THE OAKMARK INTERNATIONAL AND OAKMARK INTERNATIONAL SMALL CAP FUNDS

Fellow Shareholders,

Both of our International Funds, Oakmark International Fund and Oakmark International Small Cap Fund generated acceptable absolute returns for the quarter. Though we are disappointed with the relative short-term performance of both Funds, we believe that it is more important to focus on the portfolios’ quality, valuation, and long-term performance. At this time, we are quite enthused with the make-up of the portfolios, and we believe that these portfolios will continue to outperform in the long term. We feel that risk is being mispriced in global equity markets and that the undervalued and high quality companies in our portfolios will eventually deliver strong performance. As you will read in the individual Fund letters, today’s “dogs”—those stocks that have been a drag on portfolio return—often turn into tomorrow’s stars. We are quite confident that those securities that have dampened performance will not only recover but will lead to solid absolute and relative performance.

China, Unsafe at Any Speed?

We continue to receive lots of questions on why we remain uninvested in China, the world’s fastest growing major economy. Recall that our investment style is that of long-term value investors. We seek to invest in companies that are of high quality but also sell at low prices. Today the stocks of Chinese companies represent neither: they are richly priced and they are of low quality. As an example, the major Chinese bank stocks trade at over three times book value and 15-20 times earnings. Most of the banks we own are at 10-12 times earnings and trade at one to two times book value. Before Chinese bank stocks could even be listed and sold to foreign investors, they had to remove the bad loans from their books, which represented 30% of their portfolios. This begs the question of whether the lending practices that caused the bad loans in the first place have radically changed, or is it simply a matter of time before history repeats itself?

Most major Chinese companies are still state controlled, which means that politics will most certainly enter corporate decision making. The state is directly involved in critical banking matters, ranging from capital allocation to pricing to investment criteria, all of which could lead to less than optimal results for foreign investors.

China is also an environmental nightmare. Though the lack of environmental regulations has helped it become a low cost country for producing goods and has attracted manufacturers from all over the world, China’s air, water, and soil have rapidly deteriorated. Any traveler to China can easily observe this well-documented phenomenon. Additionally, aggressive “entrepreneurs” have called into question the safety and quality of much of what has been produced. Recently, pet food, toys, tooth paste, cough syrup, and ATVs have been made either toxic by the addition of cheap materials or unsafe by poor design. We believe that China will have to deal with these issues, which will eventually affect the cost of production and possibly make it a less competitive place to invest and produce. In our view, if the current pace of environmental decay is maintained, it would be catastrophic not only for China but also for the globe.

Lastly, we are seeing signs that the Chinese market is now speculatively priced. Besides—and maybe because of—stretched valuations, new listings are coming to market raising billions and billions of dollars. Some are new industry participants, and some are raising capital for huge expansion projects. Often, the economic rationale of the listing is unclear, though that doesn’t seem to matter because most China-themed deals are heavily over subscribed. We cannot ignore the parallels with the tech bubble as we watch the theme “Growth of China” become so prevalent. In the late 90s, the advance of the internet was the dominant theme, but investors found out the hard way that a macro theme does not always correlate with corporate profitability.

It is true that there will be growth in China for as far as the eye can see: strong growth in fixed capital, economic liberalization, and some positive microeconomic fundamentals will lead to productivity enhancement. However, this does not mean it is safe to invest in Chinese stocks at today’s prices.