THE MASTERS' SELECT FUNDS ANNUAL REPORT
MASTERS' SELECT EQUITY FUND
MASTERS' SELECT INTERNATIONAL FUND
DECEMBER 31, 1998
LITMAN/GREGORY FUND ADVISORS, LLC
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CONTENTS
Letter to Shareholders 2
Portfolio Fit 3
The Masters' Select Concept 3
Masters' Select Equity Fund Review 4
Interview: Robert Sanborn 10
Equity Fund Stock Highlights 13
Equity Fund Portfolio Summary 17
Masters' Select International Fund Review 20
Interview: David Herro 23
International Fund Stock Highlights 26
International Fund Portfolio Summary 29
Independent Auditor's Report 32
Statements of Assets and Liabilities 33
Statements of Operations 34
Statements of Changes in Net Assets 35
Financial Highlights 37
Notes to Financial Statements 38
Definitions of Indexes 41
SERVICE DIRECTORY
FUND INFORMATION
To request a prospectus, financial report, IRA application or information, call
1-800-656-8864, 24 hours a day, seven days a week.
ADVISOR SERVICES
Registered Investment Advisors, broker/dealers and financial professionals may
call 1-925-253-5213 for advisor services.
EXISTING SHAREHOLDER INQUIRIES
To request action on your existing account, contact the transfer agent, NFDS, at
1-800-960-0188 from 9:00 a.m. to 6:00 p.m. eastern time, Monday through Friday.
MAIL CORRESPONDENCE TO:
Masters' Select Funds c/o NFDS P.O. Box 419922 Kansas City, MO 94141-6922
OVERNIGHT ADDRESS:
Masters' Select Funds c/o NFDS 330 W. 9th Street Kansas City, MO 64105
1-816-843-8468 24-HOUR AUTOMATED INFOR MATION
1-800-960-0188
For automated reporting of daily prices, account balances and transaction
activity, call 1-800-960-0188, 24 hours a day, seven days a week. Please have
your Fund number (see below) and account number ready to access your investment
information.
PUBLISHED DAILY PRICE QUOTATIONS
Daily net asset value per share of each Fund is reported in mutual fund
quotations tables of major newspapers in alphabetical order as follows:
TRANSFER AGENT
ABBREVIATION SYMBOL CUSIP FUND NUMBER
------------ ------ ----- -----------
MstrSeltEq MSEFX 576417109 305
MstrSeltInt MSILX 576417208 306
The Masters' Select Funds Annual Report December 31, 1998
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Dear Fellow Shareholder:
The year just past was one of the most volatile in recent memory. In addition,
it was an eventful year for the Masters' Select Funds:
+ Your Funds grew their assets by 46%.
+ Our focus on taxes, aided by a volatile market, led to very small taxable
distributions in 1998. For Masters' Select Equity, there was a $0.03
per-share distribution. This amounted to less than one-quarter of 1% of net
asset value. Masters' Select International paid a $0.09 distribution. This
was slightly less than 1% of net asset value. Although most years won't be
this tax benign, we will continue to do what we can to minimize taxable
distributions so long as it is not at the expense of performance.
+ Jean-Marie Eveillard, one of Masters' Select Equity's six managers, was
replaced.
In the following pages, we examine 1998 in detail, discuss the performance of
both Funds and evaluate the Masters' Select concept.
We appreciate your continued confidence and will continue to put forth our
maximum effort on behalf of the shareholders of the Masters' Select Funds. We
continue our policy of working hard to minimize Fund expenses. Toward that end
we will once again voluntarily waive 0.1% of our management fee on the Masters'
Select International Fund, reducing the effective management fee that
shareholders pay from 1.1% to 1.0% for 1999. We also continue our waiver of
0.02% of our management fee on the Masters' Select Equity Fund, reducing the
effective management fee to shareholders from 1.10% to 1.08% for 1999.
Thank you for investing with Masters' Select. We look forward to serving your
investment needs in 1999.
Sincerely,
/s/ Ken Gregory
Ken Gregory
Litman/Gregory Fund Advisors, LLC
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PORTFOLIO FIT
As with all Equity Funds, Masters' Select Equity and Masters' Select
International are appropriate for investors with a long-term time horizon, who
are willing to ride out occasional periods when the Funds' net asset values
decline. Within that context we created the Funds to be used as core Equity and
core International fund holdings. Although performance in each specific down
market will vary, we purposely set the allocations to each manager with the
objective of keeping risk about equal to that of their overall benchmarks. At
the same time, we wanted enough exposure to small-caps and growth stocks to
attempt to deliver good performance in a bull market. In the end the focus on
the highest-conviction stocks of a group of very distinguished managers with
superior track records is what we believe makes the Funds ideal core equity and
core International fund holdings.
THE MASTERS' SELECT CONCEPT
In constructing the Masters' Select Funds, our goal was to design funds that
would isolate the stock-picking skills of a group of highly regarded managers
and also serve as core equity fund holdings for almost any long-term investor
seeking domestic or international stock market exposure. To meet this objective,
we designed the Funds with both risk and return in mind, placing particular
emphasis on the following factors.
1 First, only investment managers we believe to have exceptional long- term
performance in their respective specialties were chosen to manage each
Fund's portfolio.
2 Second, and of equal importance, each stock picker runs a very focused
portfolio of not more than 15 of his or her favorite stocks. We believe that
most stock pickers have an unusually high level of conviction in only a
small number of stocks and that a portfolio limited to these stocks will, on
average, outperform over a market cycle.
3 Third, even though each manager's portfolio is focused, the overall Funds
are well diversified by style, industry and number of stocks. Given the
diversification across styles, we don't expect the Funds to top the charts
in any single period. We are shooting for superior performance over a full
market cycle, counting on the Funds' structure and the managers' talent to
get us there.
The Masters' Select Funds Annual Report December 31, 1998
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MASTERS' SELECT EQUITY FUND REVIEW
AS WE'VE MENTIONED IN THE PAST, there is no ideal short-term benchmark for the
Masters' Select Equity portfolio because of the Fund's diversification. Over the
long term, we seek to outperform the Wilshire 5000 Index, which is
representative of the performance of the entire U.S. stock market. It is a
capitalization- weighted index, so larger companies have a proportionally larger
weight. Thus the index is heavily influenced by the performance of the large-cap
sector. Over the long term, we also seek to outperform the Lipper Growth Fund
Index, a composite of large-cap-oriented U.S. stock funds. It is important to
note that Masters' Select Equity is not a large-cap fund and at times has less
than 50% of its assets in large companies; therefore, over shorter time periods
(five years or less), we also measure our performance against a global equity
index we created. This index mirrors the asset-class weights likely to persist
in our Fund given our man- dates to the portfolio managers. Though the weights
will vary somewhat over time, we expect the following typical portfolio mix for
Masters' Select Equity:
+ 70% mid- and large-cap U.S. stocks
+ 20% small-cap U.S. stocks
+ 10% foreign stock
For virtually all equity investors, 1998 was a wild ride. Happily for investors,
stocks ended the fourth quarter with a surprising burst of strength that
resulted in yet an- other year of double-digit returns. Masters' Select Equity
participated in this year-end rally, returning 34.6% from the market bottom on
October 8 through December 31. For the full year, our returns were high on an
absolute basis, but disappointing relative to our long-term benchmarks. Read on
for an in-depth discussion.
COMPARISON CHART
The value of a hypothetical $10,000 investment in the Masters' Select Equity
Fund from its inception (12/31/96) to present (12/31/98) as compared to the
Wilshire 5000 Index.
Masters' Select Equity Fund Wilshire 5000 Index
--------------------------- -------------------
Dec-96 10,000.00 10,000.00
Jan-97 10,290.00 10,536.00
Feb-97 10,319.84 10,531.15
Mar-97 9,859.576 10,065.36
Apr-97 10,209.59 10,504.31
May-97 10,919.16 11,248.54
Jun-97 11,529.54 11,765.30
Jul-97 12,789.72 12,669.82
Aug-97 12,499.39 12,193.56
Sep-97 13,559.34 12,913.10
Oct-97 12,848.83 12,482.96
Nov-97 12,779.45 12,891.66
Dec-97 12,909.80 13,129.89
Jan-98 12,843.96 13,201.19
Feb-98 13,922.85 14,162.24
Mar-98 14,415.72 14,871.76
Apr-98 15,080.28 15,048.74
May-98 14,557.00 14,648.44
Jun-98 14,731.68 15,162.60
Jul-98 14,579.02 14,830.54
Aug-98 11,849.71 12,521.43
Sep-98 12,210.45 13,339.07
Oct-98 13,139.63 14,331.50
Nov-98 13,883.33 15,233.96
Dec-98 14,834.39 16,208.78
The hypothetical $10,000 investment assumes an investment at Fund inception and
includes changes in share price and reinvestment of dividends and capital
gains. The Wilshire 5000 Index is unmanaged, does not incur fees or expenses and
cannot be invested in directly.
Past performance is no guarantee of future results. Share price and returns
fluctuate, and investors may have a gain or loss when they sell shares.
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AVERAGE ANNUAL RETURNS
This chart tracks the performance of your Fund and its benchmark indexes for the
full calendar years 1998 and 1997 and also since inception.
CUMULATIVE RETURN AVERAGE
SINCE INCEPTION ANNUAL
1998 1997 (12/31/96) TOTAL RETURN
---- ---- ---------- ------------
Masters' Select Equity Fund 14.90% 29.11% 48.34% 21.79%
Global Equity Index* 21.04% 27.91% 54.82% 24.43%
Wilshire 5000 Index 23.45% 31.30% 62.09% 27.31%
Lipper Growth Fund Index 25.65% 28.09% 60.94% 26.86%
Lipper Small Cap Fund Index -.85% 15.10% 14.12% 6.83%
* The global equity index we created consists of 70% S&P 500 Index, 20%
Russell 2000 Index, and 10% Morgan Stanley Capital International Europe,
Australasia and Far East Index (MSCI EAFE).
All returns assume reinvestment of dividends and capital gains. Indexes are
unmanaged, do not incur fees or expenses and cannot be invested in directly.
Past performance is no guarantee of future results. Share price and returns
fluctuate, and investors may have a gain or loss when they sell shares.
THE PREMISE OF THE MASTERS' SELECT EQUITY FUND
Following a year of relative underperformance, we stop and ask ourselves if the
premise of the Masters' Select Equity Fund is sound. The original strategy
behind the Fund was -- and is -- based on two strongly held beliefs.
First, we believe that we can identify a group of skilled stock pickers who can
deliver superior performance relative to their benchmarks on an ongoing basis.
Second, we believe that these managers can do even better over a market cycle if
allowed to run concentrated portfolios that reflected their highest-confidence
stock picks on an ongoing basis.
How has the Masters' Select concept played out so far? Have these two
fundamental beliefs proved out? A look "under the hood" suggests to us that they
have.
PREMISE #1: THE MASTERS RELATIVE TO THEIR BENCHMARKS
Excluding Jean-Marie Eveillard, whom we replaced as a manager for the Fund in
October 1998, and Robert Sanborn, who has been with the Fund for only a few
months, there are five managers who have been with the Fund since its inception
two years ago. Three of these are primarily mid-cap and large-cap managers; two
are primarily small-cap managers. The following table depicts how these five
have performed relative to their benchmarks this year and since inception, after
taking into account all fees.
The Masters' Select Funds Annual Report December 31, 1998
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THE MASTERS VS. THE INDEXES
Cumulative Return Average
Since Inception Annual
1998 (12/31/96) Total Return
---- ---------- ------------
Masters' Mid- and Large-Cap Managers 1* 30.2% 76.0% 32.7%
S&P 500 Index 28.6% 71.4% 31.0%
Russell Midcap Index 10.1% 42.0% 19.2%
Masters' Small-Cap Managers 2* 0.9% 35.8% 17.7%
Russell 2000 Index -2.7% 19.2% 9.2%
1 Mason Hawkins, Sig Segalas and Shelby Davis
2 Foster Friess and Dick Weiss
* The returns for the Masters' managers are an equally weighted average of the
managers' returns since inception. Though the percentage of the Fund's
assets allocated to each manager has drifted slightly over time, equally
weighting the per formance of the three large-cap managers and the two
small-cap managers should be a very close approximation of the actual
performance if it had been calculated based on the daily asset levels of
each manager.
All returns assume reinvestment of dividends and capital gains. Indexes are
unmanaged, do not incur fees or expenses and cannot be invested in directly.
Past performance is no guarantee of future results. Share price and returns
fluctuate, and investors may have a gain or loss when they sell shares.
