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.

It seems most mutual fund managers don't do much pleasure reading. I guess our jobs involve so much reading that when we encounter those precious hours of free time, reading usually finds itself far down the list of preferred activities. During the summer, playing softball on our in-house team, The Mighty Oaks, is always at the top of my list. Even CNBC knows not to ask for a Wednesday evening appointment! Last quarter a book was published that vaulted pleasure reading way up on my list—Moneyball by Michael Lewis. A favorite author writing about two of my favorite topics: value buying and baseball. Moneyball tells how a small market team, the Oakland Athletics, consistently wins despite having one of Major League Baseball's smallest payrolls. They achieve that feat by valuing players using statistical analysis that is ignored by most other teams because it goes against conventional baseball wisdom. Paul DePodesta, assistant to the A's general manager said, "I get excited about a guy when he has something about him that causes everyone else to overlook him and I know that it is something that just doesn't matter." Speed: overrated. Homerun hitting: overvalued by the market. Get the players who avoid making outs. Walking and slapping groundballs to the opposite field is where the real value is. To those who know Oakmark, this should sound familiar! I'm not sure if I liked the book more because of its similarity to our investing style or because it valued the skills of an aging Mighty Oaks' first baseman!

Don't make outs—if you just get on base, scoring runs takes care of itself. With stocks, we defer thinking about the upside until after we evaluate the risks. If you avoid losing money, making money takes care of itself. Just like Warren Buffett's two rules of investing—"Rule No. 1: Never lose money. Rule No. 2: Never forget rule No. 1." Explaining his approach to acquiring players, DePodesta says, "We don't get the guys who are perfect. There has to be something wrong with them to get to us." That's why Michael Lewis calls the Oakland A's "baseball's answer to the Island of Misfit Toys." He'd probably say the same about our portfolios. Not much glamour. Something "wrong" with each of the stocks we have collected. Short term outlooks that are too cloudy. Businesses that are too cyclical. Industries that are too dull. Companies with no better use for cash than buying back stock. Pursuing stocks that meet our strict valuation criteria usually means making compromises. But like DePodesta, we try to limit those compromises to "something that just doesn't matter" to a company's long-term business value. The one compromise we will not intentionally make is on the quality of management because that's a factor we consider too important to risk.

Highlights

We buy stocks like the Oakland A's buy players—looking for flaws that don't matter.

We will not compromise on management—management and shareholder goals must be identical.

Our sole concern in proxy voting is maximizing the long-term value of our investment.

Because of recent scandals like Enron, Tyco, and WorldCom, quality of management and corporate governance have become stock market and regulatory hot-buttons. It's no surprise that in their annual letters to shareholders this year, most CEO's increased their focus on corporate governance. However, it seemed that the worse the results were, the more ink they dedicated to highlighting their good governance efforts! In a move designed to make mutual funds increase their focus on governance, funds will soon be required to report to shareholders their proxy voting policies and eventually their complete proxy voting records. At the risk of spoiling the suspense, here's what you'll find: we usually vote with management. Allow me to explain.

First, why is this whole governance topic so important? Unlike a single proprietorship, the management of a public company does not bear the economic costs of bad decisions, except to the extent they are also shareholders. We do. For that reason, shareholders elect a board of directors that is responsible for running the corporation. Law in Delaware (where most public companies are incorporated) states that directors owe the duties of care, loyalty, and good faith to the corporation and its shareholders. Unfortunately, this statement is not as precise as what Warren Buffett wrote in the Berkshire Hathaway Annual Report a decade ago: "I believe directors should behave as if there is a single absentee owner, whose long-term interest they should try to further in all proper ways." As usual, Buffett's common-sense language leaves less room for debate than does the legal language! In fact, some interpretation of the legalese gets to a position one hundred and eighty degrees opposed to Mr. Buffett. The New York Times last quarter quoted directors of a public company as saying, "Corporate Directors have a fiduciary duty to act in the best interests of the corporation. Directors' duties toward the corporation, however, do not generally encompass a duty to the company's shareholders." Although this view is extreme, much of the literature on good corporate governance acknowledges that directors may consider constituencies other than shareholders when evaluating possible courses of action. To us, any agenda other than maximizing the long-term, per-share value of our shares constitutes mismanagement.

So, how should we protect our assets against mismanagement? Last June's quarterly letter explained our investment criterion of identifying managements that act in the interest of shareholders. When considering an investment, if we decide a company is mismanaged, we simply won't buy it. Our approach is similar to TV viewers who see an objectionable program. By simply switching the channel and refusing to watch, they increase the probability of the show's cancellation. By not buying the stock, we help increase their cost of capital and increase the probability that management will be changed. Some argue that to be responsible citizens, mutual funds should purchase poorly managed companies and then fight to reform them. We believe that the returns from that strategy are sub-par. It is just too easy to underestimate the damage that a bad management can inflict while the shareholders are attempting to replace them.

Sometimes our management judgments prove to be wrong. When we come to believe one of our holdings is being mismanaged, we usually sell the stock and invest the proceeds in a similarly undervalued company in which we have more confidence in management. In rare circumstances, we have believed that a company was so undervalued and of such high quality that change was worth seeking. At companies such as Saatchi & Saatchi and Dun & Bradstreet our firm was instrumental in changing top management, and Oakmark Family shareholders benefited from those actions. However, despite a couple great shots from the rough, our strong preference is still to drive onto the fairway!

Our process intends to identify and invest in companies in which management goals and shareholder goals are identical. When this happens, by definition, voting with management is voting to maximize the expected value of our investment. Were a management to propose actions contrary to our interests, by definition, we made a mistake in evaluating them, and we would seek our profit-maximizing or loss-minimizing course of action. Usually that means selling the stock. Unfortunately, not everything in proxy voting is so black and white. For example, options are a useful part of a management incentive plan, but many companies have over-utilized options. Reasonable people disagree as to what level of options issuance crosses that line. We routinely vote against options plans when total options exceed fifteen percent of shares outstanding (and we vote in favor of expensing options). We also routinely vote against staggered boards, super-majority votes, and poison pills. Though we vote against management on these proposals, we do not consider them as evidence of mismanagement.

We expect to have a summary of our proxy voting policies posted to our Internet site (www.oakmark.com) later this quarter, and our annual proxy voting records will be available at the end of August 2004. Voting is a relatively small part of our process. Ensuring that management's goals are aligned with ours is a very large part. As both shareholders and fiduciaries, our sole goal is maximizing the long-term, after-tax return of our investments. So when you read our filings, don't think that a high percentage of pro-management votes means we don't care about corporate governance. Instead, it is confirmation that our process of investing with shareholder aligned management is working.