Fellow Shareholders,

Your Funds ended the quarter with a return of 4% and 7%, respectively, for The Oakmark International and International Small Cap Funds. This compares to a return of 4% for the MSCI World ex U.S. Index.¹⁸ The returns were mixed versus the relevant index primarily due to an underweighted position in the strong Japanese market. More importantly, over the past year, your Funds performed 62% and 85%, respectively, while the MSCI World ex U.S. Index returned 57%.

Favorable Conditions v. Screaming Buys

As equity markets have recovered very strongly over the past year, we no longer believe the markets are significantly over-sold. However, we do believe a much more favorable investment climate exists. Notwithstanding the upcoming election in the U.S. as well as continued fears surrounding terrorism, the world, in our view, is in pretty good shape.

Growth is very strong in places like North America, Australasia, East Asia, and India. The UK and "New Europe" are also performing well. Hopefully, "Old Europe" and Japan (which is showing some signs of life) will also catch the growth wave. However, we do not believe that either of these two areas are capable of sustainable economic growth unless bona fide structural reform occurs.

Given the level of per capita income and overall economic improvement in the developing markets and large population centers like China and India, we believe we have reached the inflection point where these markets have a significant impact on the world economy. This provides a nice tail wind for many of the companies in which your fund is invested.

Company Valuations: The Earth in Balance

With a much tamer macroeconomic environment, we are witnessing far less extremes in global company valuations. In the late 90s we witnessed huge valuation differentials between tech related and non-tech related stocks. Also, small cap companies traded at a significant discount to large caps, and emerging markets were coming off a harsh bear market. Today, though tech stocks are pricey, they are not as outrageously priced as they were in ‘99 and ‘00. The differential in valuations between foreign large and small cap stocks has evaporated, and emerging market stocks are back in vogue. In fact, we would argue that in certain places, such as China, India, and Hong Kong, stocks are now expensive, which is not all that surprising given the focus these regions have attracted.

We have been able to find value in the most obvious types of companies: developed market blue chips. After years of underperforming, stocks in the consumer non-durable, pharmaceuticals, and financial service sectors have lagged, whereas their prospects and valuations have improved. We are very happy to invest in these quality businesses that fulfill our value definition of being both high quality as well as inexpensively priced.

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