THE OAKMARK SMALL CAP FUND Report from James P. Benson and Edward A. Studzinski, Portfolio Managers

 

THE VALUE OF A $10,000 INVESTMENT IN THE OAKMARK SMALL CAP FUND FROM ITS INCEPTION (11/1/95) TO PRESENT (12/31/03) AS COMPARED TO THE RUSSELL 2000 INDEX13
	Annual Average Total Returns1
	(as of 12/31/03)
	Total Return Last 3 Months*	1-year	5-year	Since Inception (11/1/95)
Oakmark Small Cap Fund	10.94%	26.81%	6.00%	11.07%
Russell 2000	14.52%	47.25%	7.13%	9.48%
S&P Small Cap 60014	14.77%	38.79%	9.66%	11.98%
Lipper Small Cap Value Index15	16.46%	47.54%	12.67%	13.12%
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

Looking back over 2003, it is hard to believe how rapidly and positively events unfolded. It is easy to forget that until mid-March stock prices were generally under pressure and questions concerning an economic recovery were numerous. As of the close of the year, we suspect most investors were very happy with the gains they achieved during 2003 after the difficult market conditions experienced over the prior couple of years. The double-digit positive returns we achieved during the fourth calendar quarter of 2003 built upon the solid returns of the prior two quarters. Investors appeared to become more confident in the future growth of corporate profitability and this confidence was reflected in higher equity prices. As we stated in our last letter, we believe the fiscal and monetary stimulus in the economy is likely to create a sustained economic recovery. Our primary objective in 2004 is to invest in reasonably valued companies that we expect to do well in an economic recovery, but these companies must also possess the staying power to do reasonably well if the economy unexpectedly fades. During the just concluded quarter the S&P 500 Index⁵ rose by 12% and the Russell 2000 Index climbed by 15%. Your Fund experienced a gain of 11% during the past three months, which places its performance just below the S&P 500 Index and the Russell 2000 Index.

Consistency

As measured by the broad-based S&P 500 Index, 2003 was the first year this Index recorded a positive return since 1999. Over the past four years there have been three years of decline for the broad market as measured by the S&P 500, yet your Fund has achieved positive returns in three of the last four years. The key reasons for our success are: 1) Small cap stocks have generally performed better than their larger cap peers, thus we enjoyed a "tailwind" over the past few years (the Russell 2000 Index has realized positive returns in two of the past four years); 2) Our value-based investment style leads us to be principally invested in companies that we believe should generate solid cash flows over time. This value bias often means we are sometimes not heavily invested in a sector of the stock market that is doing well because our analysts believe the expected future cash flows from these businesses are insufficient to justify owning these stocks. By staying disciplined in our approach, we believe we can avoid many (although clearly not all) valuation mistakes. Despite your Fund's 27% gain in 2003, we trailed the annual return of our benchmark index, the Russell 2000¹³, for the first time since 1999. We prefer to invest in companies where we believe our invested capital can earn above average rates of return over the long-term and we do not change our investment approach based upon the short-term stock price movements of some stock sectors.

Portfolio Additions

Despite generally higher stock prices during the fourth quarter of 2003, our analysts were able to uncover several attractively priced stocks. During the past quarter we purchased shares in Herley Industries, Teledyne Technologies and USI Holdings Corp. Herley is a supplier of microwave components and systems to both military and commercial aerospace customers. Teledyne produces aerospace engines and defense electronics and we believe both Herley and Teledyne should benefit from increased defense spending and a recovering commercial aerospace sector. USI is a growing distributor of insurance and financial products and services to businesses in the U.S. We believe USI's product and service offerings are becoming increasingly attractive to businesses as insurance products become both more complex and more expensive. In addition to the three stocks we purchased we will be receiving shares in Levitt Corporation when its spin-off from BankAtlantic is completed in early 2004. Levitt is a growing builder of homes for retirees in Florida and based upon demographic trends we believe Levitt has a bright future.

Portfolio Deletions

During the third quarter we sold four stocks from your Fund's portfolio. The companies we sold were Berry Petroleum, Department 56, Inc., Prime Hospitality Corp. and Surebeam Corp. We sold Berry after this stock appreciated to the point where we believed it had reached a fair valuation for the underlying business. Department 56 was sold based upon our belief that intensifying international competition would continue to pressure their profit margins. We sold Prime Hospitality after this hotel operator's stock almost doubled from its 2003 low and reached a price that we considered to be its fair value. Surebeam was sold as slower than expected acceptance by consumers of irradiated food products hindered their results.

Summation

We would like to thank our shareholders for your continuing interest in and your support of The Oakmark Small Cap Fund. We look forward to communicating with you in 2004.

James P. Benson, CFA Portfolio Manager jbenson@oakmark.com	Edward A. Studzinski, CFA Portfolio Manager estudzinski@oakmark.com

Schedule of Investments—December 31, 2003 (Unaudited)