AS THE TABLE SHOWS, THESE FIVE MANAGERS HAVE BESTED THEIR BENCHMARKS BY HEALTHY
MARGINS.
We are very pleased with this performance, especially with respect to our
large-cap managers. As has been widely noted, the S&P 500 has been a very tough
index to beat over the past two years, because the stock market has been
dominated by mega-cap stocks which are heavily weighted in the S&P 500. Our
large-cap managers' portfolios, as a group, have been much less large-cap than
the- S&P 500-in fact, our managers have held some mid-cap stocks in addition to
their large-cap exposure. Yet they still outperformed the S&P 500 by an
impressive margin. Our small-cap managers beat their benchmark by an even wider
margin.
PREMISE #2: THE MASTERS RELATIVE TO THEIR OWN FUNDS
The performance of the five managers relative to their own Funds is also as
expected. Concentration seems to be working. The following table illustrates the
weighted return of the managers' own Funds compared with their weighted Masters'
performance (again, this includes the same five managers and weighting and is
after all fees):
Cumulative Return Average
Since Inception Annual
1998 (12/31/96) Total Return
---- ---------- ------------
Masters' Portfolio Performance 18.3% 52.8% 23.6%
Individual Funds' Performance 14.1% 41.6% 19.0%
Weighted Masters' portfolio performance equals the total return earned by each
manager on his Masters' portfolio multiplied by the percentage of total assets
of the Fund allocated to each manager (Davis, 20%; Hawkins, 20%; Segalas, 20%;
Friess, 10%; Weiss, 10%).
Weighted individual funds' performance equals the total return earned by the
unaffiliated no-load funds managed by the managers multiplied by the percentage
of Masters' assets allocated to each manager. There may be differences among
these funds with regard to charges, expenses and investment policies that affect
performance.
6
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If we do the same analysis including all six managers (Eveillard through
October 31, 1998, and Sanborn for the last two months of 1998), the performance
is as follows:
Cumulative Return Average
Since Inception Annual
1998 (12/31/96) Total Return
---- ---------- ------------
Masters' Portfolio Performance 14.9% 48.3% 21.8%
Individual Funds' Performance 13.8% 41.2% 19.1%
So far these numbers strongly support our second premise: that in the right
hands, concentration will enhance performance. We think this will be especially
true over a market cycle.
DISCUSSION OF OVERALL PERFORMANCE
Despite the strongly encouraging performance of the managers relative to their
benchmarks and the positive impact of concentration, Masters' Select Equity has
trailed its benchmarks. Why is this, and what do we expect in the future? Two
factors held back your Fund.
FIRST, the market has been dominated by large-cap growth stocks since the Fund's
inception. Our exposure to small-cap domestic stocks and our mix of foreign
stocks hurt absolute performance. In addition, despite the inclusion of two
pure-growth managers, we have a bias toward value.
The Fund's built-in diversification has led to exposure in areas that have not
performed as well as the large-cap-dominated indexes that are our long-term
benchmarks. Masters' Select Equity is not a large-cap growth fund, so in an
environment dominated by mega-cap growth stocks, your Fund is at a disadvantage
relative to its large-cap benchmarks and, to a lesser extent, to its more
diversified benchmark (which assumes 70% large-cap exposure). As of December 31,
1998, our equity exposure included 52.9% in large-cap stocks (some of which are
value stocks) and 19.5% in mid-cap stocks. Thus only slightly more than half the
Fund's assets were in large U.S. companies; and during much of the Fund's life,
large-cap exposure was even smaller.
The fact that some equity groups have not performed well over the past two years
relative to large-caps does not mean that they never will. In fact, small-caps,
which have lagged for several years, are now selling at price-to-earnings ratios
that are as low, relative to large-caps, as they have been in 25 years. Foreign
stocks present a mixed bag of opportunities, and all of our managers have the
ability to selectively include foreign stocks in their portfolios if they
believe them to be compelling (though most do not invest in foreign stocks, and
all but Mason Hawkins are encouraged to focus only on U.S. companies).
In the long run, we believe that the Fund's diversified structure will deliver
good long-term performance. Consider the past. Each equity group has had
periods of good performance. As the following chart indicates, however, each
group has had periods of over- and underperformance relative to the others.
The Masters' Select Funds Annual Report December 31, 1998
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EQUITY CLASS RETURN CYCLES
1975 Through 1983 1984 Through 1988 1994 Through 1998
----------------- ----------------- -----------------
Small-Caps 1 1,421.0% 46.4% 75.2%
Foreign Stocks 2 231.1% 360.8% 55.3%
Large-Cap Growth 3 191.2% 86.2% 242.8%
Large-Cap Value 4 367.6% 149.9% 148.0%
1 Data used for the period 1975-1983 is taken from the Stocks, Bonds, Bills
and Inflation Year book published by Ibbotson & Associates. Used with
permission. (C)1998 Ibbotson & Associates, Inc. All rights reserved.
(Certain portions of this work were derived from copyrighted works of Roger
G. Ibbotson and Rex Sinquefield.) Later periods are based on the Russell
2000 Index.
2 Morgan Stanley Capital International Europe, Australasia and Far East Index
(MSCI EAFE)
3 BARRA Growth Index
4 BARRA Value Index
All returns assume reinvestment of dividends and capital gains. Indexes are
unmanaged, do not incur fees or expenses and cannot be invested in directly.
Over time there will be many different market environments. Performance
differentials between the different equity groups will be volatile over the
short term, but we expect them to be less so over the long term.
THE SECOND FACTOR that hurt the Fund's returns was the performance of Jean-
Marie Eveillard's portion of the portfolio. His small-cap value plays and some
Asian exposure were not in favor over the past two years. Though it may appear
that way, our decision to replace Eveillard was not driven primarily by
performance. We expect our managers to go through periods in which their styles
will not work well or they make mistakes -- mistakes that will be magnified by
the concentrated nature of their portfolios (of course, their successes will be
magnified as well). Our concern with Eveillard was our growing view that his
long-held preference for broad diversification made him less than comfortable
with the concentration mandate. This is why we initiated discussions with him
that eventually led to our decision to make a change. We continue to have the
utmost respect for Eveillard's skills as an investment manager and expect him
to continue delivering the type of stellar long-term, risk-adjusted performance
that has made him a household name in financial circles. For this Fund, however,
we believe that Robert Sanborn is a much better fit. Sanborn has delivered
consistent long-term returns and has always been comfortable running a
concentrated portfolio. Please see the interview with Sanborn on page 10.
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THE FUTURE
Overall, we believe that Masters' Select Equity's first two years make a strong
case for the Masters' Select concept. Looking forward, there are many reasons
for our optimism, the foremost being the quality of our managers and our
commitment to maintaining a structure that improves the odds for success.
Primarily, this means keeping the asset base manageable- we will close the Fund
when it reaches $750 million in assets.
So we go forward with an accomplished group of stock pickers. All are
comfortable with concentration and all have a strong commitment to this Fund. In
addition, we will do what we can to maintain awareness of tax-cost tradeoffs
and bring expenses down.
FINAL THOUGHTS: WHO SHOULD INVEST IN MASTERS' SELECT EQUITY?
We are looking for shareholders who:
+ Want a core equity investment with exposure to a broad slice of the market
+ Seek strong market-cycle performance but are less concerned about short-
term returns
+ Understand the short-term risks associated with the stock market
We also believe that it is important for our shareholders to have realistic
expectations for future returns. The past 15 years have seen exceptional stock
market returns that have been out of line with long-term historical and economic
performance. Though we can't predict the timing, we are convinced that stock
market returns will be much lower over the next 10 years than they have been
over the past decade. And though this may turn out to be an environment where
stock picking is more important than equity group performance (we think that
would be a positive for Masters' Select Equity), we nevertheless expect returns
to be lower.
We will continue to apply the Masters' Select concept in seeking the best
possible investments for your Fund.
The Masters' Select Funds Annual Report December 31, 1998
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[PHOTO OF ROBERT SANBORN]
An Interview with Robert Sanborn
Robert Sanborn Manages Approximately 20% of the Masters' Select Equity Fund.
WHAT FIRST ATTRACTED YOU TO THE BUSINESS OF STOCK PICKING?
Intending to embark on a career teaching economics, I soon learned of the
politics and lack of meritocracy in academe. This led me to look into investing,
which was the perfect fit in that it combined the intellectual nature of
academics with the scorekeeping that appealed to my competitive side.
HOW DID YOUR INVESTMENT PHILOSOPHY DEVELOP?
Growing up in Boston led me to make frequent visits to the famous "Filene's
Basement." There I learned the satisfaction and logic in buying $1 of value
for 50 or 60 cents. This predilection for value was honed in my first
investment job, where I was able to work with and observe money being managed in
a variety of philosophies and fashions. I quickly decided that a value-oriented
approach was the only one that had intellectual coherence, and I decided I
wanted to work in an environment where everyone believed in value investing.
CAN YOU DESCRIBE THE KEY ELEMENTS OF YOUR STOCK-PICKING DISCIPLINE?
I use five guidelines to invest my clients' money: (1) buy at a market price
that represents a steep discount from intrinsic value, (2) invest with
owner-oriented management, (3) trade as little as possible, (4) concentrate my
investments in our very best ideas and (5) think independently and do our own
research.
YOU'VE BUILT A GREAT LONG-TERM RECORD WITH THE OAKMARK FUND. WHAT FACTORS HAVE
BEEN MOST IMPORTANT IN DRIVING YOUR SUCCESS?
In my opinion the three key ingredients to our long-term success are what I call
the three P's: philosophy, people and place. We have a logical, intellectually
coherent investment philosophy that we use throughout the entire firm. All of us
10
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look at the world and the investing process similarly, and we speak the same
language. People refers to the continuity and stability of our key personnel in
a business that is becoming increasingly like the NBA in terms of loyalty. The
key investment people who have created our record have been working with me for
more than 10 years. We have never lost any investment professional whom we did
not want to lose. Place refers to our firm's culture. In a business increasingly
being managed by business people rather than investors, we remain first and
foremost an investment firm. In addition, our firm operates with a minimum of
hierarchy and bureaucracy, and we continue to maintain this culture.
HISTORICALLY, YOU HAVE BEEN A LOW-TURNOVER MANAGER. WHAT LEADS YOU TO SELL A
STOCK?
I buy a stock at 60% of its true underlying value and then patiently wait for
the price and value to converge, selling when it reaches its target price of
90%. Also, if we decide that we had misjudged management and that, in fact, they
are not managing the business in the interests of long-term shareholders, we do
sell. This is an unusual occurrence.
CAN YOU TELL US A LITTLE ABOUT YOUR RESEARCH PROCESS?
I work with a team of 10 analysts, all of whom had prior experience elsewhere
and who wanted to work in a pure value environment. The research process ignores
Wall Street and instead focuses on a company's management, customers and
suppliers. Because we concentrate, the research effort is intensive and the goal
is to understand a given investment opportunity as well as any outsider could.
DURING 1998 LARGE CAP VALUE LAGGED LARGE CAP GROWTH BY ONE OF THE WIDEST MARGINS
EVER. ANY THOUGHTS ABOUT WHAT IT WILL TAKE FOR VALUE TO OUTPERFORM AGAIN?
The past three years, but particularly 1998, have been big momentum years. In my
view the expensive stocks have gotten extremely expensive and the cheap stocks
(at least relatively) are ignored. The mutual fund landscape is dominated by the
hot stocks and funds, and this seems to have created a self-fulfilling cycle.
Increasingly, mutual fund managers are like contortionists trying to rationalize
the valuations of the mega-cap stocks and the growth stocks.
Our process focuses on the cheapest stocks we can find (relative to underlying
value) in businesses we understand and with management we like. We tend to not
focus on catalysts. In general, the valuation gap between, say, my portfolio and
the S&P 500 is gaping enough to eventually cause a major revaluation of the
given sectors. In prior cycles where growth has outperformed for a significant
period, however, there were what I term exemplar industries that were the most
visible and quintessential growth engines. These were the PC stocks in the early
1980s, the biotechnology stocks in the early 1990s and the Internet stocks now.
When the exemplar industry rolls over, that tends to trigger a period whereby
value outperforms. The usual trigger is gross overvaluation that causes a glut
of ever-poorer-quality IPOs. As I write this, the Internet stocks are grossly
overvalued, and there are more than 100 "dot-coms" going public.
