THE OAKMARK EQUITY AND
INCOME FUND
Report from Clyde S. McGregor and
Edward A. Studzinski, Portfolio Managers
THE OAKMARK EQUITY AND
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THE VALUE OF A $10,000 INVESTMENT IN THE OAKMARK EQUITY AND INCOME FUND FROM ITS INCEPTION (11/1/95) TO PRESENT (12/31/01) AS COMPARED TO THE LIPPER BALANCED FUND INDEX13 |
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| Average Annual Total
Returns1 (as of 12/31/01) |
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| Total Return Last 3 Months* |
1-year | 5-year | Since Inception (11/1/95) |
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| Oakmark Equity and Income Fund | 7.93% | 18.01% | 16.77% | 16.48% |
| S&P 5005 | 10.69% | -11.89% | 10.69% | 13.41% |
| Lehman Govt./ Corp. Bond14 |
0.06% | 8.50% | 7.36% | 6.96% |
| Lipper Balanced Fund Index |
6.48% | -3.24% | 8.37% | 9.69% |
| Past performance is no guarantee of future results. Investment return and principal value vary, and you may have a gain or loss when you sell shares. Average annual total return measures annualized change, while total return measures aggregate change. | ||||
| * Not annualized | ||||
"Optimism is the madness of maintaining that everything is right when it is wrong." Voltaire
Our Results
The Oakmark Equity and Income Fund returned 8% for the quarter ended December 31, bringing the calendar-year gain to 18%. For the calendar year, the Fund outperformed both the market averages and our primary benchmark, the Lipper Balanced Fund Index, which lost 3%. We are pleased with both our relative and absolute performance for the year. As always, a primary focus is to avoid sloppiness that is a by-product of complacency. All too often, short-term success leads portfolio managers to start believing their own press clippings, which often tend to conveniently gloss over the hard work and supporting cast responsible for that success. To borrow a phrase, let us say that we do not spend a great deal of time looking in the mirror, other than to comb our hair (or what is left of it).
We continue to be driven by our love of the investment business and our focus on fundamentals in assessing intrinsic business value. A large part of the thrill for us comes from being able to find the better than average business run by quality management that is truly shareholder-oriented AND selling at a large discount to our assessment of intrinsic business value. When we find such an investment, we know that it is another building block toward our goal of compounding your (and our) investment in the Fund by achieving consistent above-average real rates of return over the long-term, while taking considerably less risk than the market as a whole.
Expectations—Reasonable and Otherwise
There has been a great deal of blather about last year's plunge in the NASDAQ15 as well as the general market decline of the last two years. From the perspective of investment returns, they have been two very good years for the shareholders of The Oakmark Equity and Income Fund. One of our thoughts had been that a beneficial result of the bloodbath that sank many speculations (and we use that word deliberately rather than "investments") would be that the average investor would finally see the connection between risk and return. Some years ago, when speculation was running rampant, one of our colleagues received an e-mail from a potential investor. The e-mail stated that the investor did not have unreasonable expectations concerning his potential investment in our funds, as he was only wanting a consistent 20% a year return from the conservative portion of his portfolio, and the 50% plus returns were to come from his aggressive growth investments. Recently, we received an e-mail from an investor who was concerned that over the first two days of the year, Oakmark Equity and Income was off somewhat when NASDAQ and the S&P 500 were already up several percent. Unfortunately, these are both sides of the same coin from individuals who do not understand what we mean when we say that our focus is on providing "consistent above-average returns over the long-term."
Sooner or later we are going to underperform the broader market, and perhaps even lag our category. Some of that will be a function of regression to the mean in terms of results (we recommend the Ibbotson data concerning long-term stock and bond returns) and some of it will be a function of our selling what other people are buying and buying what is often quite unpopular. Unfortunately, expected returns from investments do not always fall neatly into quarters or years. Sometimes they do not work out at all, but that is why we are running portfolios (and that is a discussion for another letter). As value investors that is what we do and, as evidenced by both the fund's returns and the returns of this firm, it works for us. We are going to continue doing what we have always done which is a three yards and cloud of dust approach to grinding out investment results through an in-depth assessment of potential investments coupled with a decision to commit real dollars to those we select. We invite those of you who are comfortable with that approach to join us as investors.
