Equity Income & Capital Appreciation Strategies
Starting this past summer, as credit turmoil in the US began to reverberate across global markets, several factors combined to support stocks world-wide. Commodity prices, which have underpinned the boom in many overseas markets, remained strong. Fears of a potential contraction in the US economy were counterbalanced by expectations that much of the rest of the world would continue to expand. Most Asian stock markets, led by China, Hong Kong and India, in fact continued to outpace the US in 2007, reaching record highs in the second half after a mixed performance in the first half of the year.
Despite some jitters about credit markets and the housing market, the S&P 500 Index, a broad measure of the US equity market, ended in positive territory for the year despite a fourth quarter decline. Even though the performance of the S&P 500 Index was negative for the quarter, compared to value stocks, it fared relatively well, as over 50% of its composition is US large capitalization growth companies. For the year 2007, clients’ exposure to emerging markets and international developed markets gave a solid boost to returns. In other time periods, other asset classes will be the top performers, such as the year 2006, when US real estate was the top performer.
Some experts remain confident that the US economy will withstand pressures and escape recession, with a combination of Federal Reserve (Fed) interest rate cuts and the ripple effect from strong growth in places such as China and India. High quality multinational companies, such as those found in Oakwood Equity Income and Capital Appreciation portfolios, will benefit from these factors and continue to grow and expand. However, the current combination of high energy prices, weakening employment, real estate deflation and tightening credit conditions mirror the conditions of 1991, the last time the US experienced a recession.
Looking forward into 2008, we anticipate the real Gross Domestic Product (GDP) growth in the range of 1 to 2%, and profits, in general, to decrease. We also anticipate an increase in volatility, which was already on the increase in the second half of 2007. You may recall the following chart, which we have updated. At its recent peak on August 16, 2007, the Volatility Index (VIX) was up 108% from 50 trading days earlier. Since 1990, there have been only six other periods of such intense short-term volatility. Each time, the S&P 500 was higher one, three and six months later. History is not a perfect guide, but the table highlights the market’s tendency to recover, at least in the short term, after volatility spikes.
Our well diversified, high quality client portfolios were positioned to withstand the volatility during the quarter, generating very favorable quarterly and annual returns. We continue to be cautious towards the US equity market, and therefore, we remain well diversified with no individual position over 4% of the portfolio at its cost.
For this last quarter, we have added and sold certain stocks that we believe are appropriate for each of the different strategies. We would like to share with you the fundamental reasons behind these decisions. Please note that the stocks described below represent our major purchases and sales and do not include every stock purchased and sold for the quarter.
We have been underweighted for some time in the financial sector, which has been a tremendous benefit to client portfolios. We are selectively adding to the financials as we see opportunities, like the recent addition of a major bank. Its wide economic moat is derived from a geographically diverse core deposit base, higher customer switching costs, and scale advantages in the asset-management and mortgage servicing business that fortifies its profits against competition. We believe returns on equity will remain around 20% for the next five years.
Another new name in certain Oakwood equity strategies is an integrated energy firm controlled by the Brazilian government. At the end of the last fiscal year, the firm posted proven reserves of 11.4 billion barrels of oil, equivalent with average daily production of 2.3 million barrels. This company’s daily refining capacity is greater than 2 million barrels, representing more than 98% of Brazil’s total refining capacity. The company also has 6,600 retail outlets in Brazil. It plans to increase its oil and gas production by more than 7%, compounded annually, between 2006 and 2012. This firm has improved its financial flexibility and has started reducing its debt load.
In the healthcare sector, we recently added the world’s largest medical-equipment maker, maintaining greater than 50% market share in its core heart devices. It also holds market-leading positions in spinal products and insulin pumps. This company expects to launch three artificial disc systems in the United States in 2008-09, including the first cervical discs. It enjoys great profitability, with returns on invested capital that are more than double the firm’s cost of capital.
A company in the Technology sector was recently added to certain client strategies. It is a global provider of processing services to financial institutions in the US, including check services, card issuer and transaction processing services, risk management services, mortgage loan processing and outsourcing services. The company is a solid cash-flow generator with sustainable competitive advantages. It is solidly profitable, with an operating margin of 14% in the last fiscal year. Margins should improve as a result of the falloff of integration costs and economies of scale from acquisitions. We project operating margins to hit 19% by 2011.
Lastly, we recently sold a holding company in the consumer services sector at a profit. It has operations that are grouped into three segments: mountain, lodging, and real estate. While a predominant amount of its profits are derived from its ski resort properties, we felt its exposure to real estate development in this volatile environment made its risk profile no longer suitable for Oakwood client portfolios.