The Masters' Select Funds Annual Report December 31, 1998
<PAGE>
HOW ATTRACTIVE ARE TODAY'S OPPORTUNITIES, AT A STOCK-PICKING LEVEL, COMPARED
WITH OTHER POINTS IN TIME DURING your INVESTMENT CAREER? ARE THESE OPPORTUNITIES
COMPELLING ON AN ABSOLUTE BASIS OR SIMPLY A RELATIVE BASIS?
I think the recent environment has created a situation in which my stocks are
cheaper on a relative basis than at any other point in my career. On an absolute
basis, my confidence is less. But generally, at today's levels of inflation and
interest rates, I believe that my stocks will dominate any other asset class.
WHAT ARE YOUR PRIMARY CONCERNS WITH RESPECT TO THE OVERALL INVESTMENT CLIMATE?
My largest concern is that parts of the market -- the mega-caps and the
technology stocks -- are grossly overvalued. Because I own none of these, I am
insulated. It will be interesting to see, however, how the unwinding of the
market leaders of the past few years impacts the overall market.
HOW DOES RUNNING A VERY CONCENTRATED PORTFOLIO THAT IS ALSO PART OF A BROADLY
DIVERSIFIED FUND IMPACT THE WAY YOU EXECUTE YOUR STOCK-PICKING APPROACH?
Concentration comes naturally to us. We believe in our best ideas having the
most impact on our clients' portfolios.
12
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MASTERS' SELECT EQUITY FUND STOCK HIGHLIGHTS
Martin Marietta Materials, Shelby and Chris Davis*
We are drawn to Martin Marietta Materials (MLM) because of its unusual
combination of wonderful management in a dull business with excellent
economics. In these days of high-flying Internet stocks, an aggregates (gravel)
business sounds pretty pedestrian. But bear in mind:
1. Gravel never goes obsolete.
2. Pricing is local (as costs of transportation become prohibitive).
3. Environmental regulation and difficult permitting have raised barriers to
entry.
4. Reserves are very long-lived, with more than 9 billion tons of rock equaling
over 50 years' worth of shipments.
5. MLM's cash earnings benefit from adding back depletion on these long-lived
assets and goodwill from acquisitions.
6. Demand should be less cyclical over the next several years, given heavy
government spending on highways, schools and prisons. The recently passed
federal highway spending bill should increase total company revenues by 10%
in each of the next five years.
7. In past recessions, prices have not decreased but rather remained flat or
increased at a slower rate. In fact, nationwide pricing has fallen only
once (down 0.5%) during the past 20 years.
8. The industry is highly fragmented but rapidly consolidating. As in the local
newspaper business, "mom and pop" acquisitions tend to be done at very
favorable prices. MLM has been the most active consolidator in the industry,
and every deal has been immediately accretive to cash earnings with a high
return on invested capital.
9. Management is outstanding, led by a truly visionary CEO in Steven Zelnak
with whom we are proud to partner.
As MLM was spun out to shareholders of Lockheed Martin (no hot IPO) and as the
company's growth is self-financing (few investment banking fees), Wall Street
has largely overlooked this first-class company. With the market at 28 times
earnings, MLM currently trades at 19 times reported earnings but only 17 times
after-tax cash earnings (after maintenance capital- expenditures).
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quarter of 1999. Its premier product, Axys, is the industry's leading portfolio
manage- ment accounting package, and new prod- ucts Rex and Advent Browser
Reporting are quickly gaining acceptance. The Friess team expects analysts to
raise their estimates above the current consensus 1999 estimate of $1.54 per
share, as the company will easily outshine those expectations. Advent was
purchased for your Fund at $37 per share. The Friess team expects the stock to
trade at 30 times 1999 earnings, or $50 per share.
- ----------
* We add Chris Davis as co-portfolio manager to reflect the role he plays.
Chris handles much of the daily hands-on portfolio management, however
Shelby is actively involved in researching and selecting every company
that is included in their Masters' portfolio.
The Masters' Select Funds Annual Report December 31, 1998
<PAGE>
UCAR INTERNATIONAL, INC., MASON HAWKINS
UCAR International, Inc., is the world's largest producer of graphite
electrodes, with approximately a 40% global market share. The second-largest
producer, SGL in Germany, has 35% of the market, with the remainder held by a
small consortium of producers in Japan. Non-integrated steel producers
(mini-mills) consume graphite electrodes during the steel production process,
using them as a heat source to melt scrap. An electrode is quickly consumed in
this process and must be replaced. Underlying unit growth comes from the growth
in the mini-mill sector of the steel industry. Mini-mills have several distinct
advantages over integrated steel manufacturers and, as a result, have been
increasing capacity and production at approximately 4% per year.
UCAR possesses many of the attributes we desire. The company's mar gins and
returns on capital are high, earnings are generated in cash, there are good
prospects for growth (post-Asia crisis), and current electrode prices are far
below levels needed to justify capacity additions, creating a barrier to entry.
The company sells at less than half of current replacement cost of their
existing capacity and at 7.5 times current cash earnings per share of $2.50 (a
13% earnings yield). UCAR is undervalued because it recently admitted guilt in a
collusion case, a plea that led to settlement with both its customers and the
Department of Justice. This event cost the company approximately $300 million,
reducing its value and adding leverage to the balance sheet (in addition to
costing prior management their jobs).
The world's steel industry -- UCAR's customers -- is currently going through an
extremely difficult period. Due to low domestic demand and a need to generate
cash, steelmakers in regions like Russia, Japan, Korea, China, Brazil and other
troubled countries are shipping vast quantities of finished steel to Europe and
the United States. Much of this product is being sold at or below production
cost, creating very trying times for UCAR's customers, leading to cutbacks in
their steel production.
These are not trivial matters, and we do not take them lightly. The price-fixing
settlements are behind UCAR, however, and steel demand will recover after
excess world inventories are reduced. In the meantime, we are happy to clip a
13% earnings coupon as we wait for the mini-mill industry's return to growth.
EATON CORPORATION, ROBERT SANBORN
Eaton Corporation, based in Cleveland, Ohio, is an exemplar of the
medium-capitalization industrial stock that we find attractive. Eaton is a
somewhat diversified industrial company whose main product lines include truck
transmissions, engine components, power distribution products and semiconductor
testing equipment. Eighty percent of its products are either #1 or #2 in their
markets, and it consistently outcompetes its rivals in terms of returns.
Unlike some industrial manufacturers that supply very few companies, such as the
automotive or aerospace industry, Eaton has a very diverse customer base that
cannot exert much buying power on Eaton. In general, we regard Eaton in a
structural sense as being a somewhat above-average company.
I have known CEO Stephen Hardis for more than 15 years, when he was CFO. I think
he is very bright, of high integrity and very shareowner-oriented. He has
implemented compensation plans that tie top management to the long-term health
14
<PAGE>
of the company via stock appreciation. Fifteen percent of the shares outstanding
are owned by employees, creating a very vital bond between the human resources
and the owners of the company. Unlike many CEOs, he is independent and will not
follow the current Wall Street fad unless it is in the long-range best interests
of the shareholders of Eaton Corp. He fully understands capital allocation, one
of the key functions of senior management, especially in a free cash flow
generator like Eaton. I am very confident in Eaton's top management.
Most important, the valuation of Eaton Corp. is far too modest in this market
environment. We estimate that, after adding back non-cash amortization, Eaton
will earn $6.75 per share this year. At the current stock price of $71, Eaton
sells at only 10.5 times this year`s earnings, less than half the multiple of
the S&P 500!
COLUMBIA BROADCASTING SYSTEM, SPIROS SEGALAS
The Columbia Broadcasting System (CBS) is undervalued. The stock currently
trades at 7.5 times 1999 EBITDA (earnings before interest, taxes, depreciation
and amortization)1, while comparables trade at about 10 times. Just to achieve
valuation parity with its brethren, the stock should be at $34 to $35 right
now. In addition to buying the assets cheap, you also get one of the best
operators in the business -- Mel Karmazin (more on him below).
We expect after-tax cash flow per share (a close proxy for EPS) to grow from
about 80(cent) in 1998 to $1.25 in 1999 and $1.65 in 2000, for compounded growth
of 44% (assuming a benign economy). This may seem to be a tall order for a
company in a business that is losing market share (network television).
Two-thirds of CBS's earnings, however, come from fast-growing businesses that
are taking market share: radio, outdoor, and cable networks. The radio and
outdoor businesses are cheaper for advertisers to buy than any other media, and
as drive times have lengthened and consolidation has made it easier for
advertisers to achieve blanket market coverage with one buy, both radio and
outdoor are far outpacing overall media expenditure growth. We think these
businesses will continue to take share over the next several years. When these
share gains are combined with the tremendous operating leverage inherent in
these businesses, earnings growth can be quite prodigious. The fact that the CBS
assets were fairly low margin and undermanaged before Karmazin took over, with
good upside remaining, further augments the growth outlook.
Moreover, with the recent (and highly successful) sale of an 18% stake in
Infinity (which is basically the radio and outdoor assets), CEO Mel Karmazin has
created a totally unleveraged entity with a high-priced currency that is well
positioned to make accretive acquisitions in the coming months. There is still
substantial consolidation room left in the radio and outdoor businesses. Our
estimates and target price derivation assume no acquisitions.
As for CBS proper, we believe that Karmazin will use the company's prodigious
free cash flow (and relatively unleveraged balance sheet: debt/EBITDA = 1.3,
thanks to the Infinity sale), to greatly expand payments to shareholders,
probably in the form of stepped-up buybacks. Management feels comfortable with
debt/EBITDA of 5 times, which suggests $6 billion of untapped borrowing
potential, against a $22 billion market capitalization. We also believe it
likely that Karmazin will dispose of the cable assets (despite their good
- ----------
1 This assumes $1 billion in value for the network (likely conservative) and
takes into account the value of the publicly traded Infinity shares owned by
CBS.
The Masters' Select Funds Annual Report December 31, 1998
<PAGE>
growth), which don't fit strategically all that well with the other businesses
and which the market is clearly undervaluing. This could be worth another $2 to
$3 billion.
As to the broadcast TV businesses, there are two pieces: the TV stations (30% of
earnings) and the network (a breakeven business). The TV stations are recording
double-digit revenue growth thanks in part to the snaring of the NFL contract,
which also greatly enhances CBS's efforts to draw younger male viewers to the
network's other fare. As for ratings, all the major broadcast networks have lost
market share to cable (and Internet surfing) in the past year, but CBS has
gained market share vs. NBC, ABC and FOX in the process, with several potential
breakout hits on the air currently. NBC is clearly surrendering its #1 status,
with the loss of Seinfeld and football (the latter to CBS), among other losses.
The leadership role is up for grabs. Although pricing pressure in the flash
market abates it can take several years for a new leader to become fully
dominant, CBS is arguably as well positioned as anyone to assume that role.
CBS's market share (in dollars) is lowest, and this represents tremendous upside
for both the network and the TV stations. Note that the NBC network (network
only, ex the stations, CNBC and MSNBC) made $570 million in EBITDA in 1998. By
comparison, CBS' s total precorporate EBITDA in 1999 will be $1.8 billion.
Finally, we believe that the broadcast network business will be granted
regulatory relief. Currently, even though a Viacom or a Time Warner can own
multiple cable networks (and broadcast networks too! The WB at Time Warner, and
UPN at Viacom), no company can own more than one broadcast network. This is a
regulatory artifact from a different era, and virtually all observers
(including, we think, those in government) know it. When this restriction is
lifted, the economic impact of consolidation will be enormous.
SANDISK CORPORATION, DICK WEISS
SanDisk Corporation is the leader in flash semiconductor memory cards used to
store data in consumer electronics. SanDisk's products are used in computers,
cellular phones and digital cameras. The company has a war chest of 72 patents,
which generate more than $30 million per year in royalties. SanDisk has
established its Compact Flash technology as the standard for digital cameras and
is thus tied to the growth of this lucrative market.
I bought the stock in November 1998 for $10 and believe it should trade up to
$18. The royalty stream alone is worth $7 per share, and the company has $5 per
share in cash with no debt. These values, combined with 1 time core revenues,
yields the $18 target. This value should be realized as and Japan (30% of sales)
recovers.
Additional upside is possible if the digital camera market takes off in 1999,
which is likely if technology advances can drive retail camera pricing from the
current $550 level down to the low $300s. These price reductions are likely as
many firms work to convert the image processors to a CMOS-based technology. This
change will enable an integrated, low-cost, single-chip solution. Lower prices
and better imaging should thus drive strong digital camera sales by Christmas
1999, allowing SanDisk to earn significantly higher royalty income.
