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 (9/30/98) AS COMPARED TO THE RUSSELL 2000 INDEX

9/30/98 NAV $12.63

Total Return
Last 3 mos.

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

The Oakmark Small Cap Fund

-26.8%

14.9%

Lipper Small Cap Fund Index**

-21.4%

5.0%

Russell 2000 w/inc**

-20.2%

8.8%

S&P Small Cap 600 w/inc**

-20.9%

10.9%

*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 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 small market capitalization. Past performance is no guarantee of future results.

Fortunately, The Oakmark Small Cap Fund's fiscal year ended on September 30, 1998. Results for the fourth quarter and the fiscal year were very disappointing. The shares of small cap companies have not performed well this year and continue to trail the broad market. Unfortunately, The Oakmark Small Cap Fund's results lagged the relevant small cap indices.

"It was the worst of times, it was the best of times." SJR, PM.

Small cap stocks have been through a very difficult period. It is not uncommon to see a company's shares trading at prices that are down 30% or more from their annual highs. Nor, is it uncommon to see a company's shares trading at prices that represent their annual lows. The indices that measure the performance of the shares of small cap stocks have underperformed the broad market indices for years. The question I am frequently asked is: "When will small caps start to do well again?" I honestly don't know the answer. I don't think we will really know the answer until we can clearly see it in the rear view mirror three to six months after it has happened. Robert McGough of the Wall Street Journal wrote in a recent article: "Predictions of the revival of small-company stocks have been coming about as regularly as Elvis sightings—and so far have had about as much substance too." Leaving predictions to the gurus and pundits, our focus should be on where we are now.

I believe we are in the midst of the mutated Dickens quote from above. While there is no doubt that there are some very unsettling events occurring across the globe, we need to look beyond the headlines. As investors, we need to be forward looking. The underperformance of the shares of small cap companies is an opportunity. Historically, small cap stocks have traded at price earnings (P/E) ratios that are greater than those of large cap stocks. Very rarely do small cap stocks trade at a P/E ratio equal to or less than large cap stocks. Right now is one of those rare occasions where small cap stocks are cheaper than large cap stocks. In fact, we are able to buy small cap stocks that are trading at P/E multiples that are less than ten times earnings, which is less than half the small or large cap P/E multiple. Our experience has been that remaining patient and consistent with our investment philosophy will be rewarded.

REDEMPTIONS, DISTRIBUTIONS, AND RE-OPENING

One year ago, the total assets of The Oakmark Small Cap Fund were over $1.5 billion. At the end of this past fiscal year total assets are over $600 million. Although it feels like we lost about $900 million, we did not. In fact, net redemptions, the amount shareholders take out of the Fund less the amount they put into the Fund, amounted to over $600 million of the change in assets. What is the effect of redemptions on the Fund? There are several that stand out. First, redemptions require the Fund to sell portfolio securities in order to make payments to shareholders who have elected to redeem their shares of the Fund. Essentially, the Fund was selling solely to create liquidity for redemptions, not because these investments had met our investment targets. The second effect, although not quantifiable, is the effect forced selling of our investments has on the share prices of these companies.

There are several unavoidable events in life—they include death, taxes, and mutual fund distributions. The Internal Revenue Service requires that mutual funds annually distribute to shareholders any income and realized capital gains. Since the Fund's inception, there has been relatively low turnover and hence very little realized gain distributed to shareholders. Unfortunately, another significant effect of net redemptions after the portfolio has appreciated is that they force the Fund to realize a significant amount of gains. Those gains, which were all long-term, were distributed to shareholders in early August. We anticipate that any additional distribution will be minimal. It is also worth noting that the Fund currently is carrying a fairly significant unrealized loss in the portfolio. Hence, going forward we should be in a fairly benign tax position.

Investors' disinterest in small cap stocks has reduced the level of competition for both the sourcing and purchasing of new investments for the Fund. During the quarter we added five new companies to the portfolio. These companies are all close to their annual lows and between thirty and seventy percent below their annual highs. In order to take advantage of the opportunities we were seeing in the marketplace, the Fund "re-opened" to new investors at the beginning of September. This has helped stem the level of redemptions, mitigating the adverse effects noted above. We believe that new shareholders, as well as existing shareholders, own the Fund for the right reasons . . . meaning that they want exposure to small cap value stocks and are intrigued by the long-term opportunities available to us. In the future, should the level of inflows be too large or our opportunities to prudently invest the money not be available, we will take the appropriate action.

