A Word From The Advisor

Managing the Complexity of Change

The financial markets are intricate and complex, and if there is one word that characterizes them, it is change. Change is what makes active money management challenging. Oakwood’s active research process in both the equity and fixed income areas is designed to unearth how changes in the economic, market, and company-specific environments affect individual stock and bond prices. We continuously review the short and long-term prospects of these stocks and bonds in order to determine how they alter the overall risk/reward profile of client portfolios. Change is what makes active money management rewarding. All Oakwood strategies for the year 2004 surpassed their respective benchmarks and have enjoyed longer-term success as well.

The goal of our active management process is to produce for our clients a positive return over a market cycle and to accomplish that with reduced risk. The positive return over a market cycle is easy to measure. One way that we measure the risk is to compare our strategies’ performance and variability to those of a market index like Standard & Poor’s 500 (S&P 500).

While many investors believe that a broad market index like the S&P 500 reflects an equal weighting of US industries, and that by indexing they are participating in this broad market, the fact of the matter is that sectors often become highly imbalanced. For example, in 1980, at the height of the energy crisis, stocks in that sector comprised approximately 27% of the index. Today it is approximately 7%. And in 1999, during the dot.com craze, technology shares made up about 28% of the index. Today it is about 16%. The index gets distorted by those companies that are doing the best from a price standpoint. Currently, the financial services sector comprises approximately 20% of the S&P 500 Index, up from about 13% ten years ago. Certainly, many of these financial companies are subject to interest rate risk - their recent upsurge in profits has been tied to the huge boom in mortgage refinancing due to extremely low rates, and capturing a nice spread between the interest rate charged to borrowers and the low cost of capital required to make those loans. Now that rates are on the rise, these ballooning profits become vulnerable.

Our investment methodology and discipline have led us to currently have an overweighting in financial services companies in our client equity portfolios. The difference in the quality of our holdings and the index’s holdings is the selectivity we have employed in the companies we own. Rather than owning all the financial services companies, and hoping that the good ones will offset the bad ones, we focus on a handful of companies that have excellent fundamentals from the following standpoints:

• Superior financial strength, including an underlever-aged balance sheet, with high return on equity and capital;
  
  
• Limited product and/or interest rate risk which makes for a predictable business;
  
  
• Predictable free cash earnings, with limited cash requirements for growth;
  
  
• Franchise or cost advantage, a “good” business, with long term competitive advantages.

Oakwood’s discipline has led us to select only what we believe are the highest quality US financial companies. One of these companies concentrates in issuing only variable rate mortgages which makes it interest rate insensitive. In addition, this savings and loan’s experienced credit analysis is unparalleled, its return on equity is approximately 20%, and its insider ownership is also around 20%, signifying high conviction from management. A high degree of insider ownership also reflects a high degree of alignment with shareholders who bought and paid for their shares, as opposed to companies whose management has options on the stock which typically cost them almost nothing. Companies whose management owns a high percentage of their own shares want to increase the share price prudently over the long term.

Indices are a reflection of what is happening and what has happened in the marketplace. Passive investment products merely aim to mimic a given index. When investors choose to index, they are surrendering themselves to the whims of the marketplace, buying the good with the bad. Oakwood, as an active manager, operates with acuity in finding and holding onto the gems of the marketplace.

At Oakwood, all our years of experience are focused on the issues that affect client portfolios and we remain carefully attuned to developments that will provide outstanding investments for our clients. Looking forward to 2005 and beyond, we as always remain vigilant in our effort to pinpoint economic developments, company-specific and geopolitical events that affect our goal of building and maintaining our clients’ wealth.