The Oakmark Fund

THE VALUE OF A $10,000 INVESTMENT IN THE OAKMARK FUND FROM ITS INCEPTION (8/5/91) TO PRESENT (9/30/99) AS COMPARED TO THE STANDARD & POOR'S 500 INDEX
9/30/99 NAV $34.37	Total Return Last 3 mos.	Average Annual Total Return* Through 9/30/99 From Fund Inception 8/5/91
The Oakmark Fund	-13.6%	22.9%
Standard & Poor's 500 Stock Index w/inc**	-6.2%	18.5%
Dow Jones Industrial Average w/inc**	-5.4%	19.1%
Value Line Composite Index**	-10.3%	6.9%
*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 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 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

The fiscal year ending September 30, 1999 was very disappointing to me. Your Fund lagged significantly behind the overall market, and this is especially frustrating after our lackluster 1998. While your Fund generated positive absolute returns each year, it has dramatically lagged a very strong overall market.

On the one hand, your Fund has had a dearth of big winners to compensate for some disappointments. Of our sixteen positions greater than 3 percent of assets, only four performed better than the Standard & Poor's 500—Brunswick, Nike, Boeing, and Eaton. This does not really surprise me, because in general the big winners in this market have been the fast-growing technology stocks that represent a big portion of the overall market. As most of you know, we find these stocks to be grossly overpriced and do not own any (see next item for more).

However, your Fund had a number of losers during the year that are more troubling and deserve discussion. Of our aforementioned sixteen largest holdings, five stocks—Lockheed Martin, Mattel, Philip Morris, Bank One, and Washington Mutual—were down for the year. Individual declines ranged from 13 percent for Washington Mutual to 35 percent for Lockheed Martin.

One needs to differentiate between stocks that went down due to a decline in underlying business value, and those that went down because...they went down. Our investment methodology involves buying stocks in businesses we understand, with owner-oriented management, and, most important, that sell at a significant discount to underlying value. In our view, two of our losers—Philip Morris and Washington Mutual—have performed as expected as BUSINESSES and our buy-and-sell targets are at least as high today as they were a year ago. While we monitor developments closely, we view the declines in these two stocks as opportunities.

Bank One did experience a fundamental disappointment during the year as growth at its large credit card business was less than expected. While we have adjusted our earnings estimates somewhat, we do not view this development as a major hit to underlying value. We still have great respect for the First USA credit card operation and, selling at less than 10x next year's earnings, we view ONE as a bargain.

Mattel and Lockheed Martin both experienced major declines in our estimate of underlying value. In the case of Mattel, the culprit was the disastrous acquisition of The Learning Company. After closing this deal in the second quarter of this year, MAT announced in the THIRD quarter that TLC was nowhere near as profitable as originally thought. In fact, at this date, the Company is still apparently trying to ascertain the extent of the problems at TLC. We have dramatically lowered our earnings estimates and our buy-and-sell targets.

In the case of Lockheed Martin, this is a case of The Gang That Cannot Launch a Satellite Straight. Very poor execution in a number of its businesses and in some cost-cutting initiatives have caused our earnings estimates for the years 1999 and 2000 to be cut in half versus prior expectations. Our buy-and-sell targets have been similarly cut.

When doing a post-mortem on these two, it is clear in the case of MAT that management was not up to the critical job of capital allocation. When a management issues stock equal to more than one-third of its shares outstanding, it better have a firm handle on what it is buying. It is clear in the instance of TLC that management's due diligence is highly suspect. In the case of Lockheed Martin, management also is to blame for its problems. As we watched this company make a very large number of acquisitions—each of which was logical on its face—we concluded that management was up to the task of integrating these disparate cultures. In retrospect, we were wrong.

In the case of both Mattel and Lockheed, we have had extensive and continuous contact with top management. Despite this, we clearly misjudged management's abilities. This is especially frustrating, because we as a firm traditionally seek out superior managements and have spent a lot of time with a lot of CEOs. While we as a group are not known as being bashful, we recognize that our questioning of management must be even more direct and pointed in the future.

What are we doing with these stocks? As our schedule of investments indicates, we have retained the vast majority of our shares in both companies at the current time. While I am discomfited about holding shares in companies in which we have serious doubts about management, the market has driven the shares of both stocks to levels that are too cheap. Both stocks sell at less than 10x next year's cash earnings, huge discounts to the overall market. With both vulnerable to either financial or strategic buyers, with both companies leaders in their industries, and with management under the gun to produce, I have elected to retain both holdings for now.

While it is important to look back and understand one's investment results, it is even more crucial always to look to the future and not be burdened by history. While the past couple of years have produced unacceptable performance, I am more confident about your Fund's prospective relative performance than I have ever been. My colleagues and I have experienced similar periods before and we have seen our patience rewarded.

A TALE OF TWO ACQUISITIONS

The history of financial markets tells us that the more things appear to change, the more they stay the same. Reading about the South Sea Company in 1720s England reminded me of the stock market in 1999 America. Despite the grandiose name, the South Sea Company had no business except converting illiquid government annuities into stock shares. The intrinsic value per share was easily obtained. Despite this, South Sea stock became a sensation and soared far above this value, attracting first government officials and royalty, then professional traders, and then, towards the end of the bubble, the proverbial widows and orphans.

