THE OAKMARK AND OAKMARK SELECT FUNDS (a)

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.

In the movie Rounders, Mike McDermott (Matt Damon) is a law student with aspirations of becoming a professional poker player. After recovering from a night of devastating losses, he says, "Few players recall big pots they have won, strange as it seems, but every player can remember with remarkable accuracy the outstanding tough beats of his career." Maybe there is a similarity to stock market investors—that's why it doesn't feel like the market has gone up since the July and October lows! Last month marked the three-year anniversary of the bull market's demise. Although The Oakmark and Oakmark Select Funds have gained in value over those three years, the damage to most investors has been very serious. Not many bear markets have lasted for three years, not many have cut the S&P 500⁴ nearly in half, and not many have left investors so confused.

In March, New York Magazine ran a cover story "Down and Out on Wall Street" that showed an ex-investment banker working as a hot dog vendor. The Chicago Tribune ran a feature on an equity mutual fund manager crediting him for making a "daring move" during the first quarter putting his portfolio one hundred percent in cash. And it's not just the media staking out the bearish turf. In his annual report to shareholders, Berkshire Hathaway Chairman Warren Buffett states, "Despite three years of falling prices, … we still find very few (stocks) that even mildly interest us." Buffett goes on to say "Unless we see a very high probability of ten percent pre-tax returns, we will sit on the sidelines."⁵ Also last quarter, renowned author and portfolio manager Peter Bernstein created a stir when he encouraged market-timing by asserting "For now, equities aren't the best place to be in the long run."⁶

Of course not everyone is bearish—Bill Miller is the only fund manager to beat the S&P 500 for twelve consecutive years. In his January report to shareholders, Bill shared his market outlook saying "I think the odds favor a solid year after three bad ones. That is based not just on the rarity of four consecutive down years as a matter of market history, but on the difference between valuation—what's in the price—and what I think is likely to happen as the year unfolds."⁷ Also checking in with a positive outlook is John Bogle, founder and former CEO of The Vanguard Group. In the late nineties, John presciently warned that returns in the upcoming decade were destined to be disappointing. He postulated that the S&P 500's P/E ratio⁸, which, in 1999 hovered around thirty times, was likely to revert to its historical average of just over half that level. The decline in P/E would offset most of his projected six percent annual earnings growth, leaving an expected annual return of just slightly over the one percent dividend yield. But in a recent speech, he updated that forecast by acknowledging that the severe price decline had basically eliminated the excesses that troubled him. Bogle stated, "The future investment return (yield plus growth) could be in the eight percent range. And with P/E's now at fifteen times, it is even possible we will see a slight increase—let's say to eighteen times—bringing the annual market return to nine percent."⁹ Relative to one percent money market returns or four percent long bond yields, I think we would all agree that an S&P return of nine percent per year would be welcome.

So, with investors more confused than ever, the brightest minds in the industry unfortunately aren't of much help because their outlooks are all over the map. Where do we at The Oakmark Family come out on this argument? Were I to pick a side, I would side with the bulls, and I would base that on valuation—P/E's deserve to be high based on record low bond yields; supply/demand—money fund assets are at their highest level ever as a percentage of equity values; and sentiment—the media and most individuals are giving up on stocks, which I view as a contrary indicator.

Despite these reasons, we find it very difficult to add value by making top-down decisions—rather than trying to forecast where the stock market is headed, we much prefer analyzing individual companies and projecting where we think their stock prices should be several years from now. We make decisions on individual stocks rather than predictions about the market for two important reasons. The first is greater clarity. We can more easily analyze dividend yield, expected business value growth, and the implications of the current valuation than we can forecast how the overall market ought to be priced. Second, even if one correctly forecasts the market, the wrong individual stock decisions could still be made. Three years ago, we thought our stocks were very attractive notwithstanding the pricing bubble in large-cap growth and technology stocks. Despite our correct call on the bubble, our shareholders fared much better with our portfolio of undervalued stocks than they would have in cash.

Three of our largest holdings in The Oakmark and Oakmark Select Funds are Washington Mutual, H&R Block, and YUM Brands. They are in three very different industries: savings and loans, consumer services, and restaurants. We own these stocks not because we are bullish on the stock market, but because we believe they meet our investment criteria—they sell at a discount to a growing business value and are run by managers that consistently act in the interest of shareholders. Each sells at a below average P/E ratio⁸—as a package it is priced at twelve times current year estimates and under eleven times 2004 estimates. The group provides a two percent dividend yield and is expected to continue growing earnings more rapidly than the S&P 500⁴. If the P/E ratio doesn't change, we expect compound annual returns in excess of ten percent. But in addition, we believe the P/E discount is undeserved. Five years from now, if the P/E ratios better reflect our belief that these are above-average companies, annual returns could be substantially above ten percent.

In closing, I would like to thank an Oakmark shareholder, Stephen Royce, for the following:

"Stocks have just declined thirty-five percent, sliding several percentage points a week for months on end. Many famous issues have been cut in half with terrifying speed. Current business news is terrible and many authorities feel that things are likely to get even worse. There have been several spectacular bankruptcies of international importance. Unemployment is up. There is a grave unresolved national problem. The brokerage business itself is in the dumps."¹⁰

You may be wondering which business periodical ran that summary of recent events. The answer is none. Mr. Royce excerpted it from the book The Craft of Investing, written a decade ago by John Train. In the book, Train listed each of these events as typical of market bottoms. None of us know for sure whether or not the stock market has bottomed, but one thing does seem certain—the view ahead is better than the view in the rear-view mirror!

William C. Nygren, CFA
Portfolio Manager
bnygren@oakmark.com