16
<PAGE>
MASTERS' SELECT EQUITY FUND PORTFOLIO SUMMARY
Portfolio Composition (12/31/98)
As reflected below, your Fund is well diversified in terms of industry exposure
and market capitalization exposure. Masters' Select Equity holds 78 securities,
exclusive of cash equivalents.
Cash and Other 2.9%
Foreign 7.8%
Small-Caps 16.8% 1
Mid-Caps 19.5% 2
Large-Caps 53.0% 3
1 Market capitalization < $1 billion
2 Market capitalization > $1 billion and < $10 billion
3 Market capitalization > $10 billion
SCHEDULE OF INVESTMENTS AS OF DECEMBER 31, 1998
<TABLE>
<CAPTION>
COMMON STOCKS (97.12%) INDUSTRY SHARES HELD MARKET VALUE PORTFOLIO %
- ---------------------- -------- ----------- ------------ -----------
<S> <C> <C> <C> <C>
BASIC MATERIALS
Geon Company Chemicals 60,000 $ 1,380,000 0.34%
*IVEX Packaging Corporation Packaging 45,100 1,048,575 0.26%
----------- -----
2,428,575 0.60%
BUSINESS SERVICES
Waste Management, Inc. Waste Disposal 228,000 10,630,500 2.62%
----------- -----
CAPITAL GOODS
*Integrated Electrical Services, Inc. Construction Materials 130,800 2,910,300 0.72%
Martin Marietta Materials Construction Materials 40,000 2,487,500 0.61%
Sundstrand Corporation Airplane Materials 100,000 5,187,500 1.28%
----------- -----
10,585,300 2.61%
CONGLOMERATE
*Berkshire Hathaway Inc. Class A Insurance, Confections,
Furniture, Footwear, 117 8,190,000 2.02%
*Berkshire Hathaway Inc. Class B Publishing, Cleaning
Systems 29 66,975 0.02%
Philips Electronics N.V. Electronics, Software,
Recording 175,000 11,845,312 2.92%
----------- -----
20,102,287 4.96%
CONSUMER PRODUCTS
*Ann Taylor Stores Corporation Apparel 138,400 5,458,150 1.35%
Brunswick Corporation Sporting Goods 255,000 6,311,250 1.56%
Masco Corporation Building Materials 156,200 4,490,750 1.11%
Mattel Inc. Toys 180,000 4,106,250 1.01%
Nike Inc. Apparel 150,000 6,084,375 1.50%
Philip Morris Companies Inc. Tobacco 160,000 8,560,000 2.11%
Seagram Company, Limited Beverages 288,500 10,963,000 2.70%
*SPX Corporation Automotive 44,400 2,974,800 0.73%
Stanley Works Hardware 200,000 5,550,000 1.37%
----------- -----
54,498,575 13.44%
</TABLE>
* Non-income-producing securities
The Masters' Select Funds Annual Report December 31, 1998
<PAGE>
SCHEDULE OF INVESTMENTS AS OF DECEMBER 31, 1998 (CONTINUED)
<TABLE>
<CAPTION>
INDUSTRY SHARES HELD MARKET VALUE PORTFOLIO %
-------- ---------- ------------ -----------
<S> <C> <C> <C> <C>
CONSUMER SERVICES
Applebee's International, Inc. Restaurants 137,500 $ 2,866,016 0.71%
*Bj's Wholesale Club, Inc. Specialty Foods 57,500 2,662,969 0.66%
Bob Evans Farms, Inc. Restaurants 126,300 3,287,747 0.81%
Cato Corporation Retail 170,000 1,673,437 0.41%
*Foodmaker, Inc. Restaurants 175,000 3,860,937 0.95%
McDonald's Corporation Restaurants 128,600 9,853,975 2.43%
*Merkert American Corporation Retail 125,000 1,898,438 0.47%
*U.S. Foodservice Retail 35,000 1,715,000 0.42%
*Whole Foods Market, Inc. Retail 20,000 970,000 0.24%
28,788,519 7.10%
----------- -----
ENERGY
Cabot Oil & Gas Corporation Oil and Gas Exploration 110,000 1,650,000 0.40%
*Harken Energy Corporation Oil and Gas Exploration 900,000 1,743,750 0.43%
Pioneer Natural Resources Company Oil and Gas 560,000 4,900,000 1.21%
Pogo Producing Company Oil and Gas Exploration 130,000 1,690,000 0.42%
----------- -----
9,983,750 2.46%
FINANCE
American Express Company Financial Services 94,400 9,652,400 2.38%
BankAmerica Corporation Banking 30,017 1,804,755 0.45%
Citigroup Banking 53,500 2,651,593 0.65%
Chase Manhattan Corporation Banking 91,000 6,193,687 1.53%
Executive Risk, Inc. Insurance 39,000 2,142,565 0.53%
MBNA Corporation Banking 240,050 5,986,247 1.48%
Morgan Stanley Dean Witter & Co. Financial Services 69,600 4,941,600 1.22%
Progressive Corporation Insurance 25,000 4,234,375 1.04%
Transatlantic Holdings, Inc. Insurance 61,000 4,609,313 1.14%
Washington Mutual, Inc. Savings and Loan 160,000 6,110,000 1.50%
Wells Fargo & Company Banking 189,000 7,548,188 1.86%
----------- -----
55,874,723 13.78%
HEALTH CARE AND PHARMACEUTICALS
ADAC Laboratories Imaging Systems 119,100 2,378,278 0.59%
Columbia/HCA Healthcare Corp. Facilities 300,000 7,425,000 1.83%
Schering Plough Corporation Pharmaceuticals 128,700 7,110,675 1.75%
*Ventana Medical Systems, Inc. Equipment 105,000 2,264,062 0.56%
----------- -----
19,178,015 4.73%
MEDIA
Columbia Broadcasting System (CBS) Broadcasting 228,800 7,493,200 1.85%
*Clear Channel Communications, Inc. Broadcasting 105,500 5,749,750 1.42%
*Emmis Communications Corporation Broadcasting 32,500 1,409,687 0.35%
Knight Ridder, Inc. Publishing 35,000 1,789,375 0.44%
News Corporation Limited, ADR Multimedia 340,000 8,988,750 2.21%
----------- -----
25,430,762 6.27%
REAL ESTATE
Host Marriott Corporation Hotels and Resorts 633,000 8,743,313 2.15%
*Crestline Capital Corporation Hotels and Assisted Living 63,300 925,762 0.23%
----------- -----
9,669,075 2.38%
</TABLE>
* Non-income-producing securities
18
<PAGE>
SCHEDULE OF INVESTMENTS AS OF DECEMBER 31, 1998 (CONTINUED)
<TABLE>
<CAPTION>
INDUSTRY SHARES HELD MARKET VALUE PORTFOLIO %
-------- ----------- ------------ -----------
<S> <C> <C> <C> <C>
TECHNOLOGY
*Advent Software Software 69,900 $ 3,289,669 0.81%
Autodesk Software 112,400 4,794,562 1.18%
*Cadence Design Systems, Inc. Software 166,000 4,938,500 1.22%
*Cisco Systems, Inc. Computer Networks 63,375 5,883,973 1.45%
*Complete Business Solutions Inc. Software 55,000 1,859,687 0.46%
*Comverse Technology Software 46,700 3,314,241 0.82%
*Dell Computer Corporation Computer Hardware 82,000 6,003,937 1.48%
Eaton Corporation Instruments 90,000 6,361,875 1.57%
Electronic Data Systems Corporation Computer Services 150,000 7,537,500 1.86%
First Data Corporation Services 250,000 7,921,875 1.95%
Hewlett-Packard Company Computer Hardware 94,100 6,428,206 1.58%
*InfoCure Corporation Software 106,200 3,478,050 0.86%
International Business Machines
Corp. Computer Hardware 51,300 9,477,675 2.34%
*Maxtor Corporation Hardware 155,000 2,179,688 0.55%
*NCR Corporation Computer Services 60,000 2,505,000 0.62%
*ORACLE Corp. Software 205,200 8,855,663 2.18%
*SanDisk Corporation Hardware 182,000 2,582,125 0.64%
*Sterling Software, Inc. Software 135,000 3,653,438 0.90%
Texas Instruments, Inc. Semiconductors 151,100 12,928,493 3.19%
*UCAR International, Inc. Electronic Instruments 417,100 7,429,593 1.83%
*Unitrode Corporation Semiconductors 163,100 2,854,250 0.70%
114,278,000 28.19%
----------- -----
TELECOMMUNICATIONS
*MCI WorldCom, Inc. Communications Services 149,400 10,724,118 2.64%
*Qwest Communications Services 54,400 2,718,300 0.67%
*Reltec Corporation Wireless Communications 125,000 2,773,438 0.69%
----------- -----
16,215,856 4.00%
TRANSPORTATION
*FDX Corporation Express Mail and Freight 181,000 16,109,000 3.88%
----------- -----
Total Common Stocks (cost $330,361,046) 393,772,937 97.12%
REPURCHASE AGREEMENT (3.68%) PAR VALUE
- --------------------------------------------------------------------------------------------------
State Street Bank & Trust Co. $14,776,000 at 4.35%
(agreement dated 12/31/98; to be repurchased at
$14,783,142 on 1/4/99; collateralized by
$10,780,000 in U.S. Treasury Notes due 5/15/17;
value $15,087,214) (cost $14,776,000) $14,776,000 14,776,000 3.64%
State Street Bank & Trust Co. $165,000 at 4.6%
(agreement dated 12/31/98; to be repurchased at
$165,105 on 1/5/99; collateralized by $170,000
in Federal Home Loan Bank Notes due 5/15/17; value
$171,439) (cost $165,000) 165,000 165,000 0.04%
------------ ------
TOTAL REPURCHASE AGREEMENTS (COST $14,941,000) 14,941,000 3.68%
TOTAL INVESTMENTS (COST $345,302,046) 408,713,937 100.80%
LIABILITIES IN EXCESS OF CASH AND OTHER ASSETS (3,256,050) -0.80%
------------ ------
TOTAL NET ASSETS $405,457,887 100.00%
============ ======
</TABLE>
* Non-income-producing securities
See Notes to Financial Statements.
The Masters' Select Funds Annual Report December 31, 1998
<PAGE>
MASTERS' SELECT INTERNATIONAL FUND REVIEW
COMPARISON CHART
The value of a hypothetical $10,000 investment in the Masters' Select
International Fund from its inception (12/1/97) to present (12/31/98) as
compared to the MSCI EAFE Index.
Masters' Select International Fund MSCI EAFE Index
---------------------------------- ---------------
Nov-97 $10,000.00 $10,000.00
Dec-97 9,880.00 10,087.00
Jan-98 9,909.64 10,547.98
Feb-98 10,989.79 11,225.16
Mar-98 11,679.95 11,570.89
Apr-98 11,929.90 11,662.30
May-98 11,770.04 11,605.16
Jun-98 11,360.04 11,693.35
Jul-98 11,440.04 11,811.46
Aug-98 9,400.03 10,348.02
Sep-98 9,140.03 10,030.33
Oct-98 9,870.03 11,075.49
Nov-98 10,580.04 11,642.56
Dec-98 $11,039.21 $12,101.28
The hypothetical $10,000 investment assumes an investment at Fund inception and
includes changes in share price and reinvestment of dividends and capital gains.
The MSCI EAFE Index is unmanaged, does not incur fees or expenses and cannot be
invested in directly.
Past performance is no guarantee of future results. Share price and returns
fluctuate, and investors may have a gain or loss when they sell shares.
AVERAGE ANNUAL RETURNS
This chart tracks the performance of your Fund and its benchmark indexes for the
full calendar year 1998 and also since inception.
Cumulative Return Average
Since Inception Annual
1998 (12/1/97) Total Return
---- --------- ------------
Masters' Select International Fund 11.74% 10.40% 9.58%
Lipper International Fund Index 12.66% 13.54% 12.43%
MSCI EAFE Index 19.97% 20.65% 17.46%
Lipper International Small Cap Fund Index 9.71% 7.50% 6.40%
All returns assume reinvestment of dividends and capital gains. Indexes are
unmanaged, do not incur fees or expenses and cannot be invested in directly.
Your Fund trailed its benchmarks primarily because of emerging markets and
small-cap exposure. Though neither an emerging markets fund nor a small-cap
fund, Masters' Select International does have some exposure to both sectors.
The performance of emerging markets was so negative that even a relatively
small allocation made a big exposure to emerging markets and small-cap
difference. The MSCI EAFE Index has no emerging markets or small-cap holdings,
though it does have Japanese and a small amount of Asian ex-Japan exposure.
