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.

"Investors should remember that excitement and expenses are their enemies. And if they insist on trying to time their participation in equities, they should try to be fearful when others are greedy and greedy only when others are fearful."

Warren Buffett—Berkshire Hathaway 2004 Report to Shareholders

In reviewing 2007's first quarter, with the S&P 500³ increasing by less than 1%, one could reasonably assume that it was a relatively uneventful quarter. As long-term investors, we'd basically agree with that assessment. Contrast that point of view with what we see and hear in the financial media: "Mortgage Armageddon" or "Dow suffers worst single day decline in four years." One needs to remember that the goals of the media and the serious investor are not well-aligned. The media wants to create excitement. During the NCAA basketball tournament last month, one show hosted an investment tournament with bracket match-ups that mimicked the NCAA's. Another hosted a reality show investment competition where the best performers avoided getting "voted off the island." These contests can be exciting and probably even help ratings. They shouldn't in any way, however, be confused with real investing. The timeframe is so short that stock movements aren't tied to business fundamentals, and rewarding the largest return without imposing any cost for losing money encourages the most risky behavior. Though it would no doubt make for dull television, successful long-term investing is much closer to "three yards and a cloud of dust" than it is to the West Coast offense!

On February 27th the stock market fell 4%. Perhaps we've all gotten spoiled with a market whose path has been nearly straight up for three years, but the reaction to that decline seemed intensely negative. Time Magazine headlined their March 12th issue with: "Is the Stock Market Getting Too Risky?" The Wall Street Journal told the story of an individual who bought some stock at $98 a share. The investor said "Before I could blink, the stock had sunk to $96, so I started selling at a loss."⁴ Many have become convinced that investing requires constant monitoring of news and price moves and believe that a serious investor needs to be a hyper-active trader. These reactions are exactly the opposite of our response at Oakmark. In the absence of negative fundamental news, if a stock falls from $98 to $96 it has become more attractive, not less. Likewise, the time to ask if the market is getting too risky is before, not after it declines. Following that drop, I had several calls from reporters, all asking the same question: "The market is down 5%, what does that mean?" My answer, which not surprisingly wasn't used by any of them, was that five-year compound annual returns were now going to be 1% higher than they were before the market fell. That answer didn't convey quite the level of fear they wanted.

The other question I was repeatedly asked by both reporters and shareholders was: "What are you buying?" First, that's a question we never answer. Our portfolio changes are only discussed on a quarterly basis. To communicate portfolio changes at other times would simply increase the risk of us getting front-run. But further, the question shows a lack of understanding of how we manage portfolios. The Oakmark Fund and The Oakmark Select Fund's portfolios are generally fully invested. That means that unless shareholders invest additional capital, we can't be net buyers. Whether the market has gone up, down, or sideways, we are always on the lookout for opportunities to sell fully valued stocks, and then use that money to buy undervalued stocks. Unfortunately, the first quarter decline was quite uniform. In fact, on the day of the big drop, only two of the S&P 500 stocks were up, and not one fell by over 10%. That's not the kind of volatility that produces great swap opportunities. Another thing to remember when analyzing changes in our positions is to look at whether shareholders have increased or decreased the capital they've invested in our Funds. In both Oakmark and Oakmark Select, we've had modest net redemptions. So if you want to see where we've increased positions, remember to include those stocks that we've opted not to trim.

The opportunity to take advantage of market corrections is in asset allocation – how much of your wealth is invested in stocks, in bonds, in cash and so on. Over long time periods, stocks have outearned other assets and have become the primary investment for most long-term investors. Despite that long-term performance, short-term results have been erratic. Depending on how you measure when one stock market decline stops and when a new one begins, the stock market has averaged a 10% drop once every year or two. Unfortunately, fearful investors pulled money out of stocks after those declines and re-invested after recoveries. Such mis-timing is one of the surest ways to earn less than the market return. It's been almost four years since we've had a 10% correction. When it happens again, and it most certainly will, we encourage you to either realize it is normal and ignore it—or even better, use it as an opportunity to invest more at higher prospective returns.

One sector of the market that continued to decline in March as the rest of the market recovered was the consumer lending companies, especially those involved with subprime mortgages. A mortgage is generally termed subprime if the borrower does not have strong enough credit to qualify for a traditional "prime" mortgage. And just like in the corporate market, where junk bonds have higher yields than investment grade bonds, mortgage lenders charge a premium on their riskier subprime mortgages to compensate for higher default risk. But in the past few years, with defaults on most corporate and consumer debt at very low levels, those premiums collapsed as investors convinced themselves that cycliclow default rates had become permanent. Subprime mortgages were being underwritten at such narrow premiums that if defaults returned to historic norms, they would no longer be worth the full amount of the mortgage. That's what happened last quarter. And with so many subprime lenders having very high leverage, even a small decline in mortgage values was enough to throw them into a tailspin. Many of the most aggressive subprime companies were forced out of business, and sale of their mortgage portfolios put further pressure on prices. Reporting on those sales has seemed pretty one-sided. When a TV reporter states that loans were sold for "pennies on the dollar," I don't think they are conveying reality when the number of pennies was actually in the nineties!

Although the decline in the subprime market negatively affected several of our holdings, shareholders focused on one of our largest: "How does this affect Washington Mutual (Wamu)?" We believe Wamu has built a very valuable retail bank. The stock appears inexpensive based on its low P/E⁵, high yield, and above-average growth in retail banking income. It is also priced very inexpensively relative to the deposit premiums that have been paid in recent banking acquisitions. Those plusses, however, fade to the background when investors worry about the mortgage market. Like all banks, Wamu has significant financial leverage, holding about $390 of assets per Wamu share. About 5% of those assets, $20 per share, are subprime mortgages. Let's assume a pretty negative case – 10% of those loans get foreclosed, and proceeds from sales of those homes are 20% less than the mortgage amount. The after-tax loss in that case would be well under 10% of Wamu's earnings. Wamu has been warning for several years that premiums on many newly written mortgages were not large enough. We believe they've acted prudently by selling those mortgages and retaining mortgages backed both by stronger personal credit and more valuable collateral. Even if one assumes a worse outcome, where much higher defaults spread to prime mortgages, it is difficult to imagine an outcome much worse than Wamu's business value not growing this year. Wamu has been a positive contributor to our Funds over the years we've owned it. Despite that, there have been short time periods, including last quarter, when that was not the case. We believe that from its current price, Wamu has a very favorable risk-return profile, and that justifies it continuing to be one of our largest holdings.

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