January 2002

Portfolio Comments

Market View

Dorato Services

Stock Focus: Phillips Petroleum

A Deeper Understanding

Portfolio Comments

The portfolios have performed well this year (month-by-month and composite results are available here. And remember, past performance is no guarantee of future results). This statement requires more than the usual qualifier, since the composite results were up about five percent for 2001. A couple of years ago, no one would have been happy with this kind of return. But given the other alternatives, and particularly the performance of the major indices, the composite results are reasonably good.

Toward the end of the year, I made changes in the taxable accounts to take advantage of capital gains and losses. Also, in all accounts that held it, I sold Clayton Homes, which had nearly doubled in price for most accounts. I replaced it with Masco Corp., a manufacturer of kitchen and bathroom products, such as faucets and cabinets. The decision was based on the relative expected returns of the two companies.

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 Market View

The interest rate yield curve for US-government issues has become steeper throughout 2001 as the Federal Reserve continues to lower short-term interest rates, to below 2%. The goal is to bring down the cost of debt in order to stimulate the economy. The problem is that long-term rates, which affect a large portion of debt, including mortgages, haven't budged much from the 5% range. This is why the Treasury decided to phase out the issue of 30-year bonds. As the supply of 30-year bonds is reduced, investors should drive up the price (price goes up, yield or interest rate goes down). And as investors move to 10 and 20-year bonds with the unshakable guarantee of the US, the yields on those securities fall as well. That's the plan, but bond investors are a skeptical bunch. They're more concerned about inflation than the supply-side manipulations of the Treasury. Aside from a spike at the time of the announcement, long-term rates are staying put.

In fact, the short-term view on inflation is still good. Commodities such as grains, metals, oil, and gas are flat or down in price for the year. If commodities start rising, you'll start to hear more talk about inflation; otherwise, inflation shouldn't be a worry.

I find it helpful to look at the bond market both for bond investors' view of the future (remember last year when the bond market predicted a recession?) and for a value for long-term interest rates. Lower long-term rates translate into higher values for stocks.

Another key factor for stock values is earnings. The big debate playing out in the stock market right now has to do with how quickly the US economy will recover from the recession, and how strong the recovery will be. Some folks seem to think that the economy will recover quickly, we'll have a strong recovery, and the technology stocks will resume their rightful place as the leaders of the next wealth accumulation phase of the stock market. Other folks maintain varying degrees of skepticism regarding one or some of those assumptions. You can count me in the latter camp. My view is that while the economy is likely to pull out of a recession, we are unlikely to see the same level of growth we saw in the late 1990s. Both consumers and businesses are unlikely to rush back into the high-spending ways of a few years ago.

Assuming a moderate economic recovery, the prices of many technology companies, in particular, look expensive. In a classic case of driving by looking in the rearview mirror, investors have bid up the prices of many technology stocks 200-300% from their mid-September lows. Since technology stocks gave us the last great ride, we don't want to miss the next one. The problem is that the ride is no longer a zippy sports car, it's now a family sedan. With a moderate economic recovery, technology companies are unlikely to realize the earnings growth rates of the late 1990s. That can make for a disappointing ride if you're expecting so much more.

I think the moderate growth scenario is the most likely, but other scenarios are certainly possible, from the rosy outlook I've already mentioned to the disaster scenario. The disaster scenario involves more terrorist attacks or a coup in Saudi Arabia or some other nastiness that scares consumers and businesses, turning optimism into pessimism. Because I take a middle-of-the-road view, I continue to believe investors are well-served by a healthy allocation to stocks, with expected returns in the 8-12% range.

As always, I recommend investors stick to their long-term asset allocation strategies and retain a diversified stock portfolio.

Steve TeSelle

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Dorato Services:

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Articles by Steve TeSelle are available on the following financial planning topics:

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Stock Focus

An Insight Into Dorato’s Investment Style

Phillips Petroleum

Phillips Petroleum is an integrated oil company, which means that Phillips owns oil reserves, explores for oil, refines oil into various end products, including gasoline, and sells gasoline to retail customers. In the last year, Phillips completed the purchase of Tosco, a refining company, resulting in one of the largest refiners in the US; and Phillips has proposed a merger with Conoco, which would create a combined entity that is sixth in the world in terms of oil-related revenue.

