The Oakmark Small Cap Fund

Report from Steven J. Reid, Portfolio Manager

THE VALUE OF A $10,000 INVESTMENT IN THE OAKMARK SMALL CAP FUND FROM ITS INCEPTION (11/1/95) TO PRESENT (6/30/98) AS COMPARED TO THE RUSSELL 2000 INDEX

6/30/98 NAV $19.59

Total Return
Last 3 mos.

Average Annual Total Return*
Through 6/30/98
From Fund Inception
11/1/95

The Oakmark Small Cap Fund

-5.8%

30.8%

Lipper Small Cap Fund Index**

-3.9%

15.4%

Russell 2000 w/inc**

-4.7%

19.3%

S&P Small Cap 600 w/inc**

-4.5%

22.3%

*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 Lipper Small Cap 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's third fiscal quarter ended on June 30, 1998. During the quarter, the Fund lost 5.8%. For the nine months of the fiscal year, the Fund gained 0.6%. Although The Oakmark Small Cap Fund has significantly outperformed the relevant indices since its inception, the recent short-term results are a bit of a disappointment. It is important to remember that investing is a marathon, not a sprint. The true measure of the success of our individual investments in the Fund will not be known for years. As always, we will be consistent and not deviate from our disciplined investment philosophy. Over the long term we believe our value-oriented style of investing will produce results that meet your investment objectives.

For several years now large companies have produced investment returns that are significantly better than smaller companies. That trend has continued this year. However, it is worth noting that smaller companies' earnings growth has been greater than larger companies yet their shares sell at lower valuations. The inflow of money into equities has pushed the stocks of large companies to unprecedented levels of valuation. As an example, General Electric Company's (GE—$92.625) market capitalization recently crossed $300 billion. GE is clearly an outstanding company; it is a leader in its businesses and extremely well managed. As a value investor it is hard to accept the stock market's valuation of their shares. Based on consensus estimates, GE sells at a price-earnings ratio in excess of 30 times this year's earnings. In contrast, the shares of our favorite slipper maker (see last quarter's report), R.G. Barry Corporation (RGB—$17), are valued in the marketplace at a price-earnings ratio that is less than 15 times. Although these companies are not directly comparable, I feel much more comfortable owning the shares and products of RGB.

MEA CULPA

 Many shareholders have inquired about the precipitous drop in the shares of U.S. Industries (USI—$19). On July 2nd, the share price of USI fell over five dollars. The reason for this was a decline in earnings from two of the Company's non-core businesses. This is a great example of a herd-like overreaction to bad news. The earnings at USI for the current fiscal year have been reduced by $0.20 per share, or roughly 12%, yet the share price dropped 22%. The market, in essence, valued the reduction in earnings at a price-earnings multiple of more than 28 times. Furthermore, the shares of USI are now being valued at a price-earnings ratio of a little more than 12 times. Although disappointed by this event, my experience with this management team is that they will act quickly and decisively to correct the problems facing the Company. Thus I continue to believe that USI remains an undervalued investment opportunity.

A NEW ADDITION TO THE FLEET

During the quarter, Teekay Shipping Corporation (TK—$24) was added to the portfolio. TK is an owner and operator of a large modern fleet of oil tankers. Their size has allowed them to capture a significant share of trade in the Indo-Pacific Basin. Their modern fleet is both very economical to operate and environmentally sound. These factors make them a ''first call'' by customers, which include many of the well-known international oil companies. These favorable relationships, combined with excellent fleet management, allow TK to operate at utilization rates of up to 85% versus their competitors who operate at rates as low as 50%. This disparity in utilization rates allows TK to earn a superior return on investment. In a recent visit with management we came away impressed by their strategies to enhance and optimize the opportunities in their business. We also take comfort in the fact that insiders own in excess of 50% of the outstanding shares. Most important, the shares of TK are attractively valued at about nine times current fiscal year earnings. At the present time there is very little coverage of TK by Wall Street, which has allowed us to purchase shares at their 12 month low.

OUTLOOK

Although challenged by the current investment environment, your Fund is committed to its investment philosophy. I am encouraged by the operating performance and valuations of our holdings. Investor focus on large companies has helped create opportunities for investment in small companies. That focus has reduced the competition for investment in small companies, which improves our ability to find undervalued investments.

Once again, I would like to thank everyone involved, especially our shareholders, for your support of The Oakmark Small Cap Fund.

Congratulations to the Chicago Bulls on their sixth NBA Championship!!

