Equity Market Strategy
Opportunities Ahead

In our last Oakwood Outlook, we published our short list of market-defining items for 2006, which included the end of the Federal Reserve tightening cycle and the continuing instability and underlying secular increase of oil prices. As the first quarter of the year has come to a close, we see these same items at the top of our list, and add to that the high rates of resource utilization and elevated commodity prices that could boost inflation. Despite these lingering uncertainties, stocks picked up in the first quarter of 2006 where they left off in late 2005, potentially setting the stage for a fourth straight year of equity gains following the brutal bear market from 2000 through 2002.

We see continuing, though slower, US economic growth, steady or moderately higher price-to-earnings ratios (P/Es), a slowing in housing activity and moderate increases in core inflation. The corporate earnings outlook remains positive with elevated wage pressures being positively balanced with solid productivity trends, respectable earnings growth expectations, and increased corporate spending. Corporate net cash flows grew by a strong 18.5% on an annual basis. The historically high $2 trillion level of cash on corporate balance sheets has to date been utilized fairly conservatively, but as we progress further into 2006, yielding to shareholder pressure, companies are becoming more aggressive in terms of acquisitions, capital spending, hiring, dividend increases and share buybacks.

Much of the character of the 1980s and 1990s bull market is still in evidence today. Valuations are reasonable, yields are lower, profits around the globe are growing at a rapid pace, excess liquidity is prevalent, productivity still remains strong, innovation continues at a healthy pace, and capitalism is spreading at an accelerating rate around the world. The continuing acceleration of global economic activity this year, as the US economy settles into a more modest rate of growth, will benefit the multinational nature of many of the holdings in Oakwood client portfolios.

Our focused research effort has identified companies that have competitive advantages that will create long-term opportunities for shareholders. We buy when the fundamentals of the company and the price of the stock dictate a buy, and we view the stock as having the potential to add value to the overall portfolio.

A company poised to capture the explosive growth in the Information Technology sector is the king of cell phones, capitalizing on its economies of scale and powerful branding to introduce new phones. This company’s brand has been rated as one of the most valued in the world. Thinking like a consumer goods company, it has segmented the market by targeting different phones to different consumer niches. It has made significant strides in the Code Division Multiple Access (CDMA) market, the one major protocol it doesn’t dominate. Having a strong portfolio of CDMA products will provide entry to the key markets of China, India, and the US. The overall financial position of this company is outstanding. It generates generous free cash flow, much of which it is returning to shareholders via dividends and share buybacks. It also has more than $12 billion in cash and investments on the balance sheet, with almost no debt.

An excellent opportunity we have uncovered in the Healthcare sector is a very well positioned medical device company that has been a going concern since 1906. We like the company’s very high return on equity, return on capital, stable free cash flow, and strong competitive position. The exceptional management of this firm has had the foresight to reinvest cash flow from its mature businesses into value-added products. Over the past two decades, management incurred sizable research and development costs to make long-term commitments to safety-engineered products—which prevent workplace hazards such as needle-sticks—and expand into high-margin, fast-growing areas such as medical devices for diabetes, including blood glucose monitors and flow cytometry. Those investments are paying off, as these products are less than one-third of total sales, but accounted for half of 2005 revenue growth. International markets for safety-engineered medical devices represent its biggest sources of growth. International conversion rates to safety-engineered products from older-generation products are as low as one third the level of the US. This firm’s international safety-engineered sales grew 34% in 2005, to $273 million.

As highlighted in the Word from the Advisor, world energy production is approaching its peak, and reserves are declining each year without replacement. Responding to this reality, we have selectively overweighted the Energy sector. Examples of the types of companies in client portfolios include:

• Domestic production companies with significant reserves and exploration potential. These undervalued companies may be acquired at premiums to their current prices, as major energy companies compete to add reserves as fossil fuels become increasingly scarce.
  
  
• North American natural gas companies. We like these companies because we believe:
  • They have more price leverage than oil oriented companies over the next 5 years, when adjusted for supply/demand conditions;
  • Gas is currently undervalued on a BTU basis versus oil;
  • Gas is the premium, preferred fuel as its burns much cleaner than oil and coal.
    
    
• US and Canadian-based companies. Companies based in North American have a margin of geographic safety, given world geopolitical problems. Foreign oil companies’ assets are at increasing risk due to the instability of their geographic locations.

An example of an energy company widely held in client portfolios is one of the world’s largest independent oil and gas producers. Primarily consisting of natural gas, its US properties constitute 72% of the firm’s overall reserves. Natural gas is the clean, preferred fuel, in general selling at about 20% of current oil prices. Sizable American reserves limit the firm’s political risk and put it in the middle of the world’s largest energy market. We purchased this stock at what we believe to be 60% of its current intrinsic value, and expect its value to increase with rising energy prices. Owning these assets protects our clients from energy driven inflation and from devaluation of the US dollar as well.

We have deliberately sought out and bought companies that will benefit client portfolios by adding value in these more challenging times of global uncertainty. An example of this type is a company that explores for and produces gold, silver, and copper in the Americas and Australia. Gold companies tend to be countercyclical. They also provide an excellent hedge to inflation and geopolitical risk. This particular mining and production company does not engage in the forward selling of gold. This unhedged position allows the company to benefit when gold prices rise. With nearly 2 million probable tons of ore at one of its larger facilities, it has many years of high-grade production ahead of it. Gold has recently run up to $600 per ounce.

We have recently added to client portfolios a world class multinational, multi-industry, media and financing giant that has excellent growth prospects. Corporate managers, especially those who captain conglomerates, must shine at asset allocation, and this company, throughout its long history, ranks among the best. This company invests heavily in research and development ($12.5 billion over the past five years) and has evolved into a technology company with an unmatched breadth of products and services. This company’s genuine competitive advantage is that it is able to use various technologies across business segments.

Another fine company recently added to client portfolios is the most global of the US-based packaged-food companies. It has a strong international presence, with sales outside the US accounting for more than 60% of annual revenue. This company’s brand, which is placed on everything from ketchup to baked beans to baby food, is a $3 billion global powerhouse, accounting for one third of the firm’s total revenue. Having been manufactured and sold in the United Kingdom for more than 100 years, this brand has become a national icon, with many Britons actually believing that it is an English firm. Dominating the ketchup market in the US, garnering more than 60% of retail and food-service sales each year, this firm also controls around 70% of the available market in Western Europe. This company enjoys very stable, high free cash flow in all economic environments. We purchased the stock at a fraction of its intrinsic value and have been pleased to see its market price increase significantly in the last month.

As always, we will continue to look for opportunities to invest in companies where the stock is currently priced at a material discount to the long-term intrinsic value. Our focus continues to be on identifying attractively priced companies with high returns on capital, positive free cash flows and solid earnings prospects with shareholder oriented management.