Report from Clyde S. McGregor, Portfolio Manager
QUARTER REVIEW
The second fiscal quarter demonstrated the value of our balanced approach in a difficult period. Your Fund returned 1.4%. Both stocks and bonds were profitable despite the fact that in March the Federal Reserve raised its target interest rate for Fed Funds for the first time in two years.
We are pleased that the Fund extended its record of positive returns in each quarter since inception. Balanced funds are not immune to market swings, but they do reduce volatility of returns. Part of this lower volatility is an outcome of owning different kinds of assets, and part results from a greater proportion of return coming from income (which is more certain) and less from appreciation (which is less certain). In the current environment where stock prices are at record highs and Alan Greenspan is putting upward pressure on interest rates, The Balanced Fund speaks to the needs of long-term investors seeking growth, income, and capital preservation.
I would also like to take this opportunity to point out that the Fund’s expenses are now capped at 1.5% per annum. The Fund’s returns have been quite competitive within the universe of similar funds (11th place out of 290 for the 52 weeks ended April 3) despite an above average expense ratio. This handicap departed as of March 1.
MARKET OUTLOOK
At Harris Associates we do not attempt to forecast the economy, nor do we develop our portfolios based on some understanding of the investing environment. We build our portfolios from the bottom up selecting only securities which we determine to be significantly undervalued regardless of the macro picture. As manager of The Oakmark Balanced Fund, however, I am committing assets to several different asset classes, so it is important that I have a point of view about the overall context.
Federal Reserve policy is always one of the key factors creating the investing environment, but given the March rate hike, Fed policy has taken on even greater importance. The Fed last began to tighten money in 1994, eventually raising rates six times during the year. These actions had a dramatic impact on the bond market in 1994, which suffered its worst year since the 1920’s. The bond market’s weakness also made it impossible for stocks to make any headway despite a respectable increase in corporate profits.
I do not believe that 1997 is setting up to be a close copy of 1994. Economic conditions are quite different:
1. Interest rates began this cycle much higher across the entire yield curve than they were at the beginning of 1994. Real rates (interest rates after subtracting the rate of inflation) are at historically high levels.
2. Price indices for industrial commodities are falling today, but in 1994 they were showing increases. Corporate managers continue to complain that they have no ability to increase prices.
3. Gold’s price is particularly weak. In the 1994 cycle it rose more than 10%.
4. The dollar is quite strong relative to other currencies.
5. The Federal budget deficit has shrunk considerably over the last three years even without a balanced budget agreement. In fact, the Treasury will actually pay down approximately $65 billion in outstanding debt this calendar quarter.
Aside from these fundamental indicators, I also see a vital difference in the structure of the markets. Today, the kind of aggressive speculation in the bond market which was present at the beginning of 1994 is not evident. In 1992 and 1993 large amounts of speculative capital had been devoted to the “carry trade” (borrowing short term and investing in intermediate term Treasury notes). When short rates began to rise, the economics underlying these highly leveraged bets began to turn unfavorable, and the resulting rush for the exits greatly intensified the bond market’s pain.
I believe that Fed Chair Greenspan defines his role in terms of smoothing out US economic activity and stamping out speculation wherever it may be found. Greenspan has studied the Japanese experience of the last decade where speculation in several asset classes was not damped but was often unwittingly aided. Having brought reality back to the bond market in 1994, he is seeking to prevent a speculative blowoff in stocks now. He spoke first of "irrational exuberance” in December, reiterated his warning in February, and, equity investors still not listening, he acted in March. Having observed the recent strong recovery in the markets, he will probably do so again.
Given this interest rate backdrop, I look for the markets in 1997 to be choppy and erratic, but I do not expect a great bear market in bonds as in 1994 or a stock market collapse as in 1987.
BOND CALLS AND TENDER OFFERS
Our strategy when investing in corporate bonds and preferred stocks is to identify issues from companies which are enjoying material improvement in their financial condition. Ideally, we will invest in such issues before the bond rating agencies and other investors have recognized this improvement.
One problem with this approach is that the issuing concerns sometimes experience more rapid improvement than we might prefer. The result is often an early bond call or a tender offer.
In the second fiscal quarter a tender offer for one bond, a partial call of another, and a complete call of a third related to the unexpected takeover of the issuer caused your Fund’s commitment to corporate fixed income investments to shrink. I am aggressively seeking replacement issues. I will not, however, compromise our standards because we have become “underweighted” in this area.
In the fixed income market, yield spreads between issues of higher and lower quality move around over time. I perceive current spreads to be inadequate, reflecting considerable optimism about our nation’s economy. I, too, believe that the economy is in fine shape, but I will not invest The Fund’s assets based on that assumption. When we can again find issues that meet our standards of improving financial condition combined with attractive pricing, I will rebuild this segment of the portfolio.
As always, I welcome your questions or comments. For all of you internet communicators, please note my new address for e-mail.
