THE OAKMARK EQUITY AND INCOME FUND Report from Clyde S. McGregor and Edward A. Studzinski, Portfolio Managers

THE VALUE OF A $10,000 INVESTMENT IN THE OAKMARK EQUITY AND INCOME FUND FROM ITS INCEPTION (11/1/95) TO PRESENT (6/30/02) AS COMPARED TO THE LIPPER BALANCED FUND INDEX14
		Average Annual Total Returns3 (as of 6/30/02)
	Total Return Last 3 Months*	1-year	5-year	Since Inception (11/1/95)
Oakmark Equity and Income Fund	-3.19%	5.77%	13.99%	15.31%
S&P 5001	-13.40%	-17.99%	3.66%	10.01%
Lehman Govt./Corp. Bond15	3.75%	8.25%	7.47%	6.94%
Lipper Balanced Fund Index	-6.61%	-7.54%	4.76%	7.92%
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

"The power of accurate observation is commonly called cynicism by those who have not got it." George Bernard Shaw

Our Results

The Oakmark Equity and Income Fund decreased 3% for the quarter ended June 30, 2002, bringing the calendar-year gain to 1%. For the calendar year, the Fund outperformed both the market averages and our primary benchmark, the Lipper Balanced Fund Index, which has lost 6% year to date. While we are modestly pleased with performance so far this year, getting there has not been pretty. Historically, volatility has been the friend of the value investor, presenting us with opportunities to exploit mis-pricing and invest in securities selling at a substantial discount to their intrinsic value. Given the acceleration of information flows in today's world, those opportunities have tended to be relatively short-lived. In recent weeks, those opportunities have grown in frequency and duration, in what seems a direct correlation to an increased investor concern about the accuracy of financial reporting data in general and the trend of financial markets specifically. The end result was that while we have continued our activity in initiating or adding positions in those businesses that had fallen out of favor with investors, in many instances the gap between intrinsic value and share price has continued to widen beyond where we made our initial investment. Continuing a theme of past quarters, the fund has expanded its holdings in the healthcare area. New positions were initiated during the quarter in Abbott Labs, Bristol-Myers and Schering-Plough. Other new positions included CONOCO, Gemstar-TV Guide, Mentor Graphics, and Phillips Petroleum.

Playing Defense

A few quarters ago, we wrote about the investor who was "only expecting 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." If you were to examine the long-term distribution of investment returns from the S&P 500, not surprisingly, you would see a bell-shaped curve. Recent experience however has differed from the normal distribution, and has been of a more fat-tailed variety, resulting in out-sized returns two or three years ago, and now out-sized losses. Thus, in today's world of either more normal (or sub-par depending on your point of view) investment returns, success in investing will be defined by those who can avoid the major "blow-up". We can see some proof of this in the returns of the major indices. As investors moved toward larger capitalization stocks for reasons other than valuation and expected returns, the effect of a "torpedo" stock disaster on a portfolio has been magnified. In some months over the past year, almost 10% of all stocks in the Russell 1000¹⁶ have underperformed by 30% or more (or, the odds of a single stock "blowing up" has been almost 6 times higher than average). Being on the wrong side of a disaster can cause substantial underperformance.

What has that specifically meant to the management of your portfolio? As the size of the portfolio has grown, the impact of a single-stock debacle has somewhat lessened. Also, we have increased our focus on not just having a margin of safety, but looking for a larger margin of safety. If as has been suggested investing is the search for asymmetric payoffs with upside opportunity exceeding downside risk, the greater the discount to intrinsic value at which one makes a purchase, the greater the margin of safety. Finally, we have been looking to limit those situations with a high probability of gain but significant downside risk.

We Are Where We Are, So Deal With It

We are often asked about things that might cause us to sell a security before it reaches our estimate of intrinsic value. Those factors have been discussed many times before. What hasn't been discussed in depth are the sorts of things that perhaps subjectively influence investment choices, especially when the discount to intrinsic value in a group of securities is approximately similar. In a nutshell, it all comes back to making sure that our egos do not get in the way of making the best investment decisions.

What are some examples of this? Michael Mauboussin of CS First Boston has identified several examples of the psychological traps into which investors tend to fall. First, a tendency of all investors is to have too high an opinion of their abilities, especially in areas outside of their circle of competence (often referred to as the "smart person trap"—I'm smart about X, therefore by definition I am smart about Y and Z). To avoid that trap, make sure you stay within your circle of competence. Next, people in general often tend to weigh heavily the first information they glean about a subject, which then leaves them with an anchored bias. We fight against this tendency by seeking information from a variety of sources (there can never be too many) and always trying to stand our assumptions on their heads. Third, as pollsters and users of polls have discovered, how a question is constructed can dictate the answer. Investors often make the same mistake, which can also impact the assessment of outcomes and expected returns. One deals with that by always looking at things from a "worst case" perspective, rather than the sugarcoated "good, better, best" scenario analysis that has led many corporate managements to destruction. Fourth, individuals and investors have a tendency to seek out confirming information that supports their existing point of view while dismissing or avoiding any contradictory inputs. We have found that one good way to avoid this trap is to seek out and examine the information that "short" investors have either about a particular company or industry. Finally and not surprisingly, both individual and institutional investors tend to make choices that justify past decisions (throwing good money after bad), notwithstanding a change in circumstances. The most common example of this is the retail investor who says "I'll sell when I get even" and the institutional investor who says "I could have sold this last week for X+$5, I'm not going to sell here for X." That is why we make a practice, when examining your portfolio, of asking ourselves, "Looking at this as a new investment and knowing what we know now, would we still make it?" There is no place for the "woulda, coulda, shoulda" analysis. Sunk costs are sunk costs. Our interest is the future return of and on your investment, so our due diligence is ongoing. We are where we are now.

Has Anything Worked

Several of our best performing stocks in the quarter have been in the portfolio for a while, and include Rockwell Collins, Saint Mary Land & Exploration and Catellus. They also reflect our commitment to continuing with investments where the price to intrinsic value discount continues to be fairly wide, notwithstanding that these are investments that have gone up in price from when they first went into the portfolio. As we have stated in the past, our holding period for an investment would ideally be forever if the price and intrinsic value lines continue on parallel rather than intersecting courses. At the same time, two of our worst performers during the quarter were Ceridian and UST, both for non-company specific reasons, in the one instance having to do with the payroll processing industry in general and the other with tobacco company litigation (which does not apply to UST). In that instance too, it reflects a continuation of what we have said to you is our philosophy in investing your money—we are not going to be swayed by short-term market fluctuations, but are more concerned with what a business is actually worth.

We reiterate our commitment to seeking out investments with a considerable margin of safety, selling at a substantial discount to our assessment of intrinsic value. As this letter is being written, a great deal of concern and focus is being devoted to the question of accounting issues and management fraud. Those are issues that have followed the investment world from the beginning of time, and given the part that greed plays in the human psyche, will always be present in the investment arena. We recognize that while we have no unique abilities to uncover deceptive managements or fraudulent practices, we do expend our time trying to identify those businesses run by real people (whose shareholder orientation we get comfortable with) and that are selling in the marketplace at a discount to their real intrinsic value. Looking at a lot of different businesses and talking to many different managements (and people) is a good way to assess those differences in both management intelligence and management integrity that confront us every day. 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

July 2, 2002

Schedule of Investments—June 30, 2002 (Unaudited)