Equity Market Strategy
The Spring Brings Mood Swings

Benjamin Graham, in Chapter 8 of his classic, The Intelli-gent Investor, created the manic-depressive character Mr. Market, and he was indeed manic and depressive in the first quarter of 2005. Mr. Market appears every day and offers you a quote on every stock. When he’s scared, he’s afraid you’ll sell him your shares so he offers you a low price. When he’s euphoric, he offers a sky-high price. The critical advantage a disciplined investor has is that they control their own reaction and response to Mr. Market’s offers. A successful investor has the skill to properly assess the value of a company and its stock from their own analysis and study. Price fluctuations merely provide investors with options: They can sell when market prices are too high relative to their value, and they can buy when the market price falls sharply below their value.

The first quarter of 2005 proved a challenging experience for all investors, even the most disciplined, in virtually all asset classes. Despite solid growth and another positive outlook, albeit slowing for corporate earnings this year, the equity markets failed to gain consistent traction during the quarter. High oil prices and the related concerns for inflation, interest rates, and corporate profit margins dominated market sentiment, with the equity market, as measured by the S&P 500 Index, finishing in a negative position for the quarter. Ironically, earnings estimates have been revised higher in recent weeks. With productivity growth generally continuing to contain unit labor costs, companies appear to be regaining some pricing power, which could mitigate any erosion in profit margins stemming from rising input costs.

Our inflation expectation is in the 3.0% range this year, and a good portion of it is already priced into both individual sectors and the overall market. Our focus is on unanticipated changes in inflation, and how these changes could affect our investment universe. We are continuously screening our companies to evaluate how unanticipated increases in energy, commodity, and other costs are affecting their bottom line. We spend a lot of time focusing on the downside in evaluating stocks.

We like companies that are capable of taking any increases in their cost inputs and passing them on to their customers. Of course, there is no such thing as perfect pricing power since no company produces a product that is perfectly price inelastic. However, through our rigorous stock selection process, we are able to identify those companies that display a good degree of price inelasticity, with an example being the health care coverage companies and HMOs in Oakwood client portfolios. These companies are able to pass along their cost increases by increasing their premiums, without sacrificing their customer base.

Our selectivity of stocks in the healthcare sector paid off as each healthcare issue outperformed the market in the first quarter. These stocks performed well this quarter and will continue to perform well due to attractive valuations and earnings growth rates that are perceived as not being subject to the cyclical concerns of the market place. We have avoided owning the pure play pharmaceutical stocks, an area that has been in a secular decline in recent years. Pharmaceutical stocks are struggling with substantial structural issues. These include declining sales per unit of capitalized research and development, political risk, since 80% of the industry’s global profits come from the US, loss of pricing power as the government becomes a larger buyer of pharmaceuticals, and a number of branded drugs coming off patent in the next few years coupled with a weak new product pipeline.

While high energy costs have spelled trouble for parts of the financial markets, record-setting crude oil prices have fueled strong earnings growth at many energy companies and sent their stocks up sharply. Energy prices can be quite volatile in the short run, and we may very well see a pullback in oil prices and energy stocks. This pullback would be a result of profit taking and a seasonal drop in energy demand between the end of the winter heating season, and the start of the summer air conditioning and vacation travel season.

Oakwood made large investments in energy companies a few years ago and these have proven to be very successful. As prices rose, our calculated future returns on the high quality, smaller energy companies in client portfolios diminished greatly, even after assuming current oil prices in the mid-$50’s for the next ten years. As these projected returns diminished and our evaluation of risk to these stock market prices increased, we recently sharply reduced our holdings.

The energy sector is about to change. The dynamics of global energy consumption add up to the fact that an additional 6% to 7% in new oil production must be found, developed and brought to market each year to meet global energy demand. This is a difficult challenge for the energy industry, and one of the reasons that we will likely see more consolidation in the industry. Recently, the energy sector as a whole has participated in the sharp run-up in prices, but we are entering an era where you can’t just buy the sector and watch it go up. Our security selection process has always been the key to our success and, in this period of industry consolidation, we will continue to identify which companies will win and lose.

An illustration of a company currently in specific client portfolios that has a unique competitive advantage is a significant energy company participating in the natural gas area. This company has underdeveloped gas leases in the Pennsylvania area. As its customer base is located mostly in the Northeastern and Midwestern United States, its physical proximity to these areas provides it with an advantage over its competitors in delivery of the end product.

Another example of the type of company that we favor is a mining company whose ability to cover its costs of copper mining with gold production basically has created zero cost production of a commodity. Like the energy company, its major mining operation is in close physical proximity to one of the world’s largest consumers of copper, China, providing it with a distinct distribution advantage as well as a cost production advantage.

One of the attractive multinational companies broadly held in client portfolios is a firm that, through its operating companies, is the world’s most comprehensive and broadly based manufacturer of health care products, as well as a provider of related services, for the consumer, pharmaceutical, and medical devices and diagnostics markets. This company, which employs over 100,000 men and women in over 55 countries, truly touches everyone’s life in all parts of the world, and has extremely strong branding and customer loyalty.

A fine financial firm owned in some client portfolios fell sharply this quarter. Nothing had changed fundamentally in the quality of the business. It maintains a strong franchise with a durable competitive advantage with strong pricing power. The management founded the company and has run the business for the last 33 years, and remain large shareholders. The company’s performance remains at the top of the largest 100 financial firms. Its industry is in recession and other companies have suffered major declines in their earnings and their stock prices, while this company has continued to grow its earnings and perform consistently.

What changed for this company this quarter was the market perception. Analysts have questioned the integrity of management and their accounting, and they believe that management must implement a plan to make the complexity of their business transparent to the market, so that the intrinsic value of their business becomes clear. Oakwood knows the firm inside and out and has exhaustively valued its stock, and currently believes its intrinsic value to be a large multiple of its price. Currently, we remain confident in the integrity and competence of the Board of Directors and management, as well as the durable competitive advantages of the business. We believe the price of the stock should recover and continue to improve.

In additional to other fundamental measures, the decisions that a company’s management makes with regard to shareholders’ cash flow are extremely important. Is management investing it wisely at a high return, paying a dividend and/or buying back stock, or are they utilizing it in a self-serving manner, by increasing their own salaries and perquisites? A shining example of a company that, in our opinion, wisely utilizes the shareholders’ cash flow is one of the largest US natural gas and oil storage and transportation companies, broadly held in Oakwood client portfolios. This high-integrity company is run for the benefit of the shareholder, with executive salaries capped at $200,000 with accompanying modest benefits. Essentially, the management makes money as the shareholders make money.

Oakwood’s goal is to build our client’s net worth. We select the finest, highest return on capital and return on equity companies, and seek to maximize the long-term growth in intrinsic value for client portfolios, which we believe is ultimately recognized by market prices. For example:

• We calculate ten year earnings and dividend yields of each company, as a way of maximizing the yield on our client’s assets;
  
  
• We calculate both five and ten year compound annual rates of return for each potential holding and seek to maximize the return of each client’s portfolio in each Oakwood strategy;
  
  
• We calculate predictable free cash earnings and cash requirements for growth; and
  
  
• We stringently evaluate the durable competitive advantage, and the management of the companies we own.

Our process is proven over the long historical records of our strategies and in the satisfaction of our clients in our prudent investment process and growth of their assets. Oakwood’s entire professional investment group has a substantial portion of their own net worth invested alongside our clients. We are confident of our investment process and adhere strictly to our discipline, despite Mr. Market’s mood.