiness of our fixed income portfolios by owning corporate bonds and preferred stocks from issuers which have already undertaken restructuring activity. We look for companies which are likely to improve their financial position by issuing new equity. In particular, we seek out companies which have enjoyed significant stock price gains but whose bonds have not been upgraded.

The Fund’s holding in Samsonite notes is a fine example of our approach. Samsonite, the luggage company, has had a somewhat tortured history over the last decade. Previously part of a large conglomerate, Samsonite became a separate publicly traded company in 1994. The company had significantly increased its debt load with the purchase of its largest competitor. We looked at the bonds after Samsonite’s board had brought in vigorous new management. In 1996 the stock quadrupled, and this has given management the opportunity to sell new shares this month. Next year Samsonite will use a portion of the proceeds from this sale to call 30% of the outstanding notes. The bond rating agencies, however, still call this issue a “B-” credit.

I am pleased that the fixed income market still avails the Fund this kind of opportunity. Through the end of the fiscal quarter the Samsonite bonds have returned over 14% in their less than 9 months in the Fund. Our goal for corporate fixed income securities is to find and own issues which have return potential competitive with the stock market. I believe that the Samsonite notes have met that test.

As always, please feel free to Email me with your questions or comments.

Clyde S. McGregor
Portfolio Manager
hacsm@aol.com
February 5, 1997

*Total return includes change in share prices and in each case includes reinvestment of any dividends, interest and capital gain distributions.

**Each of the three indexes or averages is an unmanaged group of stocks whose composition is different from the Fund. The Lipper Balanced Fund Index Composite is comprised of 30 Balanced Funds. The Lehman Govt./Corp. Bond Index includes the Lehman Government and Lehman Corporate indices. The S&P 500 is a broad market-weighted average dominated by blue-chip stocks. Past performance is no guarantee of future results.

THE OAKMARK BALANCED FUND

Schedule of Investments— January 31, 1997 (Unaudited)

Notes:
(a) Non income producing security.