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.

Next quarter when you notice that we no longer own AOL, don't assume that we sold our position. In a press release last month, AOL announced they would change their name back to Time Warner Inc. This was an acknowledgement that the company's future belongs more to their outstanding portfolio of traditional media assets than to their Internet access company. Jerry Levin and Steve Case, the CEOs who four years ago united these companies in what they referred to as the "merger of the century", have both since resigned. AOL stock, which traded at nearly $100 in the Internet bubble, today is priced at just $15. Though we believe it is significantly undervalued, it will almost certainly fail to produce a profit for those who bought into the merger hype.

The success of corporate strategies, business leaders, and, yes, portfolio managers can only be determined after long periods of time. Perhaps that's what makes reading old business books so entertaining. Bookstores are filled with newly published texts promoting recently successful business strategies. On the bargain counter, one of our portfolio managers found one such book, Lessons from the Top⁴ by Neff and Citrin. (As we've said before, our value approach is deeply ingrained!) It was written in 1999 during the peak of the "Marquee CEO" approach to investing as a study of "the 50 most successful business leaders in America." Since one of our three key stock selection criteria is investing with good management, I decided to give the book a quick read.

To their credit, the authors concluded that successful business leaders share common traits such as a passion for their work, strong competitive drives, clarity of thought, and the ability to clearly communicate those thoughts. (Not coincidentally, we believe these traits are also shared by successful investors.) But what makes the book more entertaining today is how events of the past four years have changed the way we read the quotes. Tyco CEO Dennis Kozlowski's claim that "there is a lot one person can do" was read differently in 1999 than it is today after Tyco's turmoil. When Bernie Ebbers from WorldCom said, "I look at my stewardship of this company as an opportunity that the Lord has given me," or when Ken Lay attributed the strength of Enron's culture to, "my basic value system" it didn't produce the sighs or smirks it does today. Yes, all three of them were considered Top 50 business leaders (as was AOL's Steve Case) just four short years ago! In fairness, among the Top 50 were also many CEOs still considered exceptional such as Michael Dell of Dell Computer, Herb Kelleher of Southwest Airlines, and Bob Tillman of Lowe's. Their companies have each enjoyed four great years since the book was written. So, how would an investor who bought stock in all the profiled companies have faired over the past four years? Unfortunately, not too well. An investor who equal-weighted positions would have underperformed the equal-weighted S&P 500 by about three percentage points. Likewise, an investor who weighted positions based on market capitalization would have underperformed the cap-weighted S&P 500 by a similar amount.

Highlights

We seek to avoid overvalued, low-growth, or poorly managed companies.

Our investment approach has been consistent over time.

Only shareholders with long time horizons should buy our funds.

Why does this sort of investment strategy almost always fail? After all, the authors went to great lengths to make sure their selections were based on solid quantitative measures of excellence that were free of industry bias. Though their approach was very logical, stock market prices generally incorporate the obvious. Investors were aware of these excellent leaders' track records and had bid up prices of these stocks. Simply put, betting on a single-factor model rarely outperforms the market. If you buy the highest growth or best-managed companies, the stocks' valuations are generally too high to make the strategy work. Likewise, if you buy only the cheapest stocks, you end up with too many businesses that have either stopped growing or are poorly managed.

That's why at The Oakmark Family we utilize a three-pronged approach to stock selection. We aren't necessarily looking for the statistically cheapest stocks, but we are looking for stocks priced at a bigger discount to business value than most. We don't require our businesses to be the fastest growers, but we do want the combination of dividend yield and projected per-share value growth to be at least average. And we don't require the managements to be recognized as among America's most successful business leaders, but we do require them to be smart, honest, and working to further the shareholders' interests. Although we make our share of mistakes, when we find a business that is growing, being managed to benefit shareholders, and is priced at a discount to business value, we can purchase the stock with the knowledge that, given time, the price and the value will usually converge.

We write these reports with the goal of helping shareholders and potential shareholders better understand how we approach investing their money. On our website we include all the quarterly reports we have written since 1997 and our annual reports from two years before that. Our hope is that by reading a history of these reports, one would know what to expect from us. The danger of allowing access to our old reports is that our mistakes, much like those in the Top CEOs book, may look even more glaring in hindsight. The benefit to those studying our funds is that history can be revisited and one can see what we were saying back then. You can see what we got wrong on stocks like USG Corp or Electronic Data Systems. You can also see what we got right on stocks we still own, like Washington Mutual, and on those we fortunately never owned, like the Internet stocks. But most importantly, you can see that our investment approach has been consistent throughout The Oakmark Family's history.

Our reports also explain our thinking on the importance of protecting shareholders. Over the past quarter, mutual fund industry news was dominated by allegations about special privileges being accorded to hyper-active traders. Following the negative publicity, market timers now seem to be universally hated. Interestingly, just two years ago US Congressman Thomas Tancredo wrote a letter to the SEC Chairman expressing concern about the industry's "increasingly discriminatory practices towards market timers."⁵ He further stated, "I have an issue with these nefarious attempts by mutual fund families to limit this key benefit (the flexibility to buy and sell at will) that they have been promising." Amazing how fast the winds change! You don't have to wonder what Oakmark's attitude was back then towards timers. You can read our quarterly letter from June 1999 when we put redemption fees on those funds that appealed to market timers. From day one, we have told potential investors that our funds were only suited to investors who have the same long-term time horizon that we use when selecting stocks. When, despite our efforts to thwart frequent traders, we found them using our funds, we instituted redemption fees that eliminated the profit potential from their trades. All of The Oakmark Family portfolio managers have made substantial personal investments in our mutual funds—it gives us the same economic alignment with our shareholders that we look for in the companies in which we invest.

PS: Last quarter this report discussed the Michael Lewis book Moneyball and the successful use in baseball of a value investing strategy by Billy Beane, General Manager of the Oakland Athletics. Congratulations to Mr. Beane on another in a string of successful seasons for his penny-pinching American League Western Division champs! And congratulations to our hometown favorites, the Chicago Cubs, on their first of what is hopefully a long string of division championships!