Fellow Shareholders,

The Oakmark International and International Small Cap Funds returned 16% and 18% respectively for the quarter ending December 31st while the MSCI World ex U.S. Index²⁰ returned 17% for the same period. The strong recovery in global stocks that began in March continued through the rest of 2003 with the Funds gaining 38% and 52% for the calendar year respectively versus the MSCI World ex U.S. Index which returned 39%. Given the availability of value in overseas markets, we continue to remain enthused about prospects in global equity markets.

This quarter we'll discuss the specific winners and losers for calendar year 2003 in the separate letters for Oakmark International and Oakmark International Small Cap.

Who would have thought…?

The year ended very differently than it started. Recall the thoughts occupying investors in early 2003: the continuation of the equity bear market, the raging bull market in bonds ("why be in stocks?!"), fears of war, fears of deflation, etc.

Though investors' emotions were encouraging equity market avoidance ("sell!"), fundamentals suggested the opposite: prices and valuations were attractive. Inflation was/is low, interest rates were/are low, conventional valuations like price to cash flow and dividend yield were/are (still) attractive. These two situations were not unrelated: equity market attractiveness was a manifestation of the fears listed above.

Disciplined, long termed investors won. The lesson: Don't let short-term fears cloud your vision to long-term prospects.

The China Syndrome

Recently, we have been getting lots of calls and letters asking why neither of the two Oakmark International Funds have any direct stock investments in Chinese companies. The questioners believe that because China is rapidly growing and is extremely vibrant economically, there must be stocks worth buying.

The truth is, at this point in time, we cannot find any Chinese stocks that meet our strict value criteria. First, we are not yet satisfied by corporate governance structures. Nearly all the listed companies in China are at least partially owned by the state and in nearly all cases, controlled by the state. This creates a giant conflict: what is good for the government may not be good for the other owners, especially foreign minority owners. For example, a listed company may buy another non-listed company at an inflated price. This would benefit the governmental entity that's selling to the detriment of the listed entity owned, at least partially, by outsiders.

Additionally, companies are primarily viewed as political instruments. The corporation is viewed as handy tool to accomplish various goals, and building shareholder value is typically absent from the checklist. As an example, employment, whether or not its actually economically productive, is oftentimes an important goal for these companies.

Even setting aside the presence of corporate governance conflicts, prices of the larger, more liquid Chinese companies (listed in Hong Kong) do not look attractive. The current trendiness of portfolio investment has really pushed valuations upward. So, when you consider price and quality, which is how we define value, we have yet to find opportunity.

In our view properly weighing risk and return in emerging markets is critical to success. Emerging markets in general have performed strongly over the past several years, especially relative to the developed markets of Europe. Many of these markets are now pricing in a lot of optimism, with little discount for the political and economic instability that comes along with the exciting growth prospects.

In fact, these calls for "Why aren't you in China?" sound similar to the query that we heard in late 1999 and early 2000, "Why aren't you in tech stocks?" It is easy to confuse the presence of growth with the presence of value. We will happily invest in Chinese companies when we find stocks that fit our investment criteria. Until then, we own and will continue to look for stocks in companies listed elsewhere that are benefiting from China's rapid growth and that are run for the benefit of shareholders. Currently, Giordano, a HK based pan-Asian retailer, has hundreds of stores in China and a operational plan to make solid profits over time. We could continue: BMW sells cars in China, Swatch sells watches there, et.al.

Remember it was only five years ago that most foreigners threw up their hands and fled emerging markets—creating what we thought was a tremendous buying opportunity. We will continue to monitor China as well as other emerging markets for investments that meet our investment criteria—price and quality.

Thank you for your continued confidence and support.

David G. Herro, CFA Portfolio Manager dherro@oakmark.com	Michael J. Welsh, CFA, CPA Portfolio Manager mwelsh@oakmark.com