The Oakmark Select Fund Report from Bill Nygren, Portfolio Manager

For fiscal 1998, The Oakmark Select Fund increased in value by 3.6%. That performance looks especially good versus the 6.3% decline in the S&P MidCap 400. In fact, your fund outperformed 98% of the other funds classified by Morningstar as midcap value funds. Continued strong performance by our cable TV holdings, especially our largest holding Cablevision Systems, was the main contributor to these results. Unlike the full year, the fourth quarter was disappointing as the fund's decline exceeded the drop in the Index. Although the fund declined less from the July 20 peak than did the MidCap Index, (16.0% vs. 18.2%), we weren't able to overcome the loss that occurred in the first week of the quarter when US Industries reported disappointing results.

Our equity weighting at the end of the quarter, 88.3%, was slightly below the 90% level that I've indicated would normally be our minimum. This situation was created by an unusual combination of events on the last two days of the quarter including new money coming into the fund, a sharp down market and a tactical decision to defer purchasing a new position. You should view the current cash position as extremely unusual and very temporary (it will likely be back to normal by the time you receive this!). We have no ability to predict the market level, and because of that, we don't use cash as a market timing tool.

Declines in individual stock prices this quarter seemed to have little correlation with underlying business value. Because of that, your fund had more turnover than usual as we opportunistically took steps to improve the portfolio. As always, we look for transactions that maximize the portfolio's undervaluation and our confidence in that undervaluation. In addition, we strive to make portfolio changes as tax-efficiently as possible. I think the portfolio today is unusually attractive relative to other stock market opportunities. The S&P 500 at September 30 sold at about 23 times estimated 1999 earnings. Excluding our two cable TV holdings (which aren't valued on a P/E basis), The Oakmark Select Fund had a weighted average P/E on 1999 estimates of 11.5 times. Look at the quality companies we own and I believe you will agree that a 50% discount to the market P/E is excessive. This inexpensive valuation should allow us to continue toward our goal of exceptional long-term performance.

HOW BIG IS TOO BIG?

By far the most frequently asked question in your e-mails is: "When should The Oakmark Select Fund close?" The topic of optimal fund size has received a great deal of attention this year thanks largely to the excellent work John Bogle, Jr. of Numeric Investors did explaining why his funds closed. Unfortunately, it seems his conclusion—close the funds—has received much more press than has his well-articulated rationale. I'd like to look at that rationale and see how it applies to The Oakmark Select Fund.

Intuitively, we all know that there are limits to how much money can be effectively managed with any investment strategy that attempts to perform better than the overall market. As assets under management grow, the number of investments goes up, each position size increases and the cost to enter and exit each position also goes up. What Mr. Bogle did was to measure the reduction in his return caused by price movements his own trading created. By quantifying those costs, Mr. Bogle found that his investment approach maximized expected excess return with just $350 million under management.

What can we learn from his analysis? Most important, because trading costs are the key issue, capacity is constrained by trading volume, not assets under management. Since different investment styles require different levels of trading, they have different capacity. Mr. Bogle identifies three variables that determine a fund's trading cost: the average holding period, the amount of a company being purchased and, lastly, the role stock price momentum plays in the stock selection process. His style, short holding periods for small cap companies that show positive price momentum, has very limited capacity. At the other extreme, a contrarian approach of buying and holding very large companies would have nearly limitless capacity.

How does The Oakmark Select Fund compare? Mr. Bogle's average holding is an $800 million market cap company that he holds for four months. Our average market cap today is about $4 billion and our turnover implies a three-year holding period. Per dollar in the fund, he trades nine times as often as we do and is buying companies that are about 20% as large as ours. By multiplication, our Fund could handle 45 times more assets. Further, costs per trade are much higher for strategies that wait for positive price action before a stock is purchased. While our approach is indifferent to stock price momentum, generally our buy targets are hit when a stock is unloved, and our sell targets hit when the stock is quite popular. Because our trades often go against the trend, our market impact is typically much less significant.

Capacity for The Oakmark Select Fund, as measured purely by trading costs, would be a very large number. In fact, we have imposed a much tighter constraint. We have said that the fund will generally hold twenty or fewer positions and we want the ability to make meaningful investments in midcap companies when we feel they are attractively priced. The midcap universe today is commonly defined to have an average market cap of about $3 billion (that definition was created when stock prices were much lower, and I think it should now be well above $3 billion). To invest 5% of the fund's assets without owning more than 5% of an average midcap company, our assets could not be greater than the size of that average company.

What benefits do current shareholders receive from allowing assets to increase? The most significant benefit is increased tax-efficiency. Because of our long-term holding periods, our gains are normally not only deferred, but also taxed at lower long-term rates. A growing fund gets additional tax benefits. First, some realized gains are avoided because position sizes can be reduced by simply allowing new money to dilute these positions. In a closed fund, it would require a sale, which would generate a taxable gain. Second, both realized and unrealized taxable gains are shared with the new investors even though they didn't benefit from them. The flip side of the argument, that it may be unwise to buy into a fund with a large unrealized gain, is that existing investors have their per-share taxable gains reduced.

So, if The Oakmark Select Fund becomes larger than an average midcap stock, we don't develop a large unrealized gain, and we haven't addressed closing, send me e-mails reminding me of this letter. Until then, we welcome new investors because we believe we all benefit from their joining us. Thank you for your continued support.

WILLIAM C. NYGREN
Portfolio Manager
bnygren@oakmark.com
October 1, 1998

THE OAKMARK SELECT FUND Schedule of Investments—September 30, 1998

(a) Non-income producing security.

(b) Represents an American Depository Receipt.

(c) Represents foreign domiciled corporation.

(d) See footnote number five in the Notes to Financial Statements regarding transactions in affiliated issuers.

(e) At September 30, 1998, net unrealized appreciation of $8,772,910, for federal income tax purposes consisted of gross unrealized appreciation of $155,507,575 and gross unrealized depreciation of $146,734,665.