THE OAKMARK SMALL CAP FUND

Report from Steven J. Reid, Portfolio Manager

INTERMISSION
April 30, 1997 marked the half way point of The Oakmark Small Cap Fund’s fiscal year. For the six month period, your Fund gained 15.0%. This is substantially better than the relevant indices. The Fund’s second fiscal quarter ended with a $0.01 decline in the net asset value; this equated to a loss of 0.07%. The indices to which your Fund is compared declined considerably more.

Several significant events occurred that explain recent results. On the positive side, Kysor Industrial Corp. was acquired by Scotsman Industries Inc., also a holding of your Fund, for $43 per share in cash. Our only regret is that Scotsman did not offer the option of receiving their shares in lieu of cash. SPX Corp., your Fund’s largest holding, announced that they would repurchase up to 18% of their outstanding shares in a Dutch Auction at prices up to $56 per share. Triarc Companies, Inc. announced several transactions that are expected to increase the value of the company over the long term.

On a less than positive note, we were not exempt from the overall market decline. Financial companies were generally hit the hardest as a group. Several of our holdings did not or were not expected to produce the near-term results on which other investors focus so closely. As long-term investors, we see these situations as opportunities and we can and do try to take advantage of them.

THE VALUE OF LONG-TERM INVESTING
During the quarter it seemed that a lot happened, but very little changed. The Fund rose to an all-time high in early March and promptly gave up those gains and then some before returning to virtually where we were at the end of January. Why did this happen? Well no one knows for sure, but it appears that Wall Street became obsessed with several short-term events—the Fed’s decision to raise interest rates and anticipation of second quarter earnings, coupled with the fear of companies not meeting expectations. Last, many investors became concerned over the possibility of an overall market correction. I am pleased to be able to say that the overall operating results and prospects of the companies in which we have invested continue to be quite good. The only significant changes we saw were in the price of their shares.

Our perspective as long-term investors is to focus on investing in individual companies. While the overall level of interest rates will affect economic activity and the valuation of companies, the recent increase in rates is relatively unimportant for the companies in which we have invested. We look at the goods or services our companies provide and the long-term prospects for them. In fact, we do not attempt to predict the direction, or magnitude of change in interest rates or the stock market. I realized long ago that many of the well known pundits of prediction had very poor batting averages over the long term. Thus, we happily accept that the risk of not being invested is far greater than attempting to invest based on predictions of macro outcomes over the long term.

I was particularly amused by an article in the Wall Street Journal regarding the superior share price performance of small companies vs. large companies. The article referred to this as the “small-cap effect” and offered that a recent study showed that $1 invested in small companies at the end of 1926 would be worth $3990 at the end of 1996. Whereas, $1 invested in large companies would only be worth $1370 over the same period. Several experts were interviewed to garner their views on the subject. One particularly vocal opponent contended that if one were to eliminate the 9 year period from the end of 1974 through the end of 1983, the returns from small companies since 1926 were inferior to those of large companies.

Several thoughts come to mind. First, the data might not be reliable. It is very likely that small companies in 1926 either don’t exist anymore or are large companies now. After all, large companies are small companies that grew up. Second, data manipulation is a dangerous thing. The elimination of 9 years from a 70 year study seems statistically significant. Such that I am willing to predict that if we eliminate the economies of China and India, global economic development will not be as robust as once estimated. What we can take away from this data is the importance of investing for the long term, or in other words, being there—not to mention the very desirable returns of equity investing over the long term.

WHAT WOULD A RATIONAL BUSINESS PERSON PAY TO OWN THIS?
This is the question we ask ourselves when valuing the companies in which we invest. I mentioned earlier that Triarc Companies Inc., the producer of Royal Crown and Mistic Brands beverages and the franchisor of Arby’s restaurants, made several strategic changes to their business mix. Of particular interest was the purchase of Snapple. Snapple was acquired by Quaker Oats in late 1994 for $1.7 bil. At the time, we did not understand the rationale for the price Quaker paid. It was a time when ready-to-drink teas were experiencing tremendous growth and the brand commanded a premium. In March of this year, our friends at Triarc bought Snapple for $300 mil. The important point is that Triarc’s managers think like owners (which they are), so they waited until the price was right. This kind of patience pays off for all of us.

WEATHER
Having used up my allotment of one prediction per letter, I will forgo any thoughts on the weather. I will share with you that one of our readers, and a graduate student in meteorology, is particularly interested in my prediction of snow for the Midwest in May. Earlier this week, parts of Michigan and Wisconsin received more than 8 inches of snow. I feel relieved not to have predicted the once-in-100-year flooding.

Once again, I would like to thank everyone involved, especially our shareholders, for your support.


STEVEN J. REID

Portfolio Manager
sreid@oakmark.com
May 14, 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 Small Company Growth Fund Index is comprised of 30 Small Cap Funds. The Russell 2000 Index measures the performance of smaller companies, and represents approximately 10% of the total value of publicly traded companies in the U.S. The S&P 600 Index measures the performance of selected U.S. stocks with a small market capitalization. Past performance is no guarantee of future results.

THE OAKMARK SMALL CAP FUND

Schedule of Investments—April 30, 1997 (Unaudited)

Notes:
(a) Non-income producing security.
(b) At April 30, 1997, net unrealized appreciation of $34,718,766 for federal income tax purposes consisted
of gross unrealized appreciation of $61,140,703 and gross unrealized depreciation of $26,421,937.
(c) This bond is currently in default and the fund is no longer accruing interest.
(d) See footnote number five to the financial statements regarding transactions of securities of affiliated issuers.

See accompanying notes to financial statements.