April 2003

Portfolio Comments

Market View

Dorato Services

The Library: articles by Steve TeSelle

Stock Focus

Portfolio Comments

Prices of stocks jump around like the line on a polygraph test. That's the nature of stock investing. But when a stock's price falls more than 50%, it's hard not to feel that maybe you've made a mistake.

However, price alone shouldn't be the primary reason to sell. That approach leads to more trading, higher costs, and what is likely to be a poorly performing strategy of reacting to yesterday's results. For me, a deterioration in a company's financial position, or a loss of confidence in management is a more compelling reason to sell.

Safeway is a good example of a company that I believe has solid long-term prospects (see back page). At $60, it was too expensive; at $40, it was reasonably priced; and at $20, I think it's a great value. The nearly 70% drop in price over the last several years offers a good opportunity to buy a piece of a good company.

In contrast, Interpublic, an advertising company, looks like a mistake. The price of the stock is down about 80% from its high. Not only has the company been hurt by the slow economy, but management seems lost - in the last year, the company has restated prior earnings three times before claiming to get it right, a negative adjustment of $180 million. Now the company faces a cash crunch because it promised to make a minimum level of cash payments on convertible bonds, in case the stock price fell. Guess what? The stock price fell. Interpublic may fix its problems, but management doesn't inspire confidence. There are enough good companies selling for reasonable prices that we can sell Interpublic and move on. [top]

 Market View

I continue to be surprised at the extent of investor pessimism. Perhaps this is a kind of pendulum effect, in response to the excessive optimism of the late 1990s. Perhaps world events are weighing on investors. Who really knows? What we do know is that companies are selling for better prices than they have for many years.

If you believe that the United States is on a downward spiral, that we have an economy that is likely to stagnate for many years, and that US companies are uncompetitive, then it makes perfect sense to swear off stocks. The price of a stock represents the forward-looking prospects of the company; if the future looks bleak, so do stocks. But if you believe this current period is just part of a cycle, and that companies have a decent future ahead of them, then you should be thanking other investors for giving you the opportunity to buy stocks at such reasonable prices.

It's tempting to think that we'll wait until there's more certainty in the world before we invest our hard-earned money. After all, everything seems a little crazy right now. Unfortunately, the world is always full of uncertainty, even if we don't always realize it. Usually, the best time to invest in stocks is when everyone else is talking about uncertainty.

Since mid-2001, the dollar has fallen more than 30% in value relative to the Euro. As a result, imports are relatively more expensive, and we are starting to see some inflationary pressure. The latest figures show inflation running at an annual rate of about 2.5%, up from less than 1% last year. The current account deficit (more imports than exports) is still quite high relative to the size of the economy, at about 5% of Gross Domestic Product, but a weaker dollar should begin to lower that figure. At its current price, the dollar is probably close to fair value, based on purchasing power of currencies. If we see further weakness in the dollar, inflation becomes more of a worry.

Curiously, the Treasury bond market doesn't seem worried about inflation at all. The yield on 10-year US Treasuries, at 3.5%, is as low as it's been since Truman was President. I remember thinking in early 1999 that stock prices of technology companies couldn't go much higher. I think tech prices doubled that year. I believe the same phenomenon is occurring in US Treasuries. It could be that bond investors are a sharp bunch and that they see deflation around the corner, which would justify buying Treasuries at these prices. But my guess is that investors are more comfortable going with the trend than they are questioning value. This is usually what leads markets to overshoot fair value. Beware when the trend turns.

Even though I'm a cheerleader for stocks right now, I'm staying away from American car companies. Ford and General Motors have huge pension liabilities; they can't seem to sell cars without incentives; their high-profit SUVs face more competition; and there is over-capacity in global auto production. That is a fairly unhealthy list of factors, and I can't see how any of these factors changes in the foreseeable future.

As always, I recommend investors stick to their long-term asset allocation strategies and retain a diversified stock portfolio.

Sources: Economist, Wall Street Journal, Value Line

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The Library: articles by Steve TeSelle:

• College Savings Options
• Retirement: What's the Target?
• Fun Facts About Taxes
• Understanding Your Finances
• Risk, Anyone?
• A Primer on Asset Allocation
• Debt, Friend or Foe?
• Life Insurance Basics
• Calculating a Return
• Estate Planning

To read them online, simply click on the title. To obtain a printed copy, please call us at 303-733-4999, or e-mail me at steselle@doratocapital.com.

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Stock Focus

An Insight Into Dorato’s Investment Style

Safeway

Safeway is the third-largest grocery chain in the US, with $35 billion in sales in 2002. The company operates nearly 1,700 stores in the US and Canada.

The stock currently trades at about $20 per share. This price translates into a Price to Earning (P/E) ratio of about 9, and a price to cash flow ratio of just over 4. A couple of years ago, Safeway traded at $60/share - a P/E of about 25, and a price to cash flow ratio of about 20. Generally, the higher the P/E ratio, the more excited investors are about the company's future.

A few years ago, investors figured that Safeway could increase earnings at a steady rate because people have to buy groceries, no matter what's happening in the economy. Grocery stocks used to be considered safe investments. But Safeway has been hit both by competition, and lately, by rising labor costs.

One of the primary changes in the competitive landscape has been the addition of Walmart. WalMart got into the grocery market in the late 1990s and has steadily increased its share of the business - currently about 12% of the grocery market. Walmart competes on cost, which has forced Safeway and the other grocery chains to keep prices low. This is great for the consumer, not so great for the companies in the grocery business.

Part of Walmart's cost advantage comes from low labor costs. Safeway estimates that it pays $5-6 per hour more than Walmart. In addition, healthcare costs for Safeway's unionized labor force are rising. Safeway is trying to force employees to shoulder some of these costs, as it tries to reduce the gap in labor costs between itself and Walmart. Not surprisingly, this has created some friction between management and the rank and file.

I don't want to minimize the challenges facing Safeway. However, I think investors are over-reacting. The labor issues will be worked out. That is a short-term problem. Walmart as a competitor is more of a long-term threat, but Safeway is an efficient operator with healthy cash flow and a strong customer base. The grocery industry has been competitive for years, so I expect Safeway to be able to adjust to Walmart's presence. I don't think Safeway can compete with Walmart on cost and price (witness Kmart), but it can offer better quality and better customer service, much as Target has done in the discount shopping market. In fact, I'm much more concerned about paying 25 times earnings for Walmart, as everyone happily assumes the good times will continue for that company, than in paying 9 times earnings for Safeway.

Risks? The biggest one is operational - that Safeway goes into a slow spiral of lower sales and profits, as Walmart and other competitors attract customers away from Safeway. If Safeway's management dismissed Walmart as a competitor, I'd be more worried. But they seem to be taking Walmart quite seriously. I have confidence that they will respond to the competitive threat.

Of course, I could be wrong. That's why I keep diversified portfolios. After all, if I were certain that Safeway were going to double in price, why would I hold anything else?

Sources: Value Line, Safeway, Yahoo.

"I invest only in 'no brainer' stocks. My results aren't very good, but at least I don't have to think too hard."

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