Equity Market Strategy
The Global Economy in Transition

The stock market’s behavior in the third quarter of 2006 provided more drama than investors have experienced in some time. As major US stock indices all neared or hit lows for the year in mid-July, Oakwood’s client portfolios were defensively positioned and outperformed the market. After the Fed decided in early August to pause in their two-year-plus campaign of raising interest rates, a narrower stock market rally proceeded in earnest through the end of the quarter.

Meanwhile, commodity prices, accentuated by the speculative debacles of prominent hedge funds, continued to fall during much of September amid signs of slowing economic growth worldwide. These price declines, while certainly tangible, are an antithesis to the natural supply/demand dynamics of scarce resources whose need is increasing. In particular, the decline in energy prices accelerated during the month with crude prices losing over 10%, wholesale gasoline falling more than 15%, and natural gas plunging over 29%. Although good news for the consumer and businesses, this caused stock prices in the energy sector to soften. Our longer term commitment to these areas caused our portfolios to underperform in September. In response to this, we pared back holdings in this area, taking some nice profits in our positions.

If, as we expect, the economy slows to 2.5% growth in 2007, there will be many benefits. Reduced inflationary pressures will give the Fed the flexibility to stay on hold or even reduce rates if economic growth seems to be stagnating. The Fed’s actions have stabilized consumer confidence and spending, and seem to be ensuring that the housing-led slowdown won’t accelerate into a hard landing for the US economy. Corporate profits growth will slow in tandem with the economy, but still manage gains. As investors feel more confident that profits are sustainable and inflationary pressures are abating, then the market price-to-earnings ratios should rise. We think this should set the stage for a good year for investors who are willing to look past some of the current uncertainties and stay focused on the positive forces within the economy and the capital markets.

Despite our recent lightening up in the energy sector, we are still believers in owning high quality companies in this area for several reasons: the geopolitical dynamics surrounding OPEC, their support of the current price level, and the fact that peak production levels have been or are near being reached. From a valuation standpoint, oil and gas stocks produce 25% of the S&P 500 earnings but only have 10% of the market capitalization, which indicates that these stocks as a whole are undervalued.

A company which we recently added in the energy area is one of the largest US-based independent oil and natural-gas companies. With about 90% of its reserves and production in North America, this company has a lower risk profile than some of its more internationally focused competitors. We purchased this position near its bottom during a recent downswing in energy stocks, at less than half its true value. Soon thereafter, better than expected results from its deep-water Gulf of Mexico drilling program were announced, and among independent exploration and production companies, it is the largest leaseholder in the promising deep-water Gulf of Mexico market. Energy prices will remain volatile in the short term but inexorably increase over time, due to demand exceeding supply. We accept the volatility and gain strong strategic value from these wonderful assets located in the US, free of all geopolitical risk.

We are also still favorable on the healthcare industry, buying great companies on a price dip. A company we recently added to client portfolios is a top performer in the managed care area which recently suffered a major price drop in reaction to media hype regarding the company’s treatment of options. It has taken advantage of recent opportunities in Medicare, and has market leadership positions in Medicare Part D and Medicare Advantage. It has been acquisitive in its growth, potentially a risk, but we believe the consistent and strong returns on invested capital during this time are evidence it has made good acquisition choices and integrated them successfully. The company continues to yield significant free cash flow which is growing strongly, giving it ample capital to reinvest in the company, to repurchase shares, or from which to pay dividends.

Another quality healthcare company recently added to client portfolios is a leading provider of orthopedic devices, surgical equipment, and medical furniture. This company generates excellent returns on invested capital, and we especially like the way it pursues attractive niches within the healthcare industry. It dominates the highly profitable orthopedic implant market, which possesses difficult entry barriers and sticky customer relationships. The firm sent its bone-growing protein, OP-1, to the Food and Drug Administration in an important spinal indication in 2006. If approved, the company could enjoy a little growth spurt starting next year from this high-margin orthobiologic.

Another recent addition to Oakwood equity portfolios is in the rail transport industry, again opportunistically purchased on a depression in price. Long-term rail trends are favorable, as highway congestion, high fuel prices, and a shortage of drivers cast a shadow over the trucking industry, boosting demand for rail transportation. This company’s second quarter earnings report caused the market to take an incredibly short-sided and negative view, thereby creating an excellent buying opportunity for us. The company reported a solid 11% revenue increase in the quarter, driven by a 4% increase in volume. Its free cash flow and operating ratio are among the best in the railroad industry, despite stiff fuel-cost headwinds which are completely passed on to customers in fuel surcharges. We are continuing to increase our weightings in the consumer staples, healthcare and financial sectors.

As we move into the fall season, we feel there are potentially a number of circumstances that could take a market that has reached new highs and correct it mildly downward. We are poised to make quality long-term investments when prices become more attractive. In managing our client portfolios we will continue to focus on owning premier 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. We value the opportunity to work with you and to build your wealth.