The funds in the Lipper International Fund Index- generally have less emerging
markets and small-cap exposure than your Fund has held over the past year. As
of 12/31/98 the Fund's stocks was 14% and 16%, respectively.
20
<PAGE>
As was the case in the United States, foreign markets experienced a high level
of volatility during 1998. In the end big-cap European stocks chalked up a great
year, but small-caps, Japan and the emerging markets fared poorly. The following
table illustrates 1998 returns for different segments of the foreign stock
universe.
RETURNS 1998
------- ----
MSCI Europe Index (in dollars) 26.5%
MSCI Japan Index (in dollars) 4.3%
MSCI Emerging Markets Free Index (in dollars) -27.5%
Since the Fund's inception, two of our managers have beaten their benchmarks
by a wide margin. Two are slightly trailing their benchmarks, and one is
significantly behind.
As mentioned above, we believe that the Fund's slightly disappointing
performance is due to its emerging markets and small-cap exposure at a time
when emerging markets have been pummeled and small-caps have lagged. The good
news is that performance has been picking up, and the Fund has gained
significant ground since September 30, 1998.
With respect to emerging markets, we believe that they will continue to be
volatile and that much change must take place before this volatility declines.
We also know, however, that there are some fundamentally strong, well-run
businesses in the emerging markets and that volatility breeds opportunity. When
these markets are in a fear-driven phase, stocks can be driven to levels that
reflect exceptional bargains. And though we have given all our managers the
flexibility to pursue emerging markets investments if they wish, most of the
Fund's emerging markets exposure has been through David Herro, a tough
contrarian who is not afraid to take bold positions when he is convinced he is
right. Currently, Herro's view is that there are high-quality businesses in
emerging markets whose stocks have been driven to "absurdly low levels." He
believes that the upside is enormous. Although he is unsure about the timing, he
believes that the potential is so great that it is worth waiting for. Some of
this upside has been coming through recently. Please see the interview with
Herro on page 23.
The Fund also has some small-cap exposure, mostly through Bruce Bee, a dedicated
small-cap manager. For many years Bee has run concentrated portfolios. He
searches for growth stocks selling at value prices. He expects to find only a
handful of new companies each year that meet his criteria and, consequently,
bases each decision on an enormous amount of company research. Though small
companies did not perform as well as large companies in 1998, Bee believes that
small-cap stocks are very cheap right now and feels strongly about each of the
companies he owns in the Masters' portfolio. Other small-cap exposure is through
Mark Yockey and David Herro, both of whom opportunistically invest in smaller
companies.
The Masters' Select Funds Annual Report December 31, 1998
<PAGE>
THE FUTURE
Looking forward, we remain enthusiastic about the Fund because of the high
quality of the five managers. Mark Yockey was just named Morningstar
International Manager of the Year for 1998. Helen Young Hayes has put together
one of the best international fund records in recent years. In our view, David
Herro, Dan Jaworski and Bruce Bee have the proven discipline and stock-picking
skills to put up market-beating numbers over the long term. We continue to
believe that the quality of our managers coupled with a structure that allows
them each to focus on their highest-conviction stocks will work well over a
market cycle. All five managers are highly committed to the success of your
Fund. We are doing our share as well. In addition to our usual efforts to
minimize Fund expenses, we will continue our policy of voluntarily waiving 0.1%
of our management fee in 1999, reducing the effective management fee from 1.1%
to 1.0% for the year.
We also believe that the future of international investing is bright. Europe is
undergoing historic change that, with a little luck, will be very positive. The
emerging markets have been severely thrashed, but positive change is slowly
occurring and values appear very attractive. Japan remains a conundrum, with
long-term structural problems including the general lack of a profit priority in
much of the private sector. But things are gradually changing in Japan, and some
investment opportunities are popping up. Our managers echo these sentiments.
22
<PAGE>
[PHOTO OF DAVID HERRO]
An Interview with David Herro
David Herro manages approximately 22.5% of the Masters' Select International
Fund.
WHAT FIRST ATTRACTED YOU TO THE BUSINESS OF STOCK PICKING?
I had been interested in the stock market since high school, and by the time I
was in college I had a full-fledged portfolio. Having an early interest in
economics and current affairs combined with being a caddy for a stock broker
probably played important roles in generating such a strong interest so early in
life.
HOW DID YOUR INVESTMENT PHILOSOPHY DEVELOP?
My investment philosophy evolved over time, but centers around the very simple
concept of "buy low, sell high." It's a function of combining my academic
training as an economist, reading the likes of Ben Graham and David Dreman and
applying common sense.
CAN YOU DESCRIBE THE KEY ELEMENTS OF YOUR STOCK-PICKING DISCIPLINE?
Key elements of my discipline center around determining the proper value of a
business and having the conviction to purchase under valued stocks even though
they may be out of favor. To me the value of a business is ultimately determined
by the amount of free cash that is generated and how that free cash is used or
"recycled" by the management. Once a value is determined by these two factors,
it is compared with the current price of the company. If the company's value is
significantly below its current market price (30% or more), it is a potential
investment. As long-term investors (as opposed to short-term speculators), our
patience and discipline enable us to take advantage of bargains that the
"traders" don't have the patience for. It is common for the market to base its
assessment of company value on the next couple of quarters, whereas we believe
that the true value of a business is determined by its ability to generate cash
over the long term.
The Masters' Select Funds Annual Report December 31, 1998
<PAGE>
THOUGH 1998 WAS A TOUGH YEAR, YOU'VE BUILT A GREAT LONG-TERM RECORD IN THE
INTERNATIONAL STOCK-PICKING ARENA WITH OAKMARK INTERNATIONAL, AT THE STATE OF
WISCONSIN AND, BEFORE THAT, WITH THE PRINCOR WORLD FUND. WHAT FACTORS HAVE BEEN
MOST IMPORTANT IN DRIVING YOUR SUCCESS?
There are two important factors that lead to success in this business in my
opinion. Factor one is using a sound investment analysis process. And two, maybe
even more important, is having the discipline and conviction to stick to your
philosophy in bad times. Far too often managers scramble when the going gets
tough, only to change at the most inopportune time (the bottom). To be
successful one has to stick to one's guns, and I believe that doing this, along
with having a great approach, has brought me investment success.
WHAT ARE YOUR MOST IMPORTANT SOURCES OF INFORMATION?
The most important source of information for me is company visits. Though they
are not the only important source of investment info, they are the most
direct. I really don't believe in brokerage house research, because the writers
of the research have different objectives than do we, the buyers.
HOW MUCH OF YOUR RESEARCH DO YOU DO YOURSELF, AND IN WHAT WAYS DO YOU RELY ON
OTHER MEMBERS OF YOUR TEAM?
We utilize a team approach at Harris Associates. Though I still spend close to
50% of my time traveling and interviewing managements, chances are that more
than one of us will work on a specific area. We have a team of seven analysts
and, generally, all the research I base our investment decisions on is our own.
DESPITE ANOTHER VERY TOUGH YEAR FOR EMERGING MARKETS, YOU HAVE FOUND A NUMBER OF
STOCKS IN LATIN AMERICA AND ASIA THAT YOU LIKE. SEVERAL OF THEM PERFORMED POORLY
DURING THE YEAR, BUT YOU'VE MAINTAINED A HIGH LEVEL OF CONVICTION WITH RESPECT
TO THEIR LONG-TERM POTENTIAL. CAN YOU GIVE US SOME INSIGHT INTO THE FACTORS THAT
GIVE YOU CONFIDENCE TO HOLD STOCKS IN PARTS OF THE WORLD THAT ARE FACING
MACROECONOMIC AND LIQUIDITY-ORIENTED RISKS?
The fact is that macroeconomic conditions are temporary. And given the herdlike
instinct of most investors, when there is the first sign of weakness in an
economy, especially an emerging market, they will sell everything. To them
quality of a business, strength of financials and price of the company make no
difference. As a result, high-quality businesses are driven down to absurdly low
levels. This is where we come in. Ultimately, economies will recover and the
herd will clumsily be back to try to pick up the high-quality, underpriced
companies, and they will stage spectacular rallies. We avoid the herd and think
that, over time, the wisest course of action is to buy these companies when, for
temporary macroeconomic factors, they are at the lowest prices. Remember: Buy
low, sell high! Ultimately, the price and quality of a business will determine
return, and it is based on this that we are so compelled to invest in places
like the emerging markets.
24
<PAGE>
ARE THERE STILL GOOD STOCK-PICKING OPPORTUNITIES IN EUROPE?
Europe has had a great run -- it's where the herd is grazing now. In fact, so
great that there is a limited opportunity in European blue chips. However, there
are two BIG exceptions: the second-liners of Europe and British stocks. In both
of these sectors, there is a ton of investment opportunity for solid, long-term
returns.
HOW ATTRACTIVE ARE TODAY'S OPPORTUNITIES, AT A STOCK-PICKING LEVEL, COMPARED
WITH OTHER POINTS IN TIME DURING your INVESTMENT CAREER?
I feel that this is an extremely unique period in terms of the abundance in
investment opportunities. The emerging markets appear to be as cheap as they
ever have been, the non-emerging Pacific Rim has been unfairly hit and selective
segments in Europe offer outstanding bargains. To me it is very similar to the
post-1987 crash or the post-1992 European sell-off.
WHAT ARE YOUR PRIMARY CONCERNS WITH RESPECT TO THE GENERAL INVESTMENT CLIMATE?
My primary concern is that politicians upset the trend toward greater economic
liberalization by instituting protectionist or xenophobic policies that destroy
the corporate world's ability to make profits for the owners (shareholders).
As it stands today, in general, the trend is toward economic liberalization,
which will be very beneficial to owners of capital. It's another reason why I am
so bullish.
HOW DOES RUNNING A VERY CONCENTRATED PORTFOLIO THAT IS ALSO PART OF A BROADLY
DIVERSIFIED FUND IMPACT THE WAY YOU EXECUTE YOUR STOCK-PICKING APPROACH?
Actually, concentration is very consistent with how we at Harris Associates
manage money. It is predicated on the beliefs that one should follow one's
convictions and that over-diversification kills returns over time. We have a
high degree of confidence in our ability to pick good equity investments;
therefore, we think that concentration actually adds to performance.
The Masters' Select Funds Annual Report December 31, 1998
<PAGE>
MASTERS' SELECT INTERNATIONAL FUND STOCK HIGHLIGHTS
INVESTEC CONSULTADORIA INTERNACIONAL, BRUCE BEE
Investec Consultadoria Internacional is a leading Portuguese media company, with
ownership in the top sports newspaper (the Record), the only locally produced
women's fashion magazine (Maxima), and minority stakes in a newspaper
distributor (Deltapress) and the top private television channel (SIC). Any
soccer fan in Portugal knows the Record well. In the past few years, management
has turned this paper into a popular -- and profitable-operation. The television
station is also a strong cash generator, again the result of a strong management
influence from Investec.
The company is relatively unknown outside of Portugal yet it holds a major
position in the media sector of the country. It trades at just above 10 times
earnings, which we expect to grow between 10% and 15% per year for the next few
years. Many large-cap European media companies with lower growth rates trade for
multiples almost twice as high. Given the strong growth prospects in Portugal
and the consolidation of many industries in Europe, we think the market or some
outside buyer will recognize the strong value in this media franchise. If you
value the components of the company, you can easily justify a business value 60%
to 70% above the current stock price. The problem is that as an operator in a
small country, few investors are currently paying attention to the company.
That will change as the company continues to churn out results and add value.
The company management is strong. Francisco Capelo, the CEO, is highly
professional and genuinely interested in shareholder value. His purchase of the
stake in SIC, the television station, was well-timed and inexpensive. And he has
shown strong cost-cutting skills on the newspaper and magazine side and a
willingness to close non-performing publications.
GIORDANO INTERNATIONAL, DAVID HERRO
Giordano International is a Hong Kong-based retailer of casual clothing. Perhaps
one of the only true, pan-Asian clothing retailers, it has a strong reputation
for selling high-quality casual clothing at a reasonable price while providing a
high level of service. The company has retail operations in most major Asian
locations, including China, South Korea, Taiwan and the Philippines. Because of
this the company's profits have been hit by the slowdown, and its shares are off
more than 80% from their all-time high, which was reached a little over two
years ago.
The company has an extremely strong brand name, has great growth prospects and
is solid financially. In fact, though most of its markets are in recession,
Giordano continues to earn profits, has generated positive cash flow and has net
cash on its balance sheet. Furthermore, as weaker retailers are perishing in
Hong Kong, Giordano is taking over their prime locations while paying lower
rents. In other Asian markets like Korea and the Philippines, it is growing
same-store sales at near double-digit levels. Though the stock has recently
rallied, we still believe that there is huge upside.