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

STEVEN J. REID
Portfolio Manager
sreid@oakmark.com
October 6, 1998

THE OAKMARK SMALL CAP FUND
Schedule of Investments—September 30, 1998

Shares Held/
Principal Value

Market Value

Common Stocks—91.9%
 

Food & Beverage—11.2%

Ralcorp Holdings, Inc. (a)(b)

1,750,000

$24,500,000

Triarc Companies, Inc. (a)(b)

1,250,000

19,453,125

Vlasic Foods International Inc. (a)

500,000

9,343,750

International Multifoods Corporation

500,000

8,218,750

M & F Worldwide Corp. (a)

750,000

7,453,125

 

 

68,968,750
 

Retail—3.7%

Department 56, Inc. (a)

520,000

$14,040,000

Ugly Duckling Corporation (a)(b)

1,676,200

8,695,288

 

 

22,735,288
 

Other Consumer Goods & Services—13.0%

First Brands Corporation

1,250,000

$27,265,625

Scotsman Industries, Inc. (b)

983,000

22,240,375

Libbey, Inc.

420,500

12,404,750

Barry (R.G.) Corporation (a)(b)

849,100

11,781,262

P.H. Glatfelter Company

500,000

6,531,250

 

 

80,223,262
 

Banks & Thrifts—11.5%

People's Bank of Bridgeport, Connecticut

2,000,000

$49,000,000

BankAtlantic Bancorp, Inc., Class A

1,000,001

7,187,507

Northwest Bancorp Inc.

550,000

5,637,500

Niagara Bancorp Inc. (a)

400,000

3,925,000

PennFed Financial Services, Inc.

260,000

3,445,000

Finger Lakes Financial Corp. (b)

188,000

2,068,000

 

 

71,263,007

Insurance—2.3%

Financial Security Assurance Holdings Ltd.

292,600

$14,264,250

 

 

 

Other Financial—5.5%

ARM Financial Group, Inc., Class A

1,000,000

$17,750,000

Duff & Phelps Credit Rating Co. (b)

350,000

16,121,875

 

 

33,871,875
 

Broadcasting & Cable TV—6.8%

Cablevision Systems Corporation, Class A (a)

689,800

$29,790,737

Ascent Entertainment Group, Inc. (a)(b)

1,500,000

12,000,000

 

 

41,790,737
 

Telecommunications—0.9%

ROHN Industries, Inc. (b)

3,000,000

$5,812,500

 

 

 
 

Computer Services—1.5%

Symantec Corporation (a)

725,000

$9,560,938

 

 

 
 

Automotive—7.9%

SPX Corporation (a)

500,000

$20,656,250

Stoneridge, Inc. (a)

1,000,000

16,187,500

Standard Motor Products, Inc.

500,000

12,187,500

 

 

49,031,250
 

Transportation Services—2.7%

Teekay Shipping Corporation (c)

900,000

$16,368,750

 

 

 
 

Machinery & Industrial Processing—1.9%

Northwest Pipe Company (a)(b)

500,000

$9,250,000

The Carbide/Graphite Group, Inc. (a)

240,000

2,670,000

 

 

11,920,000
 

Forestry Products—0.8%

Schweitzer-Mauduit International, Inc.

216,500

$4,708,875

 

 

 

Other Industrial Goods & Services—10.3%

Ferro Corporation

900,000

$17,887,500

Columbus McKinnon Corporation (b)

900,000

17,325,000

MagneTek, Inc. (a)

1,500,000

16,406,250

H.B. Fuller Company

200,000

7,575,000

Binks Sames Corporation (b)

275,000

4,675,000

 

 

63,868,750
 

Commercial Real Estate—4.1%

Catellus Development Corporation (a)

1,500,000

$19,500,000

Prime Hospitality Corp.

800,000

5,600,000

 

 

25,100,000
 

Diversified Conglomerates—7.8%

U.S. Industries, Inc.

3,200,000

$48,200,000

 

Total Common Stocks (Cost: $633,782,649)

567,688,232

 

 

 

Short Term Investments—7.8%

 

Commercial Paper—5.6%

American Express Credit Corp., 5.27%–5.55% due 10/1/1998–10/6/1998

$15,000,000

$15,000,000

Ford Motor Credit Corp., 5.40% due 10/2/1998

5,000,000

5,000,000

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

15,000,000

15,000,000

Total Commercial Paper (Cost: $35,000,000)

35,000,000

 

Repurchase Agreements—2.2%

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

$13,543,000

$13,543,000

Total Repurchase Agreements (Cost: $13,543,000)

13,543,000

Total Short Term Investments (Cost: $48,543,000)

48,543,000

Total Investments (Cost $682,325,649)—99.7% (d)

$616,231,232

Other Assets In Excess Of Other Liabilities—0.3%

1,763,530

Total Net Assets—100%

$617,994,762

(a) Non-income producing security.

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

(c) Represents foreign domiciled corporation.

(d) At September 30, 1998, net unrealized depreciation of $66,094,417, for federal income tax purposes consisted of gross unrealized appreciation of $47,329,047 and gross unrealized depreciation of $113,423,464.