Spotlight on Concentrated Value Strategy
Positive Performance in Each Year of the Recent Bear Market

If we lived in a monochrome financial universe, we would, as investors, all have the same financial goals and attitudes about risk. This would lead us to all choose the same types of investments. The truth is that we live in a richly colored world, and know that one-size-doesn’t-fit-all. At Oakwood, our array of equity strategies reflects that knowledge. As an Oakwood client, you have the benefit of choice from four very well defined equity strategies that complement our fixed income and balanced strategies.

Since its inception in 1997, where it outperformed the S&P 500 Index, the Concentrated Value Strategy has an annualized return of more than double that of the S&P 500 Index. It is noteworthy to add that the annual returns of the Concentrated Value Strategy not only outperformed the S&P 500 Index in each year of the 2000, 2001 and 2002 bear market, it also generated positive returns in each of these three years. The Concentrated Value Strategy continued to outperform for 2003, as we began to pull out of the bear market. (Additional information is available upon request. Past performance is not indicative of future results.)

A basic goal of portfolio management is the desire to limit risk and maximize return. Achieving this goal is not always easy, largely because risk can be difficult to define and measure. The traditional risk measurement tools used by investment professionals include beta (the relative movement of an investment versus a benchmark) and price volatility. Theoretically speaking, the more risk that we take on, the more payoff we should receive in terms of higher returns. In Oakwood’s Concentrated Value Strategy, risk is defined somewhat differently. Risk is defined as the possibility of long-term loss of capital employed. The Concentrated Value Strategy over the short term can be volatile. Because of its concentrated nature, changes in the market value of a single issuer could cause greater fluctuations in the value of the portfolio than would occur in a more diversified portfolio.

Investment philosophy
In the Concentrated Value Strategy, we seek to achieve superior long-term performance by acquiring equity securities of financially strong, well-managed companies, at market prices significantly below our assessment of their business, or intrinsic value. A guiding principle is the view that common stocks are units of ownership of a business, and we as investors are becoming owners of the business, not just holders of a stock certificate. We are patient investors, not market timers. We believe that, over time, the price of a stock will rise to reflect the value of the underlying company. The Concentrated Value Strategy, as its name implies, is non-diversified, and as such, will own a minimum of four equity securities and a maximum of fifteen equity securities. While the strategy may incur short term paper losses, the focus is on avoiding long-term loss of capital employed. This is achieved mainly from the margin of safety in the price paid for the stock, and the quality of businesses in our investment choices. Under normal market conditions, the strategy will remain fully invested.

Investment process
Because we seek to identify undervalued companies, the investment process is not solely based on such macro-economic factors as the performance of the economy or the direction of interest rates. We employ an intensive, in-house research process to identify companies that meet our value criteria. The equity research process for the Concentrated Value Strategy starts with an analysis of a company’s financial reports to determine its value. The balance sheet and earnings history and prospects of each investment are extensively studied to appraise fundamental value. We establish contact with and hold numerous conversations with company management. We are looking for companies where the appraised (or intrinsic) value exceeds the current stock price by a significant margin.

We look for those companies that display the following characteristics:

• High return on equity, on capital, and on reinvested capital, with distribution of excess capital to shareholders;
  
• A management that is shareholder driven, that are preferably shareholders themselves, and who spend shareholder money prudently;
• Financial strength in terms of cash flow and an underleveraged balance sheet;
• Predictable free cash earnings with limited cash requirements for growth; and
• Strong franchise or cost advantage - these businesses tend to have a wide “moat”.

The next step in our analysis is to select the companies that are capable of delivering greater than a 15% probability-adjusted compound annual return over a 5- to 10-year time horizon. The price of the stock, its Free Cash Flow [FCF] growth rate, its FCF growth rate predictability, its Return on Equity [ROE] and its ROE Retained to Common Equity [RTCE] play a large role in our proprietary valuation methodology.  We adjust our projected 5- to 10-year forward rate of return by the probability of achieving it, to determine an expected, or probability adjusted, rate of return.  Qualitative and quantitative estimates factor into our probability analysis, based on many years of investment experience.  All calculations are post-stock option expense calculations, an adjustment that radically changes the expected return of many popular companies.

The construction of the Concentrated Value Strategy portfolio is the result of a collective effort of Oakwood analysts and portfolio managers to identify the best values in the market. Equities purchased at prices substantially below their intrinsic value protect capital from long-term loss and can also appreciate substantially once the market recognizes the company’s economic value. For example, if we buy a company for half its intrinsic value, 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 narrowing of the gap between the purchase price and the intrinsic value, while one-third comes from the business’ value growing.

We are long term holders of stocks even if fully priced as long as the intrinsic value grows at an average of 15%. Generally, we will sell if the business materially deteriorates, if we disagree with substantive management actions, if we find we have erred in our evaluation analysis or if new unfavorable material facts come to light.

In the Concentrated Value Strategy, investors enjoy the benefit of a well-defined fundamental investment strategy that leads to the construction of a focused equity portfolio comprised of a small number of only the highest quality stocks.