Last 3 mos.
Through 7/31/97
From Fund Inception
11/1/95
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THE VALUE OF A $10,000 INVESTMENT IN THE OAKMARK EQUITY & INCOME FUND FROM ITS INCEPTION (11/1/95) TO PRESENT (7/31/97) AS COMPARED TO THE LIPPER BALANCED FUND INDEX
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| 7/31/97 NAV $13.98 | Total Return Last 3 mos. |
Average Annual Total
Return* Through 7/31/97 From Fund Inception 11/1/95 |
|
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| The Oakmark Equity & Income Fund | 15.0% | 22.6% |
| Lipper Balanced Fund Index** | 13.6% | 20.7% |
| Lehman Govt./Corp. Bond** | 5.3% | 6.9% |
| S&P 500 w/inc** | 19.6% | 35.5% |
| *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. | ||
WHAT'S IN A NAME?
This is the first quarterly letter I have written since the change of name for the Fund from Balanced to Equity & Income. It will also be the last quarterly letter that I write in August during my vacation, as we will switch to a calendar quarter reporting period beginning in September. Some shareholders have wondered why we at The Oakmark Funds have now gone through the bother of changing the names of two of our funds. The simple answer is that in both cases experience taught us that the original name was not effectively communicating the investment objectives and implementation strategy of the funds. Equity and Income is not an asset allocation fund as the former name "balanced" suggested. Rather, it is a fund which seeks to generate attractive rates of return through selection of equities and equity-equivalents while increasing income and moderating volatility with a core position in Treasury notes.
Our firm's Chairman Victor Morgenstern has described Equity and Income as "The Oakmark Fund with an airbag." Airbag refers to the Treasury note position, not the portfolio manager. When renaming the Fund, I considered other possible names (though "Airbag Fund" was not one of them) but kept returning to the realization that this Fund is basically the most conservative equity fund in The Oakmark Family but with an income orientation. So, we simply elected to put the two most descriptive words into the name.
Please understand that nothing has changed with the Fund but the name. When I was young, everyone knew me by a nickname which my grandfather had called me. When I reached adulthood, however, I found that my nickname no longer fit. Something similar happened to The Equity and Income Fund.
QUARTER REVIEW
As you probably already know, the latest quarter continued the Fund's string of positive returns since inception. Somewhat more noteworthy is the fact that the nearly 15% return in the quarter was the highest in the Fund's history and exceeded the result for all of fiscal 1996. Declining interest rates supported the amazing rally in stock prices, but returns to stock market indices more than tripled bond market returns. As you would expect given the size of the advance, economic and political conditions in the quarter approached perfection from a stock investor's point of view.
Given the recent rally, the biggest problem for the securities markets today is complacency. With stocks at current valuation levels, investors will not tolerate negative surprises. High valuations themselves are not sufficient to produce price declines. They do, however, increase vulnerability and volatility. To sum up, stock prices are high, but they should be given the underlying fundamental picture.
WHAT'S A POOR INCOME MANAGER TO DO?
For at least the last four quarters I have found it difficult to maintain the Fund's income yield. Stock prices have risen far faster than dividends have grown. A recent report by Peter Canelo of Morgan Stanley Dean Witter (to whom I am also indebted for the title of this section) contrasted the dividend yield of issues in the S&P 500 in mid-1994 and mid-1997. In 1994 a manager could find a substantial number of equities with dividend yields in excess of 3%. In addition, a greater number of high-yielding convertible issues were available. Today one can find few issues with 3% or better yields that are not utilities or real estate investment trusts. The S&P 500 Index itself now yields 1.6%, a record low.
It is also harder to find yield today in the fixed income market. Creative minds on Wall Street have developed a new investing vehicle, the collateralized bond obligation, the successful marketing of which has increased the demand for high-yield debt. And, as I discussed in last quarter's letter, the long economic expansion has allowed many companies to call or tender for their higher interest paying obligations, reducing the supply.
So, what is a portfolio manager with the word "income" now in the name of his Fund to do? I will not change the asset allocation of the Fund merely for the purpose of enhancing income. Neither will I lower our quality standards to populate the portfolio with risky high yield issues. I will, however, continue to seek out unexploited or obscure areas of the investing universe where yield may still be obtained.
In the July quarter I noticeably increased the Fund's commitment to the preferred stock sector. In particular, I initiated the Fund's first two investments in an unusual instrument, the "trust preferred." These issues benefit from a quirk in the tax code which helps to make them relatively cheap sources of capital for financial institutions. The institution seeking capital creates a trust which then issues the preferred stock. The trust invests the proceeds from the preferred stock sale in a new issue of bonds from the financial institution. The advantage of this arrangement is that the institution can deduct the interest payment on the bonds for tax purposes (which reduces the effective rate of interest) while still counting the preferred stock as part of its capital base. Jim Benson, who recently joined our firm, has identified two attractive issues for use in the Fund, both of which yield more than 9%. One is an obligation of a bank which is held in The Oakmark Small Cap Fund.
The answer to the question which began this section is simply to keep looking but don't compromise standards. As always, I welcome your questions or comments.
