The Oakmark Equity and Income Fund

Report from Clyde S. McGregor, Portfolio Manager

THE VALUE OF A $10,000 INVESTMENT IN THE OAKMARK EQUITY AND INCOME FUND FROM ITS INCEPTION (11/1/95) TO PRESENT (9/30/98) AS COMPARED TO THE LIPPER BALANCED FUND INDEX

9/30/98 NAV $13.99

Total Return
Last 3 mos.

Average Annual Total Return*
Through 9/30/98
From Fund Inception
11/1/95

The Oakmark Equity & Income Fund

-6.9%

15.4%

Lipper Balanced Fund Index**

-5.8%

14.1%

Lehman Govt./Corp. Bond**

5.0%

8.6%

S&P 500 w/inc**

-10.0%

23.5%

*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 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.

THE SUMMER OF OUR DISCONTENT

Last quarter saw the end of two wonderful streaks: Cal Ripken Jr.'s record for consecutive baseball games and the Equity and Income Fund's heretofore unblemished record of positive return quarters. Time and volatile markets made it inevitable that these streaks would end, but both are regrettable developments. Investor confidence seemed to evaporate worldwide during the summer, and the resulting "flight to liquidity" proved quite painful for some of our mid-cap equity holdings. The portfolio's fixed income position did its part to buffer volatility, however, earning a positive total return of 4.6%.

It is important to remember that the market prices on businesses are far more volatile than the intrinsic values of those businesses. None of the Fund's holdings announced a loss, fraud, or dividend cut during the quarter. Some bought back their shares, others announced new repurchase authorizations, and most saw high levels of share purchases by their own management and directors. In all cases management has been and is now working hard to increase the value per share of their business.

In keeping with these deflationary times, the stock market has declared a clearance sale on most issues. At The Oakmark Family of Funds, we own pieces of businesses that the stock market has allowed us to purchase for less than their intrinsic value. We believe that the opportunities which the summer's selloff has created will prove to be the foundation of future investment returns.

THE STRENGTH OF THE (FIXED INCOME) STRATEGY

While the stock market's difficulties have gotten most of the press recently, times have also been very tough in the corporate bond market. Risk premiums for corporate bonds have widened dramatically over the last six months, in part because of the well-publicized problems of a major hedge fund.

Since the Fund's inception, my strategy in fixed income investing has been to maintain a "quality barbell" of at least 25% in US Treasury notes augmented with high yield investments developed as byproducts of our equity work. I have avoided investment grade corporate debt because the spreads versus Treasury notes were inadequate for all but the most perfect environment. Now that the world is seen as a risky place again, spreads have expanded to more typical levels.

How has the strategy worked out in this period of transition from "all news is good news" to "all news is bad news?" Splendidly. Returns on the Fund's fixed income position were positive in every month of fiscal 1998. This outcome resulted in part because I let the percentage allocation for high yield issues diminish during the year. The one area of increased commitment has been preferred stocks, specifically trust preferreds (discussed in my August 1997 report). I am pleased to report that all of the Trust preferreds achieved a positive return in fiscal 1998 despite unfavorable market conditions.

In closing this section, I will note that should current trends continue, I might have the opportunity to add investment grade issues to the portfolio. I am not opposed to higher graded bonds; I am opposed to overpaying for them.

MIGHTY OAKS AWARDS

With the close of the fiscal year it is time to issue the Mighty Oaks Awards. The awards recognize the stock and fixed income investments which achieve the highest rates of return. Though 1998 proved to be a difficult year, several issues did make large contributions to the Fund. While two-time award winner Bill Nygren (of Oakmark Select) made a strong showing in the equity category with Liberty Media (up 84%), he lost out to analyst Jim Benson who scored a 110% return from Lexmark International.

Clients often ask us why our portfolios do not have representation in the technology sector. The answer to this question derives from our investment philosophy. Before we invest in a company's stock, we ask whether we would be willing to own the entire company at the current price if we could never sell shares again. Put differently, could we live off the cash flows that the business produces if we paid today's price for the entire company? Leading edge technology companies pose a great problem for our philosophy because of the risk of obsolescence. We are, happy, however, to own companies that turn technological innovation to their advantage.

Lexmark International is such a company. Originally the division of IBM which made Selectric typewriters, Lexmark is now the second largest manufacturer of printers. The business economics fit the razor/razor blade model. Lexmark's profits from printers are small, but the company achieves high margins on associated supplies (e.g. ink cartridges).

Jim recommended Lexmark for the Fund in May 1997, when the stock had dipped on earnings and product worries. Part of what we do as value investors is to position our portfolios to benefit from unexpected good fortune, and Lexmark exemplifies this effort. Shortly after we purchased the stock, the company introduced new products that were well received. And, the company's free cash flow proved to be strong enough to support a significant share repurchase. Congratulations to Jim for this wonderful recommendation.

This year's fixed income winner is Harris Associates' fixed income analyst, Chris Pilat. Chris advised that I extend the duration of the fixed income portfolio but keep overall quality high. The Fund's 7-year Treasury notes returned 18% for the twelve months, 4% more than the Fund's highest-returning high yield issue. Thanks, Chris, for pushing me out further on the yield curve.

THANKS

As the Fund nears its third anniversary, I would be remiss not to thank long term shareholders for their support. The consistency and interest of the Fund's shareholders has been most helpful. Please feel free to e-mail me with your comments, questions or ideas for quarterly reports.