STEVEN J. REID
Portfolio Manager
sreid@oakmark.com
July 8, 1998

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

 

Shares Held

Market Value

Common Stocks—92.5%

Food & Beverage—9.1%

Ralcorp Holdings, Inc. (a)

2,000,000

$37,750,000

Triarc Companies, Inc. (a)

1,500,000

32,906,250

International Multifoods Corporation

1,000,000

27,500,000

M & F Worldwide Corp. (a)

917,600

9,118,650

 

 

107,274,900

Retail—4.9%

Cole National Corporation (a)

1,000,000

$40,000,000

Ugly Duckling Corporation (a)

1,750,000

16,953,125

 

 

56,953,125

Other Consumer Goods & Services—7.3%

Scotsman Industries, Inc.

1,000,000

$27,750,000

First Brands Corporation

1,000,000

25,625,000

Barry (R.G.) Corporation (a)

810,000

13,365,000

Libbey, Inc.

300,000

11,493,750

P.H. Glatfelter Company

500,000

7,906,250

 

86,140,000

Banks—12.8%

People’s Bank of Bridgeport, Connecticut

2,950,000

$102,143,750

Brookline Bancorp, Inc. (a)

800,000

11,900,000

BankAtlantic Bancorp, Inc., Class A

1,000,001

11,812,512

Northwest Bancorp Inc.

550,000

8,696,875

Niagara Bancorp Inc. (a)

500,000

7,375,000

PennFed Financial Services, Inc.

260,000

4,306,250

Savings Bank of the Finger Lakes

188,000

3,501,500

 

149,735,887

Insurance—9.3%

RenaissanceRe Holdings Limited.

1,009,000

$46,729,312

Financial Security Assurance Holdings Ltd.

750,000

44,062,500

Highlands Insurance Group, Inc. (a)

1,000,000

18,500,000

 

 

109,291,812

Other Financial—3.6%

ARM Financial Group, Inc., Class A

1,000,000

$22,125,000

Duff & Phelps Credit Rating Co.

350,000

19,512,500

 

 

41,637,500

Broadcasting & Cable TV—9.8%

Cablevision Systems Corporation (a)

1,000,000

$83,500,000

Ascent Entertainment Group, Inc. (a)

2,000,000

22,250,000

Granite Broadcasting Corporation (a)

800,000

9,500,000

 

 

115,250,000

Publishing—0.7%

Lee Enterprises, Inc.

250,000

$7,656,250

 

 

Telecommunications—1.2%

ROHN Industries, Inc.

3,000,000

$14,062,500

 

 

 

Automotive—6.4%

SPX Corporation (a)

600,000

$38,625,000

Stoneridge, Inc. (a)

1,376,500

25,121,125

Standard Motor Products, Inc.

500,000

11,125,000

 

 

74,871,125

Transportation Services—1.1%

Teekay Shipping Corporation

530,000

$13,283,125

 

 

 

Machinery & Industrial Processing—4.0%

The Carbide/Graphite Group, Inc. (a)

750,000

$20,859,375

DT Industries, Inc.

600,000

14,550,000

Northwest Pipe Company (a)

500,000

11,750,000

 

 

47,159,375

Oil & Natural Gas—2.3%

Titan Exploration, Inc. (a)

3,000,000

$26,625,000

 

 

 

Other Industrial Goods & Services—9.4%

MagneTek, Inc. (a)

2,500,000

$39,375,000

Columbus McKinnon Corporation

1,000,000

26,000,000

Ferro Corporation

1,000,000

25,312,500

Binks Sames Corporation

247,000

10,790,812

H.B. Fuller Company

145,000

8,038,438

Binks Sames Corporation, Restricted Shares

28,000

1,076,460

 

110,593,210

Commercial Real Estate—4.1%

Catellus Development Corporation (a)

2,750,000

$48,640,625

 

 

 

Diversified Conglomerates—6.5%

U.S. Industries, Inc.

3,066,400

$75,893,400

 

 

Total Common Stocks (Cost: $924,038,518)

1,085,067,834

 

Principal Value

Market Value

Short Term Investments—6.7%

Commercial Paper—4.7%

American Express Credit Corp., 5.56% due 7/6/1998–7/9/1998

$10,000,000

$10,000,000

Ford Motor Credit Corp., 5.53%–5.61% due 7/2/1998–7/6/1998

 15,000,000

 15,000,000

General Electric Capital Corporation, 5.57%–6.00% due 7/1/1998–7/8/1998

 30,000,000

 30,000,000

Total Commercial Paper (Cost: $55,000,000)

55,000,000

 

 

 

Repurchase Agreements—2.0%

 

 

State Street Repurchase Agreement, 5.65% due 7/1/1998

 $22,802,000

 $22,802,000

Total Repurchase Agreements (Cost: $22,802,000)

22,802,000

 

 

 

Total Short Term Investments (Cost: $77,802,000)

77,802,000

 

 

 

Total Investments (Cost $1,001,840,518)—99.2%

$1,162,869,834

Other Assets In Excess Of Other Liabilities—0.8%

9,860,544

 

 

Total Net Assets—100%

$1,172,730,378

 

 

(a) Non-income producing security.