Highlights |
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The Good and the Not So Good and Other Faux Pas
Last year we reported we were seeing a lack of discrimination in the market place in the prices being asked for bad businesses versus good businesses. This last quarter we took advantage of that opportunity by initiating investments in CVS Drug Stores (CVS), International Game Technologies (IGT), and IMS Health Inc.(RX). CVS Drug Stores (CVS) is the number one drug store chain in the country in terms of number of stores. An earnings disappointment and the resulting sell-off presented us with an opportunity to invest in what has been a better than average business at a bargain price. International Game Technologies (IGT) is the number one slot machine manufacturer, a business that requires very little in the way of ongoing capital expenditures and throws off lots of cash. Management has been quite astute at deploying that cash, making huge share repurchases since the company went public and also making opportunistic acquisitions. When the market believed after September 11th that all travel-related businesses were going to fall off a cliff, we took the opportunity to invest in International Game Technologies (IGT). IMS Health Inc. (RX) is the world's leading provider of information solutions to the pharmaceutical/healthcare industry. Fear that the slowing growth of the pharmaceutical companies would result in reduced prospects for RX caused this low capital expenditure, high free cash flow company to be ejected from growth portfolios and sell at what we consider to be a bargain price. CVS and International Game Technologies were two of our strongest performers in the quarter.
Two of our sub-par performers in the quarter were Cooper Industries (CBE) and Watson Pharmaceuticals (WPI). Cooper is a well-run industrial company that received an unsolicited take-over offer from Danaher, which it subsequently rejected. Cooper management indicated they were pursuing other options to unlock shareholder value when the company got hit with the "taint" of asbestos. Management has still indicated it is staying the course with regard to pursuing a capital reallocation strategy. The other sub-par performer was Watson Pharmaceuticals (WPI), a company with both branded and generic products. After missing its numbers in November, the company announced it would be restructuring its generic business to focus more on its branded portfolio. Our initial mistake was in over-valuing the generic portion of WPI's business, given the impact of low barriers to entry from competition AND the pricing caps imposed by managed care companies. Neither of these factors are unique to Watson but will impact all generic drug businesses. That said, the distressed price to which the stock fell ignored the still ongoing profitability of WPI's branded business as well as an attractive research pipeline and manufacturing assets. We used the opportunity to almost double our position (which has since appreciated), and at some point will sell our high-cost stock to reap the tax benefits for our shareholders.
Once again we affirm our commitment to seeking out investments with a considerable margin of safety supported by a valuation gap. As this letter is being written, a great deal of intellectual capital is being expended on the question of whether the economy will emerge from recession sooner or later. Recognizing that we have no particular skill-set or insights to bring to that debate, we continue to prefer to expend our time, a truly nonrenewable resource, on searching out real businesses run by real people selling in the marketplace at a discount to their real intrinsic value. Looking at a lot of different businesses, learning to assess the often subtle differences between the very good and very mediocre, especially as they play out over the long-term, will always be the best use of our time. We thank you for your continued support of the Fund and we look forward to reporting to you, our partners, at the end of the next quarter.
Clyde S. McGregor, CFA
