Equity Market Strategy

The current challenge facing all stock market investors is how to react to a stock market in a trading range, such as the one the stock market is currently experiencing. The comparatively smooth solid uphill one-year run of the S&P 500 Index from March 2003 to March 2004 has given way to choppy waters, with the index trading in a 5.5% range, between 1090 and 1150. The biggest contributors to these short-term movements have been oil prices, inflation, and interest rates. On days with higher oil prices or more aggressive comments from Fed officials, inflation and interest rate fears have driven stocks lower. On days when oil prices have retreated or the inflation outlook has seemed benign, stocks have gained. The ending tally shows the S&P 500 Index’s return of the second quarter exactly matching the first quarter’s 1.7%, with a year-to-date return of +3.4% through June 30, 2004. The Dow Jones Industrial Average returned a positive 1.2% for the second quarter, giving it a year-to-date return of +0.8%.

Investors have been treading water, holding back ahead of the widely anticipated June 30th interest rate hike and worries about inflation. With this rate hike over, investors continue to hold back, focusing intently on economic and corporate announcements. Although few major companies have predicted bad earnings, the warnings that have come from several small and midsize technology companies regarding disappointing sales and earnings in the second quarter have dampened investor enthusiasm. Compounding this is the constant stream of news flow that stems from terrorist threats and geopolitical concerns based in part on a continued US military presence in Iraq and Afghanistan. All contribute to investor uncertainty, which in turn impacts the stock market.

While a number of exogenous factors may figure in the securities markets’ performance for the rest of this year, it is important to take a step back and evaluate the underlying fundamentals that drive stocks over the long term. The most significant change we have seen year-to-date is the upward revision in earnings. Earnings, which exert a powerful force on valuations and prices, are not only rising at a healthy rate, but the rate of growth has been increasing as analysts have upwardly revised their estimates for 2004 and 2005. At the beginning of the year, the estimate for earnings growth in 2004 by Wall Street strategists was 12%, now strategists are projecting a 16% increase. Likewise, earnings estimates for 2005 have risen from 7% at the beginning of the year to 9% now.

Oil prices, after rising from about $29.00 per barrel a year ago to a high of $42.32 per barrel in early June, have now settled into a range between $36.00 and $41.00 per barrel. While higher energy prices can act as a drag on profit growth, the growth in oil prices in the last year has primarily been driven by global demand, an indication of increased business activity. We found good value in some great energy companies last year. We continue to overweight, in client portfolios, the energy sector versus the S&P 500 Index, given the higher oil prices and healthy refining margins, as well as a significant increase in earnings estimates in energy companies.

In the financial sector, we are seeing upward, although more modest, earnings revisions as well.  The financial sector can be sensitive to near term changes in interest rates, so we’ve been slightly underweighted with the exception of the Equity Income Strategy, which focuses on dividend paying stocks trading at attractive values. Our carefully selected issues in the healthcare industry display the characteristics that define our investment approach: very attractively priced companies with good earnings growth prospects that are not sensitive to near-term economic events. This allocation in the second quarter added to the positive return in client portfolios. In the Consumer Cyclicals and Industrial Products and Services areas, we have a positive outlook for the companies we own because of our favorable outlook for the economy, consumer spending and capital investment. Technology is one sector where we are underweighted versus the index, and our decision has been confirmed, based on valuations and recent earnings guidance.

It’s important to keep in mind that all strategies are driven by individual company fundamentals as well as macro-economic and industry considerations.  At Oakwood, our fundamental investment approach is based on achieving superior long-term performance by acquiring equity securities of financially strong, well-managed companies run by capable managements at market prices significantly below our assessment of their business, or intrinsic value. Our focus is on companies that sustain high return on equity, high return on capital, and predictable free cash earnings. This results in portfolios constructed of companies with financial strength that can maintain their profit margins, in the presence or absence of inflation. These companies, due to the strong franchise nature of their businesses, have the ability to pass along cost increases to their customers in the form of higher product prices.

In this world of uncertainty, the higher quality and lower historical volatility of the stocks that comprise Oakwood client portfolios provide a sound foundation for the remainder of 2004 and beyond. Although the market is digesting concerns, continued improving earnings and valuations will provide strong footholds for a positive stock market in 2004. Stocks have historically performed well in the months following a trough in the Fed Funds rate. In addition, the S&P 500 Index is already trading at its lowest price-to-earnings level in five years, as shown in the following chart.

Robust top-line growth, as well as strong productivity gains, could push earnings growth further. If stocks remain in a trading range for the near future, continued growth in earnings will lead to more price-to-earnings ratio compression, setting the stage for the next leg up in the market. The better performing stocks this year are companies with long-term track records of delivering actual earnings-per-share growth, many of which are owned in Oakwood equity portfolios. In contrast, recent past periods have favored more speculative companies with high potential for earnings growth versus actual growth.

We will carefully manage through the current environment by continuing to focus on owning companies with positive cash flow characteristics, strong returns on capital, increasing dividends and healthy earnings growth prospects trading at attractive valuations. We are long term holders of stocks even if fully priced as long as the intrinsic value grows at an average of 15%. We will sell only if the business or management materially deteriorates, if we disagree with substantive management actions, if we find we have erred in our evaluation analysis or new unfavorable material facts come to light.