THE OAKMARK AND OAKMARK SELECT FUNDS

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.

The New York Times began the New Year with a business section headlined "Wall Street Down a Third Year, Leaving Fewer Optimists." Yes, the market had its third losing year in succession, and yes, 2002 was the worst in both breadth and magnitude. But no, three down years does not increase the probability of suffering further losses. That logic is backwards—lower prices increase the probability of achieving good returns. Realizing the difficulty of viewing lower prices as an opportunity, Warren Buffett used an analogy to a mundane consumer product:

"If you plan to eat hamburgers throughout your life and are not a cattle producer, should you wish for higher or lower prices for beef? If you expect to be a net saver during the next five years, should you hope for a higher or lower stock market during that period? Many investors get this one wrong. Even though they are going to be net buyers of stocks for many years to come, they are elated when stock prices rise and depressed when they fall. In effect, they rejoice because prices have risen for the ‘hamburgers' they will soon be buying. This reaction makes no sense."

Last quarter, we were presented with an opportunity to acquire inexpensive "hamburgers". H&R Block (HRB) has been one of our largest holdings for several years. The business has performed well, as has the stock. In November, a small independent research firm published a sell report that was highly critical of HRB. They highlighted a likely end to the rapid growth of the company's cyclical mortgage origination business and touted that HRB was being sued for an amount that exceeded its shareholders' equity.

When reading any research report, one has to sort carefully through what is factual and what is opinion. In addition, while most scenarios are "possible," one needs to consider how likely those possibilities really are. Last year we were all reminded of the obvious conflicts between research and investment banking and the tendency for reports on banking clients to have a positive spin. Most business schools even teach students to be suspicious of opinions expressed in research on banking clients. Because of that inherent conflict, "independent" research, meaning no investment banking ties, has been put on a pedestal. But the lack of banking ties by no means insures that independent research is unbiased. Some "independent"firms are funded largely by short-sellers, and their reports often have the goal of scaring investors out of stocks their clients are already short. We believe the chance that investors will be misled by these reports is higher because their conflict is less obvious. The sell report on HRB knocked the stock down from $40 to $29 in just a few days. Our first reaction was less thinking about Warren Buffett's hamburgers and more thinking of Randy Newman's lyrics "short people got no reason to live."

Highlights

Lower stock prices have increased the probability of good returns.

Buying growing businesses gives us the luxury of a long timeframe.

Biased stock research highlights the value of depending on our own research.

The Wall Street Journal piled on with a negative article on HRB (on the very day it hit its low!) that stated disparagingly that in the prior year, their tax business "grew just 23%." Just 23%? We would be happy if most of our holdings grew half that fast! After fighting through the frustration, and sorting out the misinformation, we asked, "Does HRB still fit our investment criteria? Is it selling below 60% of a growing value, and does its management act in our interest?" Answering those questions with enthusiastic yesses, we concluded the price drop was uncalled for and we added substantially to our position.

In previous letters, we have addressed our willingness to have extremely long holding periods, our criteria for managements, and our calculation of business value. Using HRB as an example, let's look at how we project business value growth. Why do we want businesses that grow? A big risk of value investing is that the statistically cheapest stocks are frequently structurally disadvantaged companies. They may be facing market share losses, declining sales prices or unusually high capital expenditures. Their value five years from now may be less than today. To avoid that "value trap," we look for companies whose value is likely to grow at above average rates. This growth gives us the luxury of investing for a longer timeframe than most of our competitors. How do we find undervalued stocks in which per-share business value is growing at above average rates? Although the market is reasonably efficient at pricing sales growth, we think it is less efficient at differentiating between cyclical and secular growth, evaluating multi-division companies, and translating balance sheet change into per-share value change.

HRB has a great tax preparation business. It has strong secular growth resulting from growth in the number of tax returns, growth in the percentage of filers who use paid preparers, and growth in its industry leading market share. Combine that with its strong cash generation—it is one of few businesses that can grow revenues ten percent without needing either higher capital expenditures or more working capital—and you get a business we believe is deserving of a very high multiple.

Skeptics argue that HRB's mortgage origination business sharply increases the risk of owning the stock. That division has performed so well over the past several years, primarily due to the cyclic refinancing boom, that a rapid return to trendline earnings might cause a one year decline in HRB's reported EPS⁸. We acknowledge that possibility and even agree it is likely. But we are not focused on EPS growth. Instead, we look at business value growth.

To see how the value of a company changes over time, we make projections for each of its divisions, and then sum up the values. We project the HRB tax business will continue growing at an above-average rate, albeit probably less than the "only 23%" it achieved last year. We expect HRB's total income to grow more slowly than its tax income grows since we are not forecasting growth in the mortgage business. The multiple we use to value the mortgage business—a competitive, commodity-like business—is much lower than the multiple we use for the tax business. Because the percentage of HRB's earnings coming from the tax business will be increasing, the multiple we think is appropriate for the entire company will also be increasing. Finally, the mortgage business and the tax business each produce large amounts of cash beyond what needs to be reinvested in the business. Management expects to continue using that cash to repurchase stock. So, looking out five years, we see higher earnings, a mix shift toward a higher multiple business, and fewer shares outstanding. These factors combine to produce an expected rate of per-share value growth that is far above average.

After purchasing our "hamburgers" on sale, we got something we don't experience very often—near instant gratification. HRB settled its lawsuit for a small amount of money – which is consistent with what we and the company had always expected. HRB's stock price, which hit $29 the day the Journal wrote their negative story, topped $39 five trading days later. In the long run, business value always wins out over attempts to drive stock prices away from underlying value. As much as we knew that to be true, the market's quick reaction was still comforting.

One last comment on HRB—not H&R Block, but rather Henry R. Berghoef—co-manager of The Oakmark Select Fund. For the last several years, Henry has served as our Associate Director of Research in addition to contributing many of the stock recommendations that have driven Oakmark's performance. Effective the first of the year, Henry became Director of Research, assuming full responsibility for our research department. The research group Henry inherits is, I believe, the best in the business. His leadership assures a continuation of Oakmark's strong research heritage. We will continue to benefit from Henry's input as an analyst and co-manager of The Oakmark Select Fund. In addition, we will now benefit from the imprint he puts on all of our research. Congratulations Henry!