THE OAKMARK INTERNATIONAL AND OAKMARK INTERNATIONAL SMALL CAP FUNDS

Fellow Shareholders,

Despite the recent volatility in global markets and specific weakness in the companies and sectors in which we are invested, we are extremely enthused about the prospect for our international portfolios.

The U.S. dollar continues to depreciate against the global currencies. During the quarter we initiated hedges on the Euro exposure in the Funds while we maintained our Sterling hedge exposure as previously discussed in the Semi-Annual Report. We believe both currencies have appreciated above the range of their intrinsic values as measured by the purchasing power parity and other economic fundamentals.

Why Are We Lagging in 2007?

More than a few shareholders have asked why our results are sluggish in 2007—especially since 2006 returns were so strong. Before I answer this question in detail, I would like to note that we are long-term value investors. We believe that long-term investment success requires determining a company's value and then buying it at a significant discount to its worth. This approach distinguishes us from momentum "investors" who buy stocks that have increasing prices and then hope to sell them before their prices drop. Usually, these investors do attach themes to their decisions as a way of explaining stocks' upward movements, but these themes are often not linked to corporate fundamentals. Therefore, this strategy frequently leads to significant losses of capital. For example, during the technology bubble of the late 90s, investors bought expensive stocks and then used the theme of the growth of information technology, the internet and new media to justify their purchases. Initially, prices actually appeared to be disconnected from fundamental business value. Yet, in the end, fundamentals reasserted themselves, and the high share prices dropped precipitously. Resisting these trends hurt our returns at first, but in the longer term, our investors were protected from this mania.

Today, we face a similar situation. In the global equity markets, so-called investment experts proclaim that the business cycle is dead and that growth in emerging markets will provide a "super-cycle," which will push material and resource prices upwards indefinitely. Indeed, the prices of materials and resources have been quite strong to date, as indicated by the share prices of companies in these industries. As of September 30, the MSCI World Index's¹⁰ energy sector was up 24.7%, materials were up 35.4% and metals and mining were up 47.9% year to date! We have no exposure to these hot areas. Additionally, we are over exposed to the cold ones: the consumer discretionary sector is up just 3.9%, pharmaceuticals are 0.4%, and financials are 1.2%.

We believe that these price movements are widely exaggerated. In the past five years, global economic growth has averaged 4.5% per year according to the IMF. In that time, the prices of copper and nickel have more than quadrupled, while oil has more than tripled. Consequently, share prices of resource companies have performed quite strongly—some have increased at the same exponential rates as the individual commodities. We are not invested in these businesses for a reason: we believe that these sectors are significantly over-priced.

We reject the notion that the forces of supply and demand have been suspended. Instead, we anticipate that today's high prices will generate huge increases in supply. For example, it is hard to find a mining company that is not dramatically expanding output. Despite continued economic growth for the globe, we believe that both supply and demand will negatively affect prices. As supply increases and demand declines or grows at a slower rate, prices will respond significantly.

On the other hand, we believe it is the out-of-favor sectors that offer the best long-term value. We are aware of the current challenges to the global financial system; however, looking beyond the short-term, we are able to find great franchises in growth areas like asset management, media, consumer products and pharmaceuticals at what we think are bargain prices. These businesses are characterized by strong cash generation and secure balance sheets as well as low valuations. In our opinion, they are far less attached to the business cycle than the cyclical industries mentioned above and they offer both defensive and offensive qualities.

Though current trends have dampened our short-term performance, we think we are extremely well positioned for the medium and longer term. Although we are missing the short-term spike caused by the belief in the "super-cycle," we believe we are keeping our investors out of harm's way.