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.

It was a big quarter for the word "greed." It was frequently used in courtrooms explaining the behavior of former CEOs who were standing trial. It was used in articles about fund companies that courted market timers. It was used in Warren Buffett's annual letter referencing excessive CEO compensation. And it was used to explain investors' behavior who are now more interested in buying stocks than they were a year ago when stocks were much cheaper.

In his book Origins of the Crash,⁴ one of my favorite business writers, Roger Lowenstein, also makes frequent use of the word greed. His cataloging of events leading up to the 2000 stock market collapse assigns blame to greedy CEOs, greedy accountants, greedy Wall Street analysts, and greedy investors. Even though the peak occurred just four years ago, Lowenstein's book serves as a great reminder of just how extreme the excesses were: during "the first quarter of 2000, a technology company was going public and doubling every other day—a speculative orgy without precedent in public markets." The book should be required reading before anyone is allowed to say that the bubble is now back! During the real bubble, CEOs overly incentivized by stock options became exclusively focused on the short term; audits were marketed not just on price but on leniency; analysts hyped stocks to create banking business; and investors bought stocks not because of investment merits, but because prices had risen and they wanted in on the gravy train. Lowenstein says, "The distinction between self-interest and greed … in the ‘90s was utterly lost."

In the investment criteria we list at the top of this report each quarter, we say we seek to invest with a "management that acts in the interest of outside shareholders." We have further said that we want them incentivized with stock ownership, stock options, and bonuses that pay them for increasing business value. Effectively, we want them to maximize their personal profits by doing what is most profitable for us, the outside shareholders. One could argue that by using the dictionary definition of greed—the desire for wealth beyond one's needs—we are asking management to be greedy. But many times greed and value maximization do overlap. That's why Gordon Gekko's "Greed is good!" speech to the shareholders of Teldar Paper didn't sound entirely self-serving. For tough decisions like downsizing or selling off divisions, as well as for high return investments that result in a growing business, greed may result in the same course of action as value maximization. Greed and value maximization, however, part ways when short-term goals are pursued that cause long-term damage. As Lowenstein said, in the 90s, "the credo of shareholder value … became a maxim not for enhancing business values, a process that occurs only over years, but for enhancing day-by-day quotations of shares." We have always been troubled by managements that are more concerned about their stock prices than they are about building business value. Managements often ask our advice on what they can do to get a higher stock price. Our answer has remained the same for years, and it's not necessarily the one they want to hear. "Run the business to maximize long-term value and invest excess cash in your highest return opportunities—among the opportunities being evaluated, always include share repurchase. If you do, the stock price will take care of itself." Anything short of that is not behaving like an owner. A business owner would never sacrifice long-term value in exchange for simply having people believe the business is more valuable today—unless it is being sold! A management focused only on next year's stock price won't make the necessary investments for long-term success. That's why we look at management's overall incentives. We want managements to make high return investments, even when the payoffs won't be evident for several years. Warren Buffett commented on the short-term focus that can result from an options-only incentive plan, saying "Who ever washes a rental car?" Options can help align a manager's interests with the shareholders, but true ownership creates a better long-term alignment. By focusing on a five-year time frame, we hopefully avoid most of the managers who aren't washing our cars!

Highlights

At Oakmark, we add value through stock selection rather than macro forecasts.

If management maximizes business value growth, their stock price should follow.

We don't believe current market valuations indicate a "Bubble Redux."

With so much greed in the air, some of our value peers have sold stocks and increased their cash position anticipating better opportunities (lower prices) ahead. We share some of their concerns because by definition, the higher the market goes, the tougher it is to find stocks that will continue achieving high returns. But, we have never shown an ability to add value through timing the market, or for that matter, through use of any macro level forecasts. A New York Times headline last month read "Time for Optimism? Pessimism? Pick Your Gauge." The article contained bull and bear arguments that each sounded compelling. An investor who read only one side could have been easily convinced. Last quarter Barrons ran a story about the likelihood of a strong rebound in inflation. It was well written and had strong statistical backing. However, later in the same issue, an interview with a highly successful fund manager gave an equally sound argument that deflation was right around the corner!

Usually, a compelling argument can be made for higher or lower stock prices, higher or lower inflation, economic boom or recession. Not only do we lack the ability to select the prophetic ones, but over our five-year time frame, their conclusions generally tend to be less significant than projecting how a specific business is likely to change. That's why we spend our time at the company level—trying to identify companies whose futures are being underpriced. We agree with Lowenstein's comment that "a true analyst is better equipped to appraise the medium-term future in rough terms than he is to forecast the here and now with precision." So we don't try to forecast the market—we simply buy out-of-favor stocks that appear to be selling below growing business values and hold them until the gap has closed. While it has been hard this year to find new stocks selling below 60% of value, we believe our existing holdings continue to sell at a discount and continue to see growth in their value.

When my children were younger, they enjoyed a story called "The Magic Fish" by Freya Littledale. In this story, a fisherman catches a talking fish that claims to be a prince and begs for freedom. Upon returning home and telling his wife that he set the fish free, the fisherman is berated for not getting anything in return. The wife demands he ask the fish for a new house. The fish delivers, but the greedy wife keeps asking for more and more until finally the fish takes back everything. Those who want us to believe that the current stock market is the "Bubble Redux" would say today's investor is behaving like the greedy wife. We're not so sure. Seeing two sides to most every story, we would ask if perhaps those who are waiting for double-digit expected returns while bonds yield only 4% aren't being just as greedy!