October 2003

Portfolio Comments

Market View

Dorato Services

The Library: articles by Steve TeSelle

Stock Focus

Portfolio Comments

We're coming up on the end of the year, when people start to think about taxes. OK, maybe only I do. Anyway, tax rates on capital gains and on dividends are lower for 2003. But of course, it's not that simple. As your income rises, you lose exemptions, itemized deductions, and other goodies that lower your tax. You can also bump into the Alternative Minimum Tax. So if you decide to sell stock to take advantage of the lower rates, you may be paying more tax than you expected. You or your tax advisor has to make some estimates and run the numbers in a tax software program to have any idea what tax rate you are likely to end up paying.

The end of the year is also a time when people think about adding to their investment accounts. If you're adding money to or making an initial investment in a mutual fund in a taxable account, watch for capital gains distributions. This may not be a big problem this year for stock mutual funds, but you never know. You could get taxed on a distribution without having earned anything. Many mutual fund companies make distributions in December. If a fund will have a large distribution, I suggest you defer making any contributions until after the fund distribution date.

I don't sit up at night thinking about ways to avoid paying taxes. And investment decisions should be driven primarily by factors such as return and risk, and diversification. But there's no point in paying taxes when you don't have to, or in being unaware of the tax impact of your decisions.

[top]

 Market View

Stock returns crept higher in the third quarter. Investors seem to be in a bit of a holding pattern, as they try to figure out whether the US economy will grow strongly from here, and so give companies a chance to earn higher profits. Or whether we're in for a fits-and-starts period, in which businesses have trouble earning sustainable profits.

There's certainly a lot to worry about: unemployment appears stuck in the 6% range, even though the recession was declared officially over in November 2001; terrorism appears to be a constant threat; the US budget deficit is growing faster than Jack's beanstalk; and Europe and Japan don't seem to have great prospects for growth, which limits how much the US can grow.

On the other hand, steady employment combined with economic growth means that people are more productive (that's the concept anyway). And growth in productivity means that the economy can grow without igniting inflation. Also, it's OK to have deficit spending in a recession, as long as we move toward a surplus during an expansion.

On balance, the US stock market appears fairly priced, maybe slightly on the high side, but not ridiculous. If US growth continues in the 3-4% range, investors would have an excuse to push prices higher. And if Europe and Japan were to kick in, the prospects are even better. I'm keeping my fingers crossed that politicians around the world don't go in for a bout of protectionism. That would be one sure way to muck up the engine.

Bonds have achieved a more realistic valuation. In the Spring, yields on 10-year US Treasuries had fallen to near 3%. They now stand at around a bit over 4%, after going as high as 4.6%. This equates to an inflation expectation of a little more than 1% per year for the next ten years. I think that's still optimistic, but it's not nutty.

Another thing about the bond market. The difference in yield between short and long-term bonds is now more than 4%. That's fairly steep, and it shows that bond investors are expecting the US economy to grow. It's always nice when the stock and bond markets are sending the same message. I like questioning the conventional wisdom, but there's no point in being contrary just to be contrary.

The housing market still looks expensive. I don't expect housing prices to sink, but ultimately, housing prices are tied to people's incomes. The ratio of home prices to people's incomes is quite high. And given the job market, and that interest rates have come back up, I don't see house prices going up for some time. Since houses don't trade on a market exchange, as stocks do, I expect house prices to just stay flat, not plummet.

The dollar is likely to get weaker against other currencies, especially if the Asian countries, such as Japan and China, don't take extreme measures to keep this from happening. A weakening dollar justifies at least some exposure to foreign markets, since a lower dollar increases the return on foreign investments to US investors. Also, a weaker dollar could lead to some inflation, another reason to be skeptical about a 1% inflation rate.

I wrote in an earlier newsletter about how investing in airlines seemed like gambling to me. Indeed, since then, United Airlines declared bankruptcy. On the other hand, AMR (American Airlines) has risen more than ten times. If only you could know ahead of time which company would do what.

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

[top]

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
• Allocations for retirement accounts
• Small business retirement accounts
• Retirement planning
• Advice on stock options
• Assistance with tax questions
  

[Top]
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.

[Top]

Stock Focus

An Insight Into Dorato’s Investment Style

SunGard Data Systems

SunGard has two major lines of business: investment software used by financial institutions, and backup services that allow a business to continue operating in the case of a disaster or malfunction. SunGard has more than 20,000 customers around the world, and serves many of the world's largest financial institutions. Total sales in 2002 were about $2.6 billion, split roughly in equal parts between the two lines of business.

The stock currently trades at about $28 per share, which translates into a Price to Earning (P/E) ratio of about 22, and a price to cash flow ratio of close to 11. Those are fairly high ratios to pay for a chemical company or a utility, but they're quite reasonable for a computer software company with double-digit growth.

SunGard has generated earnings growth in the 15-20% range over both a five and ten-year period. Lately, the investment division has been struggling, due to a slowdown in spending in the financial industry, but the business continuity division has shown solid, double-digit growth.

Part of SunGard's strategy is to grow through acquisitions. SunGard has proven over time that it can acquire businesses successfully. I'm usually less excited about large mergers because shareholders tend not to benefit much. Synergies are always smaller and problems are always larger than the combining companies originally project. But companies that use relatively small acquisitions as part of their business strategy, and that have successfully executed on this strategy, can make shareholders quite happy.

SunGard's financial position is strong. The company will generate cash flow of about $700 million in 2003, against capital spending of about $150 million. With $400 million in cash and only $300 million in total debt, SunGard's has a lot of options and the ability to weather most storms the business climate could send its way.

The future for SunGard's markets looks bright. Financial institutions are likely to continue spending on technology in the highly competitive and complex investment industry. And the terrorist attacks on the World Trade Center made many businesses realize the value of backup and continuity services.

As always, there are risks. In addition to the usual culprits, such as management missteps and economic recession, SunGard faces a risk specific to its products. The company operates in the computer software market, which is highly competitive and ever-changing. The markets SunGard serves and the competitors they face could look different five years from now. In fact, they probably will look different. But SunGard has a track record of meeting demand and responding to its customers' needs. Given the potential returns, I think this is a risk worth taking.

SunGard looks like a good investment to me, but I try to be realistic about what I can and can't know. The future is, by definition, uncertain. Rather than thinking I have all the answers, I try to balance the return potential of owning the stock against the risk, which includes the risk that my analysis is something less than perfect. Therefore, SunGard is just one piece of a well-diversified portfolio.

Sources: Value Line, SunGard, Yahoo.

"Hey. Hey you. Scat. We've saved for retirement. Go on. Shoo!"

[Top]

© Dorato Capital Management, LLC. All rights reserved.