April 2006

Portfolio Comments

Market View

Dorato Services

The Library: articles by Steve TeSelle

Stock Focus

Portfolio Comments

I’ve had other financial advisors tell me that I should meet with clients twice a year, so that we’ll have a relationship and you won’t want to fire me, even if I’m doing poorly. And if you do decide to fire me, you’ll feel guilty about it. Since I think guilt should be used only by mothers, and sparingly at that, I prefer to leave you alone until you ask for help.

This doesn’t mean I’m trying to avoid you, or don’t want to talk to you. I just figure we’re all busy enough with our lives that you don’t need your financial advisor trying to be your new best friend. But you should know that you are always welcome to call or write or email with any questions you have. And if you’re the kind to want to sit down and chat, we can arrange that, too. I don’t want to avoid anyone, I just want to respect your privacy and your time.

If you’re the kind to use the internet to get your questions answered, I’ve started a ‘Question and Answer’ section on the web site. I expect to add to the section over time as I come across questions that might apply to many of you.

This newsletter will be the last with a Stock Highlight section. When I started Dorato in 2000, I figured I needed to explain how I think about investing in a company. After six years, I think you probably have a pretty good idea. If you think you might miss that section of the newsletter, and you’re looking for a source for independent stock research, I strongly suggest Value Line. You can get your own subscription at a reasonable price, and it’s also available at most libraries.

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 Market View

Much has been made of the inverted yield curve (for those of us who follow that type of thing). An inverted yield curve means that long term interest rates are lower than short term interest rates. You might think people have lost their minds when they’re willing to accept lower interest rates for riskier long term debt. But the reason people will make that investment is that they think the economy will slow down or go into recession. That’s in the absence of anything else affecting the yield curve. But, of course, life isn’t so simple. Other factors are keeping long term rates lower than they might otherwise be, including buying by foreign central banks trying to keep their currencies down, and by pension funds trying to better match assets and liabilities (a lot of pension plans seem to get the same ideas at the same time). My guess is that the slightly inverted yield curve doesn’t forecast a recession, it’s more a reflection of heavy demand for long term US government debt. That’s a temporary rather than permanent phenomenon, so I expect long term rates to rise a bit in the next year.

The housing market looks like its finally starting to cool. And rising long term rates could cool it even more. Perhaps we’ll finally see whether Americans are wasteful spendthrifts who’ve been spending their home equity as though their houses were ATM machines, or whether that’s been blown out of proportion, too. My guess is that some people will struggle with higher interest rates, but we won’t see the world crash around our ears. The problem with having had that tech/telecomm investing bubble in the recent past, is that commentators see bubbles everywhere.

After some gyrations last year, the commodities markets have been relatively stable. Oil continues to hover around $60 a barrel. The various metals prices have also been pretty stable. I see no reason for commodities to move sharply, unless there’s some sort of crisis.

The currency markets, too, are pretty stable. After a three-year period in which the dollar lost about 30% relative to a basket of currencies, it’s held fairly steady in the last six to nine months. The reason I think the dollar might weaken a little from here is that both Europe and Japan are likely to raise interest rates in the next twelve months. That should help to create demand for those currencies and therefore strengthen them against the dollar.

With all that stability, my outlook for US stocks hasn’t changed - mid to high single digit returns for the year. One thing that has me a little worried is the small premium (extra return) investors are getting for taking risk. Whether it’s the interest rate differential between US debt and junk bonds, or the difference between US bonds and emerging market bonds, investors seem more concerned with the size of their return than with getting their money back at all. Some kind of crisis can upset that happy balance faster than a toddler can find an electrical outlet.

I keep using the word crisis, so I guess I better define it. I don’t consider slower economic growth or higher inflation a crisis. A crisis has to be pretty big, like a missile attack on Saudi Arabia, or some country unexpectedly refusing to pay interest on its debt. It has to be a big, unexpected event that investors hadn’t planned for. Or they thought they planned for, but find out they didn’t, like so-called portfolio insurance in October 1987. Crises do happen from time to time, but by their nature are unpredictable. So I don’t think you should invest based on the expectation of a crisis. Rather, you should be aware that one can strike at any time.

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

Cisco Systems

Cisco Systems (CSCO) is one of the world’s largest technology companies. It generated revenue of about $25 billion in 2005, primarily from selling products and services that route and process all that information and data that zooms around the world. Cisco recently agreed to buy Scientific Atlanta, the company that makes those set-top boxes for your television, with the intention of turning that set-top box into another networking device.

A few years ago, everyone and their gerbil owned shares of Cisco. I remember somebody telling me that owning Cisco was a no-brainer; the stock price doubled every year, just like clockwork. Unfortunately, that clock stopped ticking. Cisco now trades at about $21 per share, a ways down from the high of $80 per share it reached in early 2000.

At its current price, Cisco has a PE ratio of about 22, and a price to cash flow ratio of about 19. I don’t expect Cisco’s earnings to grow at 40-50%, as they did in the 1990s. However, I think it’s reasonable to think that earnings can grow in the 15% range, which makes the current price a decent one. Strikingly, Cisco’s earnings are more than 50% higher than they were in 2000, even as the stock price is down 75%. The price of Cisco was nutty in 2000, but this isn’t a company that has stopped growing.

Cisco has always had no debt, a lot of cash, and healthy cash flow. That may sound wonderful, but with interest rates so low, it makes a lot of sense for them to take on some debt (debt isn’t necessarily good or bad, it’s simply a tool), which is what they’re starting to do. They’ll still have a very strong financial rating, and will easily be able to cover the interest. And it should mean higher returns for shareholders.

Cisco has been a huge user of stock options. And why not? If the accounting rules don’t require you to recognize it as an expense, you can give them away like candy and make your employees happy, and earnings never suffer. But a new accounting rule will require Cisco to recognize the cost of stock options in the future. The change will show up in 2006 earnings, and make Cisco’s earnings look stagnant compared to 2005. In later years, after this one-time change, earnings growth should continue. Without any change in policy, Cisco’s earnings will take a hit year after year for this expense. But I think the company will change how it uses stock options, and perhaps achieve a healthier balance between the interests of employees and shareholders.

I have no doubt that the market for processing information and data will keep growing. With larger bandwidth, people will think of more and more things to send down those pipes, which will require more investment in the kind of equipment that Cisco makes. The question is how profitable it will be. Cisco has to keep innovating to maintain its competitive advantage, and it will bump into rivals such as Microsoft and EMC as it expands into home networks, data storage, and security. Again, I wouldn’t want to count on 40-50% growth rates, but a 15% earnings growth rate seems reasonable.

As always, I have to consider the possibility that I don’t know what I’m talking about. And even if my vision of Cisco’s future is based on solid reasoning, events could conspire to make it look silly. So I’ll stay diversified. Cisco will comprise only a portion of any portfolio.

Sources: Value Line, Cisco, Yahoo.

"I'd say this qualifies as a crisis."

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