January 2001

Portfolio Comments

Market View

Notice of Form ADV

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Stock Focus: Jones Apparel Group

Portfolio Comments

During the quarter, I made no changes to the portfolios.  At the end of the year, all clients finished with positive returns.

I am restricted by regulation from saying much about the performance of the portfolios.  Without full disclosure, any discussion of performance could be misleading.  If you’re interested in how I’ve done this year for all clients, please visit my web site, where I update performance monthly and where I have a full disclosure statement.  You can also give me a call.  I’d be happy to send you the performance report with the full disclosure statement.

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 Market View

Many investors seem to be getting nervous.  It has happened before; it will happen again.  Signs of nervousness can be found in both the stock and bond markets.  In stocks, technology stocks, those unstoppable engines of growth, have fallen from their euphoric highs, as the engines sputter and cough more than the optimists expected.  Even companies that haven’t warned of slower growth have seen their share prices fall.  Also, the prices of drug stocks such as Merck and Schering Plough, which are already expensive, are rising.  Drug stocks are typically seen as safe investments as long as nobody’s planning health care reform.

In the bond market, interest rates across all maturities for US government debt have fallen.  Rates move inversely to prices, so this means prices have risen.  The increased demand for US debt could mean that investors believe the Federal Reserve will cut interest rates soon.  But the demand could have more to do with investors’ flight to safety, since the US government tends to pay its debts come rain or shine.  Combined with the fact that rates for other types of debt, from corporate to foreign country issuers, have risen (prices have fallen), I think investors are not buying US debt because of optimism about the future, but because they’re worried.

Do investors have reason to be worried?  Sure.  Corporate earnings have faltered.  Companies of all stripes, from Microsoft to Bank of America to Target, have warned that earnings will not meet analysts’ estimates.  One company that used to be considered a blue chip, Xerox, is on such shaky financial ground that banks are reluctant to lend it any more money.  Xerox’s stock price has fallen to $5 a share from more than $60 in early 1999.

Given slower corporate growth, slower growth throughout the US economy should come as no surprise.  The surprise has been the speed with which the economy has cooled.  The US economy grew at a pace just over two percent in the fourth quarter, about a percent lower than the average analyst expected.  Within the space of six short weeks, the Federal Reserve went from being primarily concerned about inflation to being primarily concerned about recession.

Maybe Mr. Greenspan will wave his magic wand of lower interest rates and riskier investments will get their glass slippers back; but maybe not.  The US has a huge current account deficit (imports greater than exports) that has been financed by foreign investors.  Foreigners are attracted by the strong US economy and the strong dollar.  If the economy or the dollar starts to look weak relative to foreign markets, foreigners could take their money home.  This would limit the Federal Reserve’s ability to reduce interest rates because a weaker dollar could translate into inflation via imports.  The Federal Reserve would not want to reduce interest rates when the rate of inflation is increasing.  I describe this possibility not to scare anyone into fleeing the market, but to point out that risks are always with us, whether Mr. Greenspan is steering the ship or not.  Generally, the realization that stocks can fall as well as rise is a healthy phenomenon.

So what happens from here?  Well, people could get really nervous and drive all stock prices down.  That’s certainly a possibility.  But trying to guess how nervous investors will be in the future is like formulating a five-day weather forecast in the Rockies – nothing you’d want to bet on.  Rather than focus on other investors, I prefer to fix my eyes on the many good investments in the US market now.  A uniform drop in equity prices would only make those investments more enticing.

Technology stocks have taken such a drubbing since they reached their highs in March that some of them are starting to look like good investments again.  Many of the companies that were no more than ideas will probably never come back.  Good riddance.  Other firms still look more like venture capital investments than holdings for a core portfolio.  But solid companies, such as Dell, are almost bargain basement specials.

For investors willing to look beyond technology stocks, there are still good opportunities in the shares of financial, retail, and industrial companies.

Steve TeSelle

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Notice of Form ADV

Some of you prefer to use Dorato as an investment vehicle similar to a mutual fund account, in which funds are invested and Dorato has little additional involvement in your finances.  That’s fine.  But if you would like additional services, such as help with retirement planning, or devising a strategy for exercising stock options, or advice regarding other investments, please feel free to contact me.  Once you have an account with Dorato, these other services are available at no additional cost. 

What is Dorato’s mission?

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.

Written pieces are available on the following financial planning topics:

College Savings Options

Retirement:  What’s the Target?

To get a 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

Jones Apparel Group

Jones Apparel Group designs and markets a broad range of clothing for women; jeans and casual sportswear for men, women and children; and shoes for women.  The company’s brands include Jones New York, Evan Picone, Bandalino, Rena Rowan and Nine West.  Jones sells its merchandise through department stores and via company-owned specialty and outlet stores.

Jones was incorporated in 1975 and first sold stock to the public in 1991.  Throughout the 1990s, the company has consistently increased both earnings and cash flow per share – over the past five years at an annualized rate of approximately 30%.

At $33 per share, the stock trades at a price to earnings ratio (PE) of 13, based on year 2000 earnings of $2.50 per share.  Most analysts don’t expect the company to continue to generate earnings growth of 30%, but they do expect growth in the high teens.  Paying a PE of 13 for a company that’s expected to generate earnings growth in the high teens looks like a pretty good deal.

Cash flow per share tells the same story.  Because Jones used purchase accounting for its acquisitions of Nine West, Sun Apparel and Victoria over the last few years, non-cash charges for depreciation and amortization are much higher relative to earnings than in the past, amounting to approximately 80 cents per share.  The 2000 cash flow of approximately $3.30 per share translates into a price to cash flow of 10, at the low end of where the stock has traded in the past.

The above-mentioned acquisitions resulted in a higher level of debt, from next to nothing in 1997 to more than $1 billion.  This increases the financial risk of the company in a recession; that debt has to be repaid whether or not Jones can sell clothes and shoes.  But debt isn’t all bad: interest on debt is tax-deductible.  Also, the acquisitions broadened Jones’ product line, which lowers the company’s operating risk.  By having more products, the company diversifies its revenue sources and is better able to withstand a failure in any particular line.  Given Jones’ ten-year record of consistent growth, I like the probability that they will continue to meet consumer preferences for fashions.

Another risk in buying Jones is that the economy slows considerably and consumers pull back on their spending.  Even if the company can repay its debt, revenue and earnings will be hurt by slower sales.  This is certainly a possibility, but since we can’t predict the short-term movements of the economy with any certainty, we’re better off not basing our stock decisions on such possibilities.  When other people are worried about those kinds of issues, we get a chance to pick up a good company at a reasonable price.

As always, I beat the drum for diversification.  Jones is not likely to provide much diversification benefit if investors sour on stocks in general or if interest rates increase, but it will provide diversification from, say, a slowdown in technology spending by businesses, or from rising costs for health care companies.

Steve TeSelle

Sources: Bloomberg, Jones Apparel Group, EDGAR filings, Value Line.

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