CLYDE S. MCGREGOR
Portfolio Manager
mcgregor@oakmark.com
August
5, 1997
The Oakmark Equity & Income Fund |
| Shares Held | Market Value | |
|
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| Equity and Equivalents—59.3% | ||
| Food & Beverage—2.5% | ||
| Philip Morris Companies Inc. | 16,100 | $726,513 |
| Other Consumer Goods & Services—17.0% | ||
| Lexmark International Group, Inc., Class A (a) | 26,000 | $846,625 |
| Borg-Warner Automotive, Inc. | 15,000 | 836,250 |
| Juno Lighting, Incorporated | 46,300 | 735,012 |
| Armstrong World Industries, Inc. | 9,600 | 708,600 |
| National Presto Industries, Inc. | 17,000 | 671,500 |
| First Brands Corporation | 31,000 | 656,812 |
| Promus Hotel Corporation (a) | 13,400 | 526,788 |
|
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| 4,981,587 | ||
| Banks—5.5% | ||
| Banc One Corporation | 17,022 | $955,368 |
| Mellon Bank Corporation | 13,400 | 675,862 |
|
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| 1,631,230 | ||
| Insurance—6.3% | ||
| PartnerRe Ltd. | 23,000 | $951,625 |
| Old Republic International Corporation | 25,500 | 892,500 |
|
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| 1,844,125 | ||
| Broadcasting & Publishing—8.8% | ||
| Dun & Bradstreet Corporation | 33,000 | $891,000 |
| Lee Enterprises, Inc. | 33,900 | 868,688 |
| Tele-Communications, Liberty Media, Class A (a) | 31,700 | 810,331 |
|
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| 2,570,019 | ||
| Aerospace & Defense—2.9% | ||
| McDonnell Douglas Corporation | 11,000 | $841,500 |
| Other Industrial Goods & Services—5.8% | ||
| Premark International, Inc. | 31,500 | $994,219 |
| Lear Corporation | 15,000 | 718,125 |
|
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| 1,712,344 | ||
| Commercial Real Estate—7.2% | ||
| Catellus Development Corporation (a) | 46,728 | $957,924 |
| LaSalle Partners, Inc. (a) | 20,000 | 597,500 |
| Equity Office Properties Trust (a) | 19,000 | 551,000 |
|
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| 2,106,424 | ||
| Diversified Conglomerates—3.3% | ||
| U.S. Industries, Inc. (a) | 24,000 | $967,500 |
| Total Equity and Equivalents (Cost: $12,988,160) | 17,381,242 | |
| Shares Held/ Principal Value |
Market Value | |
|
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| Fixed Income—36.4% | ||
| Preferred Stock—6.7% | ||
| Banks—2.7% | ||
| RBI Capital Trust I, Preferred, 9.10% | 42,500 | $425,000 |
| BBC Capital Trust 1, Preferred, 9.50% | 14,000 | 364,000 |
|
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| 789,000 | ||
| Insurance—0.7% | ||
| American Heritage Life Investment Corporation, Preferred, 8.50% | 3,000 | $185,625 |
| Broadcasting & Cable TV—1.6% | ||
| Tele-Communications, Inc., Preferred Junior Class B, 6.00% | 5,800 | $469,800 |
| Other Industrial Goods & Services—1.7% | ||
| James River Corporation of Virginia, Preferred Series O, 8.25% | 20,000 | $505,000 |
| Total Preferred Stock (Cost: $1,819,125) | 1,949,425 | |
| Corporate Bonds—3.6% | ||
| Other Consumer Goods & Services—0.8% | ||
| Samsonite Corporation, 11.125% due 7/15/2005, Senior Subordinated Note Series B | 200,000 | $226,500 |
| Aerospace & Automotive—0.5% | ||
| Coltec Industries, Inc., 9.75% due 4/1/2000 | 150,000 | $160,500 |
| Building Materials & Construction—0.5% | ||
| USG Corporation, 9.25% due 9/15/2001, Senior Notes Series B | 150,000 | $158,062 |
| Utilities—0.6% | ||
| Midland Funding Corporation, 11.75% due 7/23/2005 | 150,000 | $177,000 |
| Other Industrial Goods & Services—1.2% | ||
| UCAR Global Enterprises Inc., 12.00% due 1/15/2005, Senior Subordinated Note | 300,000 | $342,000 |
| Total Corporate Bonds (Cost: $1,028,497) | 1,064,062 | |
| Government and Agency Securities—26.1% | ||
| U.S. Government Bonds—25.1% | ||
| United States Treasury Notes, 7.50% due 5/15/2002 | 2,500,000 | $2,666,075 |
| United States Treasury Notes, 7.125% due 9/30/1999 | 2,400,000 | 2,466,456 |
| United States Treasury Notes, 7.875% due 11/15/2004 | 2,000,000 | 2,218,500 |
|
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| 7,351,031 | ||
| U.S. Government Agencies—1.0% | ||
| Federal Home Loan Bank, 6.405% due 4/10/2001, Consolidated Bond | 300,000 | $303,540 |
| Total Government and Agency Securities |
| |
| (Cost: $7,494,114) | 7,654,571 | |
|
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| Total Fixed Income (Cost: $10,341,736) | 10,668,058 | |
| Short-Term Investments—4.9% | ||
| U.S. Government Bills—1.7% | ||
| United States Treasury Bills, 5.04% due 10/9/1997 | 250,000 | $247,585 |
| United States Treasury Bills, 5.07% due 10/16/1997 | 250,000 | 247,324 |
|
| ||
| Total U.S. Government Bills (Cost: $494,909) | 494,909 | |
| Commercial Paper—2.6% | ||
| General Electric Capital Corporation, 5.50%5.55% due 8/18/4/1997 | 750,000 | $750,000 |
|
| ||
| Total Commercial Paper (Cost: $750,000) | 750,000 | |
| Repurchase Agreements—0.6% | ||
| State Street Repurchase Agreement, 5.76% due 8/1/97 | 168,000 | $168,000 |
|
| ||
| Total Repurchase Agreements (Cost: $168,000) | 168,000 | |
|
| ||
| Total Short-Term Investments (Cost: $1,412,909) | 1,412,909 | |
| Total Investments (Cost $24,742,805)—100.6% | $29,462,209 | |
| Other liabilities in excess of other assets—(0.6)% | (161,376) | |
|
| ||
| Total Net Assets—100% | $29,300,833 | |
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Notes:
(a) Non-income producing security.