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.

It's unusual for a book about economics to be described as "eminently readable." It's also unusual, perhaps with cause, for a book about economics to make the New York Times bestseller list. But that's exactly what's happened to Freakonomics³ by Steven Levitt and Stephen Dubner. Levitt is the unorthodox economics teacher at the University of Chicago who was named the best American economist under the age of forty. He has little interest in GDP, the stock market, or currency exchange rates. Instead, he uses economics to explain everyday human behavior. As Levitt says, "When moral posturing is replaced by an honest assessment of the data, the result is often a new, surprising insight. Morality, it could be argued, represents the way that people would like the world to work—whereas economics represents how it actually does work." He goes on to list several fundamental ideas that drive his thinking. First, "Incentives are the cornerstone of modern life. And understanding them … is the key to solving just about any riddle." Second, "The conventional wisdom is often wrong." Levitt uses these and other principles to examine a series of off-the-wall topics such as the accuracy of on-line dating ads.

Conventional wisdom would suggest that wealthy men and attractive, thin, blond women would have above-average response rates. In fact, they do. (Conventional wisdom isn't always wrong!) So, given that they have an incentive to lie, do on-line daters still tell the truth? The percentage claiming to earn over $200,000 per year is four times the national average. Over 70% claim to possess above-average looks and weigh twenty pounds below the national average. And 28% of on-line daters claim to be blond, far exceeding the percentage of blonds in the U.S. population. When there's incentive to lie, and the data skew strongly in the incentified direction, Levitt concludes honesty has been abandoned. His analysis of varied topics includes teachers inflating test scores, sumo wrestlers intentionally losing matches, and realtors getting better prices for their own homes than for their clients' homes. He challenges conventional wisdom on issues such as the profit potential in selling illegal drugs and the impact that additional police have on reducing crime. Despite being a fun, quickread—I read most of it during a day of standby jury duty—Freakonomics is a book that challenges the reader to be a more disciplined thinker.

Levitt's disciplined thought, analysis of incentives, and willingness to challenge conventional thinking showed parallels to The Oakmark Funds' approach to investing. Implementing our investment philosophy, which is always printed at the top of this report, requires disciplined thought. We need discipline to focus consistently on the long-term. Temptation is strong to let news flow and short-term results drive one's investment choices, but history has shown that abandoning long-term thinking in an attempt to boost short-term results is almost always counter-productive. Discipline is also required to invest only in those companies selling at significant discounts to intrinsic value. Many e-mails from shareholders remind us of the fact that our recent performance would have been better if we had more exposure to such areas as electric utilities or commodity cyclic companies, and they encourage us to buy those stocks now. Clearly these e-mails are driven by a rear-view mirror, or momentum, thought process as opposed to a forward-looking, value approach. I remember one specific letter from six years ago begging us to own just a few technology stocks to help our short-term performance. Staying true to our discipline in 1999—and avoiding investing in any companies we deemed to be fully valued or over-valued—probably had the greatest positive impact on portfolio returns of any decision we've ever made.

Incentives are the Cornerstone of Modern Life

In Freakonomics, Levitt is always examining incentives—incentives to work, to cheat, or to obey the law. In one chapter, he examined the problem of late pickups at a daycare center. The moral pressure to pick up children by the scheduled time was proving inadequate, and late pickups were becoming a business problem for the daycare center. To encourage better promptness, the center introduced a schedule of small fines for tardy pickups. The surprising result was that late pickups increased—a small financial disincentive was inadequate relative to the more significant disincentive of guilt from breaking the implied contract for timely pickups. The solution? The financial penalty needed to be larger—large enough that parents strove to avoid it and that the daycare center could profit from parents being late.

At Oakmark, we dedicate a good part of our analysis to understanding management incentives. Though managements have a moral contract with their public shareholders to maximize long-term business value, we feel more confident when managers also have a strong personal economic incentive to maximize value. A corporate CEO receives numerous streams of value for his or her performance: monetary rewards such as salary, bonus, and options, as well as non-monetary rewards such as lifestyle fringe benefits, community status, and fame. We want to make sure that the economic gain a manager receives when business value increases (through stock ownership, bonuses, and options) outweighs the values that accrue simply from longevity or size. It is important to us that, when key decisions are faced, a manager thinks like an owner. And as Levitt says, you can solve almost any riddle once you understand the incentives. For most of our holdings, starting with the largest, Washington Mutual, the CEO's largest personal investment is in his own stock.

Challenge Conventional Wisdom

A point that Levitt makes throughout Freakonomics is that one should consider the possibility that conventional wisdom is wrong. He points out that the sources for conventional wisdom are often biased and have a vested interest in seeing their view of the world become the consensus. He challenges us to consider the lack of evidence that children who watch more television perform worse in school or that drinking eight glasses of water per day is healthier than drinking eight glasses of other liquids. Applying his skepticism to the markets, one might question the motivation of the financial media telling its viewers and readers that each day's news has life-or-death importance to their investment portfolios. Do pundits honestly believe this, or are they motivated by increased ratings and circulation? Almost by definition, a value investor is frequently investing against the conventional wisdom. Whereas conventional wisdom generally believes that recent trends will continue, value investors often believe they will reverse.

Extrapolating recent performance, it seems that two of today's strongest consensus beliefs are that it isn't worth paying up for quality businesses and that stocks will not provide adequate returns from current levels. Not surprisingly, we reject both ideas. Typically, higher quality businesses sell at somewhat higher P/E⁴ multiples than do lower quality businesses. Five years ago, those premiums became excessively large as high quality, large-cap stocks frequently commanded P/E multiples more than twice that of the market. From that level, those businesses needed exceptional earnings growth just to produce average stock returns. Today, many of those same high-quality companies are priced in-line with the market. Now, average performance by these businesses is all that is required to produce average returns for the stocks. We think most will perform better than that, and if we are right, premium P/E's should return. As for the overall market, trailing five-year returns are still negative, and year-to-date returns on bonds have far exceeded stocks. We started the year thinking stocks were less fully priced than bonds, and there has been no fundamental news that has altered our view. The continued out-performance of bonds only strengthens our conviction that from today, stocks are likely to achieve long-term returns significantly higher than bonds do.

Best wishes,

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