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Commentary on The Oakmark and Oakmark Select Funds
3/31/2006

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.

Are you a patient investor? Try this quick test:

1. A bat and a ball cost $1.10 in total. The bat costs a dollar more than the ball. How much does the ball cost?

2. If it takes 5 machines 5 minutes to make 5 widgets, how long would it take 100 machines to make 100 widgets?

3. In a lake, there is a patch of lily pads. Every day, the patch doubles in size. If it takes 48 days for the patch to cover the entire lake, how long would it take for the patch to cover half the lake?

(Answers at the end of this commentary.)

Just the phrase standardized testing is enough to cause some to break into a cold sweat. The pressure of having years of work summarized by one test score can be enormous! Ive had discussions with my highschool-aged children about upcoming ACT exams and their importance for college admission. The nations colleges will use this four-hour test, with 215 questions, to decide who is and who isnt worthy of admission. It is amazing that a four-hour test is considered more predictive of college success than is a four-year grade point average! And standardized testing doesnt end with ones academic career. Many employers now use such tests to influence who does or doesnt get hired. Even in the NFL, a profession not often mistaken for rocket science, players are given an intelligence test before they get drafted. Last month a college star was rumored to have hurt his draft position by scoring barely higher than a rock on his exam.
The Wonderlic, named for its founder, is a 50-question exam given over 12 minutes to college players who are entering the NFL draft. According to Wonderlics website, For the NFL, years of testing shows that the higher a player scores on the Wonderlic, the more likely he is to be in the starting lineup for any position. Again, its interesting that a 12-minute test has more predictive value than does a four-year grade transcript! If a player who is projected to be drafted fifth scores poorly on the test and falls to tenth, it results in him earning about $3 million less in annual salary. Talk about pressure! (Note: There is a limit to how much the test can help ones NFL potential. My colleague Jim Benson had to settle for an investment job with us despite his perfect Wonderlic score!)

With testing in the news, it caught my eye when the New York Times ran an article about a test that could predict whether or not one was a patient investor. I found this interesting, because patience is one of the most valuable traits an investor can possess. If it takes 215 questions to see whether or not youre smart enough for college, and 50 questions to see if youre smart enough for the NFL, then how many does it take to identify a patient investor? It turns out that the three questions at the top of this page is all it takes to separate the patient investors from the crowd. Each question has a logical answer that quickly pops into ones head, but is wrong. Test takers that are more patient avoid this intuitive answer and calculate the correct one. And patient decision-making in the test seems to correlate with patient decision-making in other endeavors, including investing. On the Ball: Cognitive Reflection and Decision Making by MIT professor Shane Frederick explores the correlation between ones score on this three-question test and ones preferences about money. As an example, those taking the exam, mostly college students, were asked if they would rather get $3400 this month or $3800 next month. Of those who went three-for-three on the test, a solid majority said theyd wait for the $3800 a good choice given the implied annualized return of 280%. Of those who scored zero, only about one-third were willing to wait.

I think there are important similarities between this quiz and being a value investor. To succeed on the quiz, subjects need to ignore the obvious intuitive answers that end up being wrong. Similarly, successful value investors need to ignore obvious negative news that has been more than fully reflected in a stocks price. Recently, I received an e-mail from a shareholder who was concerned about our Fund, saying he questioned every single stock we owned because anyone watching the news was aware that these companies all had problems. Hes right. The reality is that value investors are always invested in companies that have problems thats why stocks become undervalued. Where we differ from consensus is in our assessment of the magnitude and duration of these problems.

As consumers, we are all used to the trade-off between price and quality. Not everyone drives a Ferrari, shops at Tiffanys, and wears Armani suits. If not for price, they probably would. Consumers who choose other products arent making negative statements about these prestigious brands, but rather are simply saying that their price premiums are too high. In consumer purchases, price prevents the best products from achieving 100% market share. But for some reason, when consumers invest their money, they seem to forget the importance of price. When we bought Pulte Homes, shareholders asked, Havent you read about the housing bubble? We have. If all stocks were priced the same, then an investors job would simply be to identify the companies with the highest combination of growth and dividends. In that world, believing that new home construction would decline would be sufficient reason to avoid owning a homebuilder like Pulte. But in reality, stocks arent all priced the same. Pulte is one of the very few stocks now selling at less than half the S&P 500 P/E multiple. At that valuation, a significant housing decline appears to be discounted in the stock price. Just like in the test, the intuitive answer that housing stocks are bad may not be the right answer.

Our portfolios are full of similar stocks: media companies that are losing advertising dollars to Google; H&R Block, which is losing market share to other tax preparers; financial stocks that earn less when short-term interest rates rise; and retailers that missed last seasons styles. By simply reading the newspaper, an investor could avoid investing in companies that are experiencing such problems. But, by the time these problems are common knowledge, it is nearly certain that other investors have already reacted, forcing stock prices lower. And at that point, even mildly negative news can be viewed by the market as positive. Although it is natural to want to avoid investing in companies that have had disappointments, this may be the same response that produced the wrong answers on the test. It is important to remember that a great business can reach a high enough price that it becomes a bad investment, and an average business can reach a low enough price that it becomes a great investment. Value investors normally own the latter: stocks priced so low that even mediocre-at-best businesses can become good investments. Most times, we believe superior businesses are priced too highly to merit consideration for our portfolios. However, today, many of what we consider to be the best businesses have lost their premium price due to uncertainty about the sustainability of their growth rates. So our portfolios now have an uncharacteristically high percentage of assets in such names. When Ferraris get priced like Fords, well gladly purchase them!

At Oakmark, we recognize that most investors use a shorter investment time horizon than we use. We also realize that while were trying to anticipate change that may be several years away, most investors, relying on their intuition, try to steer by watching in the rear-view mirror. They assume the road will continue on its present course. We assume that long-term economics will require most trends to eventually reverse their direction. This is why our portfolios rarely include those stocks that have been performing the best and have become the most popular. If you didnt do well on the quiz, hopefully you found it an entertaining, and perhaps thought-provoking exercise. If you did well on it, congratulations! Your patience is a good match for this fund family, and we continue to strive to make that patience rewarding.

Best wishes,



William C. Nygren, CFA
Portfolio Manager
[email protected]



Answers:

1. The ball costs 5 cents. The bat costs $1.00 more, or $1.05.

2. It takes 5 minutes. Five machines make five widgets in five minutes. Effectively, five machine-minutes are required to produce each widget. Making 100 widgets thus requires 500 machine-minutes, with 100 machines, requires 5 minutes of time.

3. 47 days. If 100% of the lake is covered on day 48, after the pond doubled in size that day, it must have covered 50% of the lake on day 47.

media companies that are losing advertising dollars to Google; H&R Block, which is losing market share to other tax preparers; financial stocks that earn less when short-term interest rates rise; and retailers that missed last season’s styles