October 2001

Portfolio Comments

Market View

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Stock Focus: Carlisle Companies

The Worry Factor

Portfolio Comments

I made minor changes to some of the portfolios during the third quarter, either due to buyouts of companies in the portfolios or due to stocks that have performed well and so had grown too large as a percentage of the portfolio.

In the last newsletter, I wrote about getting nervous about valuations. In this newsletter, I write about the good investment opportunity the drop in prices has given us. The market view section is, I hope, helpful in informing you about what's happening and what might happen in the economy and the stock market. However, whether I'm nervous or excited about the market, I wouldn't want to change my portfolio allocation or change the mix of stocks in the portfolios. My investing experience has caused me to be quite humble in my ability to forecast the economy or the stock market. Of course, there are exceptions. For example, if investors got a dose of euphoria flu, and bid stocks up to ridiculous levels, I would talk to you about reducing your allocation to stocks. Barring that, I encourage investors to remain faithfully invested, riding out the bumps to achieve solid long-term returns.

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 Market View

The terrorist attacks on September 11 caused many of us to re-evaluate. In the stock market, many people re-evaluated their assumptions about the future. Investors lost some of their optimism and drove stock prices down throughout the week after trading was resumed on US stock exchanges.

The shock to investor confidence is understandable, yet the attacks do not affect the basic strengths of the US economy or the long-term prospects for most companies. The attacks could push the US into a recession due to lower consumer spending, but this is a short-term issue that does not affect the long-term returns investors should expect from stocks. The sell-off in stocks, which started in August and was exacerbated by the attacks, now offers investors a good investment opportunity.

The Federal Reserve has aggressively lowered interest rates and increased the money supply, both prior to and after the attacks. This has caused short-term interest rates to drop dramatically from last year's levels, resulting in an upward-sloping yield curve. As I wrote in the last newsletter, an upward sloping curve is the normal state of affairs. Long-term yields tend to earn a higher yield due to the greater uncertainty of the future, say, ten years from now versus one year from now. While the Federal Reserve dictates short-term yields, investors determine where the long-term yields reside. In a sign that investors are a little less worried about inflation than they were a year ago, the long-term yields, too, have come down from where they were last year.

Bond investors have good reasons to think inflation is under control. Oil and gas prices appear to have stabilized at levels below the highs reached early this year, even after the terrorist attacks. Factories are utilizing capacity well below 80%, which means there are no supply bottlenecks that could cause prices to rise. And the job market is softening, so that companies are not in bidding wars for employees.

Unfortunately, what is good news for inflation and the bond market can be bad news for economic growth and the stock market. A softening job market means people are getting laid off and having trouble finding a job. This causes most of us to get a little more nervous about spending money. Since consumer spending makes up roughly two-thirds of the US economy, changes in consumer spending have a big impact on the economy.

In better times, businesses might pick up some of the slack through capital spending, but businesses are unlikely to return to the big-spending ways of the late-1990s too soon. Many businesses are struggling not with slowing growth, but with reductions in revenues. Still, the drop in business investment will not persist indefinitely. Eventually, companies will need to spend in order to attract and retain customers. The big question is how soon that will occur.

I keep reading articles in which an author compares the US in 2000 to Japan in 1989. The concern is that Japan is still having trouble, more than ten years after their stock market bubble popped. Is the US in for the same? The similarity is that asset prices got out of hand in both cases. But if you look more closely, only US technology stock prices were severely overvalued, while in Japan, both stock and real estate prices got out of hand. At their respective peaks, just about any hogwash was used to justify silly prices. Moreover, a key difference between the US and Japan is that the US market responds more quickly to poor pricing, primarily due to less government involvement. The Japanese government, even now, continues to promote policies that prop up companies and asset prices rather than allow prices to fully adjust to economic reality.

Now that investors have sold off stocks, the potential returns from stocks look more appealing. If we could have predicted the terrorist attack, we could have sold stocks and raised cash ahead of time. But that kind of event is unpredictable. This is why investors should set on allocation of stocks, bonds, and cash that allows them to achieve their goals, with the understanding that the stock portion of the portfolio will fluctuate more than the bond and cash portions.

As always, I recommend investors retain a diversified stock portfolio. The sell-off in stocks has created an opportunity for investors with diversified portfolios to earn healthy returns from this point forward.

Steve TeSelle

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Dorato Services:

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Written pieces are available on the following financial planning topics:

• College Savings Options
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• Risk, Anyone?

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

Carlisle Companies

Carlisle Companies is a manufacturing company that serves primarily the transportation and construction markets. For the transportation market, the company makes rubber and plastic components, tire and wheel assemblies, and braking products. In the construction market, Carlisle produces roofing and coating systems. Carlisle has annual sales of approximately $1.8 Billion.

During the 1990s, Carlisle's earnings increased at an annual rate of 15-20%. By the end of the decade, however, the company faced lower demand in its end markets (e.g. reduced sales of automobiles). In addition, Carlisle has been squeezed by rising costs for supplies such as rubber. The result is that even while sales have continued to increase, profits have stalled. After earning just over $3 per share in 1999 and 2000, analysts expect Carlisle to earn just over $2.00 in 2001.

At $28 per share, Carlisle sells for about 14 times 2001 earnings. If you believe that the current economic environment will persist indefinitely, and that Carlisle will have a difficult time returning to a double-digit earnings growth rate, then $28 is a reasonable price. If you believe, as I do, that Carlisle has a good chance of returning to healthy growth rates in the next year or two, then the price looks inexpensive.

Carlisle has a healthy financial position. The company generates more than $4 per share in cash flow, about half of which is used for capital spending. This leaves Carlisle a good cushion for trying times or for acquisitions. The balance sheet is in good shape. After allowing inventories to balloon in 2000, Carlisle is working down inventories in 2001. And debt, at about a third of total capital, is manageable given the company's fairly steady earnings.

The primary risk for Carlisle is that the economy falls into a lengthy recession. In that case, consumers would likely cut back expenditures on cars - a key component of Carlisle's revenues. In addition, the building construction market would also likely suffer negative consequences in a prolonged recession. I'm not ready to predict a long recession, or even a short one, for that matter. Also, a tough business climate could allow Carlisle, with its strong balance sheet, to acquire other companies on the cheap.

Another potential risk is that Carlisle's management bungles operations. After all, they let inventories build up in 2000. However, the company has a good track record of increasing revenues and earnings over time, so I think this risk is limited.

There are certainly other risks that I can't foresee; but a diversified portfolio can limit the risks an investor faces. Carlisle is a relatively small company, with a market capitalization of about $1 Billion (shares outstanding times stock price). Contrast this with General Electric at a market capitalization of more than $350 Billion, or Johnson & Johnson, with a market capitalization of $160 Billion. Investors benefit from diversification not only across industries, but also across market capitalizations. There is no good argument for owning only large stocks, or only small stocks. Carlisle fills a role as both a transportation-related company, and as a stock with a small capitalization.

Steve TeSelle

Sources: Bloomberg, Yahoo, Carlisle, Value Line.

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The Worry Factor

The series of terrorist attacks in September were horrible events. I don't feel capable of writing anything useful about the attacks, other than to discuss the financial implications. This is one of those shocks that can't be predicted. If you can weather the uncertainty and volatility that the attacks created in the financial markets, then you should be rewarded with decent returns over the next several years. But if you can't, then perhaps your exposure to stocks is too high. There is no one else who knows better than you how much worry the stock market volatility caused you. If you would like to discuss your stock/bond/cash allocation, please contact me.

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