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.

What a year! When 2003 began, anyone who expected a double-digit return was viewed as a hopeless optimist. Well, even the optimists underestimated the stock market recovery. Equity mutual funds increased in value by well into the double-digits with most showing gains of 25% or more. What a contrast to 2002 when almost all equity mutual funds showed negative returns! In 2002 we received numerous e-mails from shareholders concerned about our negative returns. They shared a common theme—what were we suddenly doing wrong? After the market began its ascent in March those e-mails stopped coming. A few even congratulated us on whatever steps we had taken to turn things around. Of course the truth is we hadn't changed anything; it was just the market that had changed. I guess you can't blame investors for believing (erroneously) that a change in what they can observe—our results—must have been caused by a change in what they can't observe—our process.

Over the holidays I read an excellent book by former Treasury Secretary and Goldman Sachs Chief Executive Officer, Robert Rubin. In his book, In an Uncertain World—Tough Choices from Wall Street to Washington,⁴ Rubin discusses his career-long approach to decision making in a world that lacks certainty and his belief that decision making should be judged by quality of process rather than by results alone. The book includes humorous anecdotes, such as complications in paying cab fare because the President never carries cash and keeping the President on hold while Rubin landed a fish he'd just hooked. The book also gives good advice to investors; of course the advice I liked best was that individuals should purchase value mutual funds! But the most useful content in the book was the material covering Rubin's approach to decision making. Perhaps I liked it because what he describes so closely resembles how we go about selecting stocks for our funds.

Rubin writes about running the Treasury: "Meetings produced the best results if those who disagreed with the accepted view were encouraged to speak out. So if a meeting seemed to be moving to a consensus… I would encourage someone to play the role of the devils advocate. Just as important as the freedom to disagree, I think was that this group of high-powered intellects in large measure avoided investing their egos in their arguments. It was a common search for the best answer…" This sounds very much like our weekly stock selection meetings. Analysts present new stock recommendations and all the other investment professionals attempt to shoot holes in their rationale. We have always said that our goal is to identify as many of our mistakes as possible before we lose any money on them. A young analyst's attack on a seasoned analyst's recommendation is not just tolerated, but strongly encouraged. At these meetings we also have reviews of existing holdings that we call "devil's advocate reviews." In these reviews an analyst is assigned to present the most negative arguments against our position. Attacking ideas without being perceived as attacking individuals is critical to the success of our process.

Highlights

Decision-making should be judged by quality of process rather than by results alone.

Short-term results will be inconsistent despite applying a consistent process.

The Oakmark Family has relied on the same investment process throughout its history.

Rubin goes on to talk about how he and Larry Summers would mark up pages of budget numbers: "Larry said to me afterward that people react to sheets of figures in two ways. Some people look at them, take them as a given, and go from there. Others look at numbers and start to question them, looking for inconsistencies, asking what they mean and what stories they tell, wondering about the relationship between them. Larry and I shared that kind of disposition, not just toward numbers but toward all sorts of supposed certainties." We're the type of people that take nothing as given. The afternoon before our stock selection meetings, a packet of reports written by our analysts is distributed to all of our investment people. The next day we each arrive at the meeting with scribbles all over the reports challenging in every way the analysts view of a company's future. Intellectual curiosity combined with a healthy level of skepticism—because things that look too good to be true usually are—has allowed us to take high quality input from our analysts and make it even better.

One of Rubin's more interesting observations concerns investor's shrinking time horizons: "When I left Washington in 1999, I was astonished at how much greater the short-term focus had become during the bull market. Commentators on the business news channels virtually never spoke about the five-year prospects of companies or had serious discussions of valuation. Today, an analyst who forecasts the five-year prospects for Ford Motor Company will probably never make a living. His customers want to know what the next quarter is like." We often say that our greatest competitive advantage is our long-term investment time horizon. We attempt to project how a business will change over the next five years, whereas most of our competitors are more worried about the next five months! Just as mutual fund investors observe a change in short-term results and erroneously assume the quality of work has changed, stock investors often observe changes in quarterly earnings and assume the quality of the business has changed. This tendency to overreact makes stock prices more volatile than underlying business values. By looking at a longer time-horizon we can apply our efforts to assessing business quality and can take advantage of such short-term over-reactions. The shorter the time frame becomes for the average stock market investor, we believe the greater our long-term advantage becomes. Since the inception of The Oakmark Family of Funds, these reports have always stressed our long-term approach. For investors in our funds to be successful, we believe it is vital that they share our long-term horizon.

As I think about the twelve year history of all the Oakmark portfolios, we have seen both economic booms and recessions. We have seen both war and peace. We have seen amazingly powerful bull markets and equally powerful bear markets. We have seen our short-term performance both lead the fund industry and trail the market averages. But throughout the life of The Oakmark Funds, one thing has remained constant—our investment process. We have always tried to identify businesses that have growing values that are managed by people who think like owners. We have purchased those businesses only if they sell at steep discounts to our estimates of value. Then we have patiently waited for the market to recognize that value. Throughout that process, our investment professionals have worked as a team to maximize our chances for making correct decisions.

Most every mutual fund advertisement contains fine print saying, "past performance is no guarantee of future results." In an uncertain world, there are obviously no promises about how future returns on any fund will compare with past returns. The only—and the best—promise we can make is that the investment process we have been using isn't changing.