The rapid price rise above value stimulated entrepreneurs to float other "bubble" companies. These companies had a huge variety of purposes. One was formed merely to trade South Sea stock; others were to settle Australia, to gather saltpeter by cleaning out all the loos in England, and to make an air pump for the brain. As an aside, there are days (and quarters) I wish that last one had panned out!

Now let's advance to 1999. The awesome albeit irregular rise in technology stocks continues and the awesome increase in IPOs to take advantage of this reality also continues. What is driving these deals, in my opinion, is the same thing that propelled the emergence of the "bubble companies" over 220 years ago—public market prices that far exceed intrinsic value.

I have discussed at length how the US stock market is roughly divided into two camps, the large-cap growth (primarily technology) companies on the one hand and everything else on the other. "Everything else" hasn't been winning, as if you did not already know. This situation has created a pervasive psychology in today's stock market, exemplified by two acquisitions that occurred the same week in September: Cisco/Cerent and H. & R. Block/Olde.

Cisco, a leading networking company, announced the over-$7 billion purchase of a private company, Cerent, that has been in business only two years and possesses an apparently nice evolutionary technology. Cerent is unprofitable and has lost $60 million to date. It has only $10 million in revenue, which is expected to grow to $300 million by 2001; it has 266 employees. By my calculations, this deal occurred at 700x revenues, 23x 2001 expected revenues, and $26 million per employee. A venture capital firm that recently invested $8 million in Cerent will soon receive more than $2.1 billion in Cisco stock. (This is a better-annualized return than even a certain First Lady's foray into the commodity markets!). The "Wall Street Journal" wrote that this transaction "...is the latest sign of the Internet's mind-boggling impact on corporate valuations."

The stock market likes this deal.

H&R Block, the tax-preparation company, is one of your Fund's larger holdings. It also announced an acquisition, buying Olde, the discount brokerage company. Block is paying 2.5x revenues and 16.5x earnings for Olde. While we have serious reservations about this deal and believe that Block could have found a far better return for its capital, we would concede that there is a credible strategic rationale for this deal.

The market hates, hates, hates this deal, and in the two trading days after the announcement, Block's market value fell by MORE than the purchase price for Olde. The market is apparently saying, "Not only is Olde worth zero, but it has negative value."

What explains the market's different reactions to the two deals? Well, my belief is that a deep-rooted psychology has taken root among investors (not to mention venture capitalists, investment bankers, and even corporate executives), that in the technology arena, particularly anything related to the Internet, valuation does not matter. One can pay virtually any multiple for any well-positioned tech company because, of course, the world has changed and the growth is going to be there. After all, the stocks keep going up, right?

Let's compare what one can own in the "brick-and-mortar" toy world versus what can own in the Net toy world. Mattel and Hasbro combined have approximately the same market capitalization ($8 billion) as eToys, an Internet toy retailer that has been in business for less than three years. Mattel and Hasbro are the two biggest toy companies in the US and own great brands such as Barbie, G.I. Joe, Fisher-Price, Hot Wheels, and many others.

Combined, Mattel and Hasbro have sales of about $10 billion and generate over $1.6 billion in pre-tax profits. eToys, in its most recent quarter, generated less than $8 million (that's with an "m") in revenues and lost $20 million. If the market is right, eToys is going to experience decades of excellent results. Personally, I think it is exceedingly remote that the market is valuing these respective businesses correctly.

There are countless examples in history of such psychology taking root for a long period of time. Of course, in the long run, the piper must be paid. In 1720 England, the fate of the London banker John Martin is instructive. Early in the summer, watching the price of South Sea soar, he argued, "When the rest of the world is mad, we must imitate them in some measure." Alas, it turned out he was late to the game, and failed to sell out before the crash. Losing his fortune, he complained of being "blinded by other people's advice."

I get many letters from you, the shareholders, complaining about my stubborn refusal to buy the tech stocks. I share—believe me!—your frustration. However, I remain very confident about our Fund and its relative value.

As I write this, investment banks are about to float a huge number of IPOs, most of which have an Internet connection of some sort. (I note that there are now a number of mutual funds that focus on investing in IPOs, and more are on the way!). All of the money raised by these IPOs will go into competing with other players. The laws of economics dictate that this capital will retard returns. In addition, venture capital firms are no doubt observing the valuations the stock market is placing on Internet plays. According to the National Venture Capital Association, the dollar value of Internet venture outlays has more than quadrupled in the last year. In that last year, the percentage of venture investments geared to the Internet has gone from 25 percent to over 50 percent. This capital will make the sector more competitive.

So, I concede that many of you must be very frustrated by our Fund's anemic performance, and I continue to appreciate your support and patience. I am not tempted to imitate the madness we see in much of the stock market and remain very confident in our portfolio. In the fullness of time, I am confident that our approach will be validated.

ROBERT J. SANBORN
Portfolio Manager
rsanborn@oakmark.com
October 13, 1999

(a) Non-income producing security.

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

(c) At September 30, 1999, net unrealized appreciation of $166,999,373, for federal income tax purposes, consisted of gross unrealized appreciation of $654,481,043 and gross unrealized depreciation of $487,481,670.