THE OAKMARK EQUITY AND INCOME FUND Report from Clyde S. McGregor and Edward A. Studzinski, Portfolio Managers

THE VALUE OF A $10,000 INVESTMENT IN THE OAKMARK EQUITY AND INCOME FUND FROM ITS INCEPTION (11/1/95) TO PRESENT (6/30/06) AS COMPARED TO THE LIPPER BALANCED FUND INDEX12
	Average Annual Total Returns
	(as of 6/30/06)
	Total Return Last 3 Months*	1-year	5-year	10-year	Since Inception (11/1/95)
Oakmark Equity & Income Fund (Class I)	1.57%	10.13%	9.44%	13.27%	13.44%
Lipper Balanced Fund Index	-0.97%	7.04%	4.32%	7.36%	7.73%
S&P 5004	-1.44%	8.63%	2.49%	8.32%	9.34%
Lehman Govt./Corp. Bond13	-0.14%	-1.52%	5.13%	6.25%	5.94%
The graph and table do not reflect the deduction of taxes that a shareholder would pay on fund distributions or the redemption of fund shares.
The performance data quoted represents past performance. The above performance information for the Fund does not reflect the imposition of a 2% redemption fee on shares held for 90 days or less to deter market timers. If reflected, the fee would reduce the performance quoted. Past performance does not guarantee future results. The investment return and principal value will fluctuate so that an investor's shares, when redeemed, may be worth more or less than their original cost. Current performance may be lower or higher than the performance data quoted. Average annual total return measures annualized change, while total return measures aggregate change. To obtain most recent month-end performance data, visit oakmark.com.
* Not annualized

"No question is so difficult to answer as that to which the answer is obvious."

George Bernard Shaw

Our Results

The Oakmark Equity and Income Fund increased 2% for the quarter ended June 30, bringing the calendar year gain to 4%. For the calendar year 2006, the Fund has outperformed both the S&P 500 and our primary benchmark, the Lipper Balanced Fund Index, which have gained respectively 3% and 2% for the year. This represents another period of absolute positive returns. In our fashion, we are moderately pleased with this result. While good relative returns might gain one admission to the Investment Managers' Hall of Fame, if such a place existed, they do little to help you, our investors and partners, preserve your capital and protect your purchasing power from the ravages of inflation. In another setting, it would be moderately amusing to note that the media now accepts what most of us have known for some time: that the government's statistics on inflation understate the actual rate of inflation by as much as 200 basis points. We wonder why this realization took so long to sink in, since consumers have been dealing with the increased costs of gasoline, real estate property taxes, grocery bills, health care insurance, prescription costs, and the like for a while now. For those living on a fixed income, inflation is not just an abstract statistic.

In one of our prior letters, we had expressed the sentiment that 2006 might prove to be a difficult year. We hoped that increased market volatility would provide opportunities to purchase attractive, undervalued securities. Indeed, since the middle of May, the market has taken many investors on the equivalent of Mr. Toad's Wild Ride. So, in hindsight we should perhaps be careful for what we wish. The real estate bubble, whose existence had been denied for some time—primarily by those who stood to and did profit mightily from it—has clearly popped. Around the country, statistics demonstrate this; in many places, inventories of both new and existing unsold homes have hit five-year highs. Builders have adopted any number of "incentives" to clear out inventory and batten down the hatches. Falling house prices, coupled with the increase in interest rates, have deprived many consumers of their last source of ready liquidity—the home equity and mortgage refinancing combination that many used as a giant piggy bank. In addition, a considerable number of home buyers opted for once-attractive adjustable rate mortgages, which are now adjusting upwards rather dramatically. Given these factors, it is easy to see that discretionary consumer spending is at risk.

Perhaps the most bitter pill for the consumer is the continued high price of energy. Gasoline prices now hover around $3 a gallon in most of the country, and there are no signs of any price relief in sight. In our opinion, the issue is not whether available oil and gasoline supplies have peaked. Rather, it is the depletion of the production and storage capacity that formerly allowed producers surge capability to meet periods of increased demand. To beat a dead horse into the ground, according to a recent article in The Financial Times, hurricanes Rita, Katrina, and Wilma cost the energy industry a total of $31B in damages, much of which has not yet and may never be repaired. Daily oil production in the Gulf of Mexico is down 15% from pre-hurricane days. Daily natural gas production is down 11%. Part of the problem, unfortunately, is a lack of skilled workers, supplies and equipment, and the logistics capability to get them in place to effect repairs. Some hopefully await either supplies of Liquefied Natural Gas from overseas or for natural gas and oil production to come down from Canada via pipeline. Yet no new construction has begun for what will be a multi-year effort. In our view, another underappreciated factor of the energy sector is demand from economies with greater wherewithal to pay for energy than the United States. A current article in The New York Times Magazine points out that from 2001 to now, highway mileage in China has doubled to 23,000 miles, behind only the U.S. The number of passenger cars on the road in China was six million. Today, it is 20 million. In Beijing, one thousand new cars are sold per day. We suspect that while other commodity prices have perhaps seen their high water mark, energy faces a different set of supply and demand dynamics.