CLYDE S. McGREGOR
Portfolio Manager
mcgregor@oakmark.com
October 9, 1998

THE OAKMARK EQUITY AND INCOME FUND
Schedule of Investments—September 30, 1998

Shares Held/
Principal Value

Market Value

Common Stocks—57.4%
 

Office Equipment—3.1%

Lexmark International Group, Inc., Class A (a)

26,000

$1,802,125

 

 

 

Other Consumer Goods & Services—6.4%

Juno Lighting, Inc.

76,300

$1,707,213

H&R Block, Inc.

33,000

1,365,375

National Presto Industries, Inc.

17,000

637,500

 

 

3,710,088

 

Banks & Thrifts—4.7%

Washington Mutual, Inc.

50,000

$1,687,500

Banc One Corporation

23,674

1,009,104

 

2,696,604

 

Insurance—4.2%

PartnerRe Ltd. (b)

32,500

$1,302,031

Old Republic International Corporation

49,500

1,113,750

 

 

2,415,781

 

TV Programming—3.4%

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

52,800

$1,937,100

 

 

 

Publishing—1.5%

Lee Enterprises, Inc.

33,900

$879,281

 

 

 

Information Services—3.3%

The Dun & Bradstreet Corporation

70,000

$1,890,000

 

 

 

Computer Services—5.8%

First Data Corporation

80,000

$1,880,000

Electronic Data Systems Corporation

45,000

1,493,438

 

 

3,373,438

 

Data Storage—4.0%

Imation Corp. (a)

125,000

$2,312,500

 

 

 

Medical Products—3.1%

Sybron International Corporation (a)

93,000

$1,778,625

 

 

 

Automotive—6.5%

Chrysler Corporation

42,000

$2,010,750

Lear Corporation (a)

40,000

1,750,000

 

 

3,760,750

 

Other Industrial Goods & Services—2.7%

Premark International, Inc.

56,500

$1,585,531

 

 

 

Commercial Real Estate—6.2%

Amli Residential Properties Trust

90,000

$1,918,125

Catellus Development Corporation (a)

127,728

1,660,464

 

 

3,578,589

 

Diversified Conglomerates—2.5%

U.S. Industries, Inc.

94,000

$1,415,875
 

Total Common Stocks (Cost: $30,820,268)

33,136,287

 

 

 

Fixed Income—33.7%

 

Preferred Stock—5.1%

 

Banks & Thrifts—5.1%

BBC Capital Trust I, Preferred, 9.50%

28,000

$714,000

Pennfed Capital Trust, Preferred, 8.90%

27,500

687,500

PennFirst Capital Trust 1, Preferred, 8.625%

70,000

673,750

RBI Capital Trust I, Preferred, 9.10%

42,500

430,312

Fidelity Capital Trust I, Preferred, 8.375%

43,500

424,125

 

 

2,929,687
 

Total Preferred Stock (Cost: $2,970,738)

2,929,687

 

 

 

Corporate Bonds—2.4%

 

Aerospace & Automotive—0.3%

Coltec Industries, Inc., 9.75% due 4/1/2000

$150,000

$157,687

Coltec Industries, Inc., 9.75% due 11/1/1999

25,000

26,188

 

 

183,875

 

Building Materials & Construction—0.3%

USG Corporation, 9.25% due 9/15/2001, Senior Notes Series B

150,000

$160,313

 

 

 

Utilities—0.3%

Midland Funding Corporation, 11.75% due 7/23/2005

150,000

$173,438

 

 

 

Other Industrial Goods & Services—1.5%

Scotsman Industries, Inc., 8.625% due 12/15/2007, Senior Subordinated Note

565,000

$560,762

UCAR Global Enterprises Inc., 12.00% due 1/15/2005, Senior Subordinated Note

300,000

304,500

 

 

865,262
 

Total Corporate Bonds (Cost: $1,395,124)

1,382,888

 

 

 

Government and Agency Securities—26.2%

 

U.S. Government Bonds—25.7%

United States Treasury Notes, 7.875% due 11/15/2004

$6,000,000

$7,107,720

United States Treasury Notes, 7.50% due 5/15/2002

6,000,000

6,616,140

United States Treasury Notes, 6.25% due 2/15/2007

1,000,000

1,122,490

 

 

14,846,350

 

U.S. Government Agencies—0.5%

Federal Home Loan Bank, 6.405% due 4/10/2001, Consolidated Bond

300,000

$311,895
 

Total Government and Agency Securities (Cost: $14,288,633)

15,158,245
 

Total Fixed Income (Cost: $18,654,495)

19,470,820

 

 

 

Short Term Investments—8.5%

 

Commercial Paper—6.1%

American Express Credit Corp., 5.27% due 10/5/1998

$500,000

$500,000

Ford Motor Credit Corp., 5.55% due 10/1/1998

1,500,000

1,500,000

General Electric Capital Corporation, 5.70% due 10/1/1998

1,500,000

1,500,000
 

Total Commercial Paper (Cost: $3,500,000)

3,500,000

 

 

 

Repurchase Agreements—2.4%

State Street Repurchase Agreement, 5.30% due 10/1/1998

$1,390,000

$1,390,000
 

Total Repurchase Agreements (Cost: $1,390,000)

1,390,000
 

Total Short Term Investments (Cost: $4,890,000)

4,890,000
 

Total Investments (Cost $54,364,763)—99.6% (c)

$57,497,107

Other Assets In Excess Of Other Liabilities—0.4%

248,748
 

Total Net Assets—100%

$57,745,855

(a) Non-income producing security.

(b) Represents foreign domiciled corporation.

(c) At September 30, 1998, net unrealized appreciation of $3,132,344, for federal income tax purposes consisted of gross unrealized appreciation of $5,429,008 and gross unrealized depreciation of $2,296,664.