April 2005

Portfolio Comments

Market View

Dorato Services

The Library: articles by Steve TeSelle

Stock Focus

Portfolio Comments

On your quarterly statements, I give you a summary of how your portfolio has performed for the quarter, for the current year, and since you opened your account. I also compare those returns with the performance of the Standard and Poor’s 500 Index (S&P500). I thought it might be helpful to review why I do that.

I use the S&P500 as my benchmark because it is a simple, low-cost alternative to using my services. You may hear people say that the S&P500 isn’t a perfect benchmark, but there’s no such thing as a perfect benchmark. One has to balance a number of factors in choosing a benchmark, including how representative it is, its cost, and whether the investor could realistically invest in it. Some firms create custom benchmarks, but that seems silly to me because you, as the investor, can’t invest in a firm’s custom benchmark, let alone at a low cost. As a measure of how the US stock market is performing, I think the S&P500 does a pretty good job.

By giving you the information about my performance and the S&P500 performance, I hope that I’m giving you one of the tools you need to make an informed decision about whether to continue using my services. There will be periods when I do better than the benchmark, and periods when I do worse, but over time, my goal is to beat the benchmark, including my fees and any trading costs. And I try to do it with a level of service that you can’t get from a mutual fund.

Past performance is not necessarily an indicator of how I’ll do in the future, and it’s not the only reason to select an advisor, but I think it’s a key piece of information for every investor to have.

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 Market View

The US economy keeps chugging along. Recent GDP growth is in the 3-4% range, and most folks, including me, expect growth to continue at that rate. For a while, the US consumer propped up the economy, as business investment remained subdued after late-1990s boom years. But business spending is beginning to pick up, which should add a dose of confidence to the predicted 3-4% growth rate.

A healthier economy gives the Federal Reserve leeway to raise short-term interest rates in its never-ending battle with inflation. Short-term rates are still low by historical standards, and will probably rise another percent in 2005.

Longer-term rates (on five, ten, and thirty-year debt) have finally started to rise as well, though I think they’re still too low. The ten-year US Treasury rate, which affects the rate for thirty-year mortgages has risen from below 4% to about 4.6% in the last couple of months.

When I say that longer-term interest rates are too low, you might ask why I think I know better than the billions of investment dollars investing in the US Treasury market what the right level of interest rates is. The key is that there are investors controlling significant chunks of money who aren’t driven by profit. Specifically, the central banks of a number of Asian countries are more interested in keeping their currencies from rising too much against the dollar than in worrying about their expected return from investing in US debt. Exactly how much of a factor these investors are is anybody’s guess, but interest rates are almost certainly lower than they would be without these folks.

So what does all that mean for the stock market? Decent economic growth is good. Rising interest rates aren’t great, but they need to be higher to keep consumers and businesses from bingeing on debt and real estate. And having interest rates adjust gradually is good. At 18 or 19 times earnings, the overall market is probably pretty reasonably priced. Since the stock market is as much a barometer of public sentiment as a pricing machine, I don’t think I can get any more specific than that.

Of course, there are always risks: The US budget deficit is a cause for concern; I doubt terrorists have given up; and policy decisions in China, Russia, or North Korea, to name a few, could make everyone a lot more pessimistic about the future. The problem is that if you want to wait for risks to go away, you’d never invest in the stock market.

In the currency markets, the weaker dollar has been getting a lot of attention. Some folks act as though this is inevitable, but I don’t think it is. The positives for the dollar are rising US interest rates relative to the Euro and Yen, that the US economy is stronger than Europe’s or Japan’s, and that the dollar is still the world’s primary currency. The negatives for the dollar are our budget and trade deficits. How these factors play out in the next six months or year is a bit of a guessing game. If you look strictly at the purchasing power of currencies, however, which should drive the direction of currencies over the long term, the dollar is already undervalued against the Euro, though still a bit overvalued against the Yen.

Most of us would rather not have the dollar get too much weaker because the weaker the dollar, the more likely we are to get a nasty bout of inflation. Also, we’d like the currency markets to remain fairly stable because when markets get roiled is when we find out some bank or hedge fund bet the farm on the idea that markets would remain calm. Currency markets have played a role in stock market jitters in the past, and will undoubtedly do so again.

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
• Allocations for retirement accounts
• Small business retirement accounts
• Retirement planning
• Advice on stock options
• Assistance with tax questions
  

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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

American International Group

American International Group (AIG) is one of the world’s largest financial services companies. AIG is the largest property and casualty insurer in the US, and also offers life and health insurance, asset management, retirement services, and God knows what else. AIG has operations throughout the world.

Insurance is one of those businesses where big, strong companies have an advantage. The bigger the company, the easier it is to spread risks across geographical regions and across products. And financially strong insurers are more attractive to consumers than weaker companies - you’d like to know the promise to pay a claim is backed by something. They also have a lower cost of capital, which enables them to offer lower rates and/or achieve higher profit margins. AIG maintains the highest or second-highest credit rating with the various rating agencies.

The stock currently trades at about $60 per share. This price translates into a Price to Earning (P/E) ratio of about 14. For insurers, it’s not all that helpful to look at cash flow because cash comes into the company from premiums paid by customers, but the company may have to pay out claims in the future. Analysts therefore tend to look at PE ratios and Price to Book Value (P/B) ratios to measure whether the company is selling at a reasonable price. At a PE of 14 and a PB of a about 2, AIG sells at a much more reasonable value than it did in 2000, when the company’s stock cost more than 30 times earnings and nearly 5 times book value.

AIG has steadily increased earnings and book value for many years. I expect that to continue, with growth rates in the 10-15% range.
So why is AIG selling for such a reasonable price? The company has gotten into hot water with regulators for insurance products that give what regulators think is a distorted view of earnings, and for how commissions are paid and bids are made in the insurance industry. And lately, how the company accounts for non-traditional insurance has come under fire.

With the corporate governance and accounting scandals of the past few years, investors are a little jumpy about any new investigation. AIG may have to work out a settlement with regulators and make some adjustments to prior-year financial statements, but I expect these actions to have a minimal impact on the company. The need for insurance is not going away, and AIG has a competitive advantage with its size and strength. I think the time to buy companies like this are when other investors depress themselves with news and headlines that may affect the company in the short term, but have little impact in the long term.

The main risks are related to management. It’s possible that AIG has more problems, but at the current price, I think that’s a risk worth taking. Also, Maurice Greenberg has recently been forced out as CEO; he’d led the company since 1968. The property and casualty business tends to go through cycles in which insurers price policies too low and lose money. Led by Greenberg, AIG has a good track record of reasonable pricing through those periods. There’s no guarantee that AIG will be as prudent in the future. Still, at the current price, AIG management doesn’t have to be perfect, just reasonably good.

As always, I don’t have all my eggs in the AIG basket. As part of a diversified portfolio, I think it offers a solid investment opportunity.

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

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