A Word From The Advisor

It is tough to imagine a year more difficult for the U.S. financial markets than 2001. The domestic economy plunged into recession and, in so doing, brought a convincing halt to the longest economic expansion in the history of this country. Continuing fallout from the disastrous technology downturn has simultaneously occasioned the steepest fall in corporate profits since the 1930’s. The largest corporate bankruptcy (Enron Corp.) in American history occurred, the Federal Reserve Board (“Fed”) found it necessary to lower interest rates a record 11 times and the stock market declined two years in a row for the first time since 1973 - 1974. Simultaneously, the capital markets contended with the aftermath of the terrorist attacks and the country went to war.

The average length of post-World War II recessions has been 11 months, implying that 2002 will see the U.S. economy emerge from recession and resume growth. A new growth trajectory is substantially aided by the significant monetary policy moves undertaken by the Fed and by fiscal policy initiatives, both those already enacted and those still to be revealed by the political process. Once growth resumes, corporate profits will increase and these two positive events can be expected to coincide with further improvement in technology fundamentals. In short, 2002 is very likely to be a better year than 2001, although economic growth will surely be back-loaded into the second half of 2002. The year 2003 is likely to be better than 2002.

The stock market in 2001 continued the dismal performance that began in the previous year. For calendar 2001 the Standard and Poors 500 (“S&P 500”) declined 11.9% and the NASDAQ Composite fell 20.8%. Thus, investors have now experienced two successive years of negative returns in stocks with the S&P 500 having fallen nearly 40% from its 2000 high to its 2001 low and the NASDAQ Composite having fallen 74% from its 2000 high to its 2001 low. The average large capitalization core mutual fund, according to Lipper Inc., was down 13.8% in 2001 with fully 83% of U.S. common stock funds posting negative returns. Large capitalization growth stock mutual funds declined 23% and, on average, international funds lost nearly 22%.

After two difficult years in the stock market and the specter of recession upon us, it is easy to get discouraged about the prospects for stock prices in the period ahead. However, we are of the belief that (1) the economy will emerge from the recession during 2002, and (2) corporate profits will begin to improve. Better results from these two important indicators of the direction of the capital markets are very likely to set the stage for a more sustained upturn in equities as the year progresses.

On the other hand, bond returns have been excellent. The Lehman Brothers Intermediate Government/Corporate bond index closed 2001 up 8.9%, following nicely onto returns of 10.1% in 2000. The average U.S. taxable bond mutual fund gained 5.1% in 2001. Oakwood’s clients who use fixed income instruments as part of their investment strategy have experienced favorable returns versus bond benchmarks while enjoying a measure of risk control, relative to recent common stock volatility. Thus, bond investors have been well rewarded in these two difficult years in the capital markets. In addition, we maintain a positive outlook for bonds in the coming year. Despite the huge amount of fiscal and monetary stimulus now in place, the economy probably faces a slower recovery than has been the case in the past. If economic headwinds prevail, interest rates, especially on the intermediate and longer end, would move lower, setting the stage for a bond rally.

We believe that the watchword for investors in the coming year is “conservative.” Now more than ever our clients need to define their long term goals, focus on how those goals can best be accomplished and identify how much risk they are willing to take in order to achieve those goals. In client portfolios, Oakwood applies conservatism in the following manner:

1) In common stock portfolios, we will continue to control risk in the following ways:

• Maintain full diversification within an active management context,
  
  
• Exert an additional measure of risk control by managing the beta of the portfolio,
  
  
• Judiciously hold cash equivalents from time to time as a means to limit the magnitude of downside risk,
  
  
• Importantly, build portfolios containing stocks which represent attractive values relative to growth rates and which have identifiable and predictable earnings streams, and
  
  
• Respond thoughtfully by selling disappointing issues when necessary.

2) In fixed income portfolios (or the fixed income portion of balanced portfolios), we will continue to apply our disciplined, quantitatively-driven investment methodology in order to ensure that our clients have the highest probability of meeting their investment objectives. This means that we will attempt to:

• Meet or exceed the return on the relevant fixed income benchmark, and
  
  
• Accept no more risk than is necessary to attain that goal.

Conservatism does not mean that we are negative on the U.S. economy or the domestic capital markets. Instead, it means that we take a diligent, disciplined and prudent approach to maximizing return within the framework of sufficient risk control to accomplish the client’s objectives. It also means that we continue to insist on solid fundamentals for the issues that are used in client portfolios while seeking to identify specific opportunities in individual names that present themselves from time to time.

The stock market’s rally off its September 21 low has surprised everyone with both its magnitude and its breadth. Thus, a market pullback some time this year would not be unexpected. Such a retrenchment would give corporate earnings time to catch up to stock prices, thus setting the stage for a more sustained move to the upside. However, the market has developed considerable momentum in recent weeks implying that large levels of cash are not appropriate. Thus, we approach 2002 optimistically but cautiously recognizing that, while we expect a decent economic recovery later in the year, we are a long way from the halcyon days of the late 1990’s.