"If you think most stocks are attractively priced, how come you don't find as many to buy as most mutual funds do?"—Representative shareholder e-mail

Oakmark is one of few mutual fund families that makes their portfolio managers accessible via e-mail. I've often been asked why we "waste" our time answering these shareholder questions. I have three reasons: 1) We consider communicating with shareholders to be an opportunity to help them understand how we think and why we invest as we do. The better our shareholders understand us, the more likely they are to be long-term shareholders—and that is good for all of us. 2) Shareholders have been very respectful of our time. With the exception of a few 2:00 AM rants that senders often regret the next day, their questions are usually honest requests for better understanding. 3) Occasionally, a consistent theme develops from these e-mails that highlights an area where our communication needs to improve.

Such a theme has emerged recently regarding portfolio construction. I think we've done a pretty good job explaining how we select the stocks we own. Our three criteria—discount to value, growth in value, and owner-oriented management—appear at the top of each of these quarterly commentaries and are frequently topics for the reports. But we have not devoted nearly as much attention to an equally important topic: after identifying stocks that meet our criteria, how do we build the portfolio? And as the question at the top of the report shows, there is some confusion on this issue!

To make sense of how we structure a portfolio, we first need to identify our goals. First, the reason our Funds exist is to make money for our shareholders. So, we take great satisfaction when we report to you that a Fund has reached a new all-time high price. Some have commented that these new-high references are "cute" or even "corny." And given how sophisticated performance measurement has become, I can see why they think that. Simple as it may be, we think it is the most important thing we can say about our Funds' performance. We view new highs as a reminder that our primary objective is to increase your capital. We're pleased that even during the past three years, when other funds have increased more than we have, Oakmark has reached a new high in nine of those twelve quarters, and Oakmark Select did so in eight. (And both have already hit new highs again this quarter.)

Another important goal is to outperform passive management. An index fund can match the stock market's return at almost no cost to its shareholders. This is important because a broad-based index, such as the S&P 500², has historically provided a return that was superior to most investment alternatives. Matching that return creates a pretty high hurdle, and if we—or any other active managers—are going to justify our fees, then over long periods of time we either have to earn a higher return than the market or deliver a similar return but with less risk. We believe our three investment criteria simultaneously address both goals—higher than average returns and lower than average risk. As active managers, we must balance the potential risk that an individual stock could perform meaningfully worse than the market with the potential benefit of concentrating our assets in the stocks we deem most attractive.

A typical mutual fund manager today spreads portfolio assets across more than 100 stocks. As a competing fund manager I was seated next to for a panel discussion once said, "We keep our position sizes small enough so that our mistakes don't hurt us." That pretty much sums up the positive case for diversification—minimize the cost of your mistakes. Though the logic of that approach is sound, it is tough, if not impossible, to diversify your way to superior performance. The law of large numbers says that the more stocks you own, the more likely it becomes that your portfolio performs like the average of all stocks. And if you are content with an average outcome, a passive portfolio, or index fund, is a lower cost solution.

Since we believe our approach can identify above-average stocks, we take a very different tack. The problem with owning so many stocks that mistakes don't matter, is that successes won't matter then either. At Oakmark, we want to own enough of each of our stocks so that our successes do matter.

The Oakmark Fund is the more diversified of the two Funds I work on. But even Oakmark is much more concentrated than the average mutual fund. At most times our portfolio is invested in about 50-60 stocks, roughly half the average fund's number of holdings. A typical position for us is just under 2% of assets, and it is unusual to have a position as high as 4% of assets. We keep Oakmark this diversified so that we are comfortable when a long-term investor tells us they have put most of their stock market investments in The Oakmark Fund.

The Oakmark Select Fund owns less than half as many stocks as The Oakmark Fund does—usually about 20 stocks. It is a non-diversified fund, and because of that, we routinely caution that it is a high-risk strategy to use it as your only mutual fund. With only 20 stocks, a normal position for Oakmark Select is about 4% of assets (bigger than Oakmark's largest position), and our top holdings are usually a double-digit percentage of the portfolio. For example, both Funds' largest position today is Washington Mutual. It represents 3% of Oakmark's assets and 15% of Select's. If Washington Mutual continues to be a profitable stock, then it will be an important positive for Oakmark, but it will be far more important to Select. And if it doesn't, Select will suffer more than Oakmark does. We believe that the risk is worth taking, but we need Select's shareholders to understand the volatility they could experience.

So when we find lots of attractive stocks, why don't we just add them all to our portfolios? Most investors define "attractive" relative to cash. When we think about adding a new stock to our portfolios, the hurdle isn't just cash, but rather all the other stocks we already own. Since our portfolios are normally close to fully invested, adding a new stock needs to be funded by selling some existing holdings. Even if we thought hundreds of stocks were priced to produce attractive returns, we wouldn't increase our number of holdings. We believe that the twenty stocks in The Oakmark Select Fund will average a higher return than the fifty stocks in The Oakmark Fund, but the offset is that the portfolio will have higher risk. Our next favorite fifty stocks, the most attractive stocks we don't own, are, in our judgment, likely to average decent returns, just not quite as high as the stocks we already own. We don't believe that further diversification of The Oakmark Fund— say to 100 stocks—would reduce risk by enough to justify accepting a lower expected return.

Outperforming the market with a value approach requires discipline and patience to get through the inevitable periods when other investors enjoy more rapid price appreciation than we do. That patience is needed not just by the investment adviser, but also by the shareholders. We trust that our commitment to answering your questions will help you be patient as we work to continue increasing the value of your investments.

Best wishes,

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