Fellow Shareholders,

The Oakmark International Small Cap Fund lost 11% in the recent quarter ending September 30, 2001, compared to larger declines of 18% and 14% in the Lipper International Small Cap Average and the MSCI World ex U.S. Index, respectively.

While we are always disappointed to be down, year-to-date your Fund’s 5% decline on a relative basis remains very strong. The Lipper International Small Cap Average is down 29% and the MSCI World ex U.S. Index is down 27%. Over the past three years, The Oakmark International Small Cap Fund is up 19% annually. It appears that international small cap stocks as an asset class may finally be gaining some recognition after a long period of hibernation.

Traveler's Log: France

On a recent trip to France we met with a number of companies from disparate industries. While each business has its individual challenges and opportunities, one overriding theme was the difficulty of restructuring their cost bases inside France. The French labor market remains one of the most inflexible in Europe.

At the time of our meetings most businesses were already experiencing slowdowns in demand, so we spent part of the time talking about management’s flexibility (and desire) to address costs. Many had already started the reduction of staff. With almost comical regularity, their US, Latin American, and Asian operations were always the first targets for personnel cuts, no matter how immaterial they were to the overall business. Next, maybe a few cuts were planned here and there on the periphery in Europe. Finally, after prodding, came a comment about how difficult it is to fire staff in France.

This year financial results, especially those in service industries, have been hit by the imposition of the 35-hour work week. During one meeting a CEO of a IT services company threw up his hands in exasperation trying to explain the damage to his business, "Have you ever heard of anything more ridiculous? A consultant working 35 hour weeks!?"

Larry Ellison, Chairman of Oracle, recently summed it up well saying that if they hire 100 people in France and later fire 5, the French government does not view it as 95 jobs created, but 5 destroyed. "If we can’t fire people, we just won’t hire them in the future," he acknowledged.

The French labor minister just last week received funding to "create" 50,000 new jobs, basically training programs and temporary student worker programs which serve no real purpose other than to pad employment statistics. I suppose we should give the Jospin Government at least some credit that the situation is not worse considering that the Communist Party is a part of his ruling coalition!

There is nothing more illustrative than a concrete example, and the sad saga of Moulinex provides a great one in this case. Moulinex is a well-known supplier of small appliances, best known in the US for their Krups coffee machines. Throughout the 1990s as their competitors outsourced and moved more and more of their production to low-cost locales, Moulinex remained saddled with their French cost base. As profitability waned, debts started piling up.

Starting in 1996, management tried to implement a number of restructuring plans, all of them really too tame to address their long-term structural disadvantages. Finally, after a series of big losses, an Italian company, Elettro Finanziaria, recapitalized the company, by buying a 74% stake. None of these actions addressed the underlying problem: you cannot be profitable building low-end microwaves and vacuum cleaners in France with high-wage, 35-hour a week employees.

This August management submitted another plan to try and save the company. It called for a cut of 4,000 employees (only 1,500 in France) out of the total workforce of 21,500, and would include the shuttering of three antiquated French production sites. Workers responded by dumping microwave ovens in front of government offices and staging protest strikes. Apparently, the argument that the company had continually piled up losses since 1998 and had little hope of surviving in its present state had little impact on the workers council. They responded by accusing management of blackmailing workers into approving the cuts.

The restructuring plan was rejected. The Italians and the bankers pulled the plug, and Moulinex is now in bankruptcy. A lot more than 4,000 workers are going to lose their jobs. The latest proposal bankruptcy administrators are entertaining is from a French competitor, SEB, which would "preserve" 2,500 French jobs (implying 7,500 job losses). One of the saddest lessons from Moulinex is that not only is it difficult to cut staff from profitable French businesses, but even from those on the verge of extinction!

Looking Forward

We will not write off all French companies because of this one negative. It is our job as analysts to make sure all of the negatives as well as the positives are imputed into our appraisal of business value. Your Fund has made some very successful investments in France and we expect that to continue. There are some terrific management teams there that are able to overcome regulatory impediments to build attractive businesses. Neopost, one of our largest positons, is a current example.

The Fund also has investments in two European temporary employment companies, Creyf’s and United Services Group, that thrive in the kind of inflexible regulatory environment described above. We believe they are both very cheap and have terrific secular growth ahead of them.

Corporate restructuring in Europe is a theme that keeps coming in and out of favor with many global investors. Rather than believing in the faddish nature of macro themes, we stick to the belief that in nearly any regulatory environment there can be interesting investment opportunities. This is why we are bottom-up, stock-specific investors.

David G. Herro, CFA

Portfolio Manger
DGH100@earthlink.net

Michael J. Welsh, CFA, CPA

Portfolio Manager
102521.2142@compuserve.com

October 8, 2001

International Diversification—September 30, 2001