Phillips' earnings fluctuate with the price of oil, a commodity that has had a less-than-stable past. In 1999 and 2000, as the price of oil jumped from $10 a barrel to more than $30, Phillip's earnings per share jumped from the $2 range to more than $7. As the price of oil has fallen back to $20, investors expect Phillip's earnings to fall as well, to $6 or $6.50 per share. Remarkably, the yo-yo earnings do not translate into yo-yo prices for the stock. Investors expect oil company earnings to fluctuate with the price of oil, and so are not willing to pay a high multiple of earnings in the good years or drive the stock price down in bad years.

At $60 per share, Phillips sells for about 10 times 2001 earnings. If Phillips were to remain one of the smaller integrated oil companies, this would be a reasonable price to pay for a good company. But with the addition of Conoco, Phillips would become one of the largest integrated oil companies in the world, with a stronger balance sheet than it currently has. As a larger company, Phillips should be able to produce more consistent earnings and so entice investors to pay a higher multiple for each dollar of earnings. For example, Exxon Mobil currently trades at 18-20 times earnings. If Phillips were able to earn $6 per share in 2001, and investors were willing to pay 15 times earnings, Phillips would be worth $90 a share.

Phillips has a good financial position. About one-third of the company's capitalization is from debt, a manageable level. Phillips uses its cash flow (approximately net income plus depreciation and amortization) for capital spending plans. In difficult times, capital expenditures tend to be more flexible than debt payments so that if the price of oil falls for an extended period, the company should be able to adjust these expenditures. A merged Phillips Conoco would have a stronger financial position than Phillips alone, assuming the proposed cost reductions were implemented.

There are two major risks for Phillips: one is that the price of oil falls and stays at, say, $10 a barrel for an extended period; the other is that the proposed merger with Conoco fails to materialize. With low oil prices, Phillips' earnings per share could fall to the $1-$2 range, as they did in 1998 when the price of oil fell to $10 a barrel. But given a moderate recovery in the US and other economies, and an OPEC that is willing to threaten a price war, I don't think cheap oil is likely. Regarding the merger, a negative response from regulators or a higher offer from a competitor is possible; but even in the absence of the merger, Phillips is a solid company with healthy finances.

There are certainly other risks that I can't foresee; but a diversified portfolio can limit the risks an investor faces. I wouldn't put all my money into oil stocks, but allocating a portion of a portfolio to this important commodity seems reasonable.

Steve TeSelle

Sources: Bloomberg, Yahoo, Phillips, Value Line.

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 A Deeper Understanding

This section deals with a deeper understanding of what Dorato is, not with a deeper understanding of life, or anything profound like that. I hope you're not disappointed. My wife keeps pointing out that she doesn't really understand what I do, so maybe other people don't either. Well here goes.

Dorato's primary focus is on creating individual, separately-managed stock portfolios. Dorato can be utilized similar to a mutual fund, where a client simply has an account; and/or as more of a financial planner, where Dorato helps with management of a client's entire portfolio and with other financial issues. I do not require that a client divulge all of his or her assets; that decision is up to the client. I do require clients to fill out a questionnaire that asks for ranges of values for net worth and income. I use this and other information to determine whether a stock portfolio is suitable for the client. For those investors without enough assets to create a diversified stock portfolio, or who have assets primarily in 401k accounts, I offer investment planning on an hourly basis.

Dorato is entirely fee-based, which means that Dorato is paid for management and advice, not for selling any type of product.

Since my main competitors in managing stock portfolios are mutual fund companies and other large organizations, I offer services such as help with tax questions, retirement issues, college savings and other financial topics. I do this because individuals have many more questions about their finances than what their return was for the last quarter, and because getting even basic return information from a large company can be a chore.

If you have any questions regarding Dorato's services, please give me a call or send an e-mail. Thanks.

And in this piece of both business and fashion news, the market is looking for a bottom.