The Oakmark Fund

Report from Robert J. Sanborn, Portfolio Manager

 

THE VALUE OF A $10,000 INVESTMENT IN THE OAKMARK FUND FROM ITS INCEPTION (8/5/91) TO PRESENT (12/31/98) AS COMPARED TO THE STANDARD & POOR'S 500 INDEX

12/31/98 NAV $35.82

 

Total Return
Last 3 mos.

Average Annual
Total Return*
Through 12/31/98
From Fund
Inception 8/5/91

The Oakmark Fund

12.5%

26.2%

Standard & Poor's 500 Stock Index w/inc**

21.3%

19.7%

Dow Jones Industrial Average w/inc**

17.6%

19.1%

Value Line Composite Index**

14.1%

8.3%

*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 S&P 500 is a broad market-weighted average dominated by blue-chip stocks. The Dow Jones Industrial Average includes only 30 big companies. The Value Line Index is an unweighted average of more than 1,000 stocks. Past performance is no guarantee of future results.

PORTFOLIO UPDATE, OR WAITING FOR GODOT

Many of you have read Samuel Beckett's Absurdist play, "Waiting for Godot," in which the tramps Vladimir and Estragon wait, and wait, and wait for Godot to show up and relieve them of their misery. So it is for us, as we continue to adhere to our disciplined value philosophy and wait, and wait, and wait for the momentum market that has prevailed over the past three years to die a deserved death. Where is Dr. Kevorkian when you need him?

In recent letters, I have described the investment climate and how narrow the market's performance has been. The only stocks that seem to be doing well are the 30 largest-capitalization stocks in the Standard & Poor's 500 (which accounted for virtually all of that index's 28 percent gain in calendar 1998 and the super-high-growth stocks, like any Internet company. The 100 largest companies in the index were up 37 percent last year, while the smallest 100 were flat. In 1998, the Vanguard Growth Stock index returned more than 27 points above its Value Stock index. Your Fund owns only one of the thirty largest companies and owns none of the high-flying growth stocks. The absence of stocks in these sectors continues to adversely impact our Fund's relative performance.

We entered 1998 believing these stocks to be very overpriced. We enter 1999 believing these stocks to be extremely overpriced. While the trailing P/E ratio of the S&P 500 is a lofty 30.3 times, the P/E ratio of the ten largest stocks is 40.3. As I have stated before, we will never try to anticipate market psychology with your hard-earned (and heavily taxed!) money. We will always choose to own an undervalued stock with no momentum rather than to own an overpriced albeit "hot" stock.

The rationales justifying the levels of Internet companies are getting really offbeat. One Wall Street analyst recently wrote a report on Amazon.com, the on-line retailer. He produced an earnings model to the year 2004, for what it's worth (i.e., not much). On his out-year estimate, the analyst slapped a 40 multiple—why not? Voila!—a $400 price target, up from the analyst's prior $150. (And, as I write this, the stock has just pierced that price target. Time to update that model!)

America OnLine, with revenues of $3 billion, is worth significantly more than Disney, with ten times the revenues, and assets such as Disney World, the ABC radio and TV network, the Disney studio and archives, and ESPN and A&E. Yahoo! is worth more than a great business like Colgate, which has 60 times the revenues. Amazon.com is worth more than J.P. Morgan, which has 45 times the revenues. These facts boggle the mind, and remind us, that for all the brain- and computer-power directed at today's markets, emotion and mass psychology can drive prices now as much as any other time in history.

The "New York Times" recently had an article about the Wall Street analyst who is the best known of the Internet analysts. At a meeting, she was asked if Internet search engine company Yahoo! (which has a market cap. of $30B, and revenues of $0.15B!) was overpriced at a certain level. "No," she said. What about at twice the price? "No." What about at four times the price? "No," she replied, "if I believe in the company, I buy the stock."

If every American used that logic to buy their cars (as I have written before), we would only see Ferraris on the roadway. But—alas!—in the long run, price always matters. Pebble Beach is a great golf course, perhaps the greatest, but it has been proven that one can pay too much to own it. Yet, the stock market right now seems to be thinking like that Wall Street analyst, with an irrational preference for growth, and a corresponding indifference to valuation.