Portfolio Manager
mcgregor@oakmark.com
Edward A. Studzinski, CFA
Portfolio Manager
estudzinski@oakmark.com
January 7, 2002
| THE OAKMARK EQUITY AND INCOME FUND |
Schedule of Investments—December 31, 2001
| Name | Shares Held | Market Value |
| Equity and Equivalents—62.5% | ||
| Food & Beverage—2.6% | ||
| UST Inc. | 800,000 | $28,000,000 |
| Retail—7.2% | ||
| CVS Corporation | 1,000,000 | $29,600,000 |
| Safeway Inc. (a) | 525,000 | 21,918,750 |
| Office Depot, Inc. (a) | 980,000 | 18,169,200 |
| J.C. Penney Company, Inc. | 350,000 | 9,415,000 |
| 79,102,950 | ||
| Household Products—0.1% | ||
| Energizer Holdings, Inc. (a) | 80,000 | $1,524,000 |
| Bank & Thrifts—0.5% | ||
| U.S. Bancorp | 280,703 | $5,875,114 |
| Insurance—5.4% | ||
| SAFECO Corporation | 955,000 | $29,748,250 |
| PartnerRe Ltd. (b) | 545,600 | 29,462,400 |
| 59,210,650 | ||
| Other Financial—1.7% | ||
| GATX Corporation | 576,900 | $18,760,788 |
| Marketing Services—1.3% | ||
| The Interpublic Group of Companies, Inc. | 500,000 | $14,770,000 |
| Information Services—1.2% | ||
| Ceridian Corporation (a) | 705,000 | $13,218,750 |
| Computer Software—5.2% | ||
| Synopsys, Inc. (a) | 500,000 | $29,535,000 |
| Novell, Inc. (a) | 6,000,000 | 27,540,000 |
| 57,075,000 | ||
| Computer Systems—1.1% | ||
| The Reynolds and Reynolds Company, Class A | 514,000 | $12,464,500 |
| Telecommunications—3.6% | ||
| CenturyTel, Inc. | 725,000 | $23,780,000 |
| Citizens Communications Company (a) | 1,452,500 | 15,483,650 |
| 39,263,650 | ||
| Printing—0.9% | ||
| Valassis Communications, Inc. (a) | 289,400 | $10,308,428 |
| Pharmaceuticals—4.2% | ||
| Watson Pharmaceuticals, Inc. (a) | 1,046,400 | $32,846,496 |
| Chiron Corporation (a) | 308,100 | 13,507,104 |
| 46,353,600 | ||
| Health Care Services—3.0% | ||
| IMS Health Incorporated | 1,671,300 | $32,607,063 |
| Medical Products—1.1% | ||
| Edwards Lifesciences Corporation (a) | 275,000 | $7,598,250 |
| Apogent Technologies Inc. (a) | 150,000 | 3,870,000 |
| Techne Corporation (a) | 15,000 | 552,750 |
| 12,021,000 | ||
| Transportation Services—0.2% | ||
| Nordic American Tanker Shipping Limited | 154,900 | $2,145,365 |
| Aerospace & Defense—2.9% | ||
| Rockwell Collins | 1,609,200 | $31,379,400 |
| Agricultural Equipment—0.2% | ||
| Alamo Group Inc. | 141,900 | $2,022,075 |
| Instruments—1.4% | ||
| Varian Inc. (a) | 463,400 | $15,032,696 |
| Machinery & Industrial Processing—4.4% | ||
| Cooper Industries, Inc. | 900,000 | $31,428,000 |
| Rockwell International Corporation | 927,500 | 16,565,150 |
| 47,993,150 | ||
| Forestry Products—2.7% | ||
| Plum Creek Timber Company, Inc. | 1,059,644 | $30,040,907 |
| Oil & Natural Gas—7.2% | ||
| Burlington Resources Inc. | 750,000 | $28,155,000 |
| XTO Energy, Inc. | 1,328,000 | 23,240,000 |
| St. Mary Land & Exploration Company | 800,000 | 16,952,000 |
| Cabot Oil & Gas Corporation | 400,000 | 9,620,000 |
| Berry Petroleum Company | 53,000 | 832,100 |
| 78,799,100 | ||
| Real Estate—2.1% | ||
| Catellus Development Corporation (a) | 1,218,500 | $22,420,400 |
| Legacy Hotels Real Estate Investment Trust (b) | 125,000 | 663,349 |
| 23,083,749 | ||
| Diversified Conglomerates—0.2% | ||
| Textron, Inc. | 46,100 | $1,911,306 |
| Recreation & Entertainment—2.1% | ||
| International Game Technology (a) | 345,000 | $23,563,500 |
| Total Equity and Equivalents (Cost: $625,993,664) | 686,526,741 | |
| Fixed Income—33.5% | ||
| Preferred Stock—0.3% | ||
| Bank & Thrifts—0.2% | ||
| BBC Capital Trust I, Preferred, 9.50% | 48,000 | $1,178,400 |
| Pennfed Capital Trust, Preferred, 8.90% | 27,500 | 694,375 |
| Fidelity Capital Trust I, Preferred, 8.375% | 43,500 | 435,000 |
| 2,307,775 | ||
| Telecommunications—0.1% | ||
| MediaOne Finance Trust III, Preferred, 9.04% | 20,000 | $508,200 |
| Total Preferred Stock (Cost: $2,715,763) | 2,815,975 | |
| Par Value | ||
| Corporate Bonds—1.9% | ||
| Retail—0.6% | ||
| Rite Aid Corporation, 7.625% due 4/15/2005, Senior Notes | $4,900,000 | $4,263,000 |
| The Gap, Inc., 6.90% due 9/15/2007 | 2,677,000 | 2,174,931 |
