THE OAKMARK INT'L SMALL CAP FUND

Report from David Herro and Adam Schor, Portfolio Managers

We are happy to report once again a satisfactory return of 6.42% for the quarter ending 1/31/97. More importantly, our annualized return since inception (11/1/95) through January 31, 1997 of 16.7% ranks this Fund as one of the top-performing international funds in the Lipper international universe.

A Name Change:

We start the new year with a new name for this Fund. As of this report, we have changed the name to The Oakmark International Small Cap Fund.

When we launched the Fund, we selected “Emerging Value,” hoping to evoke images of companies that were emerging into first tier investments. Either they were small companies on the brink of growth or they were large firms but were growing as their host countries grew. We thought Emerging Value captured the idea of buying dynamic companies before they were fully understood and exposed and while they were improperly priced. We also liked the name better than Small Value or New Value or Soon-To-Be-Valuable-When-Finally-Discovered Fund.

The Fund’s name also reflects an obvious point—investing is our forte, not marketing. We are much better at managing funds than naming them. (What’s an Oakmark anyway?)

When you hear thundering hooves, think horses. Investors who saw the word “emerging” thought that it was an emerging markets fund. In fact, our exposure to emerging markets has hovered around 50% and has never been greater than 55% of our assets. Most of our companies in the portfolio were and still are small cap companies, even those in emerging markets. If you take away Telmex, YPF and Asia Pulp and Paper, the remaining 40 or so other names in our Fund are less than $500 million in market capitalization.

Ever since Mexico jilted them, investors’ relationship with emerging markets has been rocky. We thought many investors shied away from this fund because they thought it was an emerging markets fund. So with our marketing department, we chose a clearer name. We explained that the Fund was an international small cap fund and not an emerging market fund. Suddenly, the creatives took over. The new name would be the Oakmark International Small Cap Fund. So let it be written, so let it be done.

The name change more clearly defines the investment universe of the Fund. We will continue to apply the same disciplined value-oriented investment philosophy and process. We are happy with our leading performance and hope our shareholders are too.

The change offers the opportunity to explain the differences between this fund and The Oakmark International Fund. We started The International Small Cap Fund to take advantage of a tremendous oversight in the market. As we traveled the world looking for companies for the $1.2 billion Oakmark International Fund, we saw a layer of small cap stocks that were overlooked and undervalued. Many of these firms were too small to build into a meaningful position in the large fund. But their values remained. So we saw — and still see today — an opportunity for a fund specifically geared to invest in smaller companies.

That’s what we have today and finally it is clearly labeled. The International Small Cap Fund offers investors the opportunity to invest in companies that we think are among the most compelling values around. Because the companies are smaller and less liquid than the names in the other international fund, they will be more volatile. But we hope that our patience is rewarded with returns. So far, it has gone well. But long-term investors must look ahead—and that’s exactly where we see the best value.

Latin America on the rebound...

Speaking of long-term investing brings us to this story. Two years ago, our trading desk received a call from a large global brokerage firm. They had an important U.S. client selling Latin American stocks. When asked which ones and at what price, the response was, “all of them and make a bid!”

Now, after a rebound in the markets and economies of Latin America, we have seen that patience pays. For this fund, Mexican food company Grupo Herdez, the Argentine textile/shoe company Alpargatas, and the Brazilian utility Cemig have produced great returns.

Business conditions in Latin America continue to look favorable, and we expect continued strong performance from our investments. What a difference a few years makes!

...And it’s smooth sailing in Asia ex-Japan

We still see excellent opportunity investing in Asia, including Hong Kong, where we are about four months away from reunification with China (a.k.a. The Big Event). Hong Kong is showing increasing confidence in its economy after June 30. HK company Yip’s Hang Cheung has extensive exposure in China as a manufacturer and marketer of paints, solvents and lubricants. Indonesia-based Steady Safe has a strong transportation franchise in that country in taxis, buses and soon, rail. And New Zealand fish company Sanford has valuable fish quotas and access to some of the world’s most fertile fishing grounds.

One exception to the rosy Asian picture is Japan. We still see a lot of macro problems. Furthermore, many corporate managers are unaware — or unconcerned — that they are employed by shareholders and that they should act to benefit those shareholders. We have found a few solid companies, however. One recent purchase is video game software developer Enix. Enix makes games for Nintendo and, soon, will make them for Sony. It is one of the few companies in Japan that seems to be run for its owners.

The Oakmark International Small Cap Fund heads into 1997 as we entered 1996, with confidence that the market is mispricing a lot of good, small companies. We haven’t changed the way we manage the Fund and we certainly haven’t changed our outlook. We have retained a disciplined, longterm focus. As the unfortunate sellers in Latin America have discovered over the last two years, that’s the best way to invest.

David Herro

Adam Schor
Portfolio Managers
72242.772@compuserve.com
oakix@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 Morgan Stanley World ex U.S. Index includes 19 country subindexes. The Lipper International Fund Average includes 106 mutual funds that invest in securities whose primary markets are outside the United States. The Micropal Int’l Small Co Fund Index sector average is an unweighted index comprised of all funds within the International Small Company Fund sector. Past performance is no guarantee of future results.

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THE OAKMARK INT'L SMALL CAP FUND

International Diversification—January 31, 1997

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THE OAKMARK INT'L SMALL CAP FUND

Schedule of Investments— January 31, 1997 (Unaudited)

Notes:
(a) Nonincome producing security.
(b) Represents an American Depositary Receipt.
(c) Includes transaction hedges.