Many mutual fund investors, if not most, focus purely on the returns of an investment or a fund, and do not care how those results were achieved. Many are very impatient, and think the optimal way to grow their nest egg is to buy those funds that have HAD the recent hot performance. Akin to driving while keeping your eyes glued to the rear view mirror, it leads to a lot of accidents.

Unlike many mutual fund managers, we never ponder whether a stock is "going up." Rather, we always populate our Fund with holdings that sell at the biggest discount to their true intrinsic value and have owner-oriented managements. Period. There are those that now say "Value is dead" or "The world has changed." I disagree. In our experience, price and value always come together, and that dynamic allows The Oakmark Fund to add value. Sometimes, as now, this process takes longer than some would like. However, as an investor in the Fund and as one who totally believes in our investment philosophy, I will never abandon our approach. I know it works.

I empathize with those who wished they had earned the juicy returns generated by the mega-caps and the growth stocks last year, and I sincerely appreciate the support and patience you have shown. I have no idea when our Fund will start to manifest its value, and we can do nothing to accelerate the process. In the play, Godot never does show up. In the market, "he" will, and, since I believe our Fund is more relatively attractive than it has ever been, when he does, our outperformance should be significant.

EATON CORPORATION

Eaton (ETN) is a recent addition to the portfolio, having been sourced and followed by our Bill Jacobs, and I want to briefly explain why we own it. Eaton, based in Cleveland, Ohio, is a diversified manufacturer of proprietary industrial products. Key businesses include industrial controls, truck transmissions, automotive components, hydraulics, and semiconductor equipment. Common among the business lines are the above industry-average returns each generates. This is a result of the company's long-term emphasis on Research and Development, which produces innovative, highly engineered products that face limited competition. Fully 80 percent of ETN's products have a #1 or #2 market share. Another contributing factor is the diversity of its customer base. This is unlike many industrial companies who are somewhat at the mercy of their very few customers.

The financial figures validate our belief that ETN is an above-average business. ETN has consistently earned returns on total capital in the mid-teens. Also, ETN generates substantial free cash flow after its discretionary R&D spending. Management's priority is to make acquisitions, with the goal of attaining dominant scale in a given business and being recognized as the global leader. The company also has a history of repurchasing its shares, and that is also a possibility.

In any event, we trust this management team to direct its capital optimally. CEO Stephen Hardis has a keen understanding of the global marketplace and has a strong financial background. More important, he has an independent streak that makes him appropriately skeptical of the Wall Street fad du jour. Management compensation aligns the interests of management and outside shareholders. A meaningful portion of the stock options granted over the past few years will not vest until the company reaches an EPS target of $8 in 2000, with ten percent annual increases. Employees own 15 percent of the shares outstanding, establishing an owner mindset throughout the entire enterprise.

Last, and as always, most important, the valuation of ETN is extremely attractive. Adding back the non-cash amortization, Bill estimates ETN will earn $6.75 in 1999. This includes a loss in the semiconductor business, which is very cyclical. Taking this business out of the mix and valuing it at a very conservative one times revenue, ETN is trading at less than 10 times earnings. This is much less than half the multiple on the S&P 500. It sells at a very modest one times sales. This is a very cheap stock.

In summary, ETN is a solid, above-average business, has above-average management, and yet sells at a far below-average valuation. Its $5 billion market capitalization puts it squarely in the ignored, unloved, and under-followed mid-cap category, and the stock has zero momentum. It is an exemplar of the sort of holding that we believe will generate the performance we expect.

ROBERT J. SANBORN
Portfolio Manager
rsanborn@oakmark.com
January 6, 1999
 

THE OAKMARK FUND
Schedule of Investments—December 31, 1998 (Unaudited)

 

Shares Held

Market Value

Common Stocks—96.2%

Food & Beverage—15.3%

Philip Morris Companies Inc.

13,810,700

$738,872,450

H.J. Heinz Company

3,525,350

199,622,944

Nabisco Holdings Corporation, Class A

2,472,100

102,592,150

Gallaher Group Plc (b)

2,835,500

77,090,156

 

 

1,118,177,700

Apparel—6.3%

Nike, Inc., Class B

11,457,100

$464,728,619

 

 

 

Retail—0.2%

GC Companies, Inc. (a)

397,000

$16,525,125

 

 

 

Hardware—7.1%

The Black & Decker Corporation

8,267,000

$463,468,687

The Stanley Works

2,059,700

57,156,675

 

 

520,625,362

Other Consumer Goods & Services—13.7%

H&R Block, Inc.

