Equity Market Strategy
A Stock Picker's Market
We at Oakwood take very seriously the profound responsibility that we have in managing our clients’ wealth. If we posted the rules we live by on our mirrors to remind us first thing every morning of that responsibility, they would read, in the following order:
Rule 1. Preserve our clients’ capital.
Rule 2. Generate positive returns for our clients.
The key reason we strive for positive returns is that down years damage the long term compounding effect on net worth, and counter what we are trying to do for our clients: safely compound their assets over the long term to increase their wealth. We seek to outperform the S&P 500 Index as well – over the long term, say 5 to 10 years. Wall Street speaks of “alpha” as the excess return over the index in any year. Alpha can be generated with lots of risk by gunslingers and lucky momentum players, but achieving long term results for our clients requires a proven methodology, discipline, and low risk.
Using the S&P 500 Index as a proxy for the market, the 2004 year ended with a +10.9% return. Most of this return, +9.2%, happened in the fourth quarter, which acted like a rising tide that lifted the annual returns of active managers, as well as index funds. While all Oakwood equity strategies ended 2004 by outperforming the S&P 500, it was during the earlier part of the year, through September 30, where the Oakwood methodology and discipline demonstrated superiority by outperforming the market.
Oakwood’s full spectrum of equity strategies share the same investment discipline. The margin of safety in the intrinsic value we buy versus the purchase price that we pay diminishes risk, and helps to avoid the possibility of loss of capital employed. For those strategies at the value end of the spectrum, the lower the purchase price compared to the intrinsic value, the greater the margin of safety and the greater the potential for reward. Put in simple terms, if you invest in an asset that is worth $1.00 and you pay only 50 cents for that asset, your risk of loss of capital is lessened. The key is the ability to recognize quality values of $1.00, when everyone else thinks it is 50 cents, because it is priced at 50 cents. If we buy a company for half its intrinsic value, and for example if the value grows 12% per year through retained earnings, and if the share price rises to reflect corporate worth in the fifth year, the investment will compound at 29% per year. Two-thirds of the return comes from the gap between price and value closing; only one-third comes from the business value growing. For those strategies at the growth end of the spectrum, we put more emphasis on growth potential and may be willing to pay more for that potential. For each Oakwood equity strategy, we continue to buy well managed high return on capital, high return on equity businesses below their intrinsic value, and that continues to generate low risk returns over the long term. We know that the market can misprice in the short term, but sooner or later, it recognizes the intrinsic value of stocks.
One of many examples of adhering to our discipline occurred in the second quarter of 2004. During this period, the market reflected concerns about rising interest rates, and many financial services companies suffered from the perception. One of our holdings, a diversified financial services company, experienced a short-term decline in price, due to this market concern. Because we know the company and its business so well, after a discussion with the management, we correctly perceived this sudden undervaluation as a buying opportunity, and bought at a fraction of the intrinsic value while others were selling. In addition to adding to this position, we took the opportunity to buy some other financials at bargain prices that were affected in the same way. The 2004 “market panic” didn’t differentiate between companies that are interest rate sensitive and those that are not.
We begin the 2005 year with many uncertainties, among them the direction of both inflation and oil prices. We currently believe a reasonable set of expectations is for earnings to grow by approximately 8%, which is a more modest earnings growth rate than 2004. With dividend yields currently at 1.6%, the market has the potential to deliver returns in the high single digits in 2005. Impacting that return will be changes to the market’s P/E multiple, changing expectations for earnings growth and the potential for rising dividend payouts.
The continued contraction of P/E multiples in 2005 is a possibility, as forward earnings growth expectations moderate in 2005 and 2006, relative to 2004. While inflation is not a problem at this time, inflation expectations could change as a result of the Fed’s accommodative monetary and fiscal policy. The falling dollar and rising commodity prices could also put pressure on P/E multiples, thereby reducing stock returns. While we view stocks in general as being fairly valued at this time, neither cheap nor expensive, we do believe that opportunities to add value through stock selection will emerge in the year to come.