| Ugly Duckling Corporation, 12.00% due 10/15/2003, | ||
| Subordinated Debenture | 650,000 | 552,500 |
| 6,990,431 | ||
| Office Equipment—0.1% | ||
| Xerox Capital Europe Plc, 5.75% due 5/15/2002 | $1,500,000 | $1,476,687 |
| Hotels & Motels—0.6% | ||
| HMH Properties, 7.875% due 8/1/2005, Senior | ||
| Note Series A | $3,450,000 | $3,277,500 |
| Park Place Entertainment, 7.00% due 7/15/2004, | ||
| Senior Notes | 2,750,000 | 2,757,144 |
| Prime Hospitality Corporation, 9.25% due 1/15/2006, 2006 | ||
| 1st Mortgage Note | 413,000 | 423,325 |
| Park Place Entertainment, 7.375% due 6/1/2002, | ||
| Senior Notes | 320,000 | 322,395 |
| 6,780,364 | ||
| TV Programming—0.3% | ||
| Liberty Media Corporation, 8.25% due 2/1/2030, Debenture | $3,425,000 | $3,239,677 |
| Machinery & Industrial Processing—0.1% | ||
| Columbus McKinnon Corporation New York, 8.50% | ||
| due 4/1/2008 | $1,000,000 | $930,000 |
| Building Materials & Construction—0.1% | ||
| Juno Lighting, Inc.,11.875% due 7/1/2009, Senior | ||
| Subordinated Note | $750,000 | $728,437 |
| Utilities—0.1% | ||
| Midland Funding Corporation, 11.75% due 7/23/2005 | $500,000 | $545,625 |
| Total Corporate Bonds (Cost: $20,594,654) | 20,691,221 | |
| Government and Agency Securities—31.3% | ||
| U.S. Government Notes—28.4% | ||
| United States Treasury Notes, 3.375% due 1/15/2007, | ||
| Inflation Indexed | $132,361,780 | $132,837,488 |
| United States Treasury Notes, 5.75% due 11/15/2005 | 50,000,000 | 52,822,250 |
| United States Treasury Notes, 3.00% due 11/30/2003 | 50,000,000 | 50,035,150 |
| United States Treasury Notes, 7.875% due 11/15/2004 | 25,000,000 | 27,797,850 |
| United States Treasury Notes, 7.00% due 7/15/2006 | 20,000,000 | 22,159,380 |
| United States Treasury Notes, 5.25% due 5/15/2004 | 20,000,000 | 20,853,120 |
| United States Treasury Notes, 7.25% due 8/15/2004 | 5,000,000 | 5,459,960 |
| 311,965,198 | ||
| U.S. Government Agencies—2.9% | ||
| Fannie Mae, 7.25% due 4/12/2005 | $6,500,000 | $6,592,144 |
| Federal Home Loan Mortgage Corporation, 4.75% | ||
| due 8/23/2004 | 5,000,000 | 5,080,805 |
| Federal Home Loan Bank, 5.03% due 6/21/2006 | 5,000,000 | 5,034,050 |
| Federal Farm Credit Bank, 6.35% due 3/7/2008 | 2,750,000 | 2,770,798 |
| Fannie Mae, 6.15% due 3/15/2011 | 2,050,000 | 2,062,575 |
| Federal Home Loan Bank, 5.10% due 12/26/2006 | 2,035,000 | 2,052,175 |
| Federal Home Loan Bank, 6.75% due 5/1/2002 | 2,000,000 | 2,030,416 |
| Federal Home Loan Bank, 7.85% due 6/7/2004, | ||
| Consolidated Bond | 1,250,000 | 1,280,629 |
| Federal Home Loan Bank, 4.50% due 12/26/2008 | 1,135,000 | 1,104,674 |
| Federal Home Loan Bank, 5.77% due 4/12/2004 | 1,000,000 | 1,010,089 |
| Federal Farm Credit Bank, 6.00% due 6/27/2008 | 1,000,000 | 1,008,376 |
| Federal Home Loan Bank, 3.875% due 12/15/2004 | 1,000,000 | 997,379 |
| Federal Home Loan Bank, 4.10% due 12/7/2004 | 600,000 | 601,664 |
| Federal Home Loan Bank, 5.125% due 8/6/2002 | 500,000 | 500,341 |
| Federal Farm Credit Bank, 6.24% due 12/29/2008 | 175,000 | 176,650 |
| 32,302,765 | ||
| Total Government and Agency Securities (Cost: $343,984,037) | 344,267,963 | |
| Total Fixed Income (Cost: $367,294,454) | 367,775,159 | |
| Short Term Investments—3.7% | ||
| Commercial Paper—2.7% | ||
| Citicorp, 1.87% due 1/4/2002 | $5,000,000 | $5,000,000 |
| American Express Credit Corporation, 1.81% due 1/2/2002 | 5,000,000 | 5,000,000 |
| General Electric Capital Corporation, 1.75% due 1/2/2002 | 20,000,000 | 20,000,000 |
| Total Commercial Paper (Cost: $30,000,000) | 30,000,000 | |
| Repurchase Agreements—1.0% | ||
| State Street Repurchase Agreement, 1.57% due 1/2/2002 | $11,152,000 | $11,152,000 |
| Total Repurchase Agreements (Cost: $11,152,000) | 11,152,000 | |
| Total Short Term Investments (Cost: $41,152,000) | 41,152,000 | |
| Total Investments (Cost $1,034,440,118)—99.7% | $1,095,453,900 | |
| Other Assets In Excess Of Other Liabilities—0.3% | 3,828,756 | |
| Total Net Assets—100% | $1,099,282,656 | |
| (a) | Non-income producing security. |
| (b) | Represents foreign domiciled corporation. |
