The Oakmark Select Fund

Report from Bill Nygren, Portfolio Manager

THE VALUE OF A $10,000 INVESTMENT IN THE OAKMARK SELECT FUND FROM ITS INCEPTION (11/1/96) TO PRESENT (6/30/98) AS COMPARED TO THE STANDARD & POOR'S 500 INDEX

6/30/98 NAV $20.25

Total Return
Last 3 mos.

Average Annual Total Return(*) Through 6/30/98 From Fund Inception 11/1/96

The Oakmark Select Fund

1.9%

53.8%

Standard & Poor’s 500 Stock Index w/inc**

3.3%

35.4%

Standard & Poor’s MidCap 400 Index w/inc**

-2.1%

28.6%

Value Line Composite Index**

-4.6%

19.0%

*Total return includes change in share prices and in each case includes reinvestment of any dividends 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 S&P 500 is a broad market-weighted average dominated by blue-chip stocks. The S&P 400 consists of 400 domestic stocks chosen for market size, liquidity, and industry group representation. The Value Line Index is an unweighted average of more than 1,000 stocks. Past performance is no guarantee of future results.

For the quarter ended June 30, The Oakmark Select Fund increased in value by 1.9% versus a decline of 2.1% for the S&P 400 Midcap index. The performance award for the quarter goes to the S&P 500, which was up 3.3%, its greatest quarterly outperformance of the Midcap index since S&P started its Midcap index in 1991. Your portfolio benefited from gains in Cablevision, whose undervaluation was highlighted by the price AT&T agreed to pay for TeleCommunications, Inc. and in Gucci where its competitor Prada purchased 10% of the company. For the first nine months of fiscal 1998, your Fund gained 25.2% versus 9.5% for the S&P Midcap and 21.1% for the S&P 500.

ALL INDICES ARE NOT CREATED EQUAL!

Recent press reports have discussed how poorly investment managers are performing this year with fewer than 10% of mutual funds gaining more than the S&P 500. Such a small number have outperformed that you can't even charitably argue that the results are random. Are professional investors suddenly failing en-masse? Of course not. Pretend that as 1997 drew to a close you correctly forecast the ''lapse'' fund managers would experience in 1998. Knowing how strongly the S&P 500 was likely to perform, you wisely attempted to mimic the index by putting 1/500th of your portfolio into each of the 500 companies that make up the index. At the end of June you compute your performance, trying to suppress the smug laughter. When you see that your performance trailed the S&P 500 by nearly 600 basis points (11.8% versus 17.7%) you become convinced your spreadsheet has bugs. What's going on?

The S&P 500 is a market capitalization weighted index. The greater a company's market capitalization (stock price times number of shares outstanding) the greater that company's stock influences the index. The largest company in the S&P 500, GE, accounts for 3.5% of the index. The smallest 200 companies in total account for only 7%. If we look at stocks termed mega-cap (capitalizations over $25 billion), they account for only 85 of the 500 companies, yet cap-weighted are nearly two-thirds of the index value. So far in 1998, in the stock market, bigger has been better. The average stock has increased a modest amount while the mega-cap stocks have continued to perform strongly. Although the S&P Mid-cap 400 index is also cap-weighted, because its stocks are more similarly sized, the index is not dominated by just a few companies and therefore performs much more like the average stock.

Is it coincidence that most mutual funds underperform when the S&P Midcap underperforms the S&P 500 and vice versa? Not at all. How do managers decide how much of their portfolio to invest in each stock? Most, unlike us, simply equal weight their positions. Except for index funds and closet-indexers, I don't know investors that invest more just because a company is bigger! So most funds aren't weighted as heavily in mega-cap companies as the S&P 500 is. The Oakmark Select Fund invests in a mixture of mid and large cap companies, and at present has no exposure to mega-cap stocks. Further, our position sizes are based on our judgement of how attractively priced each stock is, rather than based on market cap. For those reasons, in the short-run, our results are much more like the Midcap index than the S&P 500. In the long run, the S&P 500 will only continue outperforming if the mega cap companies continue to fundamentally outperform smaller companies. Those big companies have benefited from international growth and from cutting bloated expense structures, but small companies have the benefit of being much more flexible. We don't view big or small companies as having sustainable advantages relative to each other and therefore expect long-term performance to be much more influenced by company-specific fundamentals than company size. As you look for signposts to judge whether or not you are on track toward meeting your long-term goals, comparing to the wrong index can lead to unnecessary concern or excitement. We expect to continue achieving excellent long-term results relative to any index by buying undervalued companies with owner-oriented management.

HOTEL ROOMS 25% OFF!

As regular readers of these letters know, we very much like to see our companies use excess capital to repurchase their stock. We view repurchase as confirmation that management shares our view that their stock is undervalued and as an indication that they are more interested in increasing per-share value than in merely getting bigger. Why then would your Fund buy Host Marriott after they announced a large purchase of hotels for which they will pay by issuing equity?

