A Word From The Advisor

These days, everybody we talk to has a number. They don’t talk about the number with many people and some investors are not even conscious that they have a number. But dig into the financial psyche of any market-weary investor and the number will eventually be revealed. The number is that amount of money at which the investor will feel truly financially secure and will be reasonably confident that he or she can accomplish his or her financial goals.

It is our belief that most incorrect or inappropriate investment decisions are made because the investor believes he or she is either too far below the number, is trying to get to the number too quickly or has potentially conflicting attitudes about the number. A few years ago, many investors erroneously believed that putting all one’s money into a few technology or internet stocks was a way to attain their number very quickly. Today, that same investor may feel that he or she is too far below the number and may take too much risk and/or underdiversify again in order to achieve goals. Conversely, because of the two year bear market in stocks, some people have retrenched their portfolios to the point where they are not taking enough risk (consistent with their investment horizon and circumstances) to give themselves the best chance of meeting their number.

The tendency to chase previous winners, to wait to be bailed out of a losing situation, to take too much risk by underdiversification or to take too little risk for one’s circumstances is precisely why most investors need professional investment management. Rummaging through the sheer magnitude of investment products, understanding their confusing structures and definitions and confronting the difficult task of matching those products with individual needs are a few of the benefits professional investment management offers the individual investor.

Let’s take market capitalization, for example. From a capitalization standpoint (that is, number of shares outstanding times the price of a share) common stocks can be divided into four strata: large capitalization (above $10 billion), medium capitalization (or mid-cap) ($1 billion to $10 billion), small capitalization ($300 million to $1 billion) and micro-capitalization (below $300 million). Large capitalization stocks are those of more established companies and those with more financial history and reasonably good market liquidity. Small capitalization stocks are those of much smaller companies for which market liquidity and financial history can sometimes be lacking. Medium capitalization companies can have characteristics of both large and small capitalization companies.

Recently, the financial press has noted that small capitalization stocks substantially outperformed large capitalization stocks last year, sending many investors (those in search of a faster way to their number) scurrying into that asset class.

We offer the following thoughts about small capitalization stocks:

1. Over time, small caps will only outperform if their growth rates consistently exceed those of larger capitalization companies.
   
   
2. Because of the capability for economies of scale, international expansion, financial flexibility and their lower cost of capital, larger capitalization companies generally have greater ability to expand their growth rates.
   
   
3. Ordinarily, smaller capitalization companies are able to expand their growth rates primarily through pricing power, a phenomenon lacking in the global economy right now.
   
   
4. Last year’s outperformance in smaller capitalization stocks was primarily due to the fact that small caps had grown exceedingly cheap relative to large caps and were bid up until that multiple disparity was resolved.
   
   
5. Sharp downturns in the prices of small caps or periods of great volatility could lead to a drying up of market liquidity in these names, hindering the investor from having the ability to buy or sell them at an acceptable price.
   
   
6. The last serious rally in small capitalization stocks ended over ten years ago.

Oakwood confines its investment management activities to the large and medium capitalization arena believing that the superior operational flexibility of those companies and the superior market liquidity of their stocks bring greater benefit to client portfolios over time in the form of higher and more consistent multiples of earnings and lower price volatility.

And what about the style categories that are bandied about daily in the financial press? Doesn’t everybody want both “growth” and “value?” In order to have one, do you have to completely forego the other?

“Growth” and “value” have very specific definitions in the investment management industry. Growth stocks are those which have established a record of consistently high sales and/or earnings growth and which consistently sell at higher multiples of that sales and/or earnings growth. Investment managers who choose to manage portfolios using growth stocks believe that, over time, the stocks that outperform will be those with the higher growth rates. In order to ensure that they own primarily stocks with consistently high growth rates these managers view the price they pay for the growth as secondary to having the stocks with the highest growth rates in their portfolios.

“Value” stocks, on the other hand, are those which are selling cheaper than other stocks when measured by some common metric. The most common value measure is that of price to earnings ratio (P/E ratio). The theory is that those stocks which sell at lower P/E ratios than average will eventually see those P/E ratios rise as earnings increase over time, whatever the rate of growth of the earnings stream. As the P/E ratio expands, the price of the stock increases.

The financial press is fond of reporting that “growth” outperformed during a particular period or that “value” stocks are in vogue for a certain period. Extended periods of such reports have the effect of inducing investors to migrate to managers who emphasize a “value” style or a “growth” style, depending upon what is being reported about their relative recent performance. The truth is that both styles can make money if the investor allows sufficient time for the strategy to work out.

At Oakwood, we believe that it is possible to both identify superior growth characteristics and to obtain the stock of those companies with superior growth at times when they sell at reasonable prices. In this way, the two styles are blended but deliberate shifts are made from one to the other, depending upon market conditions.

In order to reach one’s number in the most prudent way, it is critical to be smart about the choice of investment management assistance and to select only those who approach investment management with discipline and skill. The principals at Oakwood have over 180 years of combined investment management experience. We have seen periods of hyperinflation, low inflation and stagflation, super high interest rates and super low interest rates, merger mania and huge IPO issuance, high trading volume and low trading volume, institutional dominance and day trading, “tech” companies and dot.com companies, hedge funds, shorts and option models and outperformance at various points in time by small caps, large caps, growth and value. No matter what investing fad is in style the investor is still and always best served by choosing an investment professional who understands his or her needs, works with him or her to help set appropriate objectives, establishes a cogent strategy to get to that number and then exercises the patience necessary to allow the strategy to succeed.

Once the client’s needs have been assessed and fully understood Oakwood Capital Management LLC applies the following basic principles:

• Both bond and stock management are accomplished by first applying a rigorous quantitative process to asset selection.
  
  
• Potentially attractive securities are subjected to extensive fundamental analysis.
  
  
• Risk is controlled by actively managing diversification and by monitoring the risk characteristics of each individual security.
  
  
• Portfolios are continuously monitored. All securities owned in client portfolios are reviewed every day.
  
  
• Both fundamental and quantitatively-driven sell disciplines are integrated into the investment process.

Never has it been more important to stay with the long-term strategy each investor has set for himself. Although the stock market has primarily shown investors its capability for peril over the past couple of years it can also prove eminently rewarding. As your investment advisor, please be assured that we remain vigilant and are constantly focused not only on the capital markets but also on helping you get to your number.