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 (9/30/03) AS COMPARED TO THE LIPPER BALANCED FUND INDEX16
	Annual Average Total Returns1
	(as of 9/30/03)
	Total Return Last 3 Months*	1-year	5-year	Since Inception (11/1/95)
Oakmark Equity & Income Fund	2.01%	19.75%	13.25%	14.04%
S&P 5006	2.65%	24.40%	1.00%	8.75%
Lehman Govt./Corp. Bond17	-0.51%	6.51%	6.69%	7.40%
Lipper Balanced Fund Index	2.05%	17.19%	3.62%	7.37%
The graph and table do not reflect the deduction of taxes that a shareholder would pay on fund distributions or the redemption of fund shares.
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

Quarter and Annual Review

The rebound in the equity markets enabled The Oakmark Equity and Income Fund to deliver solid absolute returns in fiscal 2003. The result for the 12 months came in just shy of 20% despite earning a relatively quiet 2% in the recently ended September quarter. The outcome for the fiscal year compared favorably with the 17% that the Lipper Balanced Fund Index, our primary standard of comparison, registered. The quarter's result came in essentially equal with the Lipper Balanced Index.

The 20% return represents the second highest fiscal year return in the fund's history. While pleasing, it must be placed in context. The fiscal year began at the tail end of a major stock market decline. This decline had compressed valuations of equities, thereby creating numerous opportunities for our talented team of security analysts to exploit. In contrast, the bond market began the fiscal year in the late innings of a powerful upward thrust. Bonds lost momentum as the year progressed, and the summer witnessed what appears to be a change in direction to higher interest rates. The net result for the Fund was that the equities contributed a robust 35% return for the fiscal year while bonds came in at only 5%. Remember, however, that in the previous fiscal year it was bonds that dominated returns. It is this variability and unpredictability of markets that makes a balanced fund such as Oakmark Equity and Income a sensible investing plan for many investors.

The Return of the Bubble?

As noted above, stocks have enjoyed a strong resurgence over the last 12 months. Given the perilous state of world affairs, it is hardly surprising that many pundits believe that the stock market has outrun its fundamental support and have described the rally as a return to the overheated conditions that eventually ended the previous bull market. We share some of this skepticism concerning current levels of valuation and fret about the miserable insider selling statistics. We also observe that it is more difficult to identify compelling opportunities. Nevertheless, we recall that several of our investing progenitors taught us "the hardest time to invest is always right now." We might not like current valuations, but the market today has favorable attributes that were not present in the bubble and that make it a much better time to be an investor.

The most definitive evidence of the health and vigor of the 2003 stock market rally is the market's breadth. "Breadth" simply measures the proportion of stocks that are rising, without taking size or other factors into account. Strong market breadth statistics characterize long-lived market rallies, and this characteristic is definitely present currently: in the first nine months of 2003 more than 83% of the issues in the Russell 3000 Stock Index enjoyed price increases. The positive returns have not skipped specific sectors but have been spread across the entire market. While this outcome is not rare, it has been absent since 1997. In contrast, the 1998-'99 stock market saw a dwindling list of very large companies keep that bull market going. In 1999, for example, the popular stock market averages rose more than 20% even though the majority of stocks declined in price that year. This deterioration in market breadth presaged the 2000-'02 bear market.

Aside from the market's own internal characteristics, economic fundamentals also appear to be very supportive of the stock market. Fiscal and monetary stimulus is approaching record levels, productivity is achieving remarkable advances, and corporate profits are both growing rapidly and improving qualitatively. Interest rates, though off of their lows, remain moderate. To sum up, the market is high but probably deserves to be. And, while it feels to us that undervalued opportunities are scarce, the experience of the last decade teaches that the market will reward our patient search for value.

Dividends

Oakmark Equity and Income is a balanced fund seeking to provide its shareholders high current income as well as preservation and growth of capital. Given the fund's income objective, we were quite pleased earlier this year when the tax cut bill included a roughly 60% reduction in the rate of taxation on corporate dividends. For the next five years the maximum marginal tax rate for both dividends and capital gains will be 15%. This change in the law has already altered corporate behavior as companies that never before paid dividends (e.g. Microsoft) have initiated payouts while others that paid token dividends (e.g. Waste Management) have drastically increased their payout.

Given the fund's mandate to produce income for its shareholders, we have always studied the available universe to discover opportunities to enhance the fund's income generation. With the change in dividend taxes, we believed that our search for income would become more difficult as investors bid up the prices of dividend paying companies. To our surprise, this has not yet happened. In fact, throughout 2003, stocks of companies that do not pay dividends have trounced dividend payers in total return, and those companies that have instituted dividends have generally not seen much favorable impact on their share price.

Experience has taught us that restrictive investing guidelines reduce total returns to portfolios. Accordingly, we have not limited Oakmark Equity and Income to income-producing securities. Nevertheless, our search for value is well suited to identify companies with the potential for meaningful dividend increases. In particular, we seek out companies with substantial free cash flow—that is, cash flow after corporate activities such as capital spending, working capital, debt repayment, and acquisitions. While the stock market's short term reaction to the tax law change remains abstruse, we expect the combination of our investing approach and lower dividend taxes to enhance returns to our shareholders over time.

The last time that we wrote about dividends in a quarterly report was in January of 2000. We noted then that dividends generally correlate positively with total returns. In both 1999 and 2003 that correlation turned negative. Rather than merely whine about it, our best course of action is to take advantage of this sort of anomalous market behavior.

In closing, we thank our shareholders for their interest and support. As always, we welcome e-mailed questions or comments.

Clyde S. McGregor, CFA Portfolio Manager mcgregor@oakmark.com	Edward A. Studzinski, CFA Portfolio Manager estudzinski@oakmark.com

Schedule of Investments—September 30, 2003

See accompanying notes to financial statements.