The Oakmark Fund Report from Robert J. Sanborn, Portfolio Manager

PORTFOLIO UPDATE

For the quarter ended June 30, 1998, The Oakmark Fund was down 2.7% vs. a 3.3% gain for the Standard & Poor's 500. For the six months ended June 30, 1998, your Fund returned about 7%, not bad in absolute terms but about half the return generated by the S&P 500. This is the Fund's worst relative performance since its inception in 1991.

Many of you probably have questions about this situation—"What is the cause? What are you going to do about it? How should the shareholders evaluate?" I will try to answer these questions.

There are several causes for our relative performance this year. First is our average cash holding of about 10%. Second is a number of large holdings that are down this year—Polaroid (-25%), Nabisco (-22%), Philip Morris (-12%), Boeing (-2%), and Columbia/HCA (-1%). The third cause is a relative lack of big winners; in a market up about eighteen percent, your Fund has only one holding—Black & Decker—up more than 30 percent. Simply, for this six month period, we have held substantial cash in a bull market and our stocks have not kept pace.

This year the market has been what is termed a "momentum" market, in which stocks that have done well continue to do well and companies that disappoint, no matter what the valuation, get hammered. This is an environment that, frankly, does not suit our investment approach. (Nor does it seem to suit other mutual funds that Lipper characterizes as "large-cap value," which are up about ten percent this year). For example, a stock that we own that becomes the market's darling and gets "hot" tends to hit our sell target (generally ninety percent of what we estimate the value of the underlying business to be) long before the stock tops out. A recent example is our cable investments, which were very successful for us; however, they have continued to appreciate far beyond the point where we sold them. I do not regard these as bad sales. Sure, it would be nice to have held on for the higher prices that did materialize. However, in the long run (which is what matters!), our sell discipline is logical and we believe in it, and have no interest whatsoever in trying to out-psyche the market. Zero.

Comparing a quintessential momentum stock to one of our "value" stocks might illustrate the current environment. BMC Software (BMCS—$53) makes and sells computer software for mainframes and has a market capitalization of $12 billion (to put this number in perspective, it is similar to that of Nike). This places the company in the large-cap category. Now, I am sure that this is a fine company with good growth prospects. What are you paying for this growth? Well, BMC sells at 17x revenues and over 25x operating earnings (and the market capitalization per employee is over $9 million!!).

We view these sorts of valuations as troublesome and will not pay them. Almost everything has to go right for a very long time to justify paying these sorts of valuations, a bet we will not make with your money. Many software, Internet, Y2K, and technology stocks sell at these kinds of valuations today. Biotechnology stocks were valued similarly in the early 1990s and I actually wrote what turned out to be a prescient quarterly letter in 1992 about why your Fund eschewed these holdings. Of the 32 biotech companies that were public in 1991, only six trade at higher prices today! This is the sort of poor long- term performance that can result in owning stocks in businesses that have been hot short-term performers. The meal can be tasty, but the heartburn is painful.

Now let's look at one of our holdings, Polaroid (PRD—$36). Polaroid is the instant-photography and imaging company that had been mismanaged for quite a while before Black & Decker executive Gary DiCamillo was appointed CEO a couple of years ago. This is not an awesome business, but it is at least an average one. It has a number of solid cash-cow businesses, a couple of gamier ones (e.g., Russian street photography), and some new ventures that are very promising.

How does the market value PRD? Well, it is valued at less than 1x revenue (!!!!) and only 10x operating earnings (and only $200,000 per employee!), which are understated due to accounting "losses" in the venture area that mask positive value. When PRD pre-announced disappointing second quarter earnings (largely due to an inventory adjustment at their biggest customer, Wal-Mart), the stock got hammered. PRD the stock is down 25 percent this year.

These relative valuations are why we own Polaroid in your Fund and not BMC. BMC may continue to soar in the market, and PRD may flounder until it gets what the Street calls "visibility" (this means that the undervaluation is obvious even to my dog). However, in the long run, I place my (and your) money on Polaroid.

We believe in our philosophy and our execution. It is easy to do so when short-term performance is good. It is crucial to do when short-term performance is weak. Investment professionals tend to lose their focus when things are not going right. Clients and shareholders complain, the media is critical, and many investors begin to doubt their approach. This is a perfect stew for poor decision-making, which leads to lousy long-term performance. We are trying our best to be immune to this malaise.

I know that shareholders want to out-perform ALL the time, every day, month, year. People, let me deliver the bad news: this is an unattainable goal. It is important for all of you to have reasonable expectations and to understand why you own certain investments. At The Oakmark Fund, our goal remains the same as ever: to deliver superior investment returns over the long term without assuming undue risk.

