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.

"Teamwork and intelligence win championships."

Michael Jordan

Following the rapid trading scandal in the mutual fund industry, many investors have recently become attracted to hedge funds, and financial services companies are showing increased interest in buying hedge fund management companies. Hedge funds, whose portfolios generally combine long and short equity positions, tend to achieve their best performance relative to the stock market during periods of declining stock prices. We believe that investors chasing recent performance are likely to be disappointed with hedge funds. First, the proliferation of hedge funds makes it much harder to argue that the industry is composed of just a handful of highly talented managers. Although some managers will continue to produce good results, as the hedge fund industry grows we believe the industry must trend toward mediocrity. Second, fee levels have stayed extraordinarily high and in many cases are increasing—in addition to a base fee that is higher than most mutual funds, hedge fund managers normally keep at least 20% of their investors' profits. And finally, most hedge funds compare themselves to the S&P 500⁴, which has a negative return for the trailing five years, an unusual event that seems unlikely to recur. So, for all those reasons, we discourage mutual fund investors from experimenting with hedge funds.

Having said that, the history of hedge funds includes some great investors such as Michael Steinhardt, George Soros and Julian Robertson. Following books about Steinhardt and Soros, last quarter Julian Robertson—A Tiger in the Land of Bulls and Bears⁵ by Daniel Strachman was published. Robertson's investment approach is certainly worthy of study, his Tiger Fund achieved an astonishing eighteen year compound annual growth rate of 32%. As an aside, one of the funniest stories in the book covers how Tiger got its name: it was suggested by Robertson's seven-year old son because that's what his father called everyone whose name he couldn't remember! The marketing department must have been glad he didn't use "dude" or "big guy."

There were certainly many ways Tiger differed from Oakmark. An obvious difference was the product, a hedge fund is designed to appeal to very wealthy investors while a mutual fund appeals to a much broader group of investors. The degree of diversification was also different. Hedge funds generally have a much higher degree of concentration than mutual funds do; therefore, the success or failure of any individual investment can have a very large effect on the fund's performance. We have made a similar argument about our most concentrated Fund, Oakmark Select, relative to the more diversified Oakmark Fund. But hedge funds go a step further. By using borrowed funds, they significantly amplify the positive or negative return of each security—that's why hedge funds are only suited to wealthy investors. In some ways, you could think of a hedge fund as a concentrated mutual fund on steroids! Regarding investment philosophy, a big difference was Tiger's frequent use of big picture, or top-down, bets versus Oakmark's bottom-up, individual stock focus. The book chronicles one of Tiger's most successful bets—that the price of a commodity, copper, would fall sharply. Although Robertson was very successful with so-called "macro" investing, we don't think many investors have that ability, and most importantly, we know we don't, so we don't try.

Despite these differences, what most struck me when reading the book was the important similarities between Tiger and Oakmark. Like Oakmark, Tiger believed in the ability of research to add value: "Robertson didn't operate on tips. In order for him to commit capital, the team would have to see and touch the industry first hand. It was a dirt-under-your-fingernails type of work. Robertson sent his analysts on planes and trains to get as much information as possible." Those same words could easily have been spoken by our Director of Research, Henry Berghoef. Another similarity was the way ideas were presented at Tiger: "A key part of the research model was the firm's Friday lunch meetings where ideas were presented. The analysts would gather around a table and go through ideas one story at a time, picking apart every little aspect and reviewing every angle of a potential investment opportunity to determine if it was worthy of being in the portfolio." Change that "Friday" to "Tuesday," and it would describe Oakmark's process. Robertson also was quick to react to new information. After an analyst convinced him that WTD Industries was not attractive, Robertson sold his entire position. Asked to explain the flip-flop, he simply said, "I was wrong." WTD later declared bankruptcy. In previous reports, I have referenced Oakmark's belief that mistake management is as important to our performance as picking our winners.

The most important similarity between Tiger and Oakmark, however, is the concept of team. After studying Tiger, the author concluded, "Non-athletes are fine, but the ones who really shine and become something on the Street are those who were part of a team, understand competition, and know the difference between winning and losing." Our Chief Investment Officer, Bob Levy, is as important to our corporate culture as Robertson was to Tiger's. Bob has often said he likes to hire individuals who enjoy the competition of team sports, but he would rather hire the ones who got cut from the team rather than the star because he knows that their competitive fire is still burning. Robertson certainly shared our belief that hiring decisions are among the most important decisions a firm makes. In fact, during Tiger's rapid growth phase, Robertson spent most of his time hiring analysts. Similarly, no analyst joins Oakmark before being interviewed by our most senior investment people. A tribute to Robertson's success is the reputation of the "Tiger Cubs"—analysts who worked for Tiger and now manage their own hedge funds. Not only are some of today's most successful hedge fund managers ex-Tiger employees, but the book claims these alumni are now responsible for 10% of all the hedge fund assets!

At Oakmark, despite a handful of our people capturing most of the media's attention, the reason for our success is the depth of our team. John Raitt's role as CEO allows our investment people the luxury of focusing on investing rather than on operating the business. Our analysts scour the investment universe in search of those stocks most worthy of consideration for our portfolios. Our traders work on acquiring and disposing of our positions with minimum price impact. That allows our portfolio managers to stay focused on what matters most to performance—which stocks we own. Like a good athletic team, we all have our roles, and the results we achieve reflect the efforts of every team member. As much as we enjoy Budweiser's Leon ad campaign (announcer: "There's no I in team" Leon: "Well, there ain't no we either"), I don't think Leon could have worked at Tiger, and I know he couldn't work at Oakmark!

William C. Nygren, CFA
Portfolio Manager
bnygren@oakmark.com

P.S.
Speaking of teams, in this space last June, I wrote about the Michael Lewis book, Moneyball. The book highlights baseball's Oakland A's method for evaluating players. Using statistical analysis that challenges conventional baseball wisdom, the A's get far more value out of their salary dollars than do most Major League Baseball teams. The similarity between Oakland's "value investing" in baseball players and Oakmark's value investing in the stock market is striking.

So, let's look at the 2004 update. In 2004, the New York Yankees had baseball's highest payroll at $183 million. The A's, at just below $60 million, were spending less than one-third what the Yankees spent. Further, two teams in the A's American League Western Division, the Anaheim Angels and the Seattle Mariners, were spending $101 million and $82 million, respectively. That's 68% and 36% more than the A's. The A's did finish 2004 an amazing twenty-eight games ahead of Seattle and went into the last week of the season ahead of Anaheim. But they fell one game short of capturing their third consecutive division title and fifth consecutive appearance in the playoffs. Despite them coming up short this year, as value investors, we have great admiration for how the A's construct their "portfolio" of players. And this October, they're saying the same thing we are saying in Chicago: "Wait 'til next year!"