Host Marriott (HMT) is one of the world's largest hotel owners. The majority of their properties are full service Marriott Hotels. If you've traveled recently, you've no doubt seen the no-vacancy signs indicating how strong the hotel business is. Despite the strong hotel market and the strong stock market, HMT fell 25% from $24 last fall to a current price of $18. The main reason for that decline is growth in new hotel construction, especially in low- and mid-priced rooms. The obvious fear is that too many new rooms means the no-vacancy signs disappear. In April, HMT announced the purchase from Blackstone Group (a LBO firm) of $1.8 billion of luxury hotel properties that included Ritz Carltons, Four Seasons and Hyatt Regencies. Like other deals CEO Terry Golden has completed, this acquisition improved the quality of HMT's portfolio, the price was below replacement cost and it was additive to HMT cashflow. What was different this time was that HMT was issuing equity.

When we met with Terry, as you might expect, we wanted to learn why he was issuing equity. We learned that the seller would not do this deal for $1.8 billion in cash. In addition to gaining tax benefits, the seller believed HMT stock was significantly undervalued. We were comfortable (as was Terry) that the per-share business value of HMT was increased by this transaction, and were glad to learn that Blackstone (who knows a great deal about the hotel business) shares our view that HMT stock is attractive. Our expectations for HMT are that capacity additions will not significantly exceed demand growth for upper-end hotel rooms, and that HMT's year-end conversion to a REIT structure will not only save a lot of taxes, but will focus other investors on HMT's undervaluation. Selling at about 7.5x estimated 1999 funds from operations, it may be harder to get a deal on an HMT room than on their stock!

Thank you for your continuing support.

BILL NYGREN
Portfolio Manager
Bnygren@oakmark.com
July 6, 1998

P.S. On July 2 one of your fund's largest holdings, U.S. Industries, reported an earnings decline. The stock fell 22% causing your fund to suffer a one-day drop of 43 cents. We were disappointed with the fundamental results, but feel this decline is an extreme overreaction. I have added to the position.

THE OAKMARK SELECT FUND
Schedule of Investments—June 30, 1998 (Unaudited)

 

Shares Held/ Principal Value

Market Value

Common Stocks—90.8%

 

 

 

Retail—9.3%

Gucci Group (b)

2,829,800

$149,979,400

 

 

 

Other Consumer Goods & Services—13.4%

Host Marriott Corporation (a)

3,750,000

$66,796,875

Ralston Purina Group

531,000

62,027,437

Brunswick Corporation

2,394,900

59,273,775

Polaroid Corporation

815,900

29,015,444

 

 

217,113,531

Banks—3.3%

People’s Bank of Bridgeport, Connecticut

1,531,000

$53,010,875

 

 

 

Insurance—7.9%

PartnerRe Ltd.

2,506,100

$127,811,100

 

 

 

Broadcasting & Cable TV—11.7%

Cablevision Systems Corporation (a)

2,270,200

$189,561,700

 

 

 

TV Programming—4.9%

Tele-Communications, Liberty Media, Class A (a)

2,053,550

$79,703,409

 

 

 

Publishing—4.9%

Dun & Bradstreet Corporation

1,780,500

$64,320,563

ACNielsen Corporation (a)

602,100

15,203,025

 

 

79,523,588

Computer Services—3.5%

Electronic Data Systems Corporation

1,410,900

$56,436,000

 

 

 

Medical Products—4.6%

Amgen, Inc. (a)

1,135,000

$74,200,625

 

 

 

Aerospace & Defense—3.3%

Lockheed Martin Corporation

505,900

$53,562,163

 

 

 

Building Materials & Construction—9.4%

USG Corporation (a)

2,819,200

$152,589,200

 

 

 

Other Industrial Goods & Services—3.6%

Premark International, Inc.

1,807,200

$58,282,200

 

 

 

Diversified Conglomerates—11.0%

U.S. Industries, Inc.

7,148,000

$176,913,000

 

 

 

Total Common Stocks (Cost: $1,198,777,769)

1,468,686,791

 

 

 

Common Stocks Sold Short—0.0%

 

 

 

Publishing—0.0%

R H Donnelley Corporation

(257,300)

$(787,981)

 

 

 

Total Common Stocks Sold Short (Proceeds: $(1,018,874))

(787,981)

 

 

 

Short Term Investments—9.2%

 

 

 

 

 

U.S. Government Bills—2.4%

United States Treasury Bills, 5.085%–5.28% due

 

 

7/16/1998–12/17/1998

40,000,000

$39,443,221

Total U.S. Government Bills (Cost: $39,432,796)

39,443,221

 

 

 

Commercial Paper—5.0%

American Express Credit Corp., 5.55%–5.65% due

 

 

7/1/1998–7/16/1998

25,000,000

$25,000,000

Ford Motor Credit Corp., 5.53%–5.65% due

 

 

7/2/1998–7/7/1998

25,000,000

25,000,000

General Electric Capital Corporation, 6.00% due

 

 

7/1/1998

30,000,000

30,000,000

Total Commercial Paper (Cost: $80,000,000)

80,000,000

 

 

 

Repurchase Agreements—1.8%

State Street Repurchase Agreement, 5.65% due

 

 

7/1/1998

29,819,000

$29,819,000

Total Repurchase Agreements (Cost: $29,819,000)

29,819,000

 

 

 

Total Short Term Investments (Cost: $149,251,796)

149,262,221

 

 

 

Total Investments (Cost $1,347,010,691)—100.0%

$1,617,161,031

 

Other Liabilities In Excess Of Other Assets—(0.0)%

 

(502,246)

Total Net Assets—100%

$1,616,658,785

(a) Non-income producing security.

(b) Represents an American Depositary Receipt.