26
<PAGE>
RENTOKIL INITIAL PLC, HELEN YOUNG HAYES
Corporate management teams in the United States have long been conscious of
their shareholders' interests. They've realized for decades that the behavior
of a company's stock is the most appropriate measure of their job performance.
Although this trend has not fully taken hold outside the United States, there
is a revolution under way in Europe, where corporate management teams are
becoming increasingly cognizant of shareholders' interest. Rentokil Initial is
one of the companies at the fore-front of this trend.
Rentokil Initial is a Britain-based firm that provides a diverse array of
commercial services including janitorial, pest control, temporary personnel,
property services and security. Rentokil's management team is consistently
striving to provide its shareholders with superior value. In the company's own
words, its primary goal is "to provide for its shareholders growth of at least
20% per annum in profits and earnings per share, whilst not detracting from
long-term growth prospects. "As a result, the company is not satisfied with its
stellar organic growth, but instead has augmented it with a series of strategic
acquisitions in the interest of becoming the "be-all and end-all" answer for
corporate outsourcing needs. This is the kind of management that we look for at
Janus: management whose interests are closely aligned with those of their
shareholders, and who know how to make their stock price go up.
We believe that Rentokil also exemplifies our vision of business operations in
the next millennium-specifically outsourcing. Companies from all over the world
are realizing that it's often more cost-effective and efficient for businesses
to concentrate on what they do best. For many companies that means outsourcing
everything but their core businesses. This trend has been gaining momentum for
the past several years, and we believe that Rentokil has done an exceptional job
of capitalizing on it.
The Masters' Select Funds Annual Report December 31, 1998
<PAGE>
ALLIED IRISH BANK, DAN JAWORSKI
Allied Irish Bank (AIB) is the largest financial services company in Ireland,
with total assets of $53 billion. It is involved in retail and commercial
banking, life insurance and investment banking. The bank operates primarily in
Ireland, 42%, but also has facilities in the United Kingdom, 23%, the United
States, 34%, and Poland, 1%. One-third of the bank's loan portfolio is retail in
nature, with exposure to residential mortgages and personal financing. The rest
of the loan portfolio is broadly spread throughout the commercial sector. Two
other areas that contribute to earnings are its life assurance subsidiary, Ark
Life, and its fund management arm. The strong and rapidly expanding Irish
economy (GDP growth 6% to 7% for 1998) has allowed AIB to increase its banking
assets, improve its loan quality and reduce its cost-to-income ratio. We
estimate that the company flow from asset management and private will increase
its EPS by 14%, its dividend by 16% and its net asset value by 15% per annum for
the next three years. In addition to its excellent growth prospects, we expect
the company to maintain its high profitability and its adequate tier 1 ratio
(common equity/risk weighted assets).
While the company's fundamentals look attractive, the stock looks just as
compelling relative to its global industry peers. AIB is trading at a 15%
earnings discount to its regional peers and a 35% discount to its global banking
peers. The stock also looks compelling both on a return-on-equity and a
book-value basis. This type of company, one with excellent sector and
company-specific fundamentals selling at a discount to its industry peers, is
exactly what we search for to invest in. We believe that investing in
high-quality, industry-leading companies that are priced below their peers will
over time lead to strong absolute and relative performance.
UBS, MARK YOCKEY
In 1998 Union Bank of Switzerland and Swissbank Corporation merged to form UBS.
The merger created a compelling institution: the world's largest money
management firm, with more than $1.1 trillion in assets; a world leader in its
other core businesses -- private banking and investment banking; and, with a
current market cap of $67 billion, Europe's largest bank.
In our view UBS is poised to capitalize on the secular growth trends that make
the banking sector in Europe especially attractive. These trends include:
restructuring, consolidation and the growth in retail and institutional money
management.
We expect that merger-related efficiencies will be immediately accretive to
earnings. And we like the fact that 65% of earnings banking.
Last fall's losses from exposure to derivatives and the Long-Term Capital
Management fund has prompted management -- which we regard as excellent -- to
reduce the bank's risk-weighted assets.
This better use of the balance sheet, combined with returns that we expect to be
high and rising, points to sharply increasing excess capital in coming years,
resulting in better opportunities for capital generation and deployment. UBS
already has considerable excess capital, and it is strongly capital generative.
Although management has indicated a possible buyback in 1999, we also expect
them to use this excess capital and the bank's formidable market cap to expand
UBS's global presence through acquisitions. At its recent price of 459 Swiss
francs, we think the stock is trading at a significant discount to its full
value.
28
<PAGE>
MASTERS' SELECT INTERNATIONAL FUND PORTFOLIO SUMMARY
Portfolio Composition by Region (12/31/98)
Other 2.1%
Australia/New Zealand 3.3%
Latin America 4.2%
North America 5.4%
Japan 5.6%
Asia (ex-Japan) 8.3%
United Kingdom 12.3%
Europe (ex-UK) 58.8%
PORTFOLIO COMPOSITION BY ASSET CLASS (12/31/98)
Cash and Other Investments 2.1%
Emerging Markets 13.9% 1
Developed Country Small-Caps 16.5% 2
Developed Country Large-Caps 67.5% 3
1 Includes Hong Kong (4.0%) and Singapore (2.7%), which are not technically
emerging markets
2 Market capitalization < $800 million
3 Market capitalization > $800 million
SCHEDULE OF INVESTMENTS AS OF DECEMBER 31, 1998
<TABLE>
<CAPTION>
INDUSTRY SHARES HELD MARKET VALUE PORTFOLIO %
-------- ----------- ------------ -----------
<S> <C> <C> <C> <C>
ARGENTINA
Quilmes Industrial Quinsa Consumer Products/Beverages 134,000 $1,247,875 1.31%
---------- ----
AUSTRALIA
Brambles Industries Limited Transportation/Commercial
Services 83,300 2,029,031 2.13%
---------- ----
BRAZIL
Usinas Siderurgicas de Minas Basic Industries/Mining/
Gerais S.A Metals 355,000 784,449 0.82%
*Telecomunicacoes Brasileiras S.A Telecommunications/Telephone
Service 13,200 959,475 1.01%
Uniao de Bancos Brasilier os S.A Finance/Commercial Bank 71,000 1,025,063 1.08%
---------- ----
2,768,987 2.91%
CANADA
*Danier Leather Inc. Consumer Products/Apparel 130,000 752,699 0.79%
Teleglobe Inc. Telecommunications 46,000 1,656,000 1.74%
*MetroNet Communications Telecommunications/Telecom
Services 81,500 2,730,250 2.87%
---------- ----
5,138,949 5.40%
FINLAND
Nokia AB Technology/Cellular Phones 28,000 3,404,589 3.58%
Nokia Corp., Sponsor ed ADR Technology/Cellular Phones 48,745 5,870,726 6.16%
---------- ----
9,275,315 9.74%
FRANCE
Groupe Danone Consumer Products/Food 3,900 1,116,079 1.17%
Cap Gemini S.A Business Services/Information
Services 15,423 2,474,411 2.60%
AXA UAP Finance/Multiline Insurance 33,000 4,780,898 5.02%
8,371,388 8.79%
---------- ----
</TABLE>
* Non-income-producing securities
See Notes to Financial Statements.
The Masters' Select Funds Annual Report December 31, 1998
<PAGE>
SCHEDULE OF INVESTMENTS AS OF DECEMBER 31, 1998 (CONTINUED)
<TABLE>
<CAPTION>
INDUSTRY SHARES HELD MARKET VALUE PORTFOLIO %
-------- ----------- ------------ -----------
<S> <C> <C> <C> <C>
GERMANY
Rinol AG Durables/Building and Construction 20,000 $ 522,021 0.55%
Porsche AG Transportation/Automobiles 527 1,201,608 1.26%
Mannesmann AG Basic Industries/Construction,
Engineering 30,303 3,472,863 3.65%
---------- ----
5,196,492 5.46%
HONG KONG
JCG Holdings Limited Finance/Diversified Financial
Services 5,703,000 1,840,247 1.93%
Giordano International Limited Consumer Products/Clothing 10,420,000 1,990,500 2.09%
3,830,747 4.02%
---------- ----
IRELAND
Allied Irish Bank PLC Finance/Banking 139,000 2,475,627 2.60%
---------- ----
ISRAEL
*Orbotech Limited Technology/Software 27,500 1,296,797 1.36%
---------- ----
ITALY
FILA Holdings SpA Consumer Products/Athletic Footwear 195,100 1,512,025 1.59%
*Banca di Roma Finance/Commercial Bank 1,000,000 1,693,429 1.78%
Telecom Italia SpA Telecommunications/Telecom Services 409,849 3,495,038 3.67%
---------- ----
6,700,492 7.04%
JAPAN
Takeda Chemical Industries Basic Industries/Chemicals 30,000 1,154,357 1.21%
*NTT Mobile Communications Telecommunications/Cellular Phones 50 2,056,612 2.16%
Enix Corporation Consumer Products/Appliances 65,700 2,144,476 2.25%
---------- ----
5,355,445 5.62%
KOREA
Woong Jin Publishing CompanyMedia/Publishing 97,100 1,501,297 1.58%
---------- ----
NETHERLANDS
Van Melle N.V Consumer Products/Food 14,000 946,399 0.99%
Royal Ahold N.V Consumer Services/Grocery Stores 27,600 1,019,556 1.08%
Philips Electronics N.V Technology/Electronics 16,714 1,120,969 1.18%
Wolters Kluwer N.V . Media/Publishing 9,769 2,089,309 2.19%
---------- ----
5,176,233 5.44%
NEW ZEALAND
Fernz Corporation Limited Basic Industries/Chemicals 375,000 1,154,362 1.21%
---------- ----
NORWAY
*Norsk Lotteridrift ASA Consumer Services/Leisure and Gaming 253,500 667,237 0.70%
---------- ----
PORTUGAL
Investec Consultadoria
Internacional S.A Media/Publishing 19,975 688,248 0.72%
---------- ----
</TABLE>
* Non-income-producing securities
See Notes to Financial Statements.
30
<PAGE>
SCHEDULE OF INVESTMENTS AS OF DECEMBER 31, 1998 (CONTINUED)
<TABLE>
<CAPTION>
INDUSTRY SHARES HELD MARKET VALUE PORTFOLIO %
-------- ----------- ------------ -----------
<S> <C> <C> <C> <C>
SINGAPORE
Electronic Resources Limited Technology/Electronics 1,250,000 $ 1,135,675 1.19%
Mandarin Oriental International
Limited Hotels 2,310,000 1,455,300 1.53%
----------- -----
2,590,975 2.72%
SWEDEN
Nobel Biocare Health Care/Biotech 70,000 947,716 0.99%
Assa Abloy AB Basic Industries/Metal Processors 41,515 1,583,996 1.67%
----------- -----
2,531,712 2.66%
SWITZERLAND
PubliGroupe S.A Business Services/Advertising Sales 2,800 856,082 0.90%
Stratec Holding AG Health Care/Medical Instruments 725 1,002,766 1.05%
Roche Holding AG Health Care/Pharmaceuticals 170 2,074,107 2.18%
UBS AG Finance/Commercial Bank 10,445 3,208,699 3.37%
Novartis Health Care/Pharmaceuticals 3,289 6,464,511 6.79%
----------- -----
13,606,165 14.29%
UNITED KINGDOM
JBA Holdings PLC Technology/Software 103,250 325,926 0.34%
Victrex PLC Basic Industries/Chemicals 300,000 852,301 0.90%
Saatchi & Saatchi PLC Business Services/Advertising Sales 525,000 1,186,244 1.25%
Tomkins PLC Business Services/Diversified
Operations 345,000 1,639,309 1.72%
General Electric Company Durables/Manufacturing 200,000 1,810,932 1.90%
Capita Group PLC Business Services/Computer Services 199,731 1,838,361 1.93%
Rentokil Initial PLC Business Services/Multiple Services 252,416 1,908,112 2.00%
Cordiant Communications Group Business Services/Advertising Sales 1,236,000 2,156,172 2.27%
----------- -----
11,717,357 12.31%
TOTAL COMMON STOCKS (COST $83,879,070) 93,320,731 98.01%
REPURCHASE AGREEMENTS PAR VALUE
- ---------------------------------------------------------------------------------------------------------
State Street Bank & Trust Co. $1,872,493
at 4.5% (agreement dated 12/31/98; to
be repurchased at $1,873,417 on 1/4/99;
collateralized by $1,685,000 in U.S.
