July 2003

Portfolio Comments

Market View

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The Library: articles by Steve TeSelle

Stock Focus

Portfolio Comments

For asset allocation, I suggest investors hold intermediate-term bonds - about five to seven years in duration. This duration usually offers better returns than short-term debt and lower volatility than long-term debt. Unless you think you can predict interest rates, you're better off sticking to a diversified, steady-duration strategy.

I recommend bond funds instead of buying individual bonds because, for most of us, a good bond fund gives you better diversification at a lower cost than you could get yourself. My favorite is the Vanguard Total Bond Market Index Fund. The fund invests in investment grade bonds (not junk) in the major US bond segments: Treasury, corporate, and mortgage. It maintains a duration of about five years. The annual fee is .2%.

For a specific need, say you'll need the money in two years, you can invest in an individual bond or note. But even then, an inexpensive, well-run bond fund gives you more diversification. It's a good idea to match the duration of the bond or bond fund with when you'll need the money, so I wouldn't suggest the Total Bond Market Index Fund for an investment you'll need back in two years. In that case, I would suggest a short-term bond fund, moving to a money-market fund as the time draws nearer.

If you'd like to know a little more about bonds, I've posted an article on the Dorato web site that describes bonds and how they work. Or feel free to call me. Strangely, I like talking about this stuff.

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 Market View

The headline issues in the financial pages these days are deflation and the weaker dollar. The worry seems to be that we face the risk of deflation and that the dollar will continue to weaken. In fact, these two scenarios are highly unlikely to occur at the same time. The primary reason is that as the dollar weakens, imports become more expensive. That is, we get inflation. On the other hand, a stronger dollar would keep import prices low, and therefore increase the chances of deflation.

I think the Federal Reserve understands the nasty effects of deflation, and so will work to keep short-term interest rates low and the money supply high. Under this scenario, the dollar is unlikely to get stronger against other currencies, especially the Euro, and worries of deflation will evaporate. However, since getting monetary policy exactly right is like walking around your house at night (it's not mistake-free), I think the Federal Reserve will probably overshoot it's goal, so that we are more likely to see a pickup in inflation in a year or two.

Bond investors don't agree with me. The bond market continues to show no fear of inflation. For short-term debt this makes sense, both because the Federal Reserve is pushing short-term rates down, and because immediate inflationary pressure is low. But I'm surprised that long-term yields are as low as they are. Ten to thirty-year bond investors, especially Treasury bond investors, seem to be betting that the Federal Reserve will keep inflation in check or that we'll get deflation.

Stock investors are a bit more optimistic now than they were in March. But don't expect a re-run of the late 1990s, when stocks marched steadily higher. What seems more likely is that we'll continue to have these price fluctuations of as much as 20-30%. Expect more fluctuations in the prices of technology stocks than in other sectors, as investors run hot and cold on the growth prospects for these companies.

Given this scenario of volatility, it's important to pay attention to asset allocation and to avoid getting caught up in whatever mood prevails at the time. For example, if you have an allocation of 70% stocks and 30% bonds, rebalance if you get more than 80% or fewer than 60% in stocks. You'll find that you often buy stocks when other people are pessimistic, and sell when everyone else is excited. I use a similar strategy within the stock portfolios to keep me from ending up with portfolios that carry more risk than necessary.

At current prices, stocks offer reasonable but not exceptional value. In January, I expected a 10% return to stocks for 2003, and halfway through the year we are already there, via a very bumpy road. It's not that I expect no return to stocks for the rest of the year, but I don't expect a continuation of the returns we've seen from March through June. Somewhere in between is my wishy-washy guess.

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

Boeing

Boeing is one of two companies in the world that produces large airplanes, and one of a handful of US companies that supplies the US defense industry. Total sales in 2002 were about $50 billion, split roughly in equal parts between the two lines of business.

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 close to 8.5.

Boeing certainly has its share of problems. The commercial jet market is struggling, as airlines defer deliveries and cancel orders. In addition, there are several hundred planes parked in the desert, waiting to be brought on line. Airbus has turned out to be a formidable competitor. And Boeing's finance arm is having some troubles as airlines struggle to repay their airplane loans. All of that explains why Boeing's stock price has dropped from $70 a share in 2000 to as low as $24 in 2003.

But the airline industry is not going away. There may be major changes in the structure of airlines, but air travel will continue to be a vital transportation alternative. Airbus and Boeing are the only suppliers of large aircraft in the world; for smaller jets, the competition increases to four, with the addition of Embraer and Bombardier. Therefore, Boeing is likely to have a viable business providing airplanes to the airline industry.

The defense business has been a bright spot. True, Boeing failed to win the contract to build the latest fighter jet, which should be worth hundreds of billions of dollars. But Boeing has won a number of other contracts for missiles, satellites, and other aircraft. The US defense budget is the largest in the world, and is likely to keep growing for years to come.

The key point about both of Boeing's businesses is that they are not highly competitive. There are large barriers to entry, which means that a potential competitor needs significant resources to start making airplanes, or air and spacecraft used by the defense industry. Less competition usually translates into higher profits. Boeing is likely to make a reasonable stream of profits for the foreseeable future. The time to buy businesses like these is not when everyone is gushing about what great businesses Boeing has. The time to buy is when everyone thinks there are problems. Defense and airplanes will be around for many years to come. And it's hard for me to imagine the competitive landscape changing much in either line of business.

One risk for Boeing is more bad news from the airline industry, say another terrorist attack involving an airplane, which could induce a rash of bankruptcies. In that event, the eventual revival of the airline industry would be pushed back several years, resulting in a delay in Boeing's recovery. However, until someone comes up with a way to beam me up to the starship, airline travel will continue to grow, even if it suffers occasional disruptions and setbacks.

Boeing looks like a good investment to me, but there are always unforeseen risks lurking in the shadows. Boeing should be just one piece of a well-diversified portfolio.

Sources: Value Line, Boeing, Yahoo.

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