ACADEMIC CORNER

I try to keep you abreast of some of the latest theoretical and academic debates pertaining to investments. The current topic is the appropriate risk premium that should be applied to equities.

One of the bedrock principles of finance is that the greater the risk (generally defined as volatility), the greater the required return. The theory is that stocks are riskier than, say, bonds, and thus must earn a higher return as compensation. Some theoreticians aver that, due to the strong relative performance of stocks in the past few years, the risk premium of stocks—i.e., the excess expected return relative to bonds—is close to zero. In other words, bonds and stocks are priced to yield similar returns going forward. The implication is that stocks, presumably riskier than bonds, are overpriced.

Not so fast, say others. James Glassman of the American Enterprise Institute argues that, based on investing data for the entire century, stocks in the long run are no more risky than bonds. Stocks have been more volatile in the shortrun, but in the long run have not been. He argues that, since stocks in fact are no riskier than bonds, the risk premium should be zero. He argues that this implies that stocks are under-valued relative to bonds. Critics respond that this is typical bull market sort of analysis.

What do I think? Well, the fact is that there exist no tools to forecast accurately what the risk premium will be in the future. Stocks do possess an inherent structural advantage compared to long-term fixed rate bonds. In periods of unexpected inflation, most stocks and bonds suffer, but stocks have the flexibility to cope with inflation. For example, if one buys a 30-year, 5% bond at par and inflation rises to, say, 10%, the bond would likely be priced to yield something north of that, which would of course result in a substantial reduction in the value of the bond. The bond can do nothing.

Equity, representing an ownership piece of a business, is better able to cope with inflation. Yes, the company's costs rise, but then so likely do the company's selling prices. Simplistically, a business is relatively immune from inflation. Given that inflation is always and everywhere a monetary phenomenon (i.e., the printing of too much money) and given that some politicians may find inflating an attractive policy, I do think that stocks' ability to weather inflation better than bonds makes equities a dominant asset class.

Of course, this is only an academic exercise here at The Oakmark Funds. We may find these debates interesting, but when investing your money, we adhere to the one-stock-at-a-time approach that has worked well for us for a long time.

ROBERT J. SANBORN
Portfolio Manager
rsanborn@oakmark.com
July 7, 1998

THE OAKMARK BOOK CLUB

It's time again for another installment of The Oakmark Book Club, wherein I recommend the books which I have read recently that might be relevant to those of you interested in investing, finance, business, and economics;

Guns, Germs, and Steel: The Fates of Human Societies, by Jared Diamond (W.W. Norton and Company, 1997); a masterful history of human societies on earth for the past 13,000 years, and an illumination of why different societies developed at dissimilar rates; the bottom line: historical processes, not intelligence, explains diversity; the most stimulating book I have read in years;

The Wealth and Poverty of Nations: Why Some are Rich and Some So Poor, by David S. Landes (W.W. Norton, 1998); similar to the above book, but covering a shorter interval—"only" 600 years;

Just Do It: The Nike Spirit in the Corporate World, by Donald Katz (Adams, 1995); an excellent history of Nike, which illuminates the company's unique culture, which has been the key to its phenomenal success; as an aside, I liked Akio Morita, then CEO of Sony, telling Nike CEO Phil Knight in 1989 that the US was on the verge of becoming a hollow industrial power;

Frozen Desire: The Meaning of Money, by James Buchan (Farar Straus Giroux, 1997); a survey of the different forms and views of money across the centuries, especially human beings' psychological attachment to the concept of wealth;

Raging Bulls, Easy Riders: How the Sex, Drugs, and Rock-and-Roll Generation Saved Hollywood, by Peter Biskind (Schuster, 1998); a dishy look at the "Directors' Decade"; lots of fun, and the investment moral: never, ever invest in the movie business;

The Commanding Heights: The Battle Between Government and the Marketplace That is Re-making the Modern World, by Daniel Yergin and Joseph Stanislaw (Schuster, 1998); a handful of intellectuals—among them F.A. Hayek and Milton Friedman—contended for decades that the larger the government relative to an economy, the lower the standard of living; this critique of Keynesian orthodoxy met a collective yawn until the early 1980s; business enterprise has always been a struggle between those who participate in the private sector—investors, workers—and those in the power elite who set the rules and tax the profits and this book is an exhaustive survey of this struggle in the 20th century.

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

 (a) Non-income producing security.

(b) Represents an American Depositary Receipt.