A Word From The Advisor

Endurance is a quality better suited to athletes than investors. Headline-grabbing accounting irregularities, allegations of corporate malfeasance and terrorist threats have recently overwhelmed a better economy and improving earnings prospects as the primary drivers of stock prices. Consequently, the market this past quarter turned in its worst quarterly results in thirty years. In addition, the market entered its third year in a bear phase and worried investors, tired of simply enduring, are wondering what could turn things around.

At issue is the urgent need to boost investor confidence by restoring trust in the system. We think that the first step in this process was the announcement by the Securities and Exchange Commission (“SEC”) last week that corporate chief executive officers (CEO’s) and chief financial officers (CFO’s) must henceforth sign oaths of the accuracy of their financial statements no later than their next SEC filing or face civil and criminal penalties. This announcement not only holds the feet of corporate officers to the accounting fire but also shows that Washington means business about restoring public confidence in the marketplace.

The second positive for the market at first blush actually seems negative; that is, that so much bad news has hit the market - the earnings and capital spending recession, the technology meltdown, the 9/11 terrorist attacks and corporate conduct issues, to name the most damaging - and the market has reacted negatively for so long that it may now have fully discounted most of the bad news. Even today’s seemingly endless barrage of bad news, which is now swamping the marketplace, can be reversed by a single event, as has happened many times in the past. Market psychology plays a critical role and can change the direction of the market on a moment’s notice.

Finally, the improving economy and better earnings comparisons going forward are the most important positives for the stock market. Throughout this market outlook we point out that the U.S. economy is showing numerous signs of being on a sustainable upturn and that corporate earnings will shortly begin to show positive comparisons. These events, ordinarily very positive for stock prices, have heretofore been ignored and it is our belief and expectation that this will not continue. To those who point out that valuations remain high we note that the market is currently selling at a little over 17 times next year’s expected earnings, not much higher than the long run average price/earnings ratio of the market.

With all of these potential positives why do we continue to feel so bad?
The short answer is: terrorism. Investors in the U.S. have adopted a totally altered view of terrorism post-9/11/01. The U.S. may have been long overdue to fully understand the appropriate sense of horror evoked by such activities but the net market result has been the building of a substantial but largely unquantifiable “terror discount” into stock prices. While our society is likely to adjust over time, as other societies have done, to the long term specter of terrorism, the impact on the stock market is likely to be the removal of the upper few points of attainable multiple from the market’s price/earnings ratio. Since the upper end of the range is probably 28 - 32 times and since the net effect is not entirely quantifiable, suffice to say that the high end of the P/E range for the S&P 500 this cycle is not likely to be attained. However, there is still plenty of room for price appreciation from current levels.

What is the story with all the accounting irregularities?
The financial statements of all publicly traded companies purport to conform to “Generally Accepted Accounting Principles,” or GAAP, as promulgated by the American Institute of Certified Public Accountants (“AICPA”), the Financial Accounting Standards Board (“FASB”) and their predecessor organizations. As part of their engagement by the company to perform an audit, a public accounting firm agrees to render an opinion as to whether or not the financial statements of the company are “fairly presented” and are in accordance with GAAP. The auditing firm does not act as a guarantor of the financial statements. The public accounting firm also does not certify that the financial statements are accurate, are free of fraud, are complete, don’t contain material misstatements or that all disclosures have been made - only that they are “fairly presented, in all material respects, in conformity with Generally Accepted Accounting Principles in the USA.”

Users of financial statements need to understand that there is frequently room for interpretation with many of the GAAP. For example, two companies in the same industry can have somewhat different approaches to the recognition of revenue and still be in conformity with GAAP.

The real responsibility for the completeness and accuracy of financial statements lies with the Boards of Directors of the corporations and the officers to whom that authority is delegated. The SEC recognized where responsibility lies with its mandate that CEO’s and CFO’s attest going forward that their financial statements are accurate. Corporate officers have a vested interest in clarifying obfuscated and ambiguous financial statements as some GAAP practices have become litigation risks to which no corporate board wants to subject itself. In fact, we can expect a rash of restatements, some of which could exacerbate market volatility, in the near term. As financial analysts, however, we welcome any incremental disclosure that adds clarity to the chief vehicle of communication between American corporations and their stakeholders.

With Wall Street analysts under fire for lack of independence and potential conflicts of interest how much does Oakwood rely on their opinions and recommendations?
Because of their access to all levels of the companies they follow, Wall Street analysts do excellent industry work and provide very thorough basic company reports. Oakwood’s equity department obtains a wealth of information from digging through these reports, much of which is useful in analyzing financial statements or in interviewing company management. However, we ignore completely any outright recommendation made on the stock as a result of these reports, especially if made by an analyst who works for the company’s investment bankers. In fact, so common is the Street analyst “buy” or “strong buy” recommendation that we have always given Wall Street’s actual recommendations no weight at all in our investment process.

Why not just sell completely out of stocks until it’s time to get back in? What is being asked is, why don’t we market time and, in our view, market timing is folly. The reason it is so futile is because it requires the necessity to be correct four separate times. First, one has to be correct in choosing what to sell. Secondly, whatever is sold must be sold at the right time. Third, one has to choose the right time to buy, that is, getting back into the market. Finally, one has to be correct in choosing what to buy. The chances of optimizing all four of those decisions, particularly in news-driven and volatile markets, while staying within the confines of one’s long term objectives, are impossible.

The Standard and Poors 500 (“S&P 500”) generated a 17.5% compound annual rate of return for the 10 years from 1991 through 2000. Missing just the thirty-one best days would have reduced that return to 6.4%. For the five years ended December 31, 1995, the S&P 500 generated a 16.5% compound annual rate of return. Missing just the twenty best days (four days a year) would have reduced that return to 7.3%. Another way to look at it is to ask whether or not a market timing investment manager would have correctly identified the 20 days that made up nearly 60% of the return of the market for the five year period and ensured that all portfolios were properly positioned to benefit. In the absence of such a conviction, it appears best to remain a market participant. Thus, market timing is not the route to maximizing stock market returns.

In the case of most shocks to the market in recent history, prices move up off a bottom rather smartly and have usually been higher six to twelve months later. However, the current environment shows little sign of such a turn and will require further patience. Recalling that market timing is not a solution the prudent investor will re-examine his or her objectives, determine whether or not they have changed, check to see if his or her portfolio is properly positioned relative to those objectives and resist the temptation to make changes based solely on emotion. If you feel that we can be of assistance in any portion of this process, please don’t hesitate to call.