Fellow Shareholders,

The Oakmark International and International Small Cap Funds lost 2% and gained 3% respectively for the quarter ending June 30, 2002, while both the MSCI World ex-U.S.¹⁹ and the Lipper International Fund²⁰ indices were down 2%, and the MSCI Small Cap World ex-U.S. Index²¹ and the Lipper International Small Cap Average²² were up 4% and 0%, respectively. For the year to date, The Funds were up 9% and 13%, respectively, while the MSCI World ex-U.S. and the Lipper International Fund indices were down 2% and up 1% respectively, and the MSCI Small Cap World ex-U.S. Index and the Lipper International Small Cap Average, were up 10% and 5%, respectively. Though the quarter was very volatile, we remain focused on our search for value in spite of terrorist threats, accounting scandals and exchange rate movements.

Playing with Numbers

The headlines are full of stories regarding fraudulent accounting practices and unethical behavior at a number of US-based companies. For us, these events demonstrate more than anything a fundamental weakness in corporate governance. The purpose of a public company should be to make money for its owners. Sadly, in some cases, the owners (and employees) are instead being taken to the cleaners.

Why is this happening? Lavish rewards for short-term performance can breed a species of management that place their own interests before their employers—the shareholders. Corporate boards, which are supposed to represent the interests of the owners, have often abdicated their oversight responsibilities. Instead of truly independent directors monitoring and evaluating management decisions and practices, a number of current boards are comprised of insiders or their friends. As a result, management is left to oversee themselves, including to the point of setting their own compensation packages and incentive schemes. This blatant conflict of interest must end.

Asymmetric compensation practices need to be curbed. The pay difference between great performance and mediocre performance is often far too small in the US. Even failure and dismissal is often richly rewarding for management. As an aside, this is in contrast to Europe, where the problem is just the opposite: high quality managers with proven track records as value creators oftentimes have a hard time earning materially more than their less successful peers.

In the UK, there is a set of corporate governance guidelines called the Cadbury Principles. One of the linchpins of these rules is the mandate that corporate boards be led by a non-executive, independent chairman. In the US, the Chairman of the Board tends to be the CEO as well, fostering the tendency for boards here to represent more the interests of management as opposed to the owners. While the concept of a non-executive chairman is no guarantee against management impropriety, it nonetheless provides one additional check for shareholders.

We find corporate governance standards vary widely throughout the world; places like Sweden, which has the involvement of large shareholders on their boards, and the UK, which at least in theory should have more independent boards, may be examples from which the US can learn. At the Oakmark Funds—both Domestic and International—we have always considered corporate governance and management incentives to be important factors that are central to our stock selection process. We feel that strong boards, sensible incentives and managers that intuitively think like owners of the business are essential to superior investment returns.

Ultimately, these abuses will have devastating consequences if left unchecked. Equity prices will trade at even higher risk premiums, thus deflating returns, as prudent investors rightly assume the worst in the absence of full and reliable disclosure. Corporate governance changes should happen rapidly and must recognize that companies exist to make money for those who own them. Managements, anywhere, which steal from their owners, must be dealt with severely.

Europe is Looking Better

With the ignominious defeat of the Left in France this June, Europe appears to be warming up to politicians who are sensitive to the fundamentals of free-market capitalism.

Add France to progressive governments already in place in Italy, Spain and Germany and there exists a real possibility that economic policies in Europe will continue to evolve from statism to capitalism. We believe his will be good for European share prices. Lower taxes, less regulation, freer labor markets, and the introduction of private pension schemes may ultimately lead to greater economic growth and corporate profits—critical elements for higher share prices. Though we have learned in the past not to get too overly enthusiastic over the potential for real change in Europe, we remain cautiously optimistic.

David G. Herro, CFA Portfolio Manager dherro@oakmark.com	Michael J. Welsh, CFA, CPA Portfolio Manager 102521.2142@compuserve.com

July 8, 2002