October 2004

Portfolio Comments

Market View

Dorato Services

The Library: articles by Steve TeSelle

Stock Focus

Portfolio Comments

A few months ago, a friend showed me a newsletter that proclaimed a coming crash in the stock market. A number of factors, including a huge US budget deficit and a huge debt burden accumulated by the average American, would cause the stock market to crash in the near future. I also noticed a book out named something like ‘The Coming Crash in Real Estate and What to Do About It.’ I don’t think we have nary a care in the world and that the future is nothing but roses, but I also don’t think the future is nothing but weeds. These kinds of predictions got me to thinking about why so-called experts make them.

I think the reason boils down to incentives. Chicken Littles will always be with us because they have a big incentive to keep saying that the sky is falling, or will be falling shortly. If they are right, even for the wrong reasons, and the stock market falls, then people will think these doomsayers are especially insightful. The doomsayer will be able to live off that prediction for some time. Back in 1987, a few people parlayed stock market crash predictions into lucrative Wall Street jobs that lasted up to a decade. By that point, most people realized that these folks really didn’t have any special forecasting ability.

And if these folks are wrong, and the markets don’t crash, nobody pays any attention. So look at it from the prognosticators point of view. If I’m wrong, I’ll be ignored. But if I’m right, I can make a lot of money selling books, newsletters, and maybe even a t-shirt or two.

Scary predictions make for fun reading, but they’re not anything you want to act upon.

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 Market View

The US stock market continues to trade in a narrow range. This makes sense, since there hasn’t been any news to get people really excited or really depressed. Most of the statistics coming out are in the fair to middling range. US growth has slowed from the 6-8% range we saw in 2003 and early 2004, down to the 3-4% range. (I use ranges because measuring economic growth is not an exact business and the numbers are constantly revised.) The price-to-earnings ratio of the overall market is in line with the long-term average. Assuming no major shocks, the ratio should stay fairly steady, which means that the price of stocks should rise or fall in line with company earnings.

I thought longer-term interest rates would rise this year. I’ve been wrong. After rising at the beginning of the year, 10-year US Treasury rates have drifted back down to the 4% range. Why? At least in part because inflation appears to be under control, and because those fair to middling statistics I mentioned before point to fair to middling economic growth. Also, people believe the Federal Reserve will successfully fight off inflation if it shows up.

As part of the inflation-fighting effort, the Federal Reserve is gradually raising short-term interest rates. We’ve moved from 1% up to 1.75%. This should translate into a slight increase in the interest that you get from savings and money market accounts. But it doesn’t affect a bunch of other rates, including thirty-year mortgage rates. That’s because long-term mortgage rates are tied to 10-year Treasury rates, not to short-term rates.

With both the stock market and bond market expecting moderate growth and low inflation, something unexpected has to happen to cause prices to move dramatically in either direction. On the negative side, this would be something like a coup in Saudi Arabia, something bad happening to Alan Greenspan, or a severe recession in China. On the positive side, it might be the price of oil falling back to $20 a barrel or the capture of Osama Bin Laden. I don’t have any special predictive powers, so I’m figuring both markets have it about right.

The dollar, like the stock market, is in a bit of a holding pattern. After some dramatic moves against the Euro in the last several years, the dollar is holding steady at about $1.20 to the Euro. The dollar is also holding steady against Asian currencies, although it should probably fall, particularly against the Yen, because these are the countries with which the US has a large trade deficit. If you have foreign investments, a falling dollar will pump up your returns.

Foreign stock market returns are all over the map. Most European markets have returned about the same as the US market. Some risky markets, such as Egypt, Columbia and Venezuela are up 50-60%. And Brazil and Argentina have bounced back in the last three months - they are now about the same as the US market after being down 10-20% halfway through the year.

Within the US market, airlines are having troubles again. USAir has dropped into bankruptcy and Delta is threatening to follow. United is already in bankruptcy and is threatening to default on its pension obligations. If they’re successful, others will be sure to follow. All this is happening even as the number of travelers has increased and airlines have filled their seats. The only company that consistently makes a profit is Southwest. If you haven’t had a chance to visit a casino recently, you could probably get as much of a thrill from putting money into the stock of most airline companies. It’s not quite the same as being at a casino because you don’t get the all-you-can-eat buffet. But the gambling part is similar.

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

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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
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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
• 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.

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Stock Focus

An Insight Into Dorato’s Investment Style

Tribune Company

Tribune is a media company that publishes newspapers and owns television stations in major markets; owns a part interest in the WB television network; owns the Chicago Cubs baseball team; publishes a national Spanish-language newspaper; and is part-owner of a national, internet-based employment service.

The company has solid finances. At about $2.7 billion, the debt is roughly a quarter of the company’s capital. The interest on the debt is easily covered by annual free cash flow (cash flow less capital expenditures) of more than $850 million.

At about $41 a share, Tribune trades at 17-18 times 2004 earnings. This ratio is on the low end of where Tribune has traded in the last ten years or so. It’s also on the low side compared to most of Tribune’s competitors, which trade at 20 to 30 times earnings. This is due in part to the company’s recent announcement that earnings will be relatively flat for the next several quarters. Looking beyond the next six months or so, earnings should grow at an annual rate of 8-12%. I think current earnings trouble is a short-term blip for a set of businesses that has otherwise produced steady growth over time.

Tribune has had a little trouble with circulation honesty. That’s another reason for the company’s lower than average price-to-earnings ratio. Managers of some of the company’s newspapers exaggerated sales figures for the last several years. If you’re an advertiser, this wouldn’t make you very happy because your ads reached a smaller audience than you thought. Tribune has set aside reserves to compensate advertisers and has fired the managers responsible. The problem first came to light several months ago. In a recent announcement, the company found a few more problems and adjusted the reserves for advertisers upward. There is some risk that Tribune could uncover more problems in its circulation numbers, but I don’t think the risk is large because both the company and an independent audit group have been investigating the problem for several months.

The big risk for the next year or so is management. It’s a little hard to get excited by a management that lied about circulation and that produces no growth while its competitors grow at a 5-10% rate. However, I think Tribune dealt with its problems quickly once they were uncovered. And even if I’m wrong and this management team can’t fix things quickly, another media company may figure they can do a better job with Tribune’s assets.

The risks over the longer term reside in the strength of the US economy and the changes occurring in the media industry. A large part of Tribune’s revenue comes from advertising. A weak US economy would lead to lower advertising spending and less revenue for Tribune. However, I think the long-term prospects for the US economy are quite good. Regarding media changes, the rise of satellite, cable and the internet could affect the value of Tribune’s assets. However, I think Tribune has a wide variety of assets, and management has demonstrated an ability to tap into the various distribution channels.

And there could be other risks I haven’t considered. That’s why you should diversify. I think Tribune is a good investment opportunity, but I’ve been wrong before and I’ll be wrong again. To limit the pain if I’m wrong on Tribune, any investment should be part of a well-diversified portfolio.

Sources: Value Line, Tribune, Yahoo.

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