Treasury Notes due 5/15/17; value
$2,358,252) (cost $1,872,493) $1,872,493 1,872,493 1.97%
U.S. TREASURY OBLIGATIONS
Federal Home Loan Bank Mortgage Discount
Note 4.70%, 1/4/98 (cost $1,499,413) 1,500,000 1,499,413 1.57%
TOTAL SHORT TERM INVESTMENTS (COST $3,371,906) 3,371,906 3.54%
TOTAL INVESTMENTS (COST $87,250,976) 96,692,637 101.55%
LIABILITIES IN EXCESS OF CASH AND OTHER ASSETS (1,472,359) -1.55%
----------- ------
TOTAL NET ASSETS $95,220,278 100.00%
=========== ======
</TABLE>
* Non-income-producing securities
See Notes to Financial Statements.
The Masters' Select Funds Annual Report December 31, 1998
<PAGE>
INDEPENDENT AUDITOR'S REPORT
TO THE BOARD OF TRUSTEES AND SHAREHOLDERS OF MASTERS' SELECT FUNDS TRUST:
We have audited the accompanying statements of assets and liabilities, including
the schedules of investments, of the Masters' Select Equity Fund and Masters'
Select International Fund, separate series of Masters' Select Funds Trust (the
"Trust") as of December 31, 1998, and the related statements of operations, the
statements of changes in net assets and the financial highlights for the
respective periods indicated in the financial statements. These financial
statements and financial highlights are the responsibility of the Trust's
management. Our responsibility is to express an opinion on these financial
statements and financial highlights based on our audits.
We conducted our audits in accordance with generally accepted auditing
standards. These standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements and financial
highlights are free of material misstatement. An audit includes examining on a
test basis evidence supporting the amounts and disclosures in the financial
statements. Our procedures included confirmation of securities owned at December
31, 1998, by correspondence with the custodian and brokers. An audit also
includes assessing the accounting principles used and significant estimates made
by management, as well as evaluating the overall financial statement
presentation. We believe that our audits provide a reasonable basis for our
opinion.
In our opinion, the financial statements and financial highlights referred to
above present fairly, in all material respects, the financial position of the
Masters' Select Equity Fund and Masters' Select International Fund as of
December 31, 1998, the results of their operations, the changes in their net
assets and the financial highlights for the periods indicated in conformity with
generally accepted accounting principles.
/s/ McGladrey & Pullen LLP
New York, New York
February 12, 1999
32
<PAGE>
STATEMENTS OF ASSETS AND LIABILITIES -- DECEMBER 31, 1998
EQUITY FUND INTERNATIONAL FUND
----------- ------------------
ASSETS
Investments in securities at market value
(cost of $345,302,046 and $87,250,976) $408,713,937 $ 96,692,637
Cash, including foreign currencies at
value (cost of $(18,395) and $388) 3,278 82,618
Receivables:
Fund shares sold 362,542 29,375
Income receivable 860,988 289,302
Investment securities sold 309,664 0
Unrealized gain on forward exchange
contracts -- 63,582
Deferred organizational costs 62,443 29,708
Prepaid expenses 38,608 22,730
------------ ------------
Total assets 410,351,460 97,209,952
LIABILITIES
Payables:
Fund shares repurchased 553,186 101,482
Investment securities purchased 2,861,062 1,570,669
Investment advisory fees 355,769 79,099
Unrealized loss on forward exchange
contracts 904,875 114,110
Accrued expenses and other 218,681 124,314
------------ ------------
Total liabilities 4,893,573 1,989,674
NET ASSETS $405,457,887 $ 95,220,278
COMPOSITION OF NET ASSETS
Paid-in capital $335,284,199 $ 92,056,228
Undistributed net investment income 432,178 0
Accumulated net realized gains (losses) 7,231,615 (6,232,204)
Net unrealized appreciation 62,509,895 9,396,254
NET ASSETS $405,457,887 $ 95,220,278
Number of shares, $0.01 par value,
issued and outstanding (unlimited
shares authorized) 29,872,346 8,694,509
------------ ------------
NET ASSET VALUE PER SHARE $ 13.57 $ 10.95
See Notes to Financial Statements.
The Masters' Select Funds Annual Report December 31, 1998
<PAGE>
STATEMENTS OF OPERATIONS -- YEAR ENDED DECEMBER 31, 1998
EQUITY FUND INTERNATIONAL FUND
----------- ------------------
INVESTMENT INCOME
Income
Dividend income (net of foreign
taxes of $107,837 and $193,171) $ 4,593,082 $ 1,841,592
Interest income 1,607,060 271,771
------------ -----------
Total income 6,200,142 2,113,363
Expenses
Advisory fees 4,072,180 962,722
Transfer agent fees 280,000 50,799
Custodian fees 183,137 220,655
Administration fees 184,423 43,313
Registration fees 109,517 36,791
Shareholder reporting fees 115,182 30,847
Professional fees 52,646 42,497
Trustees fees 15,902 15,611
Insurance fees 38,607 3,984
Amortization of deferred
organizational costs 21,316 7,552
Miscellaneous expenses 38,904 12,967
------------ -----------
Total expenses 5,111,814 1,427,738
Less: Advisory fees waived 15,281 71,699
Less: Expenses paid indirectly 7,085 6,488
------------ -----------
Net expenses 5,089,448 1,349,551
------------ -----------
Net investment income 1,110,694 763,812
REALIZED AND UNREALIZED GAINS (LOSSES)
Net realized gain (loss):
Investments 6,417,189 (6,204,568)
Foreign-currency transactions 984,501 (10,043)
------------ -----------
Net realized gain (loss) 7,401,690 (6,214,611)
Net unrealized appreciation
(depreciation) on:
Investments 40,368,076 9,868,119
Foreign-currency transactions (1,650,091) (45,100)
Net unrealized appreciation 38,717,985 9,823,019
------------ -----------
NET REALIZED AND UNREALIZED GAINS 46,119,675 3,608,408
NET INCREASE IN NET ASSETS RESULTING
FROM OPERATIONS $ 47,230,369 $ 4,372,220
See Notes to Financial Statements.
34
<PAGE>
STATEMENTS OF CHANGES IN NET ASSETS -- EQUITY FUND
For the period from
For the year ended December 1, 1997
December 31, 1998 to December 31, 1997
----------------- --------------------
INCREASE (DECREASE) IN NET ASSETS
Operations:
Net investment income $ 1,110,694 $ 243,648
Net realized gain (loss) 7,401,690 23,912,283
Net unrealized appreciation
(depreciation) 38,717,985 23,791,910
------------ ------------
Net increase (decrease) in net
assets from operations 47,230,369 47,947,841
Distributions to shareholders:
From net investment income (716,884) (243,648)
From net capital gains (257,199) (23,786,791)
------------ ------------
Total distributions (974,083) (24,030,439)
Fund share transactions
Proceeds from shares sold 152,586,067 279,009,548
Net asset value of shares issued
on reinvestment of distributions 963,287 23,567,971
Cost of shares redeemed (91,223,564) (29,719,110)
------------ ------------
Net increase from Fund share
transactions 62,325,790 272,858,409
------------ ------------
NET INCREASE IN NET ASSETS 108,582,076 296,775,811
NET ASSETS
Beginning of period 296,875,811 100,000
------------ ------------
END OF PERIOD $405,457,887 $296,875,811
============ ============
CHANGE IN SHARES
Shares sold 12,130,365 25,633,556
Shares issued on reinvestment
of distributions 76,118 1,962,362
Shares redeemed (7,397,559) (2,542,496)
------------ ------------
NET INCREASE 4,808,924 25,053,422
============ ============
See Notes to Financial Statements.
The Masters' Select Funds Annual Report December 31, 1998
<PAGE>
STATEMENTS OF CHANGES IN NET ASSETS -- INTERNATIONAL FUND
For the period from
For the year ended December 1, 1997
December 31, 1998 to December 31, 1997
----------------- --------------------
INCREASE (DECREASE) IN NET ASSETS
Operations:
Net investment income $ 763,812 $ 14,157
Net realized gain (loss) (6,214,611) (26,104)
Net unrealized appreciation
(depreciation) 9,823,019 (426,765)
------------ -----------
Net increase (decrease) in net
assets from operations 4,372,220 (438,712)
Distributions to shareholders:
From net investment income (769,458) --
From net capital gains -- --
------------ -----------
Total distributions (769,458) --
Fund share transactions:
Proceeds from shares sold 72,841,892 46,890,251
Net asset value of shares issued
on reinvestment of distributions 737,560 --
Cost of shares redeemed (27,896,100) (517,375)
------------ -----------
Net increase from Fund share
transactions 45,683,352 46,372,876
------------ -----------
NET INCREASE IN NET ASSETS 49,286,114 45,934,164
NET ASSETS
Beginning of period 45,934,164 --
-----------
END OF PERIOD $ 95,220,278 $45,934,164
============ ===========
CHANGE IN SHARES
Shares sold 6,729,487 4,700,772
Shares issued on reinvestment
of distributions 68,609 --
Shares redeemed (2,751,817) (52,542)
------------ -----------
NET INCREASE 4,046,279 4,648,230
============ ===========
1 The Masters' Select International Fund commenced operations on
December 1, 1997.
See Notes to Financial Statements.
36
<PAGE>
FINANCIAL HIGHLIGHTS -- FOR A SHARE OUTSTANDING THROUGHOUT THE PERIOD
<TABLE>
<CAPTION>
EQUITY FUND INTERNATIONAL FUND
------------------------------------ ----------------------------------------
For the For the For the For the period
year ended year ended year ended from December 1, 1997**
December 31, 1998 December 31, 1997 December 31, 1998 to December 31, 1997
----------------- ----------------- ----------------- --------------------
<S> <C> <C> <C> <C>
Net asset value, beginning
of period $ 11.84 $ 10.00 $ 9.88 $ 10.00
Income from investment operations
Net investment income 0.03 0.03 0.08 --
Net realized and unrealized
gain 1.73 2.90 1.08 (0.12)
-------- -------- ------- -------
Total from investment operations 1.76 2.93 1.16 (0.12)
-------- -------- ------- -------
Less distributions
From net investment income (0.02) (0.03) (0.09) --
From capital gains (0.01) (1.06) -- --
-------- -------- ------- -------
Total distributions (0.03) (1.09) (0.09) --
-------- -------- ------- -------
NET ASSET VALUE, END OF PERIOD $ 13.57 $ 11.84 $ 10.95 $ 9.88
======== ======== ======= =======
Total return 14.90% 29.11% 11.74% (1.20%)
======== ======== ======= =======
Net assets at end of period
(in 000's) $405,458 $296,876 $95,222 $45,934
======== ======== ======= =======
Ratio of expenses to average
net assets 1.38%+ 1.47%+ 1.55%++ 1.77%*++
======== ======== ======= =======
Ratio of net investment income
to average net assets 0.30% 0.12% 0.87% 0.42%*
======== ======== ======= =======
Portfolio turnover rate 135.41% 145.11% 73.59% 0.00%
======== ======== ======= =======
</TABLE>
* Annualized
** The Masters' Select International Fund commenced operations on
December 1, 1997.
+ Includes custody fees paid indirectly which amount to 0.00% and 0.03%,
respectively, of average net assets for the fiscal years ended December 31,
1998 and 1997, respectively.
++ Includes custody fees paid indirectly which amount to 0.01% and 0.06%,
respectively, of average net assets for the fiscal years ended December 31,
1998 and 1997, respectively.
See Notes to Financial Statements.
The Masters' Select Funds Annual Report December 31, 1998
<PAGE>
NOTES TO FINANCIAL STATEMENTS
1. ORGANIZATION
The Masters' Select Funds Trust (the "Trust") was organized as a Delaware
business trust on August 1, 1996, and is registered under the Investment Company
Act of 1940 (the "1940 Act") as an open-end management investment company. The
Trust consists of two separate series: the Masters' Select Equity Fund and the
Masters' Select International Fund (each a "Fund" and collectively the "Funds").
The Masters' Select Equity Fund is a growth fund that seeks to increase the
value of your investment over the long term by using the combined talents and
favorite stock-picking ideas of six highly regarded portfolio managers.
The Masters' Select International Fund invests primarily in foreign companies.
It seeks to increase the value of your investment over the long term by using
the combined talents and favorite stock-picking ideas of five highly regarded
international stock pickers.
2. SIGNIFICANT ACCOUNTING POLICIES
The following is a summary of the significant accounting policies followed by
the Funds.
