THE OAKMARK INTERNATIONAL AND
OAKMARK INTERNATIONAL SMALL CAP FUNDS

Fellow Shareholders,
Your International Funds, Oakmark International and Oakmark International Small Cap, ended 2004 with acceptable returns achieving 19% and 29%, respectively. This compares to the MSCI World ex U.S. Index14, which returned 20%. More importantly, the longer term results continue to be quite strong with International gaining 10% and International Small Cap increasing 14% over the last five years compared to the MSCI World ex U.S. Index loss of 1%.

The Currency Pendulum
Invariably, as currency movements aggressively sway from one extreme to the next, analysts and commentators clamor to explain such volatility. In particular, they try to predict future trends by extrapolating from the recent past. Both of these approaches are troubling, especially when it comes to currency forecasting.

Ultimately, the value of a nation’s currency is underpinned by that country’s production/economic prowess in an absolute—and more importantly—a relative sense. Today, as the dollar hits five-year lows compared to many European and Asian currencies, some experts conveniently proclaim that the dollar’s continued fall is not only likely, but certain. The usual reasons given are the “twins”: the U.S. budget and current account deficits.

This type of talk is very typical when the dollar declines. Last cycle, we heard the same chatter: “the U.S. dollar has lost its reserve status,” “the dollar is in terminal decline,” etc. About the time this talk becomes the loudest, the pendulum swings back, and valuations reverse. Recall how the Euro began its life at 1.17 in 1999 and promptly fell to .85 over the next few years. Today, of course, people aren’t speaking about a weak Euro; it’s at 1.35. Instead, we hear talk of 1.50!

People forget that the more something becomes overvalued, the stronger forces become to counteract that movement. Eventually, these forces become strong enough to reverse the direction of the movement.

We do not believe that the dollar is fundamentally doomed. Consider:

1. The U.S. is still the largest and most stable economy in the world.
2. The U.S. is extremely competitive when you consider regulation, productivity of labor, unit labor costs, and capital's ability to control its destiny.
3. The U.S. is the biggest consumer market in the world. Foreign companies must have a U.S. presence.
4. The U.S. has the largest and deepest capital markets.

To debunk the dollar bears’ arguments about the twin deficits, we would remind them:

1. The U.S. debt-to-GDP situation is better than Japan (45% compared to over 100%) and Europe (45% compared to 65% and over). The U.S. fiscal deficit is projected to fall over the next few years, and at 3-3.5% of GDP, it is not much different than the Euro economies or Japan.

Highlights
  • We see many reasons that argue against a perpetually weak dollar.
  • We selectively hedge currencies where we see significant opportunity or reason for concern.
  • It continues to be difficult to find many shareholder-oriented management companies in Japan.

2. Yes, the U.S. has a current account deficit. But, by definition, it also has a capital account surplus. This means that though the U.S. runs a trade deficit, this deficit is largely financed by foreign investors’ willingness to invest in America. Why do we feel this will continue? See 1, 2, 3, and 4 above. As long as the U.S. maintains global competitiveness, foreign money will remain. Causality is notoriously difficult to prove. Do we buy foreign goods because we have a capital surplus, or do foreigners invest in our capital because they have a trade surplus? The pundits assume the latter, but for no substantive reason.

Who knows what will happen in the short term? However, we believe that over time, fundamental forces will re-assert themselves, and the pendulum will change directions.

From an investment perspective, a stronger dollar over the long term has important implications. It bodes well, in local currency returns, for those foreign multinationals who are dollar earners. This positive impact should be more than enough to counter the negative currency move felt by U.S.-based investors who hold falling foreign currencies. In our Funds, we have also elected to hedge part of our Swiss franc and Sterling holdings, which should mitigate the later negative.

Happy Anniversary!
Fifteen years ago, on December 29, 1989, the Japanese Nikkei15 hit its all time high of 38,916. As of this writing, the market sits at 11,488, down 70% from where the market closed on that December day in 1989. We keep trying to find quality Japanese companies to invest in. Though we have had some success, it is proving difficult to find companies that have management teams that are truly concerned with building shareholder value. We will keep trying!

In closing, we would again like to thank all of our shareholders for their continued support and confidence. We will continue to work hard to find suitable investments over the long term.

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