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.

I just returned from a Spring Break vacation with my children at a resort where the primary means of transportation was by golf cart. For kids who are just a few years away from driving cars, driving golf carts was the coolest part of the vacation! When I first rode in the carts with them, cutting something of a zigzag path down the road, I was reminded of what a problem over-steering is for inexperienced drivers. When driving too far to the left, the temptation is to make a sharp turn to the right, but then the car ends up too far to the right and again needs correcting. Every drivers education course teaches that the best way to combat over-steering is to move one's field of vision further down the road. Effectively, the further down the road you are watching, the easier it is to drive straight. For experienced drivers, over-steering isn't an issue because it is second-nature to watch a long way down the road.

Even for experienced stock market investors, however, over-steering continues to influence their investment choices. Stock prices react sharply to minor changes in short-term expectations, creating opportunities for investors looking further down the road. As one extends the timeframe, one's focus also changes. In your personal life, if you are thinking about tomorrow, you might be focused on your appointments, the food you will eat, or even what the weather might be. But, if instead you think five years into the future, those issues all become trivial and the focus shifts to more substantial issues like your physical and financial well-being and spending time with the people you care about. The same holds true in the stock market. The investor trying to predict how a stock price will change this week focuses on stock charts that may help assess recent buying and selling interest, the release of economic statistics, or earnings results that are a penny different than expectations. The focus is very much on data that reflect the academic definition of risk—stock price volatility. But as Peter Bernstein wrote in his book, Against the Gods—The Remarkable Story of Risk, (yes, vacation reading was this exciting!), "Once we introduce the element of time, the linkage between risk and volatility begins to diminish."

Our greatest competitive advantage at The Oakmark Family of Funds is that we are in a shrinking group of investors who make decisions based on long-term expectations. Our approach has always been to think about how a business might change over the next five years. When one extends the investment timeframe to five years, just as in one's personal life, the key issues become more meaningful. The focus moves from stock market data to an analysis of the business—its competitive position, financial strength, growth prospects, quality of management and so on. Risk shifts from price volatility to the inaccuracy of our long-term business forecasts.

Using one of our holdings, Washington Mutual, as an example, we can see how the analysis changes. Most Wall Street reports advise on a very short time horizon. These reports are now focused on how first quarter earnings will compare to consensus expectations of 97¢, and whether or not the Fed will raise interest rates at their next meeting. Thinking about our five-year horizon, we focus on a company that is likely to be much more valuable because it will gain further competitive advantage from lowering its cost structure, and will grow its earnings and dividends by 60-100% (10-15% annual growth). If we are right, it will also likely benefit from a higher P/E⁴ ratio—its current relative P/E ratio of 30% compared to the S&P 500⁵ is near historic lows. Over our time horizon, the short-term volatility becomes trivial—a result of minor deviations from expectations; instead, the accuracy of our long-term forecasts becomes critical.

Peter Bernstein goes on to say that "For true long-term investors, that small group of people like Warren Buffett who can shut their eyes to short-term fluctuations. . . volatility represents opportunity rather than risk." By using a long-term horizon we benefit in several ways. First, our analysis looks at current intrinsic value and the likely changes to future intrinsic value. Second, we believe we are more skilled at analyzing variables that affect intrinsic value than we are at analyzing short-term stock market data. Third, our portfolios enjoy the lower costs that are associated with below-average turnover (and the related tax advantages). Conventional wisdom says long-term investing is a defensive, old-fashioned way to invest. We find, to the contrary, that investing for the long-term is our best offensive weapon—it allows us to take advantage of opportunities created by others who over-steer, or over-react to short-term events.

Mutual fund investors also hurt themselves by "over-steering." Investors obsessively monitor short-term performance and "correct" their portfolios by increasing exposure to what has recently been successful. A study of mutual fund investors, published last quarter by the Dalbar consulting firm, showed that in the last fifteen years mutual fund investors achieved annual returns of nearly ten percentage points less than returns achieved by the S&P 500. The great majority of the shortfall was not caused by underperformance of mutual funds themselves, but rather by the tendency of investors to oversteer. They zig-zagged down the road, investing in funds they wished they had owned only to find those funds no longer produced attractive returns, and then they kept repeating the process.

We have always encouraged our shareholders to take a long-term view and to use our funds as part of a balanced approach to managing their assets. Two years ago, we were strongly suggesting that the high returns in growth funds meant that investors who wanted to stay balanced needed to reduce holdings in growth funds and increase holdings in value funds. Unfortunately, many investors did just the opposite. Now, following two very good years for value investors (and difficult years for growth) we are often asked if that same advice doesn't suggest that investors should now reduce value holdings. Despite the intuitive appeal of that logic, there are two reasons why we say "no." First, investors have not yet compensated for their "over-steering" in the growth direction. According to figures compiled by Lipper, assets in growth funds still exceed assets in value funds by more than 10%. In general, investors who desire a balance between growth and value still need to steer in the direction of value. Second, the holdings in our portfolios are not static and look quite different than they did two years ago. Since growth stocks have fallen, and have begun to meet our valuation criteria, our portfolios now have heavier weightings in companies that enjoy above-average growth. Because stock prices direct changes in our portfolios, our shareholders need to rebalance less frequently. By taking the long-term view, we hope our shareholders and prospective shareholders stay focused on the importance of our investment approach—our unrelenting focus on business value—rather than merely focusing on our recent results.

We continue to believe the market is allowing us to construct portfolios that have above-average growth prospects at below-average prices. We also continue to believe that technology stocks are generally priced at unattractive values. Last quarter, Barron's increased their tech coverage, further anecdotal evidence of too much interest in technology stocks. Maybe when Barron's introduces a "Savings & Loan" pullout section, it will be time to sell Washington Mutual, currently the largest holding in both funds!

bnygren@oakmark.com

April 3, 2002