This report introduces a new, and we believe, improved format. In previous reports for The Oakmark Fund and The Oakmark Select Fund, each report has been a mixture of topical commentary and portfolio update. Starting this quarter, there will be a topical report from Bill Nygren that covers both funds, followed by a portfolio update for each of the funds. We hope this reduces the duplication between the two reports and enhances the reports' usefulness in explaining how we approach investing.

The Perils Of Performance Chasing

In 1999, the ten top performing equity mutual funds had increases that ranged from 224% to 494%. (Unfortunately none of our funds were on that list!) Investors who divided their assets equally across those ten funds at the beginning of 2000 would have seen their assets grow by 45% over the ensuing ten weeks. Pretty exciting! Unfortunately for those investors, as more time passed, the results worsened. At year-end 2001 the two-year loss on that package of funds was 71%. This confirms the fine print in mutual funds ads, "Past performance is no guarantee of future results."

We have always discouraged such performance chasing. Despite the fact that many of our funds have performed near the top of their peer groups both this year and last year, we still say it is a mistake to buy a mutual fund (even ours) solely because of its performance record, especially a short-term record. Instead, we believe investors should understand how a manager decides which stocks to own.

When Yogi Berra said, "If you don't know where you're going, you might not get there" he could have been referring to the difficulty of achieving investment goals without having a solid investment philosophy. Across The Oakmark Family we strive to maximize long-term after-tax returns by being value investors. Our focus is not on trying to buy the best companies but rather on taking advantage of the best opportunities. In the 1940 investment classic, Where Are the Customers' Yachts?, Fred Schwed highlighted this distinction: "Those classes of investments considered "best" change from period to period. The pathetic fallacy is that what are thought to be the best are in truth only the most popular—the most active, the most talked of, the most boosted, and consequently, the highest in price at that time". In our search for the most undervalued stocks, by definition, you will rarely see us owning the popular stocks.

At Oakmark we look for stocks with prices less than 60% of intrinsic value, with intrinsic value that is likely to grow, and with management that acts in the interest of outside shareholders. The combination of these factors creates our biggest competitive advantage, the ability to be more patient than most investors. We try to anticipate how a company will change over the next three to five years whereas the pundits seem preoccupied with the next three to five months, even weeks.

Value Investors Are Not All Alike

All value investors buy stocks below their estimates of intrinsic value. One way value investors differ from each other is in how they define intrinsic value. Many value investors use a single summary statistic, such as a P/E⁴ ratio, and use it across all companies as their approximation of intrinsic value. At Oakmark, when we talk about intrinsic value, we mean the highest price an all cash buyer could pay to own the entire business and still earn a reasonable return on the investment. For many companies we find a traditional value measure like P/E ratio provides a good estimate of value. But for companies that have large non-cash charges (like depreciation or goodwill amortization) or discretionary growth spending that is accounted for as an expense (like R&D or advertising), a P/E ratio may substantially understate value. So our approach is to identify, industry by industry, the "rules of thumb" that acquirors use when making acquisitions. We then use those rules of thumb as yardsticks to measure the value of companies we research. This means we sometimes own stocks that other value managers do not. Stocks that we own like Chiron with its large R&D spending or AT&T with its large depreciation expense look expensive on a P/E basis, despite their ability to generate large amounts of discretionary cash flow.

In deriving our value estimates, we quickly notice that companies that are growing more rapidly tend to have higher intrinsic values than companies that grow slowly. By setting higher value estimates on higher quality, faster growing companies, our approach again differs from other value investors. Many value investors define the "cheapest" stocks as those that sell at the lowest multiples. Our definition of "cheapest" is those stocks selling at the largest discount to their fair value. In our world a stock that sells at fifteen times earnings and is worth twenty five times earnings is a "cheaper" stock than one selling at ten times earnings that is only worth fifteen times.

That last point is especially timely. For the last two years, low P/E stocks substantially outperformed the market, and we feel the most undervalued stocks are now the above-average growers that are selling at below-average prices. We are willing to pay higher multiples today than we did two years ago because we believe we are buying better businesses. This can be confusing to those who classify mutual funds. Fund ratings services now say some of our funds (including The Oakmark Select Fund) have changed their approach and are no longer "value funds" but rather a mixture of growth and value.

Monitoring such style-box changes can be very important for investors. Many funds that have no true investment philosophy look in the rear-view-mirror, see what approach was working, and shift their approach to that style. Changing from one hot style to another rarely works. Our investors should understand that we have not changed; the market has. After a two-year bear market in large-cap growth stocks, the premiums for both size and growth have declined. After those premiums declined, large, growing businesses generally appeared to us to be more reasonably valued. In the case of our purchases, prices fell to levels we considered to be significantly undervalued. Since we buy only stocks we think are undervalued, rather than following the crowd towards the stocks that have been performing well, our shifts tend to be in the opposite direction towards stocks that have performed poorly.

Lastly, we are not simply buying stocks because they are down; we buy stocks we believe are selling at less than 60% of what they are worth. Many technology stocks are down much more than the stocks we purchased. However, based on our estimated business values, most technology stocks are still expensive. Many in the financial media seem to be obsessed with identifying beaten-up technology stocks as "values". I have had numerous interviews with reporters who called looking for quotes about tech bargains. I always explain that we believe the best values today are in growing companies outside of the technology sector. Rather than including that viewpoint in their story, they politely say, "maybe we can use you next time!" To these reporters, it defies common sense that stocks that have declined 80% or more are not yet "values". That is a testament to how powerful and unprecedented the technology mania was. Even after such large price declines, most of these stocks are still not cheap. Paraphrasing Fred Schwed, we believe technology stocks are still the most popular, and unfortunately, are therefore still the most overvalued.

So, as we enter 2002 both portfolios own relatively little in the technology sector. What we do own is portfolios of stocks that we expect on average will grow earnings more rapidly than the S&P 500⁵ does, yet our P/E ratio is below the market P/E. That is why we expect both funds to continue to produce excellent long-term returns.

William C. Nygren, CFA
Portfolio Manager

bnygren@oakmark.com

January 7, 2002