Oakmark Select Fund: Fourth Quarter 2012

The Oakmark Select Fund increased 5% during the quarter, while the S&P 500 Index was unchanged. For all of calendar 2012, The Oakmark Select Fund returned 22%, compared to 16% for the S&P 500 Index. The Fund’s absolute and relative returns are both well above historical averages. Though we are very pleased with this performance—and hope you are, too—we also want to remind you that we don’t expect to perform this well in most quarters or years.

As we’ve said throughout the year, we believe investors are still paying a larger premium than they should for low-risk securities, and that we are finding better opportunities in companies with more economic sensitivity. Our exposure to financials and cyclicals contributed strongly to the quarter’s results. Our best performer was Bank of America, up 32%. A few short years ago, Bank of America’s ability to even survive was a legitimate concern. Today, it has emerged as arguably the financially strongest multinational bank. Yet, the stock still trades at a sharp discount to its book value and a low P/E on expected 2014 earnings. Our second-best performer was global auto parts supplier TRW Automotive, up 23%. Many investors have been concerned that demand for auto parts would fall if the economy turned down again. However, we believe that investors are just starting to understand the importance of emerging markets for the automotive industry. Long term, that growth is likely to overwhelm the cyclical ups and downs of Europe and the United States.

Our worst performer for the quarter was Newfield Exploration, down 15%. It was our only double-digit decliner. When a portfolio has two stocks up over 20% and only one down more than 10%, it will usually be a pretty good quarter. Though we are disappointed with Newfield’s stock performance, we are pleased with management’s decision to decrease spending on natural gas reserve development and instead spend that money on its oil properties. We believe Newfield sells at a very large discount to the field-by-field asset value of its properties.

An important change you’ll notice in the portfolio is that our largest holding is now TRW Automotive, instead of Discovery Communications. Discovery had another very good year, up 55%. Though its business is performing well and we believe the stock continues to be somewhat undervalued, we sold some of our shares because we no longer believe its undervaluation is enough to warrant being our largest holding.

During the quarter, we eliminated our holding of BMC Software. BMC ended its strategic review with the decision to remain an independent company. We had believed BMC would be worth much more to a larger software company than as a stand-alone. The lack of a compelling offer during the strategic review forced us to conclude we were probably wrong. Though the price of BMC shares rose slightly during the time that we owned it, we concluded that its purchase was a mistake.

Kennametal replaced BMC in the portfolio. It is a classic mid-sized industrial business that appears to be benefiting from management improvement. Selling at less than 9 times our estimate of 2014 earnings plus amortization, we believe investors have not yet priced in that improvement.

On a more personal note, it felt odd last quarter seeing only my picture at the top of this report. Since March 2000, my picture had been side-by-side with my co-manager, Henry Berghoef. As previously reported, Henry retired last year, and having just seen him at our company holiday party, I can report that he is thriving in his new role. I always said it would be tough for any one person to replace Henry, but I believe that goal will be accomplished. I am pleased to report that when our prospectus is updated at the end of January, we will be naming not one, but two new co-managers: Tony Coniaris and Win Murray.

Why two? Because two exceptional candidates were available, and I saw no reason to exclude either one of them. Tony joined us in 1999 as a research assistant, a position that normally is a “two years and out” position. Our general preference is to let young analysts gain their experience elsewhere, and then we’ll consider hiring them. But we didn’t want to risk Tony not coming back. So we kept him on as a junior analyst and then promoted him to analyst. Meanwhile, Win joined us as an experienced analyst in 2003. Both Tony and Win were named partners in 2008, and Win was subsequently named our Director of U.S. Research. I have worked very closely with both of them for many years and am confident that they have not only the right skills to work on this portfolio, but as important, the right personalities.

Thank you for your continued confidence in our Fund, and best wishes for a healthy, prosperous 2013.

As of 12/31/12 Bank of America Corp. represented 6.1%, TRW Automotive Holdings Corp. 6.6%, Newfield Exploration Co. 5.0%, Discovery Communications, Inc. 6.2%, BMC Software, Inc. 0%, and Kennametal, Inc. 3.0% of the Oakmark Select Fund’s total net assets. Portfolio holdings are subject to change without notice and are not intended as recommendations of individual stocks.

The S&P 500 Total Return Index is a market capitalization-weighted index of 500 large-capitalization stocks commonly used to represent the U.S. equity market.  All returns reflect reinvested dividends and capital gains distributions.  This index is unmanaged and investors cannot invest directly in this index.

Because the Oakmark Select Fund is non-diversified, the performance of each holding will have a greater impact on the Fund’s total return, and may make the Fund’s returns more volatile than a more diversified fund.

The discussion of the Fund’s investments and investment strategy (including current investment themes, the portfolio managers’ research and investment process, and portfolio characteristics) represents the Fund’s investments and the views of the portfolio managers and Harris Associates L.P., the Fund’s investment adviser, at the time of this letter, and are subject to change without notice.