A Word From The Advisor

Each time the calendar turns over, we resolve to make this a good year, better than its predecessor — resolutions to stop smoking, to lose weight, to exercise more. And it seems that economic optimism follows a similar pattern. Each time a new year begins, the air percolates with investment buoyancy, with expectations that this year will be better than the last. As we enter an election year in 2004, we feel this optimism is warranted. The sweet concoction of record-low inflation, stronger corporate earnings and an improving job market will hold together to provide a positive environment for growth.

After three years of a grisly bear market, the rousing rally of 2003 has lifted the stock market, with the Dow Jones Industrial Average topping the 10,000 mark. Election years, along with the years that precede them, are typically bullish. According to the Stock Trader’s Almanac, for the last two years of the 43 Administrations since 1832, including 2003, the average annual gains were 17% vs. an average annual gain of 5% in those same Administrations’ first two years. While this is good news to battered investors, the strong rally means that stocks have run up in price and aren’t considered cheap any more, creating a more difficult stock-picking environment. When this environment is coupled with a likely increase in interest rates this year and the volatility this event will cause in the bond market, the value that professional active investment management adds in terms of achieving investment goals while controlling risk remains compelling.

Risk is a fact of investment life. Identifying and managing risk is a large part of what Oakwood’s professional management team does in order to create value and wealth for our clients. It is possible for the equity investment team to identify the fundamental sources of individual company risk, and thereby, manage it in the context of constructing our client portfolios. When it comes to stocks, two particularly important types of risk are operating risk and price risk. The investment team identifies the various elements of these risks to formulate a sound earnings outlook, along with the factors that might affect those earnings, and the probability of achieving those results.

Operating risk is the risk to the company of operating as a business. That includes anything that might adversely affect the company’s market share, such as a competitors successful new product, or its profitability, raw-materials costs or rising labor costs. A debt load or fixed cost position that is high compared with industry or market averages would also make for higher operating risk because it would magnify the bottom-line effects of a drop in demand. Oakwood’s disciplined analytical approach focuses on many factors, including:

• A company’s business strategy;

• Global growth potential, currency fluctuations, and cost structure benefits with respect to multinational companies;

• Competitive position in the industry;

• Strengths and weaknesses of financial position, earnings and cash flows; and

• The quality and depth of the management team.

Price risk has to do with the stock rather than the business. There are different ways to look for price risk, but probably the most common is comparing a stock’s valuation measures, such as its price/earnings (P/E) ratio and growth prospects against that of the industry, the market, or any other index that will yield a meaningful comparison. Currently, the median S&P 500 Index stock is trading at a price of about 18 times its earnings, based on analysts’ estimates of earnings over the next 12 months. Over the past 50 years, the P/E ratio for the S&P 500 Index has been on average 15 times. In a fully valued market environment, individual stock selection is more important than ever to achieving respectable returns. The market was pulled up in 2003, led, in large part, by higher risk companies that had low to negative cash flows, low returns on capital, low dividend yields, high betas and high P/E ratios. In contrast, the higher quality, higher return-on-capital stocks that are the staple of Oakwood equity portfolios provided good returns.

As we make our way into 2004, our belief is that the Federal Reserve (Fed) will acknowledge the pickup in the growth of the economy, and raise interest rates. The ability of Oakwood’s bond investment team to respond to this and other types of market events has been proven over time. The bond team’s portfolio structuring process compares cash flows from differing sectors, incorporates an in-depth study of the yield curve, and then establishes an overall duration target, which is the level of price sensitivity to a change in interest rates. The ongoing monitoring of economic and political factors allows the team to respond quickly to shifts that will affect the individual securities in the bond portfolios, and then make adjustments to enhance client returns.

Just as Oakwood’s professional investment team identifies and manages the differing types of investment risk, it makes prudent sense for an individual investor to take a step beyond the typical “asset allocation between stocks and bonds” discussion, and examine what invisible risks may be embedded in their portfolio. One area of risk that could plague an investor is not fully knowing or understanding what is owned and how it fits into a long-term investment strategy. As an Oakwood client, you have the benefit of choice from very well defined strategies, ranging from fixed income to balanced to equity portfolios, designed to achieve your investment goals.

A review of Oakwood’s four equity strategies in a risk-reward forum may assist Oakwood clients in confirming their investment expectations and may provide a solution for investors seeking professional management:

• Oakwood Equity Income - This strategy seeks high current income and the potential for capital appreciation. Common stocks used in this strategy are typically represented in the S&P 500 Index and may also include dividend paying stocks not included in the S&P 500. This strategy is most closely allied with a value-oriented investment style. In most market environments, the Equity Income Strategy maintains a risk level between 20% less risk than the market and 5% greater than the market, as measured by portfolio beta. This strategy is suitable for investors seeking above average income and moderate capital growth.

• Oakwood Concentrated Value - This concentrated strategy invests for lowest risk and highest return across all market capitalizations above $800 million. The portfolio is non-diversified and invests in the securities of a limited number of issuers. As a result, changes in the market value of a single issuer could cause greater fluctuations in the value of the portfolio than would occur in a more diversified portfolio. This strategy defines risk differently:  not as portfolio beta, but as the risk of permanent loss of capital employed. On this basis, this strategy seeks lower risk to capital over the long term.  Since portfolio beta is not considered, the strategy can be quite volatile in the short term.  This strategy is suitable for high net worth investors seeking long term gains in net worth.

• Oakwood Large Cap Equity - This diversified equity strategy will invest in larger capitalization common stocks but may occasionally use medium capitalization issues. Generally, this strategy uses the securities of the companies contained in the S&P 500 Index and pursues a blended style of growth and value. In most market environments, the Equity Strategy maintains a risk level that ranges between 15% less risk than the market and 15% greater risk than the market, as measured by portfolio beta. This strategy is suitable for investors who seek long term growth of capital.

• Oakwood Capital Appreciation - This diversified equity strategy may invest in both large and medium capitalization common stocks. The strategy uses stocks with market capitalization in excess of $1 billion as its relevant universe and is most closely allied with a growth investment style. In most market environments, the Capital Appreciation Strategy maintains a risk level that ranges between market risk and a risk level 30% greater than that of the market, as measured by portfolio beta. This strategy is suitable for investors seeking capital appreciation.

Even world-class risk management won’t eliminate unforeseen risks, but the Oakwood professional management team’s process of identifying and controlling risk will reduce the number and size of unwelcome surprises. As an investor you can eliminate a lot of digression from your investment expectations by truly understanding what you own, and how it is expected to behave in various market environments.