Equity Market Strategy
We're Cautious and Selective

The positive economic backdrop that we are currently experiencing creates, in many respects, a favorable outlook for equity market performance for the remainder of the year, despite quite modest Wall Street earnings growth expectations for 2005 and 2006. The earnings per share (EPS) growth consensus among Wall Street strategists is 8% for 2005 and 5% for 2006. Oakwood’s view is that the actual growth rates will likely be higher, in the low double digit range of 10 to 12%. Stock prices will get a boost as the lower consensus EPS growth estimates by Wall Street strategists are exceeded. By and large, we expect positive EPS surprises for the remainder of 2005 to help move equity market performance into positive territory.

An interesting phenomenon has been the build up of cash and cash equivalent balances on the balance sheets of non-financial companies. The following graph illustrates this occurrence:

These high cash balances are muting returns on equity due to underleveraged balance sheets and are reducing asset turnover. Corporate managers have accumulated these cash balances over the last five years out of a sense of risk aversion and uncertainty in the wake of the bursting of the 1990’s stock market bubble, the 9/11 terrorist attacks and the war on terror, as well the accounting scandals and incidents of corporate fraud in recent years. While, unfortunately, many of these negatives remain, we feel that confidence will build due to continued healthy GDP growth and corporate EPS growth exceeding expectations, and corporate managers will begin to put this cash stockpile to work.

Positive corporate liquidity could continue to boost merger activity, stock buybacks, cash dividends, and capital expenditures. Merger and acquisition activity has picked up slightly this year; however, corporate managers have generally pursued smaller, safer, non-dilutive deals. Absent major product innovations, most capital expenditures are focused on expanding existing capacity to meet demand and will likely grow in line with revenues. This means that the bulk of the excess cash will be put to work buying back shares and increasing dividends. In fact, with such conditions, it is not surprising to find that the S&P 500 dividend yield has pushed above 2.0% for the first time since 1996. The end result will be a triple benefit of increasing returns on equity (ROE) due to increasing asset turnover as cash balances are drawn down to more normal levels, increasing dividend payouts and increasing earnings per share as shares are repurchased through buybacks.

Our clients recognize that we exhaustively search for undervalued growth and income wherever we can find it. Oakwood is beginning to see the emergence of attractive valuations in sectors and industries where, for some years, we had been
unable until recently to find excellent companies whose prices had come down enough to meet our stringent criteria.
For example:

• Pharmaceuticals: A dominant drug company, whose valuation has suffered due to some patents that ended and to market concerns about the drug business as a whole, finally became cheap enough to meet our criteria. This company has massive balance sheet strength, strong and growing cash flows, a growing dividend and large reserves for any contingent liabilities. We expect its outstanding management to increase returns to investors via increased dividends and continued share repurchases. In fact, soon after our purchase, the company announced a large share buyback. In addition, well executed acquisitions and cost reduction programs and a strong research and development effort make this high return-on-capital firm an excellent long term investment.
  
  
• Entertainment: Rarely do we find an investment that we find suitable for client portfolios in this industry, due to generally poor return on capital and giddy overpricing of most of the stocks. However, the shares of a dominant Hispanic broadcasting company, with a superb shareholder-oriented management that we deeply respect, traded lower and lower in price over the quarter, as the market negatively overreacted to concerns about a dispute with a programming supplier. The company announced its first ever share repurchases in 2004 and 2005 as management, which owns 36% of the shares, took advantage of the undervaluation alongside our purchases. The combination of a rapidly growing Hispanic market, superb operating execution, and owners as managers give us confidence in this company for the long term.
  
  
• Technology: For the last ten years, this technology distributor (unlike most technology companies!) has demonstrated consistently high return on capital, strong and increasing free cash flow and earnings, strong sales growth, and, since 2003, a growing dividend. This company has minimal technology risk, as it sells and installs all technology brands with the exception of Dell, which is a direct marketer. The client base of this company includes state and federal government entities that, in general, have longer and steadier sales cycles than the private sector. Its stock price had been depressed due to short term concerns regarding costs associated with its second warehouse opening to support annual US sales of $6 billion.
  
  
• Manufacturing: The rising prices of steel and other raw materials and the deep malaise of US auto manufacturers drove the price of this superb, diversified, global manufacturer down into our value range. This well-managed firm markets some of the finest products in the auto, small engine and motorcycle markets and manufactures in local markets on a global basis. It holds very strong market share in the huge emerging markets of China and India. Its autos deliver very high gas mileage, an advantage in today’s high gas price environment. The company is demonstrating a new commitment to cash returns to shareholders with substantial dividend increases and share buybacks, neither of which are cultural norms in its home country.

We are quite pleased to find these excellent and growing companies at a value price. For the remainder of 2005, we expect the stock market to provide a few more opportunities for us as diligent seekers of undervalued growth.

We have begun to pare back our overweighted position in energy. While our returns have been excellent, valuations reached such levels that our long term return projections, adjusted for risk, no longer meet our strict valuation criteria.

We will continue to seek to upgrade your portfolios in terms of projected returns and the quality of our holdings, a task that never ends. Although many quality companies are fairly priced in today’s market, we continue to find attractive opportunities to add to your portfolios. While there are challenges in the current market, we believe that on balance the outlook for stocks for the rest of the year ahead is positive. In managing our client portfolios we will continue to focus on owning companies with positive free cash flow characteristics, strong returns on capital, healthy balance sheets, increasing dividends and healthy earnings growth prospects trading at attractive valuations.