Global Equity Strategy
Going Global
T.S. Eliot once wrote that April is the cruelest month, but March 2007 was certainly no picnic for investors. After the markets surged to start the year, later in the quarter many Asian markets plummeted. The Shanghai Index, which is a measure of China’s stock market, dropped 9% in one day, causing a rippling through all global markets, including the US. The US market bellwether, the S&P 500 Index, dropped 3.5% that day. It is a well-established fact that in times of “market shock”, the correlation, or synchronization, of markets increases, and this “global selloff” was no exception. It is interesting to note, however, that since this event, the Shanghai Index has recovered, and actually reached new highs, while the US market continues to struggle. Markets’ ability to recover varies by region for various reasons: the state of their economy, governments’ willingness to intervene, investor psychology, to name just a few. This de-linkage of market performance by region after a shock provides a compelling reason to invest globally.
The “flight to quality” stocks held in Oakwood client portfolios demonstrated their value when the market took its downturn. Oakwood Equity Strategies held strong while the general market dipped, and are outperforming year-to-date. Oakwood’s Structured Global Strategies held their strength through this tumultuous period, and are also outperforming to date.
The US equity market is wrestling with its economic outlook, and the subsequent potential impact on corporate profits and valuations. The door is open for a possible interest rate ease later this year, if the economy slows further and/or core inflation recedes in coming months. Stocks typically do well during midcycle slowdowns, as a pullback in demand relaxes inflation pressures and allows for lower interest rates. Knowing the stock market anticipates 6 to 9 months forward, the market may only have a modest correction as it anticipates lower interest rates to stimulate a pickup in the economy.
We continue to emphasize asset class investing in global markets, and on the domestic side, favor sectors and companies with consistent free and growing cash flow. We are well diversified, and are currently overweighted in the following US market sectors:
Energy. Over the past few months, the short-term outlook for North American natural-gas producers has improved. Last fall, a gas storage overhang resulting from a warm winter pulled the price of natural gas below our long-run estimate while drilling and service costs continued to rise. Both factors weighed heavily on gas producers’ profit margins. Recently, these pressures abated as a frigid February helped draw down gas storage, and reduced activity helped stabilize drilling and service costs.
A large global player in the oil and gas industry in client portfolios is the third-largest energy company in the US. It is well positioned to benefit from a trend toward wider spreads between the cost of lighter, high-quality oil and heavier, lower-quality crude oil. Its investment in a well-established Russian oil giant grants this company access to significant hydrocarbon reserves with large upside potential.
Telecom. Mergers in the telecom world have exploded in the last couple of years. We expect the recent pace of merger activity to continue. Despite a slowdown in the fixed-line phone business from increased competition from other services, and pressure on wireless interconnection rates by government regulators, telecom firms continue to generate significant amounts of cash flow. Most firms have increased dividends but still have excess cash. In order to boost growth rates, these firms are looking at acquisitions to increase growth.
Rural phone companies similar to our Oakwood client portfolio holding have garnered attention in recent years as safe havens in the telecom industry. The revenue opportunity in small markets often isn’t large enough to attract as much attention from rivals, and regulations can provide more insulation from competition than in urban areas. Wireless service is also sometimes spotty, making fixed-line service more attractive. As a result, this Oakwood telecom company has been and is currently generating steady cash flow, which it uses to pay a large dividend.
Industrials. We have been pleased in recent quarters by the resilience of many of our industrial holdings. By and large, raw-material and manufacturing production have remained strong, particularly in chemicals, building materials, metal products, machinery, and transportation equipment. On top of that, firms have enjoyed steady, and in some cases, improving pricing. Even with the potential for the US economy to slow further in 2007, international economic expansion keeps demand steady.
A portfolio holding in this sector has a strong global presence that has allowed the firm to weather sluggish domestic demand. Its products that have reached maturity in the US still have significant growth potential internationally. This company recently announced a $7 billion two-year share repurchase program and raised its quarterly dividend 4.3%. We’re pleased to see that the company is proactively returning cash to shareholders rather than potentially pouring it into value-destroying projects or acquisitions.
Consumer Staples. We continue to see the potential benefits of our overweighting of the consumer staples sector as the overall market experiences an increase in volatility. This traditionally defensive group provides some measure of protection against further selloffs. Additionally, we continue to believe that the combination of the impact of a slowdown in housing, combined with the accumulated affect of the Fed rate hikes, could potentially lead to a greater economic slowdown than the market is now expecting. Should this come to fruition, it should help to support this defensive sector as we go through the year.
A client holding in the consumer staples sector was recently successful in acquiring a dominant mail order pharmacy company. We like the acquisition, which will ultimately create shareholder value through economies of scale and a more compelling offering to health plan sponsors. This company will also realize growth through an increased demand for generic prescriptions. We expect the multiple to increase to a more normal P/E ratio, as investors appreciate the acquisition.
Our overweighting in real assets, which include domestic oil and gas reserves, hydroelectric and nuclear power, gold and copper and real estate, will continue to contribute to portfolio returns. New data show the tight balance between oil and gas supplies and demand becoming more critical, as massive Saudi Arabian production reaches its peak. As natural resources continue to become more scarce, our portfolios are positioned to appreciate. We take comfort that our clients are well protected by these real assets, which also protect against the falling dollar which will accompany these trends.
Often, allocating a percentage of your managed equity strategy to investments in other markets helps reduce long-term volatility and allows you to capitalize on some great non-US companies. The investment alternatives that we use to accomplish this are the Oakwood Structured Global alternatives, along with exchange-traded funds (ETF) alternatives. These help provide diversification into developed and emerging economies of our increasingly globalized world.
For exposure to non-US markets, alternatives made available through the Oakwood/DFA alliance are the International Core Equity Portfolio and the Emerging Markets Core Equity Portfolio, exclusively available through registered investment advisors such as Oakwood. The goal for the International Core Equity Portfolio is to invest across the entire developed international market and to integrate target weights efficiently to achieve a higher exposure to small cap and value stocks relative to the market. The goal for the Emerging Markets Core Equity Portfolio is similar, with the emphasis on sixteen emerging markets. The Oakwood/DFA portfolio construction method casts a wider net by starting with the entire international market universe.
Oakwood/DFA engineering and trading expertise results in both the International Core Equity Portfolio and the Emerging Market Core Equity Portfolio’s broader and more efficient exposure to the risk factors that we believe drive higher expected returns. The International Core Equity Portfolio currently invests in companies in Australia, Austria, Belgium, Canada, Denmark, Finland, France, Germany, Greece, Hong Kong, Ireland, Italy, Japan, Netherlands, New Zealand, Norway, Portugal, Singapore, Spain, Sweden, Switzerland, and the United Kingdom. The Emerging Markets Core Equity Portfolio currently invests in Brazil, Chile, Czech Republic, Hungary, India, Indonesia, Israel, Malaysia, Mexico, Philippines, Poland, South Africa, South Korea, Taiwan, Thailand and Turkey.
With respect to ETF alternatives, we have singled out, in particular, the Morgan Stanley Capital International (MSCI) Europe Australasia Far East Index Fund, or EAFE Index, which is the second largest ETF overall with about $31.2 billion in assets, and the iShares MSCI Emerging Markets Index Fund, with about $12 billion in assets.
We believe that the use of Oakwood Structured Global alternatives, along with ETFs in your portfolio will provide additional diversification as well as the potential for increased returns. We intend to add these alternatives to your managed equity strategy this year. Please contact us if you have questions or objections about using any of these alternatives. We welcome the opportunity to further discuss how Oakwood’s range of structured and managed portfolios can provide you with a targeted focus that is tailored to your personal investment goals.
