Equity Market Strategy - A Return to Rationality
With the close of the first quarter of 2004, it is quite clear that a level of rationality has come back to the market. The 2003 rally, which featured smaller-cap, technology, telecommunications, and Internet companies with dubious balance sheets, whose stock prices were doubling or tripling in value, seemed to lose momentum toward the end of the first quarter of 2004. The long-awaited rotation into the shares of larger, high-quality companies with proven records of earnings growth which comprise Oakwood’s equity universe has begun to materialize. This rotation translated into outperformance in all of Oakwood’s equity market strategies for the quarter compared to the S&P 500 Index. This outperformance is particularly compelling in light of the fact that the beta coefficients of client portfolios are at the lower end of their normal range. (Additional information is available upon request. Past performance is not indicative of future results.)
Despite a strong start in January, most major indexes closed the first quarter of 2004 very near their starting points. Stocks moved unevenly during the quarter with investors considering higher oil prices, a bundle of political issues, and continued reminders of geopolitical risk. The outlook for corporate earnings, while still respectable, is not as robust as it was in the second half of 2003. At that time, earnings were poised to surge on the wave of an economy that was, by most points and measures, finally recovering from a recession. Now, with the recovery in a more mature stage, increases in earnings are likely to become more modest. As earnings gains slow, stock gains are likely to follow suit.
Our outlook for stocks for the year remains positive. We expect corporate earnings to grow in the range of 10% to 14% in 2004 and 9% to 12% in 2005. Other positives for the stock market include the expectations for economic growth of 4.0 to 4.5% this year, a pickup in business investment, an improving job market, rising incomes, larger than normal tax refunds and yet another round of mortgage refinancing. Weighing on these positives is the prospect of inflation, gradually higher interest rates and political uncertainty in this election year which could affect future tax policy.
Modest increases in inflation and interest rates are traditionally signs of economic strength and thus would be a positive for stocks. On the other hand, significant increases in interest rates due to an inflation scare could represent a risk to price-to-earnings (P/E) multiples. Using the inverse relationship between the yield on the ten-year Treasury bond and the current P/E multiple of the stock market to gauge valuation in the market, we see the current yield on the ten-year Treasury bond of about 4.2% implies a market P/E of about 23.8 times earnings.
The P/E on 2004 earnings is currently about 19, implying a yield on the ten-year Treasury bond of about 5.25%. These relationships clearly indicate that the stock market has already priced in some expectations for an increase in inflation and interest rates. We believe we will see some contraction in P/E multiples in 2004 and perhaps in 2005. The magnitude of the contraction and its impact on stock returns depends on the strength in corporate earnings, changes in earnings growth expectations, and changes in inflation expectations and interest rates. So while changes in interest rates and inflation are a factor in stock price movements, they are just part of a wide range of fundamental and economic factors that impact these prices.
One sector that is perhaps most sensitive to changes in interest rates is the financial services sector. We are modestly overweighted in financials and have evaluated interest rate sensitivity, among other fundamentals, for each of our holdings in this sector. Our equity investment process and discipline has led us to a selection of high quality companies with strong fundamentals and excellent free cash flow generation. A rise in interest rates for these financial intermediaries means that cash flow generated will be reinvested at higher yields, allowing for more attractive spreads between their assets and liabilities. As well, many of the companies in Oakwood client equity portfolios are global in nature, which lends them some immunity to the ebb and flow of country-specific events.
Given the rate of improvement in the economy, the continued increase in corporate earnings, higher dividend payouts and a probable contraction in P/E multiples, we envision an environment of stock returns in the range of 9% to 11% per year. In the first quarter, no one sector or industry dominated the performance of the major stock indexes (although noteworthy is the fact that the financial sector and the energy sector were the top-performing sectors). There are currently many “ifs” in the investment world, the outcome of which is uncertainty, an environment that isn’t likely to establish a consistent direction. In this type of environment, Oakwood’s proven investment process and discipline and its end result, superior stock selection, becomes paramount.
Our focus in managing client portfolios has always been on investing in higher quality companies. Although quality can be defined in many different ways, our definition of quality companies includes those that have positive cash flow characteristics and attractive free cash flow yields, strong returns on capital, increasing dividends, healthy earnings growth prospects, and positive economic returns on capital, coupled with capital spending discipline.
