Equity Market Strategy

While 2004 has been marked with uncertainty at home and abroad and the S&P 500 Index returns have been quite modest, there have been a number of positive developments during the course of this year. Since the beginning of the year the forward price-to-earnings (P/E) ratio on the S&P 500 Index has dropped from 18 to 16 times earnings. With the stock market modestly positive year-to-date, it makes sense that the decline in the P/E ratio is the result of growth in corporate earnings. At the beginning of 2004, earnings-per-share (EPS) forecasts for the S&P 500 ranged from 12% to 24%. Today the consensus EPS forecast for 2004 has narrowed to 18% to 19.3%. While the market P/E ratio is not classically cheap, a P/E ratio between 14 to 16 times earnings is considered in line with historical averages, providing investors with opportunities to make money through superior stock selection.

An example of the type of opportunity we seek in fairly priced markets is a great company experiencing a temporary problem. To illustrate, if a short term perspective has affected the investment community’s view of the stock enough to cause it to fall in price, it allows those with a long term perspective, such as Oakwood, to buy it cheaply versus the intrinsic value of the stock. We found a few examples of this during the third quarter, including a superior retailer which has generated 29% return on capital over the long term. This particular company had trouble with a new management information system installation, causing short term problems and a subsequent drop in stock price. Once the management information system problems are resolved, we expect the market to reflect its long term intrinsic value.

Initial estimates on EPS growth for 2005 range from 7% to 10.2%. Dividend payments by S&P 500 Index companies have increased by a 12.3% annual rate, demonstrating that corporate managers and their boards share confidence in the quality and sustainability of their earnings growth. Certainly the lower tax rate paid by shareholders on dividends is also a factor in the increase in dividend payments. However, tax issues aside, we view this increase in dividend payments as a fundamental positive for stocks and feel that the initial estimates for 2005 EPS growth could prove to be on the low side.

Using the initial estimates of 7% to 10.2% EPS growth for the S&P 500 in 2005 and the current dividend yield of 1.75%, the implied return on the S&P 500 in 2005 ranges from 8.75% to 11.95%. This range of implied returns assumes that the EPS growth estimates are realized and the P/E ratios remain constant. These may be big assumptions. There is an array of challenges and opportunities facing equity investors in the coming year that may impact market returns.

Cost push inflation is present in the economy. This, from an investment perspective, is a two-edged sword. For those manufacturing companies that must pay the higher costs for raw materials and energy, it is obviously a negative. For those energy companies that benefit from the increase in upstream profitability, it is a huge positive.  Oakwood clients also benefit, as our portfolios are overweighted in these types of energy companies, relative to the S&P 500 Index. We recognized great quality and value in a few superbly managed, high return energy companies — and purchased them long before the recent run-up in oil and gas prices.

As a response to the potential threat that inflation pressures have on corporate earnings, we are focusing on owning companies that have pricing power. There are different elemental characteristics that can grant a company pricing power.

• Strong brand identity. Adding to the power of strong brand identity is a lack of generic alternatives. An example in client portfolios is a major global beverage company whose brand identifies so strongly in the mind of consumers that price hikes can be passed along without the threat of deterioration of market share.
  
  
• Specialized niche products that are price inelastic, i.e., price changes that do not cause much of a demand change. An example in client portfolios is a building materials company that sells very high quality kitchen faucets. This company is able to pass along higher costs that it incurs to homebuilders and contractors, as the end user is one who wants more of an exclusive product in their home, and is willing to pay for it.
  
  
• Barriers to entry. An example of a company of this type in client portfolios is a medical testing laboratory company. The industry is somewhat fragmented, with a few large players and many regional “mom-and-pop” labs. The larger national laboratory companies have a monopoly on some of the esoteric genomic tests, gene-based testing being an example, which gives them the benefit of pricing flexibility.

While there are challenges in the current market, we believe that on balance the outlook for stocks in the year ahead is more positive than negative. In managing our client portfolios we will continue 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.