THE OAKMARK AND OAKMARK SELECT FUNDS

At Oakmark, we are long-term investors. We attempt to identify growing businesses that are managed to benefit their shareholders. We will purchase stock in those businesses only when priced substantially below our estimate of intrinsic value. After purchase, we patiently wait for the gap between stock price and intrinsic value to close.

"Think big, think positive, never show any sign of weakness. Fear? That's the other guy's problem."

The above advice about fear was given years ago by an experienced commodities trader to his young protégé, Billy Ray Valentine. We think it is still good advice. Fear can be a debilitating emotion. In the non-financial aspects of life, fear of the unknown prevents the growth that comes from new experiences. In financial dealings, fear of loss can prevent one from making investments that grow long-term capital. Fear, as opposed to an analytical assessment of risk, has no place in successful investing.

We focus on analyzing risk, and avoiding it—unless we get paid enough to accept it. We don't fear mistakes. We know we will make them, and we try to control their cost. The quantitative and qualitative analysis of risk is very different than the fear that often governs day-to-day markets. Last quarter, when the S&P⁴ increased almost 2%, we had nine days where the single day move was greater than 1%. Six of those were down days; three were up days. Of the six down days, five were explained by fear of higher interest rates, and one was explained by fear of increasing turmoil in Iraq. There is almost always something to fear—recessions, inflation, deflation, political instability, and so on. We have found we have no ability to add value by incorporating these fears into our investment process. Instead, we use a time horizon that is long enough that such issues fade in importance. Our goal is to build a portfolio from the bottom up—collecting attractive stocks and waiting for their value to be recognized.

Oakmark uses an approach to investing that focuses on taking calculated risks only when we believe the odds are tilted in our favor. We want our stocks to be selling at discounts to business value. This reduces downside risk when we are wrong and increases upside potential when we are right. We want our companies to be increasing their business value. As each year goes by, we hope to be using a higher estimate of business value. Finally, we want managements that work to maximize value. We believe having their goals aligned with ours reduces the probability of transactions that grow sales without growing per-share value, and it increases the probability of transactions that make the per-share value grow faster than the normal growth rate of the business.

Highlights

Fear can prevent making investments that grow long-term capital.

Oakmark's investing approach focuses on taking calculated risks.

We believe we now own more superior businesses trading at average prices.

Five years ago, when the S&P 500 was higher than it is today, we were able to find many opportunities that had these characteristics. Many average businesses were selling at substantially lower price-to-earnings ratios than the market sold at. These were typical investments for value investors. And most value investors have enjoyed very strong relative performance in the past five years as the multiple gap between average and superior companies collapsed. In 1999, ninety-five of the five hundred S&P companies sold at less than half the S&P multiple. Today, only twenty do. We believe that all active managers will have difficulty adding the kind of value over the next five years that value managers were able to add in the past five years. It may be an especially difficult period for value managers who are not willing to buy better businesses. The good news is that we believe we have gradually shifted all of the Oakmark portfolios toward higher quality businesses. We also believe that over the next five years the market is more likely to provide a tailwind than the headwind of the past five years. More growth companies now populate our portfolios, and we are frequently explaining these investments by saying we purchased better-than-average businesses at average prices. Some have criticized that rationale, asking, "What if the average stock is way overvalued?" That's a fair question, especially given the large number of successful investors who argue that the stock market is poised for a serious fall. Though our strong preference is to concentrate on individual companies—commonly called bottom-up analysis—this issue requires a top-down perspective. So, despite the top-down commentary in the rest of this letter, don't worry that we are changing our approach. We are not.

Last month I had the privilege of speaking at the Morningstar conference—a great gathering of fund industry leaders and fund investors. The panel I was on followed a day full of bearish speakers, many of whom have spent years crafting their bearish arguments. The arguments were quite complex and some even used derivative calculus to bolster their case! As my panel started, I was asked to give a brief rebuttal to their bearish views. From a common-sense perspective, here's why we believe the stock market will deliver acceptable long-term returns. Today, an investor could purchase a seven year Treasury bond, hold the bond to maturity, and be assured of earning a return of 4% per year. A buy-and-hold equity investor has no such certainty since there is not a contractual exit price. For that reason, we need to make some assumptions about what that exit price might be. The dividend yield on the S&P 500 today is just shy of 2%, and earnings are expected to grow at 5-6% per year. If price-to-earnings multiples stay constant, the long-term investor would earn 7-8% per year. On consensus estimates, the S&P sells at about sixteen times 2005 earnings. We think that multiple is somewhere between fair and a tad on the low side, given the current yield on bonds. So, if the multiple stays the same, the market delivers annual returns of 7-8%. If the multiple rises to eighteen times, returns bump up to 9-10%. The multiple would have to fall below thirteen times for the S&P to return less than the seven-year Treasury bond. To us, that environment clearly favors equities over bonds.

How could we be wrong? First, long-term interest rates could rise sharply which would likely lower price-to-earnings ratios on stocks. This is a popular fear that we hear about almost daily in the financial media. But, because it is a consensus fear, we believe it is probably already incorporated in prices. Further, intermediate-term interest rates of 4% appear consistent with forecasts of inflation increasing to 2-3%. Second, we could be too optimistic in projecting earnings to grow at least 5% per year. But, historical earnings growth has been somewhat higher, averaging between 6% and 7% over the past forty years. Third, we could be wrong in assuming that earnings in 2005 are about normal—i.e. we would be mistaken to project "normal" earnings growth from what could be a peak number. Although this is possible, we believe it is unlikely given that we are just entering the second year of an economic recovery. Finally, we could be wrong in saying that a sixteen times price-to-earnings multiple is an appropriate (or somewhat too low) multiple given 4% interest rates. Sixteen times earnings isn't a bargain level, but over the past forty years it is about the median price-to-earnings multiple on forward earnings. Each of these negatives has some chance of occurring, and fear of them could convince investors to raise cash. Our analysis of the risks, however, suggests that the probabilities remain strongly in favor of the equity investor. That's why we believe it is prudent to take advantage of the opportunity the market is now giving us—the opportunity to purchase better-than-average businesses at average prices.