Equity Income & Capital Appreciation Strategies
A Tough Start to the Year

The drop of 9.45% in the Standard & Poor’s 500 index during the first quarter was an admittedly grim start to the new year. This decline put Oakwood clients into a new reality following five years of buoyantly bull markets. Now is the cycle’s tough time—requiring investors to hunker down, a message we playfully address in the Word from the Advisor. The surfeit of scary statistics might spur the bravest of investors to stash the cash under the mattress, to which we say: resist! We see a stock market that has recovered smartly from its lows, and a boom whose frothy exuberance has been well wrung dry. When you consider the S&P 500 from its October high to its recent low, you see an approximate 20% decline. This is the perfectly normal process by which markets shake out the excesses and form new foundations on which to build and advance. While higher volatility may continue and the markets may test the lows again, we expect improvement over the coming year.

Yes, there has been pain and suffering. Yet by applying our skill, Oakwood clients were spared the hardest knocks. Our quarterly results fared considerably better than did overall market performance. While the S&P 500 and Russell 1000 Growth Indices were both down around ten percent, our Equity Income and Capital Appreciation portfolios declined only modestly, healthily outperforming their benchmarks.

The most dramatic event of the quarter took place on March 16th, when concern over sub-prime mortgage lending took alarming form in the collapse of one of Wall Street’s most formidable houses, Bear Stearns Co. Dangerously exposed to mortgage-backed security debt and lack of liquidity, Bear Stearns may not be the last fatality of the sub-prime debacle. The story here is still unfolding, so, please stay tuned.

Unparalleled rescue actions by the Federal Reserve and the U.S. Treasury shored up the financial system in the short run, but doubts still linger about the U.S. economy’s health and the stock market’s direction. The “R” word is now openly discussed, even by Chairman Bernanke, with the only debate over how long and how deep a recession. Equity investors are buckling their seatbelts across the globe to withstand a bumpy ride.

Wall Street’s optimists believe that a turning point will arrive sooner rather than later, thanks in large part to the coordinated efforts of the Fed and the Treasury to stabilize the financial system and reduce short-term interest rates. There seems to be a concerted effort in both Washington and New York to rebuild confidence in the system.

Pessimists contend that the pain has just begun, with job losses and home price declines accelerating. Meanwhile, raw material and energy costs remain stubbornly high, despite a slowing economy that is pinching consumers and crimping corporate profits.

Our Take on the Economy

Although they are clearly synergistic, the two sets of issues confronting the equity investor are in fact separate: those of the financial system and those belonging to the economy per se. As the year progresses, we believe emphasis will shift from the financial system crisis to that of the overall economic cycle.

Given the data, we do concur that recession is upon us—factory activity is soft, confidence numbers imply deep consumer recession, the central bank is still getting minimal traction, durable goods reports are soft, the home price index is in decline, profits are running at their slowest pace since 2001, and jobless claims are rising. Altogether, not a pretty picture.

Our expectation is that recent government tax benefits and the actions of the Federal Reserve and the Treasury can help soften the severity of the downturn by the end of the year. We also have the upcoming taxpayer “stimulus” check intended to spur consumer spending that may get channeled instead into paying down the family debt.

An additional stress facing the economy is the credit market crunch. The Federal Reserve and the government are finally coming together to offer help to the credit market. The lowering of the Fed funds rate, the opening of the discount window to banks for non-liquid assets and the change of Fed policy to allow financial institutions to collateralize non-liquid mortgages, and the changing of the equity requirements for Freddie Mac and Fannie Mae to 20%, down from 30%, will go a long way to ease the strain in the credit markets.

Another area of concern is consumer debt. The consumer has piled on additional debt during this cycle so that the ratio of interest and principal payments to after-tax income is now close to an all-time high of 14.3%, which is one-third higher today than this ratio was during other periods when interest rates were in double-digits.

Inflation pressures continue to mount as evidenced by higher consumer price index (CPI) rates which are being pressured by rising commodity prices. We believe the Fed has placed their charge to fix the economy first before addressing the inflation rate. One key issue is import prices; for example, import prices from China (now approximately 15% of U.S. imports) continue to move upward adding to the inflation pressure.

The combination of slow/negative economic growth underpinned by weak housing fundamentals, credit strain, asset deflation and weak employment may continue to keep interest rates in check.

Whither the Stock Market?

From a historical standpoint, valuation metrics – price-to-next twelve months estimated earning (P/E), price-to-sales (P/S), dividend yield (DY), price-to-cash flow (P/CF), and enterprise value-to-earnings before interest, taxes, depreciation and amortization (EV/EBITA) - do not show the market as overvalued. But with a slowing domestic and international economy, earnings are questionable. Thus, the current quantitative ratios may be generous. As a result, markets continue to be volatile.

Smart Thinking

We took positive and thoughtful actions during the quarter to protect and advance the interest of our clients, and it worked. Our overweighted position in healthcare proved a good thing, as several names outperformed nicely. Our best performer, with a positive return in the quarter, is the designer/marketer of orthopedic products including reconstructive implants and fracture management devices. Also catching the growth wave of the healthcare sector is a manufacturer of specialized medical devices and diagnostic imaging agents. In general, we do prefer equipment manufacturers and health management providers to pharmaceutical stocks.

During the last half of 2007, we were substantially underweighted in financials. We continue to underweight financials in the quarter although there are some high quality names that are becoming attractively priced. Consequently, we recently added a banking name to our portfolios. The bank is a diversified global financial services company headquartered here on the West Coast with operations around the world. It’s the fifth largest US bank by assets, the ninth largest in the world by market cap, and the only bank in the United States to be rated AAA by S&P. We may add an additional financial security to client portfolios in the coming quarters.

Energy is another area we want to continue to overweight and we are once again attracted to companies that deal in magnesium, uranium, and copper.

Caution Ahead

Because of the uncertainty of valuations, we remain extremely cautious in our investing, preferring to broadly diversify and overweight the healthcare and energy sectors. In summary, our Yellow Brick Road may not glitter and sparkle with MGM Technicolor, but our underlying approach to wealth management remains strong.