Security Valuation -- Portfolio securities that are listed or admitted to
trading on a U.S. exchange are valued at the last sale price on the principal
exchange on which the security is traded or, if there has been no sale that day,
at the mean between the closing bid and asked prices. Securities admitted to
trading on the NASDAQ National Market System and securities traded only in the
U.S. over-the-counter market are valued at the last sale price or, if there has
been no sale that day, at the mean between the closing bid and asked prices.
Securities and other assets for which market prices are not readily available
are valued at fair value as determined in good faith by the Board of Trustees.
Debt securities with remaining maturities of 60 days or less are valued at
amortized cost, unless the Board of Trustees determines that amortized cost does
not represent fair value. Cash and receivables are valued at their face amounts.
Foreign-Currency Translation -- The books and records of the Funds are
maintained in U.S. dollars. The value of securities, currencies, and other
assets and liabilities denominated in currencies other than U.S. dollars are
translated into U.S. dollars based upon foreign exchange rates prevailing at the
end of the period. Purchases and sales of investment securities, income and
expenses are translated on the respective dates of such transactions.
The Funds do not isolate that portion of the results of operations resulting
from changes in foreign exchange rates on investments from the fluctuations
arising from changes in market prices of securities held. Such fluctuations
are included with the net realized and unrealized gain or loss from investments.
Reported net realized foreign exchange gains or losses arise from sales of
foreign currencies, currency gains or losses realized between the trade and
settlement dates on securities transactions, and the differences between the
amounts of dividends, interest and foreign withholding taxes recorded on the
Funds' books and the U.S. dollar equivalent of the amounts actually received or
paid. Net unrealized foreign exchange gains and losses arise from changes in the
value of assets and liabilities other than investments in securities resulting
from changes in the exchange rates.
Forward Foreign-Currency Exchange Contracts -- The Funds may utilize forward
foreign-currency exchange contracts ("forward contracts") under which they are
obligated to exchange currencies at specific future dates and at specified
rates, and are subject to the risks of foreign exchange fluctuations. All
commitments are "marked-to-market" daily, and any resulting unrealized gains or
losses are included as unrealized appreciation (depreciation) on
foreign-currency-denominated assets and liabilities. The Funds record realized
gains or losses at the time the forward contract is settled. Counter parties
to these forward contracts are major U.S.
financial institutions.
Federal Income Taxes -- The Funds intend to qualify as a regulated investment
company by complying with the appropriate provisions of the Internal Revenue
Code of 1986, as amended. Accordingly, no provisions for federal income taxes
are required.
Security Transactions and Related Income-Security transactions are accounted
for on the date the security is purchased or sold (trade date). Dividend income
is recognized on the ex-dividend date, and interest income is recognized on the
accrual basis. Purchase discounts and premiums on securities held by the Funds
are accreted and amortized to maturity using the effective-interest method.
Realized gains and losses on securities sold are determined under the identified
cost method.
It is the Trust's policy to take possession of securities as collateral under
repurchase agreements and to determine on a daily basis that the value of such
securities is sufficient to cover the value of the repurchase agreements.
Deferred Organization Costs -- Organization costs are amortized on a
straight-line basis over a period of 60 months commencing with a Fund's
operations.
Distributions -- Distributions to shareholders are recorded on the ex-dividend
date.
Accounting Estimates -- The preparation of financial statements in accordance
with generally accepted accounting principles requires management to make
estimates and assumptions that affect the reported amounts of assets and
liabilities on the date of financial statements and the amounts of income and
expenses during the reporting period. Actual results could differ from those
estimates.
Other -- Under terms of the Trust's Custodial Agreement, the Funds may earn
credits, based on custody cash balances, to be applied to custodian fees. For
the fiscal year ended December 31, 1998, said credits were $7,085 and $6,488 for
the Masters' Select Equity Fund and the Masters' Select International Fund,
respectively.
38
<PAGE>
3. MANAGEMENT FEES AND TRANSACTIONS WITH AFFILIATES
The Trust, on behalf of the Funds, entered into an Investment Advisory Agreement
with Litman/Gregory Fund Advisors, LLC (the "Advisor"). Under the terms of the
agreement, the Trust pays a fee to the Advisor equal to 1.10% of the average
daily net assets of the Masters' Select Equity Fund and Masters' Select
International Fund. Effective April 1, 1998, the Advisor has voluntarily waived
.10% of the portion of its fee calculated on the average daily net assets of the
Masters' Select International Fund. Effective October 21, 1998, the Advisor has
voluntarily waived .02% of the portion of its fee calculated on the average
daily net assets of the Masters' Select Equity Fund. The Advisor has agreed to
reimburse for any ordinary operating expenses above 1.75% and 1.95% of the
Masters' Select Equity Fund and Masters' Select International Fund average net
assets, respectively. The Advisor reserves the right to be repaid by a Fund if
expenses subsequently fall below the specified limit in future years. These
expense limitation arrangements are guaranteed by the Advisor for at least the
first year of each Fund's operations. After that, it may be terminated at any
time, subject to approval by the Board of Trustees and prior notice to
shareholders. Fee waivers and expense reimbursements are voluntary and may be
terminated at any time.
The Trust, on behalf of the Fund, has also entered into an Administration
Agreement with Investment Company Administration, LLC (the "Administrator").
Under the terms of the Agreement, the Trust will pay an annual fee, payable
monthly and computed based on the value of the total average net assets of the
Trust at an annual rate of 0.10% of the first $100 million of such net assets,
0.05% of next $150 million, 0.025% of next 250 million and 0.0125% thereafter,
subject to a minimum fee of $40,000.
Affiliated entities of the Trust received net commissions on sales of the Funds'
shares for the year of $9,563 and $0 for the Masters' Select Equity Fund and
Masters' Select International Fund, respectively.
Each unaffiliated Trustee is compensated by the Trust at the rate of $10,000 per
year.
4. PURCHASES AND SALES OF SECURITIES
The cost of security purchases and the proceeds from security sales, other than
short-term investments, for the fiscal year ended December 31, 1998, were as
follows:
EQUITY FUND INTERNATIONAL FUND
----------- ------------------
Purchases $537,998,005 $107,712,818
Sales $461,827,045 $ 60,133,924
At December 31, 1998, the aggregate unrealized appreciation and depreciation of
portfolio securities based on cost for federal income tax purposes was as
follows:
EQUITY FUND INTERNATIONAL FUND
----------- ------------------
Total tax cost $345,845,135 $87,496,979
Gross unrealized appreciation 86,511,567 15,961,181
Gross unrealized depreciation (23,642,765) (6,765,523)
------------ -----------
Net unrealized appreciation $ 62,868,802 $ 9,195,658
============ ===========
The International Fund has a capital loss carryforward of $4,971,788, which is
available to offset future capital gains. This carryforward expires in 2006. At
December 31, 1998, the International Fund has deferred capital losses occurring
subsequent to October 31, 1998 of $986,777. For tax purposes, such losses will
be reflected in the year ending December 31, 1998.
The Masters' Select Funds Annual Report December 31, 1998
<PAGE>
5. OFF-BALANCE-SHEET RISK
The Funds have been parties to financial instruments with off-balance-sheet
risk, primarily forward exchange contracts, in order to minimize the impact on
the Funds from adverse changes in the relationship between the U.S. dollar and
foreign currencies. These instruments involve market risk in excess of the
amount recognized on the Statement of Assets and Liabilities. Risks arise from
the possible inability of counterparties to meet the terms of their contracts,
future movement in currency values, and contract positions that are not exact
offsets. The contract amount indicates the extent of the Funds' involvement in
such currencies.
A forward exchange contract is an agreement between two parties to exchange
different currencies at a specific rate at an agreed-upon future date. The
contracts are reported in the financial statements at the Funds' net equity, as
measured by the difference between the forward exchange rates at the reporting
date and the forward exchange rates at the day of entry into the contract. At
December 31, 1998, the Funds had the following forward exchange contracts
outstanding:
MASTERS' SELECT EQUITY FUND
<TABLE>
<CAPTION>
NET UNREALIZED LOSS ON OFFSETTING FORWARD EXCHANGE CONTRACTS $(904,875)
==========================================================================================
MASTERS' SELECT INTERNATIONAL FUND
SETTLEMENT UNREALIZED
IN EXCHANGE FOR DATE GAIN (LOSS)
--------------- ---- -----------
<S> <C> <C> <C> <C>
CONTRACTS TO BUY
582,750 Brazilian Real U.S. $ 450,000 4/26/99 $ (4,397)
---------------------------------------------------------------------------------
CONTRACTS TO SELL
1,728,125 Brazilian Real U.S. $1,250,000 4/22/99 (75,362)
116,530,000 Japanese Yen 1,000,000 1/26/99 (34,351)
---------------------------------------------------------------------------------
2,250,000 (109,713)
UNREALIZED LOSS ON FORWARD EXCHANGE CONTRACTS $(114,110)
CONTRACTS TO BUY
2,171,730,068 Italian Lira U.S. $1,311,447 1/4/99 2,007
348,544,188 Italian Lira 210,347 1/4/99 492
---------------------------------------------------------------------------------
1,521,794 2,499
CONTRACTS TO SELL
2,000,000 British Pound Sterling U.S. $3,375,200 4/6/99 61,083
---------------------------------------------------------------------------------
UNREALIZED GAIN ON FOR WARD EXCHANGE CONTRACTS $ 63,582
- ------------------------------------------------------------------------------------------
NET UNREALIZED LOSS ON FORWARD EXCHANGE CONTRACTS $ (50,528)
==========================================================================================
</TABLE>
6. LINE OF CREDIT
The Trust has an unsecured $15,000,000 line of credit with the custodian;
borrowings under this arrangement bear interest at the federal funds rate plus
0.50% per annum. At December 31, 1998, the Trust has no outstanding borrowings.
As compensation for holding available the lending commitment, the Trust agreed
to pay the pro rata share of a .0008% per annum fee on the unused portion of the
commitment. The fee is payable quarterly in arrears commencing the quarter ended
December 31, 1998. At December 31, 1998, the commitment fee was $2,372 and $620
for the Masters' Select Equity Fund and the Masters' Select International Fund,
respectively.
40
<PAGE>
DEFINITIONS OF INDEXES
1. The Barra Growth Index comprises the common stocks of companies in the S&P
500 Index with the lowest book-to-price ratio. Book-to-price ratio is the
book value of a company's common equity divided by the company's market
capitalization.
2. The Barra Value Index comprises the common stocks of companies in the S&P
500 Index with the highest book-to-price ratio. Book-to-price ratio is the
book value of a company's common equity divided by the company's market
capitalization.
3. The S&P 500 Index comprises the common stocks of 500 of the largest (based
on market capitalization) publicly traded U.S. companies.
4. The Wilshire 5000 Index measures the performance of all U.S. headquartered
equity securities with readily available pricing data.
5. The Lipper Growth Fund Index comprises the 30 largest mutual funds within
the growth fund investment objective, as determined by Lipper Analytical
Services, Inc.
6. The Lipper Small Cap Fund Index comprises the 30 largest mutual funds
within the small- cap fund investment objective, as determined by Lipper
Analytical Services, Inc.
7. The Russell Midcap Index measures the performance of the 800 smallest
companies in the Russell 1000, which represents approximately 35% of the
total market capitalization of the Russell 1000 Index. The Russell 1000
Index measures the performance of the 1,000 largest (based on total market
capitalization) U.S. companies.
8. The Russell 2000 Index measures the performance of the 2,000 smallest
companies in the Russell 3000 Index, which measures the performance of the
3,000 largest (based on total market capitalization) U.S. companies.
9. The MSCI EAFE Index is a broad-based index that measures the performance of
common equities of selected companies in 21 developed countries in Europe,
Australia and the Far East.
10. The MSCI Europe Index measures the performance of the common equities of
selected companies in developed European countries, as defined by Morgan
Stanley Capital International.
11. The MSCI Japan Index measures the performance of the common equities of
selected companies in Japan.
12. The MSCI Emerging Markets Free Index measures the performance of the common
equities of selected companies in emerging markets countries, as defined by
Morgan Stanley Capital International.
13. The Lipper International Fund Index comprises the 30 largest mutual funds in
the international fund investment objective, as determined by Lipper
Analytical Services, Inc.
14. The Lipper International Small Cap Fund Index comprises the 10 largest
mutual funds in the small-cap international fund investment objective, as
determined by Lipper Analytical Services, Inc.
The Masters' Select Funds Annual Report December 31, 1998
