April 2004

Portfolio Comments

Market View

Dorato Services

The Library: articles by Steve TeSelle

Stock Focus

Portfolio Comments

If you know what the future holds, you don’t need to diversify. For example, if you knew that Cisco would be a successful technology company, and you knew that other investors would pay more than 100 times earnings in early 2000, you would have put all your money in Cisco in 1994 at $1 per share. Then, in 2000, you would have sold at about $80 per share. $100,000 would have turned into $8 million. Taxes would take a healthy bite out of the proceeds, but you’d still have enough to afford a decent bottle of wine or two in retirement.

Of course, you would have had to struggle through the spring of 1997 and the fall of 1998, when Cisco stock dropped 30-40%. That means that in 1998, when your $100,000 of Cisco stock had grown to about $5.5 million, you lost roughly $2 million. But you would have suffered the nail-biting drop because you were about to more than double your money in 1999 and into 2000.

There are certainly other examples out there. No doubt, you’ve heard people talking about so-and-so who got in on the ground floor of some company that subsequently grew into a skyscraper.

Unfortunately, these opportunities are much more obvious in hindsight. I can’t speak for you, but I’m not prescient enough to know the precise future travels of a company’s stock price. And I certainly wouldn’t base my strategy on other investors paying more than 100 times earnings. Implementing diversification is really an admission that the future is hazy, and that things happen that we didn’t plan on. You might get lucky investing in a single stock, but that’s not really a sustainable investment strategy.

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 Market View

The Federal Reserve is keeping short-term interest rates low, probably for all of 2004. The positive view of this action, or inaction, is that inflation still is not a problem. The negative view is that the economy is still on shaky ground and needs low short-term interest rates to keep chugging.

While the Federal Reserve is keeping rates low, it is reducing the growth of the money supply. In effect, they are trying to limit the amount of dollars sloshing around the system. This is kind of a quiet way to tighten monetary policy and should help to limit inflation.

The danger is that short-term rates remain low for too long, which would allow inflation to ignite. Yes, I’ve been saying this for a year now, and there’s still little inflation as measured by the Consumer Price Index. Good thing I’m not Chairman of the Federal Reserve. Even so, commodity prices have been rising, which is usually a sign that investors expect some inflation around the corner.

Given the interest rate and inflation environment, I suggest investors stay toward the short end of the yield curve. Interest rates are remarkably low. You might get a slightly higher yield by buying longer-term bonds (ten to thirty years maturity), but there’s a big risk that interest rates will rise and cause the value of your investment to fall.

Rising interest rates are not the end of the world as we know it. I don’t mean to invoke fear as I write about the possibility. Indeed, higher short-term rates would be an indicator that the economy is moving along at a healthy clip. And if investors continue to believe in the Federal Reserve’s inflation fighting credentials, long-term rates need not rise dramatically. It’s just that I don’t think investors in longer-term bonds are being compensated for the risk that everything doesn’t go smoothly.

While bonds don’t offer enticing returns, neither do stocks. We’ve been in a bit of a rubber-band investing environment the past several years, going from over-priced to under-priced assets. Often, when one asset looked expensive, another looked cheap. At this point, however, expected returns are pretty moderate across a number of asset classes. My expectation of 5-10% stock returns for the year still holds. Being somewhat contrarian, I am cheered by what I perceive to be a not overly optimistic investment public, and fairly constant reminders in the press about investment bubbles.

Within stocks, I suggest sticking with solid companies with strong finances. In 2003, investors who took a gamble on shakier companies were rewarded. But the potential return on those assets has shrunk to mouse-like proportions. In fact, this has happened across assets. For example, the extra yield on junk bonds relative to US Treasuries has shrunk from 10-12% in early 2003 to 4-5% today.

The bombing in Spain was a sad reminder that terrorism continues to be a threat, and that unexpected events can affect people’s optimism or pessimism about the future. These are things we have little control over. The point isn’t to try to avoid all risk, but to recognize that investing in stocks entails assuming some risk. You don’t want to take silly risks, but there is some risk that you just can’t avoid.

The dollar has stabilized against most currencies. A plunging dollar could cause foreigners to sell dollar-based assets, which includes stocks and bonds, and could lead to a nasty bout of inflation. So a reasonably steady currency is a good thing. Based on what goods various currencies will buy, the dollar shouldn’t weaken much more against the Euro, but it could fall a bit more against other currencies.

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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Dorato Mission Statement:

To provide separate account management that meets the needs of each investor, and to educate and inform both clients and the general public about investment and financial issues.

Dorato Services:

• Separately managed stock portfolios
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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
• Index Investing
• Financial Checklist

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

CVS Corp.

CVS is one of the nation’s largest pharmacy chains, with more than $26 billion in sales in 2003. The company operates more than 4,000 stores in 32 states.

The stock currently trades at about $35 per share. This price translates into a Price to Earning (P/E) ratio of about 17, and a price to cash flow ratio of just over 12. The company has increased earnings at a rate of 18% over the last five years. Given continued spending in the US on both prescription and over-the-counter drugs, the company’s healthy growth rate is likely to continue.

CVS has healthy finances. The company’s $1 billion debt is easily manageable, with $800 million in cash and annual cash flow of about $1.2 billion. Capital spending, primarily in the form of new stores, will use up maybe $1 billion of the cash flow, but that still leaves plenty to cover debt payments and dividends.

A few years ago, CVS traded at 25-30 times earnings. Pharmacy stocks were considered steady, safe investments. And after a series of industry mergers in the 1990s, there were only a handful of large pharmacy chains. But due to some operational problems, CVS’s earnings fell in 2001. So did the stock price - from the low 60s to the low 20s.

Management is having to prove itself again. Even now, after two years of higher earnings, the stock trades at only 17 times earnings. In comparison, Walgreens trades at about 28 times earnings.

The future looks pretty bright for pharmacies. The US spends a whopping amount on drugs (about $200 Billion in 2004), and that amount should only grow. CVS derives about 60% of its revenue from filling prescriptions, with the remainder coming from all those other items in a pharmacy.

The main threat for pharmacy chains is the growth of pharmacy benefit managers (PBMs). PBMs operate as a middle-man between a health insurer and a retail pharmacy. In some cases, they avoid the retail pharmacies altogether by using mail-order. CVS has a PBM division, but it is not one of the top competitors in the industry. The danger is that the middle-man will swipe some of the profits of the retail pharmacies. For the time being, however, there are only a few national retail pharmacies, so these retail chains have some bargaining power versus the PBMs.

In addition to competitive risks from PBMs, and from other retailers such as supermarkets, there’s the possibility that management could stumble again. Also, if the US goes into a recession, or there’s some seismic change in healthcare, CVS’s earnings could suffer. Still, this company with a good track record and healthy finances seems worth those risks.

A year ago, I wrote about Safeway. That looked like a great opportunity to me. It still does. Safeway’s stock price is still in the low 20s, pretty much unchanged from one year ago, even as the broader stock market rose 35-40%. I think patience will pay off, but I’m glad I didn’t put all my eggs into the Safeway basket. So, I expect, are you all. Diversification has its benefits.

Sources: Value Line, CVS, Yahoo, Reuters, Economist.

"Yeah. I'm thinking about skipping that whole career/work thing and easing right on into retirement"

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