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.

I'm pleased to say that our new fiscal year is off to a good start, with positive returns for both Funds, as compared to our somewhat disappointing 2005 year. We continue to be optimistic due to the low returns of competing investments, primarily bonds, and because of P/E³ levels that appear reasonable relative to historic norms. We also believe that the risk level in our portfolios is somewhat below our typical levels. Normally, value funds like ours tend to own many stocks that need to alter their fundamental performance dramatically in order to justify higher stock prices. Today, many of our holdings are in businesses that have performed very well over long periods, but whose historical price premiums have narrowed considerably. We usually think that stock prices are too high for businesses that have been experiencing above average growth, but we are now very pleased with the increasing opportunity to own above average businesses at average prices.

Our biggest news in the quarter was that we filed a 13-D with the SEC for our holding in Knight Ridder, which—as publisher of 31 daily newspapers—is one of the largest newspaper companies in the U.S. A 13-D indicates to the public and the company that we no longer intend to remain passive investors. In our filing, we included the letter we sent to Knight Ridder's Board of Directors in which we urged the Board to consider selling the company. Given our performance last year, some e-mailers asked why we weren't sending out more of those letters! Though the question itself is only rhetorical, I think the answer of how we relate to managements of our holdings is an important one.

One would like to believe that any investor would view their right to participate in proxy voting as an important tool for maximizing his or her investment return. But, that isn't always the case. The business section of The New York Times first edition of 2006 had a banner headline, "The Big Winner, Again, is 'Scandalot.'" The article summarized an unfortunately lengthy list of 2005 corporate scandals. Another article in the same paper, "May be the Stock Pickers Have Gone Fishing," showed that forty years ago about 80% of trading was done by "stock-pickers," but today nearly that same percentage is accounted for by passive traders—such as indexers. The tie between these two stories may not be obvious, but as fewer shareholders think of themselves as owners, fewer have any interest in corporate governance. An important check on management is being lost, and it is creating an environment that allows some managements to engage in value-destroying behavior.

As long-term investors, we highly value the voting right that comes with stock ownership. Though voting is important, it is certainly not the only way we ensure that management is representing our interest. Our initial attempt to align managements' interests with ours occurs during our research process. Long before we decide to purchase a stock, our analysts review management's incentives to assess whether or not actions that maximize a manager's wealth also maximize the wealth of the shareholders. It is nearly a sure bet that any individual will act in his or her own economic self-interest, so we want management's interest to be the same as ours. We like to see incentive plans tied to variables that we think are tightly linked to business value, and therefore stock prices. For example, we prefer a bonus structure based on EPS⁴ growth to one based on Net Income growth because the latter structure is more likely to encourage growth that is detrimental to per-share value. We also look closely at what managements have said. We like to see corporate goals that emphasize maximizing the long-term, per-share value of the company. Such language is, to us, far preferable to language that stresses the importance of various "stakeholders." While it is certainly important to consider stakeholders such as employees and customers, we want their interests to be considered only in the context of maximizing long-term, per-share business value. We also look at what managements have done. We like to see evidence of a willingness to make value-maximizing decisions, particularly when those decisions don't make the manager's job bigger. Examples include repurchasing stock, selling a division, or even selling the whole company. Only when we believe that a management team is likely to act in our interest will we make an investment.

After we make our investment we continue communicating with company management. We read their statements, listen to their conference calls, attend their speeches, talk to them on the phone and meet with them in groups and privately. Our goal is to make sure that, as we expected, they are acting in our interest.

Should we see red flags that make us question that belief, our first step is to have a private discussion with them, and hopefully they can explain their actions. I vividly remember a meeting with the CEO of one of our previous holdings, First USA. We wanted them to reduce their marketing spending, and instead use that money to repurchase their undervalued stock. The CEO respectfully listened to our criticism. Then he explained that based on how we valued the business, his marketing spending was creating value of three times its cost, whereas share repurchase would only create value of two times its cost. He was right, we were wrong, and our confidence in First USA's management was restored.

Sometimes, however, the CEO can't satisfy our concerns, and we end the private discussion convinced that our goals aren't aligned. When that happens, our first step is to evaluate how undervalued the stock is relative to other stocks we could invest in. If that undervaluation is similar to companies with better management, then we will usually sell the stock and reinvest the proceeds. But when the stock looks significantly more attractive than other investments, we will take further steps. When talking privately with a manager doesn't produce our desired result, our next step is to express our concerns privately to the Board of Directors. Only when that fails will we take the step of expressing our opposition to management publicly, as we did last quarter with Knight Ridder.

Looking beyond the issue of management, the Knight Ridder process may produce helpful information about business values, which could be important for deciding the price at which we would sell other holdings. We now consider many media companies to be attractive based on prices paid in acquisitions of similar businesses. Knight Ridder isn't the only investment we have in print media.

We also have an interest in Time Warner's magazine division, and The Oakmark Fund holds another newspaper company, Gannett. The response to Knight Ridder will, we believe, be an important statement about the value of traditional print media. Investment banking firms asked for indications of interest from anyone that might want to purchase all or part of Knight Ridder. Effectively, it appears that Knight Ridder is being auctioned to the highest bidder. For that reason, we think that the Knight Ridder results can be extrapolated to others in the industry.

When shareholders began publicly criticizing Knight Ridder's strategic direction, the stock price was $53. Most analysts and financial reporters were skeptical that Knight Ridder stock would be worth much more than that. If acquisition offers are not forthcoming, or are priced inadequately relative to the stock price, we will need to revisit the valuations of our other print media holdings. If as we expect, bidding is robust, and consistent with past newspaper acquisitions, we would consider that as strong supporting evidence for our belief that many print media companies are undervalued. We shall soon find out who is right.

Best wishes,

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