Equity Market Strategy
Looking for Opportunities

There are still ample opportunities for disciplined investors, despite developments in the economy that represent a substantial change for investors that are accustomed to a backdrop of strong economic growth and low inflation. The current valuation and earnings picture remains mixed with:

• Elevated wage pressures, but solid productivity trends that offset higher input costs;
  
  
• Decent earnings growth expectations, but mounting margin pressure from energy prices and interest rates; and,
  
  
• Solid corporate spending but multiple headwinds facing consumer spending.

All of this adds up to a more cautionary stance and a shift to more defensive portfolio construction. As always, our research effort is focused on identifying undervalued companies that have competitive advantages that will create long-term returns for shareholders. We buy when the fundamentals of the company and the price of the stock dictate a buy, and we view the stock as having the potential to add value to the overall portfolio. Adhering to this discipline, we have been emphasizing undervalued companies with strong free cash flows, which can outperform in the face of a slowing economy.

We remain overweighted in the Energy sector, which waned in the second quarter, declining mainly in the lower quality gas-related companies, companies not held in Oakwood client portfolios. We remain committed to this sector, as the long-term macroeconomic and political variables have not changed. The ever-increasing global energy insecurity evidenced in virtually all the major producing countries – Iran, Iraq, Nigeria, Venezuela, Russia and Saudi Arabia - remains pervasive. The long term demand/supply equation for oil and natural gas remains drastically imbalanced, as the supply of oil in particular is constrained by the world’s inability to produce and refine enough product to meet demand.

During the quarter, natural gas prices disconnected from their historic relationship to oil prices, creating huge discounts in certain stocks. We added a leading North American gas producer late in the quarter, at its price bottom and the stock is up strongly. This company not only has excellent long term natural gas reserves which should produce superb cash flows in the rising price environment we foresee over the next 10 years, but also is an attractive candidate.

We have added positions in the Consumer Staples sector, which includes companies that sell food and beverages, household items, and other goods that consumers continue to buy even in a less than robust economy. A global marketer of beverages with 17 of the top 20 brands, strong free cash flow and a solid dividend was purchased at a discount from its intrinsic value during the second quarter, as was the dominant marketer of sports footwear with the same characteristics. Both firms have strong share buyback programs in force, and managements that have clearly demonstrated their alignment with shareholders’ best interests.

Although we have been underweighted in Technology for some time, as it is difficult to find companies that provide long-term investment opportunities for clients on a risk-adjusted basis, we believe the avoidance of technology-related companies makes particular sense at this time. Technology companies’ fortunes tend to rise and fall with the prospects of the economy, and in a slowing economic environment, they vastly underperform the market.

The chart below depicts the relative performance of the Consumer Staples and Technology sectors going into, and coming out of, the “tech bubble.” As shown, if you owned Technology but no Consumer Staples in the late 1990s, you’d have little reason for immediate concern. But by the early 2000s, rising Consumer Staples stocks provided an updraft to your portfolio, helping weather the sharp downdraft in Technology stocks.

Although we do look at various sectors and their historical performance during different phases of the economic cycle, our main research effort focuses on a company’s fundamentals, which includes their business model and their management. A result of this effort has unearthed several companies which we like not only for their underlying financial quality, but also for their managements’ attempts to reduce their cyclicality, despite being categorized in a traditionally cyclical industry.

One example of this is a media company which has grown to become one of the biggest companies in its industry on the planet. Today, its businesses include newspapers, movie and television studios, television stations, cable networks, and satellite television providers, just to name a few.

Its business and geographic diversification—with assets in Asia, Europe, South America, Australia, and North America—puts this company in a position to weather challenging economic times relatively well. While the market in general has soured on “old media” assets, this company in particular generates generous cash flow from its newspaper businesses and television stations.

In the Consumer Cyclicals sector, we reduced position sizes in a superb energy-efficient automaker when its stock price ran up, although we continue to hold a smaller position for the long term, and in a dominant retailer. A Hispanic Television network we purchased some time ago was partially sold, delivering a superb realized return to Oakwood clients.

To further address risk management in our client portfolios, we have, in certain instances, decreased position sizes and are in the process of increasing the number of positions in client portfolios. This greater diversification, by definition, decreases volatility.

While there are challenges in the current market, we believe there are positive opportunities for the rest of the year ahead. 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 which are trading at attractive valuations.