July 2004

Portfolio Comments

Market View

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The Library: articles by Steve TeSelle

Stock Focus

Portfolio Comments

Two recent merger announcements highlight how similar transactions may have different portfolio solutions.

Banks are going through another round of mergers. Both CharterOne Financial and Greenpoint Financial, one of which is in most portfolios, are being purchased. Royal Bank of Scotland is buying CharterOne for cash; North Fork Bancorp is buying Greenpoint in a stock transaction.

CharterOne rose about 20% on news of the merger. Because the stock then traded close to the merger price and so had little potential for further gains, and because the merger is for cash and would be taxable in 2004 anyway, I sold CharterOne and reinvested the proceeds in financial stocks with a higher expected return.

Greenpoint also rose on the merger news, but the stock price now moves with the price of North Fork stock because the merger is an all-stock transaction. The combined entity will have a strong presence in the New York area and has a healthy expected return over the next several years. Therefore, I’m holding onto Greenpoint stock and will wait to receive North Fork shares when the merger is completed sometime this year. By exchanging Greenpoint for North Fork shares rather than selling the shares in the market, taxable accounts that hold Greenpoint have the added benefit of avoiding capital gains taxes because the exchange of shares is non-taxable.

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 Market View

The price of oil is getting a lot of press these days. At $40 a barrel, the price is double where it was a little more than two years ago. This is a nasty little shock, but it’s not catastrophic for the US economy. Higher oil prices also affect other countries, and so even higher prices could make the world economy start to wobble. Currently, economies seem to have adjusted without too much trouble.

Most forecasts are for the US economy to grow at about a 3.5-4% rate in the next year or two. This should translate into steady growth for many companies, with maybe higher growth in technology and health care.

In general, stock prices already reflect the forecasted growth, so the question is whether the actual growth is a little better or a little worse than the expectation. This is why unforeseen events, such as terrorist attacks, can have such a powerful effect on the stock market. At this point, I think investors are pretty much on the mark. So the key is to stick to a reasonable allocation to stocks and bonds and avoid doing anything too nutty in a quest for super returns. Assuming that prices accurately reflect reasonable expectations, stocks should return in that annual 5-10% range that I keep mentioning.

The bond market is saying that the economy is humming along fine and that inflation is becoming a bit of a concern. That’s why long-term rates have moved higher - the 10-year Treasury yield has risen from 3.1% to about 4.7% in the past 12 months. I figure the 10-year Treasury should include a 3% real return, consistent with the historical average. The additional yield above 3% accounts for inflation expectations. Today’s nearly 2% annual inflation expectation is a lot more reasonable than the 0.1% we had 12 months ago. If inflation expectations move higher, the yield on the 10-year Treasury will go higher, too, which means its price will fall. However, I continue to believe that the Federal Reserve does not want high inflation and will wield monetary policy so as to keep inflation in check. I don’t expect 10-year rates to move too much higher. The 10-year rate has a wide impact on other rates, such as fixed-rate mortgages for housing, and for stock valuations, so if it doesn’t move much higher, that’s good.

With a few gyrations, the dollar has held fairly steady against the Euro and Yen. Steady is good. A much weaker dollar would likely translate into higher inflation (through the price of imports) and would suggest that foreign investors are not excited about investing here. A much stronger dollar would hurt exports and so could slow economic growth. (The potential effects aren’t quite so simplistic, but you get the idea - stable is better than not stable.)

Foreign stock markets have generally been as flat as ours. Most European markets have increased in the 5% range in local currency, but are hovering around 0% in dollar terms. Some of the big winners of last year, such as Brazil, Argentina, and Thailand (all three more than doubled in price in 2003) are down 10-20% for 2004 and have been quite volatile - not recommended investments for the faint of heart.

Japan has been the notable exception (up about 10% in Yen and 6% in dollars). People are starting to get optimistic that Japan can end the nearly 15-year run of economic doldrums and bad government policy. The signs are encouraging because Japanese consumers are actually spending some money, so the economy does not have to rely solely on exporters. Japan still has a number of problems to overcome, including a banking system that is less than sturdy, but there’s hope. A stronger Japan would be a nice boost for the world economy.

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 Services:

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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

Pfizer

Pfizer is the largest pharmaceutical company in the world, with 2003 revenues of $45 billion. The company makes many of those drugs you’re supposed to ask your doctor about: Zoloft, Lipitor, Norvasc, Celebrex, Viagra, and Xalatan. It also produces many over-the-counter products, such as Benadryl, Sudafed, and Visine.

The company has superhero financial strength. The less-than $15 billion in total debt is easily handled with annual free cash flow (cash flow less capital expenditures) of more than $17 billion and cash on the balance sheet of $12 billion.

At about $36 a share, Pfizer trades at 17 to 18 times 2004 earnings. Earnings are expected to grow at an annual rate of 13-15%. In 1998, the big drug companies were selling at 30 to 40 times earnings as investors figured that these companies could provide steady, high growth rates. Unfortunately, many of the drug companies have struggled with competition from generic companies and with a dearth of new products. Stock prices of major drug companies have fallen as a result.

So the question is: Can Pfizer increase earnings at a double-digit rate? For several reasons, I think their chances are good. First, Pfizer has one of the strongest drug pipelines in the drug industry with about 200 products in development. This pipeline is supported by an annual research and development budget of about $8 billion.

Second, Pfizer completed a couple of large mergers in the last few years - Warner-Lambert and Pharmacia - which means that there should be a number of cost-cutting opportunities. Even if revenue doesn’t increase at a double-digit rate, earnings can grow faster than revenue if the company can lower its costs.

Finally, the healthy cash flow I mentioned earlier means the company can make more acquisitions or buy back shares.

The fly in the ointment is drug pricing. The new Medicare prescription drug program could reduce Pfizer’s profitability by limiting the amount that Pfizer can charge for its products. However, it’s still too early to see how the prescription drug program will affect the drug companies. It could increase demand by making prescription drugs more widely available to people who couldn't previously afford them. In addition, Pfizer could adjust its pricing in other countries, such as Canada, in order to maintain its profit margins.

A related risk for Pfizer is that the US adopts a government-run health care system or imposes price controls on all drugs. This would probably result in lower prices for Pfizer’s products. However, Pfizer would likely adjust its R&D budget and its international prices to respond to such a change. The net result is that Pfizer would probably be a less profitable and slower-growing company, and would have to adjust its business model to accommodate the changed landscape. Because I think the chance of either of those events is low, I don’t think they’re worth fretting about for the time being.

As always, I’m not putting all my hope and money into one stock. An investment in Pfizer should be part of a well-diversified portfolio. As such, I think the stock represents a good investment opportunity.

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

"I know I'm below average, but I figure that should still get me a few million a year."

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