Global Equity Market Strategy

The first half of 2007 saw its share of tumult in global markets. Rising interest rates and the US subprime loan crisis roiled international markets, and an exciting presidential election in France gained the world’s attention. Stock markets around the world fell sharply in late February and early March. After dropping 3.5% on February 27, the largest loss in one day since the 9/11 tragedy, the S&P 500 Index roared back to life and now sits 7.0% above where we started the year. The markets appeared to be sputtering in June, but unlike in late February, another tumble in Chinese stocks at the end of May caused barely a ripple on other global exchanges.

Emerging markets continued to lead the way for the first half of 2007. Latin American stock markets, which to a large extent means Brazil and Mexico, have had powerful returns, and so have many countries in emerging Asia. Even China’s market continues to soar, despite government actions specifically designed to rein it in. Most of Western Europe’s markets remained strong, and a slight gain in the euro versus the US dollar added a further boost to returns from all those US-based foreign holdings that don’t hedge much or any of their currency exposure.

By contrast, Japan’s market has lagged. Although the Japanese economy is showing encouraging signs, some investors still aren’t fully convinced. A more specific problem is that takeovers are much more difficult to accomplish in Japan, so the “takeover premium” that has pushed up so many stock prices in Europe and the US is much less common in the Japanese market.

Interest-sensitive sectors of the market have been experiencing volatility, and as such, US REIT prices are down for the first half of the year, after seven strong years of performance. REIT returns have variations through time that are unexplained by equity factors. They don’t behave like other stocks and they don’t fully behave like stock-bond hybrids. Another important factor to keep in mind is that US REITs have a negative correlation to non-US REITs (which means that when one variable increases, the other can decrease). For these reasons, and for their excellent potential to add return over time, REITS as an asset class are an essential component of a well-diversified Oakwood managed global strategy.

On the domestic side, a continuing housing slowdown, and high energy prices haven’t spooked the rest of the economy, which is still solid, though slowing. From an historical standpoint, a spate of US market valuation metrics, ranging from price-to-next twelve months estimated earnings (P/E), to price-to-cash flow (P/CF), among others, show the market as currently fairly valued.

We feel there is remaining strength in the US market and encourage a US bias in global investing, due to the following factors:

• Corporate capital spending discipline in recent years implies that “pent-up” demand will support business investment outlays.
  
  
• Financial conditions are still supportive of growth.
  
  
• Corporate earnings growth will continue, but at a slower pace.

As with other international markets, the US stock market continues to benefit from strong merger and acquisition activity, as both corporations and private equity firms remain active participants in this ongoing trend. US corporate takeover activity is likely to remain high in order to take advantage of a Justice Department that has shown very little interest in getting in the way of corporate marriages. The one caveat to this positive environment is a proposed change in the US tax law which may slow the pace of acquisitions by venture capitalists. However, the United Kingdom has no interest in changing their tax structure for these firms, and has created a business environment that welcomes them with open arms. The result is that many these US-based firms have moved their headquarters to London, circumventing any tax roadblocks to the flow of deals.

We continue to be cautiously optimistic towards the US equity market, although we feel volatility may increase from its current level. Therefore, we remain well diversified, favoring the following sectors: energy, telecom, industrials, healthcare, and consumer staples.

We have increased our technology weighting, adding two companies, both household names, which dominate their respective industries. The first is a company whose sales have grown from $6 billion a short decade ago to nearly $40 billion in its most recent fiscal year, and returns on invested capital have averaged a staggering 77%. This company’s operating margins hover in the high 30% range, and the firm generates more than $1 billion in cash per month. The next addition in the technology sector is the leading payroll and human-resources services firm for small businesses. Its services include 401(k) plan recordkeeping and a newly announced tax credit service, a product that provides small and medium-sized US businesses with an easy and cost-effective tool to help them identify and apply for wage-based tax credits they may be eligible to receive. This company is extremely profitable, and operating margins have been increasing as the firm takes advantage of scale economies. Lower interest rates over the past few years slowed this improvement, although operating margins were still north of 30%.

In the energy sector, we have sold a smaller capitalization company in the oil and gas services industry and bought a larger capitalization company that is the world’s largest land-drilling contractor. With a balance sheet that is in excellent shape, this company’s rig-expansion program will probably be financed with cash from operations. The management team has administered the balance sheet wisely, and its commitment to a strong financial position serves the firm well in industry downturns.

We have begun to increase both our emerging and developed international markets exposure through increased allocations to DFA Funds or Ishares in Oakwood managed Global Strategies to take advantage of diversification benefits and growth prospects.