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.

My high school-aged son came home recently telling me how excited he was that one of his school projects was a contest to create and trade a phantom $100,000 stock portfolio. At the end of one month, the student with the most money wins. I only wish that studying the stock market had been part of the curriculum back when I was in high school! I could see my son's relief: after years of frustration from a father's job that was difficult to understand, much less explain, finally a payoff. Since this is Dad's profession, he can help me win the contest! A healthy discussion followed covering how we select stocks for The Oakmark Funds. We talked about how buying a stock is like investing in a business partnership—not only do you need a good business plan and partners that you trust, but the price has to be attractive relative to what you believe the business is worth. We also talked about how the emotions of fear and greed can push stock prices away from fair value and discussed the benefit of staying rational when other investors aren't. We covered the importance of being a patient investor because it often takes several years for a stock's price to reflect its underlying business value. And we even discussed a topic that throws off some academics in finance—diversification. Diversification is a wonderful tool for the investor trying to minimize the risk of loss, but for an investor trying to maximize the probability of significant outperformance, diversification is counter-productive. I went to bed that night feeling great. I'd had a wonderful father-son discussion concerning my profession. My son had a high level of interest in my job and an understanding of why our mutual funds have been such good investments for our shareholders. The next day, he returned with a follow-up request that burst my bubble: "Dad, what I'm really looking for isn't a stock like you'd invest in. What I need is one that is at rock bottom now compared to where it will be in a month." And in the snap of a finger, I was on autopilot dealing with just another investor with unrealistic expectations! Now I'm not sure if I should be rooting for my son's choice, TASER International, to go up so he wins his contest, or to see it fall to a rational price so that he learns a lesson!

It is understandable why a school contest utilizes such a short time horizon, it unfortunately just isn't practical to spend a rational investment time frame, like five years, on a stock market study module. What is less understandable is why so many investors who don't have those same

Highlights

A long-term horizon is the most important aspect of our investment approach.

Many investors miss the big picture by focusing on short-term news.

In the long term a stock's price needs to reflect business value.

constraints also often look out only a month or so! The quarterly letters from all of our fund managers continually stress the importance of a long time horizon. This repetition isn't because we forgot we'd already written about looking at the long term or because we think our readers haven't understood! We keep writing about a long-term horizon because it is probably the single most important aspect of the Oakmark approach to investing. As we all know, in the short-run, just about anything can happen in the stock market. In the very long-run, however, the laws of economics demand that stock prices reflect fundamental business value. By looking long-term, we can rely on estimates of business value and how that value will change over time. We can search for opportunities to invest at prices below our value estimates and look to benefit from the long-term convergence of price and value. Only by looking at the long-term do stock price movements begin to look rational.

The financial media, with their need to create urgency for viewers and readers, often shifts focus to near-term issues that may affect today's trading but won't even be remembered in a few years. Combined with the fact that bad news sells better than good news, it is no surprise that the media seems to highlight the news items that might cause a market decline. Even though I work on stocks every day, I was somewhat taken aback to see that in late December, the S&P 500³ had reached a level that was 50% higher than it was as recently as March 2003. The magnitude of the gain had just snuck up on me. Over nearly two years when the attention centered on a lingering war, higher oil prices, expectations for higher interest rates, a declining dollar, the likelihood of more terrorist attacks, and a deep political division in the U.S., the stock market quietly marched upward and produced outstanding returns. Seems like the media barely even mentioned the viewpoint that an amazing rebound in corporate earnings combined with the lowest long-term interest rates in a generation justified a stock market move of this magnitude. Instead, the commentary on the market increase was usually tempered by a mention that an investor who bought an S&P index fund in early 2000 had still lost money. I'm pleased to say that like the market, Oakmark and Oakmark Select are also more than 50% above their March 2003 lows. More important, unlike the market, both Oakmark and Oakmark Select also reached new all-time high NAVs⁴ during the last week of 2004.

Another fact that kind of snuck up was the performance of both Funds' largest holding, Washington Mutual. It was a disappointing year for Washington Mutual's mortgage banking division. Because of problems in that division, Washington Mutual fell short of 2004 earnings expectations and instead showed a significant decline in earnings. I received far more shareholder e-mail expressing frustration with Washington Mutual and questioning our judgment for holding that stock than I did on any other topic. But a funny thing happened—by the end of the year, Washington Mutual stock had not only increased, but it had a total return of 10%. That Washington Mutual could perform so well in a year when earnings were so disappointing is evidence of our risk-reducing stock selection criteria. It also shows Washington Mutual's success in its other business, retail banking.

Since Washington Mutual has been held in both Funds for such a long time, it provides a good example of how a long-term focus can provide more clarity than focusing on short-term results. Washington Mutual was first purchased in Oakmark in early 1998. After briefly underperforming our other holdings, it became one of my favorite 20 stocks and was purchased in Select. Washington Mutual started 1998 at just over $28, after earning $1.43 and paying a dividend of 47¢ per share in 1997. Since then, on a per-share basis, the dividend has increased more than threefold, and earnings have grown at a double-digit rate (using 2005 consensus) as have retail banking deposits. During that period, the stock, which many have oddly considered disappointing, has returned an average of 9% per year (while the S&P returned 5%). It's amazing how the attention on quarterly earnings shortfalls and the focus on bad quarters rather than good have obscured a great retail banking success story.

I'll end this with a "hot tip" from Oakmark. Instead of reading the plethora of stories telling you where to invest your money for 2005, do yourself a favor, beat the rush and start investing now for 2010 and beyond!