7,665,800

$344,961,000

Mattel, Inc.

13,439,400

306,586,312

Brunswick Corporation

7,280,800

180,199,800

Fortune Brands, Inc.

2,746,800

86,867,550

Polaroid Corporation

4,552,400

85,072,975

 

 

1,003,687,637

Banks & Thrifts—12.6%

Bank One Corporation

8,800,548

$449,377,982

Washington Mutual, Inc.

10,530,000

402,114,375

Mellon Bank Corporation

1,000,000

68,750,000

 

 

920,242,357

Insurance—1.3%

Old Republic International Corporation

4,122,930

$92,765,925

 

 

 

Publishing—5.5%

Knight-Ridder, Inc.

7,216,100

$368,923,113

R. H. Donnelley Corporation

2,098,260

30,555,911

 

 

399,479,024

Information Services—6.4%

The Dun & Bradstreet Corporation

10,491,300

$331,131,656

ACNielsen Corporation

4,764,000

134,583,000

 

 

465,714,656

Computer Services—4.9%

Electronic Data Systems Corporation

5,331,800

$267,922,950

First Data Corporation

2,873,200

91,044,525

 

 

358,967,475

Medical Centers—4.6%

Columbia/HCA Healthcare Corporation

13,501,000

$334,149,750

 

 

 

Medical Products—1.2%

Sybron International Corporation (a)

3,135,600

$85,249,125

 

 

 

Automotive—0.8%

SPX Corporation (a)

875,200

$58,638,400

 

 

 

Aerospace & Defense—8.0%

Lockheed Martin Corporation

3,625,000

$307,218,750

The Boeing Company

8,599,400

280,555,425

 

 

587,774,175

Machinery & Industrial Processing—5.4%

Eaton Corporation

4,065,800

$287,401,237

Cooper Industries, Inc.

2,287,400

109,080,388

 

 

396,481,625

Building Materials & Construction—0.3%

Juno Lighting, Inc.

1,085,000

$25,361,875

 

 

 

Forestry Products—0.1%

Fort James Corporation

237,200

$9,488,000

 

 

 

Mining—1.1%

DeBeers Centenary AG (b)

6,546,000

$83,461,500

 

 

 

Other Industrial Goods & Services—1.4%

Parker-Hannifin Corporation

1,222,600

$40,040,150

Bandag Incorporated, Class A (a)

1,104,100

38,505,488

The Geon Company

971,600

22,346,800

 

 

100,892,438

 

 

 

Total Common Stocks (Cost: $6,116,428,491)

7,042,410,768

 

 

 

Principal Value

Market Value

Short Term Investments—3.0%

U.S. Government Bills—1.0%

United States Treasury Bills, 4.29%–5.03% due 1/7/1999–1/21/1999

$75,000,000

$74,877,535

Total U.S. Government Bills (Cost: $74,877,535)

74,877,535

 

 

 

Commercial Paper—1.4%

Ford Motor Credit Corp., 5.35% due 1/7/1999–1/8/1999

$40,000,000

$40,000,000

General Electric Capital Corporation, 5.33%–5.35% due 1/11/1999–1/12/1999

60,000,000

60,000,000

Total Commercial Paper (Cost: $100,000,000)

100,000,000

 

 

 

Repurchase Agreements—0.6%

State Street Repurchase Agreement, 4.50% due 1/4/1999

$44,288,000

$44,288,000

Total Repurchase Agreements (Cost: $44,288,000)

44,288,000

 

 

 

Total Short Term Investments (Cost: $219,165,535)

219,165,535

 

 

 

Total Investments (Cost $6,335,594,026)—99.2%

$7,261,576,303

Other Assets In Excess Of Other Liabilities—0.8%

58,464,169

Total Net Assets—100%

$7,320,040,472

(a) Non-income producing security.

(b) Represents an American Depositary Receipt.