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.

This is an excerpt from Bill's recent keynote speech at the Morningstar Investment Conference. Please see the Oakmark website for the entire text.

When we apply our criteria to today's market, where do we find investment opportunity? To answer that, I would like to take a step backwards and look at a graph of recent history. The green line on Chart 1 shows the spread of P/Es³ for the S&P 500⁴ companies in June 1999. If we look at the far right hand side of the graph, it indicates that 12% of the market value of the S&P 500 sold at a P/E above 80 times earnings. We can also see the largest grouping, at about 15% of the S&P market cap, at what would be called a market multiple, between 30 and 35 times earnings. At the left-hand side of the graph, we see that quite a bit of the S&P was selling at less than half of the market multiple, and a fair amount was even at single digit P/Es.

That was a good time to be a value investor. It was easy to construct a portfolio of stocks that was selling much more cheaply than the S&P 500 was selling. Despite the market P/E multiple of about 30 times earnings, most stocks in the Oakmark Fund portfolio sold at P/E's in the teens. It was full of what might be called "traditional value names" like Brunswick, Old Republic, A.C. Nielsen, Boeing, Eaton, Cooper Industries, Geon and Bandag. At the time, as concerned as we were about "irrational exuberance," our bottom-up analysis made us comfortable that the specific stocks we were invested in would end up having reasonable long-term returns.

The market peaked in early 2000. The NASDAQ⁵, which was over 5000, fell to near 1000. We saw the S&P 500, that had been over 1500, fall below 1000. Yet despite the market decline, the portfolio of undervalued traditional companies that we owned went up in price. The result of that divergent market—the overvalued stocks coming down in price and the undervalued going up— was that the P/E distribution graph changed significantly. The gray line on the chart shows the P/E distribution as of June 2003, just four years later. Two things are important to note: first, the average P/E has moved way to the left reflecting the significant decline in the market. Instead of over 30 times earnings, the average multiple fell to about 15 times earnings.

LARGE-CAP GROWTH STOCKS

Ticker	Company	P/E 1999-A	EPS7 '06-E vs. '99-A	Stock Price vs. 2000 High	P/E 2006-E
	S&P 500 Composite	31	67%	-19%	15.2
C	Citigroup Inc.	25	93%	-12%	11.2
DELL	Dell Inc.	90	110%	-60%	17.4
HDI	Harley-Davidson	58	325%	5%	14.2
HPQ	Hewlett-Packard	45	44%	-52%	14.9
HD	Home Depot	68	201%	-47%	11.9
KSS	Kohl's Corp.	83	273%	-14%	19.3
TXN	Texas Instruments	116	96%	-70%	17.5
TWX	Time Warner Inc.	225	142%	-79%	19.1
TYC	Tyco Int'l Ltd.	94	188%	-55%	14.8
WMT	Wal-Mart Stores	56	135%	-31%	16.4
	AVERAGE (ex. S&P 500)	86	161%	-42%	15.7

Source: FactSet data and First Call estimates. As of 6/19/06. For informational purposes only and are not recommendations of individual stocks.

Just as important, notice how much tighter the distribution is. Not nearly as many stocks sold at large discounts or large premiums to the average multiple. To us, much of that change was an accurate reflection of fundamentals. We believed that the stocks that were selling at modest discounts to the market in 2003—generally the cyclical and commodity names—deserved to sell at discounts because they had less control over their businesses than other companies did. Looking at the companies that were selling at premiums, we thought that there, too, the market had rationally reduced the giant premium required to own large-cap, growth businesses.

But as often happens, we thought the market went too far. No longer was the value investor priced out of the market for owning businesses with above average growth. Stock-by-stock, our portfolio changed. As the mediocre businesses that we had owned in Oakmark started to hit their price targets, we couldn't find traditional low P/E stocks to replace them. Instead, the best opportunities that our analysts uncovered were now the very same names that four years earlier we thought were selling at crazy prices. So one-by-one, names such as Home Depot and Wal-Mart started to find their way into our portfolios.

We believe that the best opportunities in the market today are still the fallen growth stocks: stocks that have performed poorly over the past five years but whose businesses have continued to perform well. We believe these are still growth companies, but based on stock performance, they now look more like value stocks. We don't believe the commodity price surge of the past three years will recur; in fact, we think it will likely reverse somewhat. And, if we are right, it is very unlikely that stock price trends of the past three years will continue.

So, back to the P/E dispersion chart. The black line shows where the market is on May 30, 2006. You see that we are still confronting a very tight distribution, even somewhat tighter than existed three years ago. And though this chart doesn't show it, I'd add that mid- and small-cap names no longer are priced below this average. Today, very little premium is required to buy what in our opinion are superior businesses.

Let's get more specific about some of the companies we find interesting. Chart 2 shows P/Es based on the high price in 2000 relative to trailing 1999 earnings. You can see that the S&P 500 was over 30 times earnings. The average of this list of highly thought of businesses: Citigroup, Dell, Harley Davidson, Hewlett Packard, Home Depot, Kohls, Texas Instruments, Time Warner, Tyco and Wal-Mart sold at 86 times earnings.

The next column shows the percentage gain in earnings per share from 1999 to the 2006 estimate. From 1999 to 2006, S&P 500 earnings grew 67%, about an 8% annual compounded rate. In comparison, you can see the growth that our sample companies achieved during that same time period. The range is from a low of 44% at HP to a high of over 300% at Harley Davidson. The average earnings growth for these ten companies was 161%. Contrast that with this third column, which shows the change in stock price. The S&P 500 is down 19% from its high in 2000. These ten high quality companies averaged a decline of 42%. They range from up 5% at Harley Davidson to down 79% at Time Warner. On average, these stocks lost a little more than twice what the S&P lost, despite showing earnings growth of more than double that of the S&P.

Now, price being down is often sufficient for us to get interested in a stock, but it certainly is not sufficient to argue that it is undervalued. So, the fourth column shows the current P/E for each stock and the S&P 500 based on 2006 First Call estimates. You can see the range. At the low end, Citigroup sells at 11 times earnings, and at the high end, Kohl's sells at 19 times earnings. As a group, the list today sells at 15.7 times earnings, barely half a P/E point higher than the S&P 500. So these ten stocks, which were priced at 86 times earnings just six years ago, are now priced basically at parity with the S&P.

Over the past six years, achieving earnings growth that was more than double the S&P was not sufficient to prevent these stocks from declining sharply in price. The starting P/E was just too high to overcome. But today, they face a very different outlook. They are now priced as if they are only average businesses. If they prove to be only average businesses, well, they are already priced as such. So, that's our margin of safety. But, if as expected, they show earnings growth that is superior to the S&P 500, these should now perform as superior stocks. We think it is likely that these 10 companies, all of which have been added to the Oakmark Fund in the past couple of years, will achieve long-term earnings growth significantly higher than the S&P 500 will achieve. And if we're right, not only do we make money with the higher earnings growth, but we also think it is highly likely that we'll also make money from P/E expansion.

Best wishes,

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