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.

Since March marked Kevin's and my five-year anniversary for managing The Oakmark Fund, I'm shortening this report so that we can dedicate more space to a five-year review of that Fund. We will return to our usual format next quarter.

A number of shareholders have recently asked for an explanation of why our recent performance has lagged behind other value funds. From the market bottom over two years ago, both The Oakmark Fund and The Oakmark Select Fund have increased in line with the S&P 500³. Since both Funds showed solid gains from 2000 to 2003 while the S&P 500 dropped sharply, we were quite pleased that we fully participated in the gains when the market recovered. But other funds increased more. I think our biggest mistake was underestimating the magnitude of the recovery in corporate profits. This can be seen using The Oakmark Fund's purchase of Anheuser-Busch as an example. Two years ago, Kevin and I wrote, "We own this great company—now selling below seventeen times next year's earnings—at about a market multiple." Since then, Anheuser-Busch stock is down slightly. Earnings have grown almost as much as we expected, and it now sells at fifteen times next year's earnings. The problem is that because the S&P earnings growth has matched its 50% increase in price, the market P/E⁴ ratio has not gone up. So, despite significantly underperforming the market, Anheuser-Busch still sells at about a market multiple. Had we correctly anticipated the magnitude of the corporate profits rebound, we would have realized that the price we paid for Anheuser-Busch was really a significant P/E premium. In hindsight, we actually bought Anheuser-Busch at fifteen times expected 2006 earnings when the S&P was trading at eleven times now expected 2006 earnings. Value managers that bought the lowest P/E stocks in 2003 benefited from having much more exposure to the economic recovery than we did. So, what does that mean for today? If corporate profits continue growing at far above average rates, other funds probably will go up more than we will. We primarily own businesses, such as Anheuser-Busch, that we believe are superior, yet are priced as if they were average. If, as we expect, corporate earnings growth slows to the 5-6% per year we feel is sustainable, then not only should our companies' earnings growth start looking better in comparison, but we would expect to see their P/E multiples expand to beyond the market average.

The story last quarter about my son's stock picking contest generated more shareholder e-mail than anything we've ever written! As a recap, despite lengthy discussions of the virtues of value investing, he constructed a highly concentrated phantom portfolio that was heavy in TASER International, a momentum investor favorite that had more than quadrupled in 2004. I commented that I wasn't sure if I hoped he'd win the contest or learn a lesson. Well, he learned a few things! TASER was the focus of several negative news stories, and the stock lost 43% of its value during January. My favorite comment was "Dad, you know what the problem is with buying a stock just because it's been going up? After it falls, you don't really have a reason to keep holding it." Hopefully, that's something he never forgets. As for the contest winner—a future Warren Buffett? Unlikely. Turns out some computer whizzes figured out how to trick the website into accepting additional capital and treating it as investment gains. Another reminder that when the numbers look too good to be true, they probably are!

Best wishes,

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