October 2002

Portfolio Comments

Market View

Dorato Services

The Library: articles by Steve TeSelle

Stock Focus: Verizon Communications

Portfolio Comments

Taxes. For those of you with taxable accounts, there is a silver lining to the cloud of lower stock prices. You can take up to $3,000 in losses (in excess of any gains) from your stock portfolio on your tax return. Assuming you pay about a 30% marginal rate for Federal and State taxes, taking $3,000 in losses can save you $900 in taxes. I'll be checking with you before the end of the year to determine whether you want to take advantage of any losses.

Diversification, again. Last newsletter, I wrote about diversification of a stock portfolio. Diversification also applies to an investor's total assets. For example, by combining bonds with stocks, you reduce the volatility - changes in value - of a portfolio. Bonds have a lower expected return and a lower volatility than stocks. When you add bonds to an all-stock portfolio, the expected return of the portfolio drops, but you have a better chance than with an all-stock portfolio of meeting your expected return.

Now some people say, "I just want the highest return I can get." Fine, but that chance at a high return comes with a healthy dollop of risk. Translation: There's a reasonable chance that you won't achieve that return. Usually, the higher expected return you shoot for, the greater the chance that you won't achieve it.

Given what's happened in the stock market, now is a good time to ask yourself if your appetite for risk is as much as you thought. You're the one who knows best whether the drop in stock prices has been an annoyance or the beginning of an ulcer.

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 Market View

The US stock market looks quite reasonably priced. Value Line, my source for much stock information, calculates the price to earnings ratio for the 1700 stocks it follows at about 16 - in line with the long-term average. This ratio has been more than 20 and as low as 6 (in the dark days of Watergate, price controls, and oil embargoes), so the number is only useful as a broad indicator of value, not a specific measure that can tell you whether to buy or sell stocks.

While stocks are attractive, US Treasuries look a bit expensive, as the investor herd stampedes to safety. US debt obligations have continued to rack up strong gains as interest rates drop (for bonds, lower interest rates translate into higher prices). The 10-year note now yields close to 4%, a level we haven't seen since the early 1960s. The herd seems to think that the good times will continue for US debt; I'm a bit more skeptical. If you are keeping track of your own asset allocation, now is probably a good time to make sure that your bond allocation, and especially your allocation to US Treasuries, hasn't grown too large relative to other assets.

Another asset class that seems to be expensive is housing. Housing prices have doubled or tripled in the last 10-15 years. The low 10-year rates in the Treasury market translate into low mortgage rates for homes, so people have been able to afford the higher home prices. But this doesn't continue indefinitely. With a weaker economy than we've seen in the recent past, and with the low probability of even lower interest rates, the housing market is not likely to do so well over the next several years. This doesn't mean you should run out and sell your home, but I wouldn't be buying up a lot of property right now.

Inflation continues to be a non-issue; the consumer price index shows about a 1% annual rate of inflation. Still, two potential inflation igniters loom on the horizon: higher commodity prices (grains, metals, oil), and a weaker dollar. Higher than expected inflation would hurt both the stock and bond markets.

The dollar has fallen in value against other currencies. So far, the weaker dollar hasn't resulted in a smaller trade deficit. The danger here is that the weaker dollar leads to inflation, as imports cost more dollars. If the trade deficit stays large, even as the dollar weakens, the Federal Reserve may be forced to increase interest rates to fight off inflation - even if the US economy isn't chugging merrily along.

Among sectors of the US stock market, the telecommunications and technology companies keep pushing out the date of their expected turnaround. What was once early 2001 has become early 2003. Eventually, the markets these companies serve will recover, but it might still be a while. Another weak spot is the airline industry. The large airline companies cannot continue under the current cost structure. I wouldn't be surprised to see a number of bankruptcies in that industry.

A number of folks are reducing their expectations for returns as stock prices fall. In part, this makes sense if these are people who now realize that their expectations had grown faster than Jack's beanstalk. But, in part, I think people are extrapolating the performance of the last two years. In fact, if earnings projections aren't too far out of whack, the expected return for US stocks should be rising as prices fall. This is why the average annual return I expect from stocks over the next several years has increased from 8-12% to 10-14%. Of course, this is an expectation, not a guarantee; but, generally, lower prices mean more opportunities.

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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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

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

Verizon Communications

Verizon was created by the merger of Bell Atlantic and GTE, two of the Baby Bells that resulted from the break-up of AT&T in 1984. The original Baby Bells were primarily phone companies that provided local service to certain regions of the country. Verizon has evolved into a worldwide provider of telecommunications services, such as local and long-distance telephone service and internet services, through both wire and wireless media.

In 1999, at the height of the technology/ telecommunications euphoria, Verizon (actually, Bell Atlantic and GTE separately) traded at the equivalent of nearly $70 per share, or more than 20 times earnings. Now that the euphoria has faded, Verizon trades at about $30 per share, or 10 times earnings. Whereas in 1999, analysts projected an extended period of double-digit growth for Verizon, now they project growth in the low single digits. In the space of just a couple of years, investors and analysts appear to have gone from excitement at the prospects for telecommunications to pessimism that these kinds of businesses will grow much at all.

Certainly, over the last couple of years, revenue and earnings growth have slowed dramatically. In 2001, the company generated revenue of $67 billion, and profit of more than $8 billion. In 2002, Verizon is expected to report similar numbers. The $3 per share of earnings is about where it was in 1999. The question is whether the current stagnation is likely to persist.

I thought the projections of the late 1990s got a bit too rosy. Today, I think investors are a bit too dreary. As the economy improves, spending on telecommunications services is likely to pick up. Verizon, with a full array of service offerings, and as one of the largest providers in the US, is likely to benefit.

A potential threat to this happy scenario is the competition from cable companies. Cable firms offer an alternative to the telephone companies' connection to every home. But cable companies are in a much weaker financial position than the telephone companies. Verizon generates ample cash flow to service its $45 billion debt, pay for capital expenditures, and cover its healthy dividend (5% yield). Verizon and the other major telephone companies earn high marks for their financial position. As we've seen in the last several years, healthy finances can go a long way to fight off competitive threats.

With this company, at this price, I have a hard time coming up with serious risks. The main risk is that the US enters a severe recession, with high levels of unemployment. This would cause consumers and businesses to reduce expenditures for telecommunications services, so Verizon's revenue could fall rather than stagnate. But in that case, just about every kind of business will suffer. The whole stock market would decline.

I get excited thinking about the opportunity to buy a very strong company such as Verizon at such a reasonable price. Still, it is only an investment, not a keepsake. My task as portfolio manager is not only to search for good investment opportunities, but also to manage risk. As giddy as I am, Verizon will get no greater weight than any other company in a portfolio.

Sources: Bloomberg, Yahoo, Verizon, Value Line.