THE OAKMARK AND OAKMARK SELECT FUNDS Third Quarter Report

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.

Usually it's pretty easy to tell the difference between the scandal sheets and the business section. Unfortunately, in 2002 there has been great overlap. A handful of corporate scandals, one seemingly worse than the next, has led to a level of distrust in corporate leaders that hasn't been seen for at least a generation. That lack of trust has been frequently cited as one of the leading reasons for the broad market's continued decline and has resulted in tremendous losses for those companies directly involved in wrongdoing.

A friend and former colleague recently called to tell me he had bought stock in one of the scandal-plagued companies and said, "This would be a perfect stock for you if only you could trust their management!" That statement makes about as much sense to us as saying that Happy Gilmore could play in the NHL if only he could skate! Trust in management and a belief that they are acting in our economic interest is an essential part of our stock selection criteria; when it is lacking, the stock is immediately rejected.

We used to say we wanted management that was focused on "increasing shareholder value." To us, that means that when management makes capital investment decisions, their sole goal is to achieve the highest possible risk-adjusted return on that capital. As management considers their array of choices—re-investing in the business, making acquisitions, paying dividends, paying off debt or repurchasing stock—we want them to make the selection that maximizes per-share business value. Effectively, we want them to make the same decision that a value-maximizing shareholder would select. But, that phrase is so widely used today that it has become meaningless. Most annual reports now cite "shareholder value" as a corporate objective, and there is even a new periodical called "Shareholder Value Magazine."

In a rapidly growing business, there is a natural alignment of economic interests between shareholders and management. Pursuing internal growth opportunities generally provides high rates-of-return on capital and, therefore, grows the value of the business. As the business gets bigger, the job of managing the company also becomes more financially lucrative—bigger businesses usually pay their top managers more than smaller businesses do. A company like First Data Corporation rapidly expanding its highly profitable Western Union franchise is a good example of management making their own jobs more rewarding at the same time they are growing shareholder value.

Highlights

We want company managements to make decisions that maximize per-share business value.

Managements can grow value by investing in the business, making acquisitions, paying dividends, paying off debt, or repurchasing stock.

We favor managements with a willingness to grow value by shrinking.

But not all companies have such attractive internal growth opportunities. In 1960, Henry Singleton founded Teledyne, a company that grew rapidly for a decade via a combination of internal growth and acquisitions. When the opportunities for value added acquisitions disappeared, Singleton switched gears. From 1970 to 1984 he used his cash to repurchase 82% of Teledyne's grossly undervalued common shares. The result—the stock price increased from $2 to $250.

In 1971, Washington Post went public, and its stock subsequently fell to a fraction of its intrinsic business value. Warren Buffett acquired a large stake in Washington Post and convinced its CEO, Katherine Graham, that repurchasing stock with excess cash added much more to per-share value than would any capital expenditure opportunities. Graham repurchased shares in 1979 at an average price of $22. Washington Post ended last quarter at a per-share price of $545. It is no wonder she credited Buffett for being a great mentor!

In 1980, Don Kelly was CEO of Esmark, an unwieldy conglomerate which owned Swift, Hunt Wesson, Playtex, Avis, Vickers Oil, Vigero Fertilizer, and other assorted businesses. As is often the case with conglomerates, the stock market valued Esmark well below the sum of the prices the individual businesses would have traded at were they pure plays. In 1981, Mobil Oil purchased shares in Esmark, then exchanged those shares for Esmark's Vickers Oil subsidiary. Not only did this transaction achieve a fair price for the oil division, but the Esmark shares that were returned were worth far more than an equivalent dollar amount of cash. The result—Esmark stock rose from $9 per share in 1980 to $60 in 1984 when the company was acquired by Beatrice Foods.

Singleton, Graham and Kelly were among the pioneers of maximizing shareholder value by shrinking the business. They acted against their own economic interests as professional managers but maximized value for the shareholders. Since they were also shareholders, they were maximizing their personal economics as well. At the time, share repurchase was highly controversial, and not many companies would express a desire to repurchase shares or sell off divisions. It was generally viewed as a sign of weakness, a sign of poor internal growth opportunities. Because so few companies talked about repurchasing shares, or selling pieces of their company, those that did really stood out as having their goals aligned with their shareholders. But today, most companies at least pay lip service to the idea of buying back stock when it is undervalued or selling business units when a full valuation is received. These statements have nearly become synonymous with the phrase "shareholder value." We still monitor company actions to see how they react when presented with opportunities for profitable repurchase or restructuring, but the words alone have become useless.

So what do we look for in the words of management? Any comments that suggest they are more focused on increasing business value than on furthering their own careers. Two of our companies, Mattel and Yum Brands (formerly Tricon Global Restaurants), were on a short list this year of annual reports that did not mention anything about shareholder value. In his letter to shareholders, Mattel CEO, Bob Eckert, spoke of improving Mattel's performance by building the brand and by doing a better job of managing expenses. Achieving those goals will do more to grow Mattel's business value than would any amount of asset sales or share repurchases. In the Yum Brands letter to shareholders, CEO David Novak also avoided any discussion of shareholder value. What he spoke of instead was his "customer mania"—a maniacal focus on providing an industry leading level of customer service. Mr. Novak is not serving customers to boost his ego; we believe he is doing it to boost the value of the business.

We like to see our managers own stock in the company they work for, to have a reasonable number of stock options and to have incentive pay packages that focus on variables we believe drive equity values. We favor a willingness to grow value by shrinking—like the shareholder value pioneers, Singleton, Graham and Kelly. Just as important, we like to see managements that state goals that will focus their employees on business issues that will grow the company's intrinsic value. When management views the investors as their partners, focuses on maximizing per-share business value, and communicates honestly about their results, we believe the probability of achieving above-average returns on their stock increases.

As for the company our friend purchased, it is still on our list of stocks to research more thoroughly if and when the management changes.