The investment community also underappreciates the improving intelligence and character of the energy industry's management teams. Not too long ago, managements were overly focused upon top line growth. They would fund projects without any real attention to their risk, capital costs or ultimate payback. Even if a true profit would never be made, managements would justify projects on the hopes of stimulating positive cash flow in a few years. Today's managements are much more attuned to the costs of capital and seek to achieve fair returns for their shareholders. They are taking funds generated from today's energy prices and are either reinvesting in sensible value additive projects or returning them to shareholders through share repurchases or dividend increases. For example, we continue to view the management of XTO, our largest holding, as one of the best managements we have observed in any industry.

Portfolio Adjustments

This past quarter, we positioned the portfolio more defensively, thereby generating more portfolio activity than in recent quarters. At the end of March, 62.3% of the Fund was invested in Equity and Equivalents compared to 57.1% at the end of June. We eliminated positions in Burlington Resources, Morgan Stanley, R.R. Donnelley, The DirecTV Group, Pulte Homes, and Plum Creek Timber. As previously noted, Burlington Resources was acquired by ConocoPhillips for a combination of stock and cash. Plum Creek Timber reached its sell target. The DirecTV Group was sold as a duplication of our exposure to it through our ownership in News Corporation. We initiated small starter positions in International Rectifier, Mueller Water Products, and PRIMEDIA.

Fixed Income and Helicopter Ben

In the fixed income portion of the portfolio, we remain as defensively and conservatively positioned as in prior quarters. The duration (a measure of volatility) of the fixed income portfolio is now at 1.8. We have slightly repositioned our government securities and decreased the percentage held in agencies while increasing U.S. Treasuries. We continue to use fixed income investments for tax positioning. Early this year we recognized that the takeover of Burlington would trigger larger capital gains for the Fund than in recent years. The investment in foreign sovereign debt, primarily Canadian, has also increased slightly over the past quarter, now standing at 8.8% of the portfolio. We feel that our defensive posture in fixed income has served us well over the past few years, especially as the Federal Reserve has continued to raise short-term rates, which have now reached 5.25%. Historically, a new Federal Reserve Chairman has used the beginnings of his term to prove his inflation-fighting credentials. Certainly while the signs of inflation have enabled the Federal Reserve to justify recent actions, we wonder if at this point everyone is looking at the wrong thing. Could the real issue, especially as the economy starts to slow, be credit quality? On the one hand, corporate balance sheets have improved dramatically in recent years. Year to date, corporations have also thrown lots of cash at their shareholders in the form of dividend increases and share repurchase authorizations ($53B and $100B respectively). On the other hand, the joys of being a corporate bondholder have decreased. By taking advantage of direct, "leveraged" loans that allocate higher capital to them, both hedge funds and private equity investors are placing themselves in front of bondholders in the credit seniority line. Since the beginning of the year, the $158B in leveraged loans and $51.7B in collateralized debt obligations dwarfs the $52B in high yield debt new issues. We wonder what will happen if any liquidity issues develop and someone wants their collateral. Will all of these investors try and squeeze out the liquidity door at once? According to Stephanie Pomboy of Macro-Mavens, since May 1, investment-grade fixed income paper has lost 0.8%, junk issues are down 2.4%, but asset-backed issues are pretty much unchanged. Are investors afraid to see how liquid that asset-backed security really is? With our penchant for spectator sports, we prefer to remain spectators on these questions and maintain our portfolio of high quality, very liquid government obligations. Given that the market capitalization of credit derivatives now apparently exceeds that of the corporate bond market, we think our conservatism is appropriate.

From each according to ......

Summer is a great time for institutional investors, especially if they have followed the old market adage of "Sell in May." We like this time of year because the decreased pressure allows us time to reflect so that we can consider what's gone right, what dumb mistakes we have made, and what we have learned from those mistakes. We have always believed that mistakes are only dumb if you do not make the effort to learn from them. At this point, we are frequently examining industries and companies that are becoming more attractive. Summer often provides an unrivaled opportunity to visit companies, as corporate managers also feel less pressure during the summer and they are always more inclined to meet with institutional investors who come to them. From this perspective, we agree with a British fund manager's comment about face time. We should not be seeing faces, including our own, in the office at this time of year. Rather, the faces should be out and about, learning by wandering around. In that vein, one great aspect of our job is that it rewards the naturally curious, and the naturally curious also tend to be most successful at it. As we are out and about, we continue to search for businesses that are priced safely within the discount to intrinsic value range that we like. We remain grateful to you, our shareholders and partners, for your patience and confidence in entrusting us with your capital to manage.

Schedule of Investments—June 30, 2006 (Unaudited)