July 2005

Portfolio Comments

Market View

Dorato Services

The Library: articles by Steve TeSelle

Stock Focus

Portfolio Comments

A private equity firm recently announced its intention to buy SunGard Data Systems for cash. The transaction should be completed within the next couple of months. For clients with taxable accounts, the buyout will result in a taxable gain. That got me thinking about taxes. And that got me thinking about the difference between good problems and bad problems.

Nobody likes to pay taxes, but if you have to pay taxes because you’ve made a profit, I think that falls in the category of a good problem to have. A bad problem is something like a car that won’t start or a leaky roof or you don’t know how to come up with enough money for your next meal. Yuck. In the investment world, a few years ago, some mutual fund investors had losses in their accounts even as they had to pay taxes, due to how capital gains are passed through to investors. Yuck again.

Fortunately, with the SunGard purchase, we’re dealing with a good problem. When you own stocks directly, rather than in a mutual fund, there are a couple of solutions to this good problem. One is to pay the tax. Another is to sell another investment for a loss, to offset the gain. Although, even if you have a loss, you may not want to sell because the company in which you have a loss is still a good investment. If you don’t have any losses to offset your gains, I think we’re back to the good problem again. You might even call that a really good problem.

I wouldn’t be too upset if there are more SunGard-type problems in the future. Here’s to all of us having mostly good problems to solve.

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 Market View

The story about the US economy continues to be remarkably consistent: steady growth and low inflation. GDP growth is about 3%, a little slower than last year, but still quite healthy. Inflation, as measured by the Consumer Price Index, is somewhere in the 2-2.5% range.

The Federal Reserve keeps pushing short-term rates up, now to 3%, because Greenspan and Company are more concerned about a rise in inflation than a weak economy. It’s a bit of a balancing act, but they seem to be managing so far. Assuming the Federal Reserve does a decent job, we should still be able to get a reasonable return on stocks (somewhere in the 5-10% range).

Long term interest rates are even lower now than when I wrote about them three months ago and said they were low. Those low rates reflect either excessive optimism about the Federal Reserve’s ability to fight inflation or excessive pessimism about the strength of the US economy or some combination. It could be that I’m out to lunch and that these low rates make perfect sense, but if so, a notable fellow has joined me in the lunch line. Mr. Greenspan is also confused by the low long-term rates.

My guess is that he’s made his confusion public because he’d like long-term rates to rise, which would push up rates on mortgages, in order to let some air out of the real estate market. Everybody and their third cousin seem to think that making money on real estate is a no-brainer. As one friend said to me, an investment is a no-brainer until all of a sudden it isn’t anymore. But if you’re the Chairman of the Federal Reserve, you have control over short-term rates only. You can try to talk some sense into long-term rates, but that’s all you can do. If investors don’t want to listen, they don’t have to.

The currency market has changed a bit. Since reaching a low point in April, the dollar has strengthened against most major currencies. Against the Euro, the dollar has risen more than 10%. It wasn’t too long ago that we read articles about how the dollar was only going to get weaker. Whoops. Predicting the short-term path of currencies may be only slightly easier than sitting on your own lap.

India and China continue to grow quickly; Europe seems stuck; and Japan is teetering on the edge of recovery. If Europe and Japan can get their economies to improve, the outlook for global economic growth would grow sunnier.

European stock markets are slightly positive in local currency terms. But the stronger dollar has turned most of those returns negative for a US investor. Developing markets have been a little more profitable. One of the best-performing markets of 2005 is Egypt, which is obvious if you don’t think about it.

With small changes in value in most markets since the end of 2004, you might not be surprised that my outlook hasn’t changed. There’s no need to make any wholesale changes to your portfolio, unless of course your personal circumstances have changed. Stay invested in stocks, keep your fixed income investments to shorter maturities, don’t go piling into residential real estate as an investment.

If I talk about return, I have to talk about risk. It’s not too hard to imagine that world events could upset expectations. For example, an economic crisis in China or a terrorist hit just about anywhere could turn investors sour about the future. And I’m still waiting for a hedge fund to cause some kind of crisis; the question is not if, but when. The point of talking about risk is not to send anyone running for the nearest cave, but to be realistic about the possibility of losses.

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

Computer Sciences Corp.

Computer Sciences Corp. (CSC) is a large computer software company. CSC offers information technology, outsourcing, and professional services. For example, CSC operates and maintains the computer system for a health maintenance organization. In 2004, the company generated about $14 billion in annual revenue.

The stock currently trades at about $44 per share. With 2005 earnings expected to be about $3.30 per share, this price translates into a Price to Earning (P/E) ratio of roughly 13 or 14. Price to cash flow is a little above four. This, for a company that’s increasing revenues and profits at a rate of about 10% per year. In the technology euphoria of the late 1990s, CSC stock sold for as much as 40 times earnings. Forty seems awfully high to me, but 13 or 14 seems quite attractive.

CSC gets a solid financial rating. The $2.5 billion debt is easily covered by earnings, and CSC generates healthy cash flow, well above capital spending needs.

A nice thing about the IT business is that the contracts tend to be long-term, which produces a steady stream of revenue. For example, the company might sign a contract for one or two years, but the life of the contract can extend another seven or eight years if CSC meets performance targets.

The future for companies such as CSC is quite bright. Companies in every type of business realize that they need to invest in technology in order to remain competitive. And many companies are making the decision to outsource all or part of their information technology function.

Sometimes it’s obvious why a company’s stock sells for a low price. For example, in the last newsletter, I wrote about AIG, which has a number of issues to deal with. I can understand how investors might be spooked about how those issues impact the company and its stock price. But for CSC, it’s not obvious to me why the stock is on sale.

The main risks are related to competition and the economy. CSC operates in a competitive industry, bumping up against rivals such as IBM, Hewlett-Packard, and Electronic Data Systems. These rivals could start to take business away from CSC, or force CSC to lower prices and therefore reduce profit margins. Also, if the economy turned sour, there would probably be fewer contracts for CSC to bid on.

However, the industry has been competitive for some time, and CSC has managed to negotiate its way to profits so far. And the ups and downs of the economy are not predictable. We’ll have another recession at some point, but who knows when that will be. In the meantime, I think CSC will continue to increase revenue and profit at a respectable rate.

I think CSC is a good investment opportunity, but I’ve been wrong before (please see the chart on the inside of this newsletter), and I’ll be wrong again. I wouldn’t want to put everything I own into the company’s stock. However, as part of a diversified portfolio, I think an investment in CSC makes a lot of sense.

Sources: Value Line, CSC, Yahoo.

"Well, that about wraps up the meeting... If I give you a head start, would you mind terribly if I chase you to your car?"

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