CLYDE S. MCGREGOR
Portfolio Manager
mcgregor@oakmark.com
May 6, 1997
| 4/30/97 NAV $12.16 | Average Annual Total Return* Through 4/30/97 |
|
|---|---|---|
| Total Return Last 3 mos. |
From Fund Inception 11/1/95 |
|
| The Oakmark Balanced Fund | 1.4% | 15.6% |
| Lipper Balanced Fund Index** | 0.4% | 14.5% |
| Lehman Govt./Corp. Bond** | 0.5% | 4.5% |
| S&P 500 w/inc** | 2.4% | 26.5% |
*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 or funds 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.
| Shares Held/ Principal Value |
Market Value | ||
|---|---|---|---|
| Equity and Equivalents—52.9% | |||
| Food & Beverage—2.9% | |||
| Philip Morris Companies Inc. | 14,700 | $ 578,813 | |
| Other Consumer Goods & Services—13.8% | |||
| Borg-Warner Automotive, Inc. | 15,000 | $ 630,000 | |
| Juno Lighting, Incorporated | 38,300 | 593,650 | |
| Armstrong World Industries, Inc. | 8,900 | 585,175 | |
| National Presto Industries, Inc. | 14,000 | 511,000 | |
| Promus Hotel Corporation (a) | 13,400 | 472,350 | |
| 2,792,175 | |||
| Banks—2.8% | |||
| Mellon Bank Corporation | 6,700 | $ 556,938 | |
| Insurance—6.6% | |||
| Old Republic International Corporation | 25,500 | $ 720,375 | |
| PartnerRe Ltd. | 18,200 | 611,975 | |
| 1,332,350 | |||
| Other Financial—6.0% | |||
| First USA, Inc. | 14,600 | $ 702,625 | |
| Associates First Capital Corporation, Class A | 10,000 | 512,500 | |
| 1,215,125 | |||
| Broadcasting & Publishing—7.8% | |||
| Tele-Communications, Liberty Media, Class A (a) | 29,000 | $ 545,562 | |
| Lee Enterprises, Inc. | 21,400 | 526,975 | |
| Dun & Bradstreet Corporation | 20,000 | 492,500 | |
| 1,565,037 | |||
| Aerospace & Defense—2.4% | |||
| McDonnell Douglas Corporation | 8,000 | $ 475,000 | |
| Other Industrial Goods & Services—3.8% | |||
| Premark International, Inc. | 31,500 | $ 771,750 | |
| Commercial Real Estate—2.5% | |||
| Catellus Development Corporation (a) | 34,728 | $ 512,238 | |
| Diversified Conglomerates—4.3% | |||
| U.S. Industries, Inc. (a) | 24,000 | $ 867,000 | |
| Total Equity and Equivalents (Cost: $8,780,740) | 10,666,426 | ||
| Fixed Income—33.6% | |||
| Preferred Stock—1.9% | |||
| Broadcasting & Cable TV—1.9% | |||
| Tele-Communications, Inc., Preferred Junior Class B, 6% | 5,800 | $ 382,800 | |
| Total Preferred Stock (Cost: $379,100) | 382,800 | ||
| Corporate Bonds—5.1% | |||
| Other Consumer Goods & Services—1.1% | |||
| Samsonite Corporation, 11.125% due 7/15/2005, Senior Subordinated Note Series B | 200,000 | $ 222,250 | |
| Aerospace & Automotive—0.8% | |||
| Coltec Industries, Inc., 9.75% due 4/1/2000 | 150,000 | $ 160,500 | |
| Building Materials & .Construction—0.8% | |||
| USG Corporation, 9.25% due 9/15/2001, Senior Notes Series B | 150,000 | $ 157,313 | |
| Utilities—0.8% | |||
| Midland Funding Corporation, 11.75% due 7/23/2005 | 150,000 | $ 162,562 | |
| Other Industrial Goods & Services—1.6% | |||
| UCAR Global Enterprises Inc., 12.00% due 1/15/2005, Senior Subordinated Note | 300,000 | $ 336,750 | |
| Total Corporate Bonds (Cost: $1,030,811) | 1,039,375 | ||
| Government and Agency Securities—26.6% | |||
| U.S. Government Bonds—25.1% | |||
| United States Treasury Notes, 7.125% due 9/30/1999 | 2,400,000 | $ 2,440,824 | |
| United States Treasury Notes, 7.50% due 5/15/2002 | 1,500,000 | 1,559,970 | |
| United States Treasury Notes, 7.875% due 11/15/2004 | 1,000,000 | 1,067,980 | |
| 5,068,774 | |||
| U.S. Government Agencies—1.5% | |||
| Federal Home Loan Bank, 6.405% due 4/10/2001, Consolidated Bond | 300,000 | $ 296,451 | |
| Total Government and Agency Securities (Cost: $5,346,469) | 5,365,225 | ||
| Total Fixed Income (Cost: $6,756,380) | 6,787,400 | ||
| Short Term Investments—14.2% | |||
| Commercial Paper—10.7% | |||
| Ford Motor Credit Corp., 5.41%–5.51%due 5/1–5/20/1997 | 800,000 | $ 800,000 | |
| American Express Credit Corp., 5.45%–5.53%due 5/5–6/9/1997 | 550,000 | 550,000 | |
| General Electric Capital Corporation, 5.42%–5.65% due 5/1–6/13/1997 | 800,000 | 800,000 | |
| Total Commercial Paper (Cost: $2,150,000) | 2,150,000 | ||
| Repurchase Agreements—3.5% | |||
| State Street Repurchase Agreement, 5.37% due 5/1/1997 | 711,000 | $ 711,000 | |
| Total Repurchase Agreements (Cost: $711,000) | 711,000 | ||
| Total Short Term Investments (Cost: $2,861,000) | 2,861,000 | ||
| Total Investments (Cost $18,398,120)—100.7%(b) | $20,314,826 | ||
| Other liabilities in excess of other assets—(.7%) | (150,541) | ||
| Total Net Assets | $20,164,285 ========== |
||
Notes:
(a) Non-income producing security.
(b) At April 30, 1997, net unrealized appreciation of $1,916,706 for federal income tax purposes consisted of gross unrealized appreciation of $2,080,600 and gross unrealized depreciation of $163,894.
See accompanying notes to financial statements.