Net profit margins on S&P 500 stocks have risen from a decade low of 6.2% in 2001 to a 20-year high of 8.5% in 2004. As a result, the S&P 500’s returns on equity have risen from a decade low of 15.1% in 2001 to a respectable 17.4% in 2004. Correspondingly, corporate free cash flows have risen to over 2.5% of US GDP, a level not seen since 1964. Cash, at 11.5%, as a percentage of total assets for the S&P 500, has never been higher. With rising cash balances on corporate America’s balance sheets and the potential permanence of dividend tax relief, we expect to see higher dividend payouts in 2005. This potential for continued increases in dividend payouts is an important positive for stocks in the coming year. Dividend payouts increased by 12% in 2004 and we expect more of the same in 2005. Evidence of our ability to stay ahead of the curve was our recognition, prior to the preferential tax treatment of dividend income, that this was an important future return opportunity area in which to actively participate.
With record profit margins and levels of cash flows, one would expect to see returns on equity much higher than the respectable 17.4% mentioned earlier. The reason we’re not seeing higher returns on equity at this point is that corporations have been paying down debt. Debt ratios are at the lowest levels in more than two decades. Debt repayments may lower a firm’s interest expense but the process of reducing debt can reduce returns on equity in many instances. With the S&P 500’s long-term debt to total capital ratio at 33%, we believe we are reaching a point where corporations may slow down or stop paying down debt. This will free up additional cash for other purposes such as dividend increases, stock buybacks, sound mergers and acquisitions, and higher levels of capital investment, all of which are positives for stocks.
An important part of Oakwood’s methodology and valuation of companies is not only how much free cash flow is generated, but what the companies do with their free cash flow. We like to see companies that utilize their free cash to benefit their shareholders. Some examples of how we like to see management spend free cash flow include share buybacks and increased dividend payments to shareholders, (which most financial services companies in client portfolios regularly do), or reinvest cash flows at high rates of return (as a certain natural gas company does). We tend to avoid companies that spend cash on dubious acquisitions, as in many cases the returns are poor. We sold an otherwise high return financial company in the third quarter, when an ill advised and overpriced acquisition severely hampered the future ROE of the combination.
Given high free cash flows, rising cash balances and the more modest earnings growth expectations for the next couple of years, we would also expect to see a continuation of the increase in corporate merger and acquisition activities that we witnessed in the second half of 2004. We will continue to scrutinize each acquisition for economic sense.
Corporate cash balances and cash flows are sufficiently high that companies can fund somewhat higher capital expenditures. Many sectors of the economy that severely lacked capital investment during the 1990’s are now the sectors experiencing pricing power. These sectors include energy and basic materials, such as steel, lumber and paper as well as industrials. By contrast, the technology sector is still awash in capacity, being characterized by too many players doing the same thing. This is one reason why we continue to be underweighted in technology. The primary reason is based on fundamental individual company research and valuation.
The energy price shock we experienced last year modestly depressed US and global economic and corporate earnings growth. The modest energy price declines we’ve experienced of late will partially diminish this headwind. About 40% of global energy consumption is based on petroleum. About 70% of existing oil consumption comes from oil fields discovered 25 or more years ago. Approximately 4% to 5% of world crude production is depleted every year and an equivalent amount must be found and developed to maintain production volumes. An additional 2% in crude production must be found and/or developed to meet current growth in global demand. This means that an additional 6% to 7% of oil production must be saved through increased efficiency and/or must be found, developed and brought to market each year to meet global energy demand. Regardless of the short-term volatility of energy prices we continue to see this as a favorable area, which explains our overweighted positions in oil and gas energy stocks during the course of 2003 and 2004, which continues into 2005.
Even though we don’t see runaway inflation on the immediate horizon, we are ever mindful of the consequences of an inflationary environment. Our criteria for stock selection, the end result of owning only the highest quality, highest return on capital companies that have pricing power and the ability to pass on inflation costs, positions us to weather a higher inflationary environment, should this become a reality.
Although many quality companies are fairly priced in today’s market, we continue to find some “gems” to add to our portfolios. We continue to demonstrate our ability to maintain our discipline, and use our methodology to find these gems. While there are challenges in the current market, we believe that on balance the outlook for stocks in the year ahead is positive. In managing our client portfolios we will continue to focus on owning companies with positive cash flow characteristics, strong returns on capital, healthy balance sheets, increasing dividends and healthy earnings growth prospects trading at attractive valuations.
