Equity Market Strategy
Sustainable Growth
We believe US equities can continue to generate positive returns into 2006. Despite strong economic growth, the US equity market experienced a lackluster year in 2005, with very modest positive returns on the whole. Not surprisingly, particular sectors—notably oil and natural gas exploration and energy—diverged sharply and significantly outperformed other sectors of the market in large part due to high energy prices. Related to this phenomenon has been a dramatic underperformance by the auto and consumer discretionary sectors, which are most affected by high prices of oil and gasoline. We began the year 2005 with many uncertainties, among them inflation and oil prices. As 2006 begins to unfold, these same inflationary pressures seem in check due to a proactive Fed. On our short list of market-defining items for 2006 are the end of the Fed tightening cycle, the continuing instability of oil prices and corporate and personal income growth.
There are several reasons to support our conviction for a positive US equity market this year. First, US investors are feeling that inflation is under control. We are encouraged that inflation remains stable despite significantly higher oil prices. Interest rates have risen, but in a very gradual and transparent fashion which has translated into a well-engineered slowing of the economy. We believe investors may increasingly reward higher quality companies, particularly large-cap entities that generate good quality cash flow, such as the companies that comprise Oakwood client portfolios. Overall, we see quality coming to the forefront with corporate earnings growth coming in slightly above trend.
Corporate profits should continue to rise, albeit at a somewhat slower pace this year. We project that operating profits on the S&P 500 will advance approximately 11% for 2006. A larger portion of those profits will benefit shareholders via increased dividends and stock buybacks. Cash on the balance sheets of nonfinancial companies in the S&P 500 hit another record high in late 2005, at $638 billion. This has enabled companies to increase their share buyback programs. In past years, some companies used buybacks to offset shares issued in conjunction with exercised options. Now that options have to be expensed, we are seeing less of this activity, and buybacks are actually reducing the shares outstanding. This has positive implications for per-share earnings and, therefore, stock prices.
From a historical valuation basis, the equity markets are not cheap, but seem fairly priced. The price-to-earnings ratio (P/E) of the stocks in the S&P 500 Index, for instance, was 16 times estimated 2006 earnings as of the end of 2005. Some analysts interpret that to mean that stocks are cheap, although the ratio is just really returning to its long-term historical average, with the average P/E ratio approximating 15 times estimated twelve-month forward earnings. The P/E ratio ratcheted toward 40 times estimated forward earnings at the height of the 1990s excess and has been sliding downward since.
While all strategies at Oakwood Capital Management are driven by individual company fundamentals, considerations regarding macro-economic, geopolitical and industry dynamics drive long-term investment decisions for holdings in client portfolios as well. The depth and experience of Oakwood’s equity team has enabled us to identify industry shifts and to advantageously position ourselves well ahead of the curve to benefit our client portfolios. As an example, we identified the peaking of the Energy sector in the late summer, and subsequently took profits at the appropriate time.
A major transition that we believe will inexorably change our world is a shift from the current fossil resource-intensive global economy to sustainable, more regional economies. The increasing scarcity of oil, gas, and other fossil resource mineral fuels will necessitate an economic restructuring to function in a diminishing resource environment. This transition, already underway, will take a decade or two, and will create opportunities for the perceptive investor and losses for those who do not anticipate its impacts and fail to change their portfolios.
Oakwood is extraordinarily equipped with the expertise to manage this transition for its clients, and has begun to do so. All of Oakwood’s investment professionals have successful histories investing in the Energy sector, and positioning portfolios for investment success during times of great change, and great opportunity. Mineral deposit geologic characteristics, extraction costs, location, transport access and political and military stability, among other criteria, play critical roles in the investment success of each company selected for investment. Some recent additions to client portfolios that capitalize on this knowledge are independent energy companies that acquire, develop, and produce oil and gas reserves located in the United States. Some common characteristics of these companies are the long life (an average of 15 years) of the oil and gas reserves, and the undervaluation of their share price. This undervaluation provides significant value protection, and these companies carry near zero geopolitical risk.
Another holding in client equity portfolios that is poised to capture opportunities in the Energy sector is a company that has an outstanding shareholder management extremely focused on increasing cash returns. This company is an operator in commercial real estate, with power generating subsidiaries encompassing two alternative energy sources, hydroelectric power operations and biomass operations (ethanol).
A company in the Industrial Services sector that is held in some client portfolios is a service company that provides pest and termite control to residential and commercial customers throughout North America. This industry is highly fragmented with numerous small mom and pop and medium size companies. The company we hold is a highly disciplined acquirer, looking to create economies of scale through its acquisitions, as well as leverage a well known brand name.
Areas in which we have scaled back are mainly in the Consumer Discretionary sector, where the stocks sold have much lower potential returns and significant risk, particularly in light of an economy with a deteriorating housing market and unstable energy costs leading to decreased consumer discretionary income.
We are currently underweighted in the Financials sector, particularly wary of those companies that are sensitive to fluctuating short term interest rates. There are several regional banks that from a fundamental perspective are very attractive; however, their prices are too lofty at this point for serious consideration.
Companies in the Healthcare sector have been beneficial to all client portfolios, and we look for positive performance going into 2006 in this area as well. In this sector, our client portfolios have prospered with the ownership of a regional healthcare provider which owns its own healthcare services organizations, including doctors. This structure gives them control over the quality of healthcare delivered to a network of patients, resulting in much higher patient satisfaction and 15-20% lower costs than any competitor. We have recently done some profit taking in the Healthcare sector, where some of our names had fully appreciated.
At Oakwood, our fundamental investment approach is based on achieving superior long-term performance by acquiring equity securities of financially strong, well-managed companies run by capable managements trading at market prices significantly below our assessment of their business, or intrinsic value. Our focus is on companies that sustain high return on equity, high return on capital, and predictable free cash flow.
