October 2005

Portfolio Comments

Market View

Dorato Services

The Library: articles by Steve TeSelle

Stock Focus

Portfolio Comments

During the summer, Bank of America announced that it would buy MBNA, a credit-card company that several of you owned in your accounts. Even though Bank of America has a reasonably good expected return, I decided to sell MBNA in most accounts.

The reason is that many accounts already owned bank stocks. I don’t want the financial industry holdings of an account to consist entirely of banks. If you compare bank stocks with, say, insurance stocks, you can see that both are affected by interest rates, but in different ways. Banks are more likely to be affected by the shape of the interest rate curve, rather than just the level of interest rates, whereas insurance companies will do better in a higher interest rate environment and are not as much affected by whether the yield curve is flat or steep.

I don’t know what’s going to happen with interest rates and the shape of the yield curve. If I knew, I’d tell you, and we could all get wealthy. But I don’t know. So I’d rather own companies that react differently to different interest rate environments.

In an unrelated move, I sold Jones Apparel Group in any accounts that held it. Jones is getting squeezed between a shrinking number of department stores, where Jones normally sells its clothes, and rising costs. It’s possible that Jones will find someplace to make a decent profit within the retail sector, but it’s possible they won’t. Given that risk, I decided there were better and safer opportunities in other stocks.

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 Market View

The stock market seems to be stuck in neutral. That’s probably because investors disagree about the future. The optimists can point to steady growth of 3-4%, inflation that’s still under control, and a financial system that’s been able to withstand a shock or two. Pessimists can point to budget and trade deficits, pricey oil and housing, and the imminent retirement of Mr. Greenspan.

Over the next several months, I wouldn’t be surprised to see stock prices continue to bump up and down. Companies most likely to have trouble are retailers and other businesses that rely directly on a happily spending consumer. The price of oil, slower wage increases, and what I expect to be a cooling housing market are all likely to crimp spending. Still, this is a relatively short-term problem. If investors send stock prices of these companies down too far, there may be a good opportunity to buy quality companies at reasonable prices.

For the record, I don’t consider myself to be standing firmly in either the optimist or pessimist camp, but rather somewhere in the mushy middle.

The broad bond market hasn’t done much either. Admittedly, the broad bond market calm masks some underlying turbulence. Both Ford and GM had their debt downgraded to junk-bond status; so if you held either of those bonds, you might not think the bond market has been so placid. Still, overall, rates have held steady. Short-term Treasury rates are 3.5%; 10-year rates are just above 4%; and 30-year rates are under 5%. You don’t get much extra yield for taking on the risk that inflation comes back to bite us some day. And you don’t get much extra yield for buying riskier corporate, international, or junk bonds. The additional yield, or spread in bond market jargon, is relatively low by historical standards in each of those sub-categories of bonds. Since you’re not getting much compensation for taking on risk, I suggest you don’t take it on. That’s why I say you should stick to high-quality, short-term debt.

The dollar, too, is in a holding pattern. With our current account deficit at 6% of GDP, the dollar should be falling, especially against Asian currencies. But Asian central banks have been big buyers of dollars, which has helped to keep the dollar strong. Still, if investors lost confidence in the dollar, central banks couldn’t do much to stop its fall. So why do investors continue to support the dollar? Because, even with a large current account deficit, the US has a strong economy, low inflation, deep and liquid markets, and a stable government. Of those factors, inflation is the one to watch. If people lose confidence in the Federal Reserve’s inflation-fighting credentials, that’s when you’ll see the dollar fall.

The one place where investors are getting outsized returns is in emerging markets, a euphemism for countries with more risk. If you invested in these countries a few years ago, your returns have been wonderful. However, after three years of strong returns, the future returns in most of these markets are less attractive.

It’s tempting at times like these, when markets aren’t giving you much in the way of returns, to think you need to make big changes. Typically, investors will hunt for something that gets them a higher return. My advice is to sit tight and stick with higher quality. The time to take on more risk is when pessimism reigns, not when people are talking about what great returns you can get in riskier markets.

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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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
  

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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

Colgate-Palmolive

Colgate Palmolive (CP) is a consumer products company. It makes toothpaste, soap, detergent, and a lot of other stuff that you have to buy regularly. In 2004, CP generated more than $10 billion in sales and about $1.4 billion in profits.

The stock currently trades at about $53 per share. With 2005 earnings expected to be about $2.60 per share, this price translates into a Price to Earning (P/E) ratio of roughly 20. PE isn’t always a good measure of value, as in the case of a company with wildly fluctuating earnings; but it’s a good measure of value for a company with steady earnings, such as CP. The last time you could buy CP at this multiple of earnings was about a decade ago.

A nice thing about household products companies is that people need to buy their products. You’re unlikely to cut back on soap, even if the economy slows a bit. However, you don’t want to take that reasoning too far, as investors seemed to do in the late 1990s. By 1999, CP and Proctor & Gamble (P&G) were selling for more than 30 times earnings. I’m willing to pay a little extra for a good company, not a lot extra.

CP is expected to increase earnings at a rate of about 10% per year. Household products companies have been struggling with higher raw material costs, such as oil, and increased competition from private-label goods, such as Safeway brand detergent. In response to these pressures, CP is cutting costs. On the revenue side, they will raise prices and use advertising to try to differentiate the quality of their branded goods from that of private-label goods. The US and Western Europe markets are slow-growing and very competitive. CP is therefore looking to new markets in Latin America and Asia to boost the company’s growth rate. Considering all these factors, an earnings growth rate of 10% seems like a realistic and attainable goal.

CP has an excellent financial rating. The company’s steady and predictable cash flow easily covers capital spending needs, the dividend payment, and the interest on the debt.

The main risks are related to competition and how management responds to it. I’ve mentioned private-label goods. If CP pushes its prices too high relative to these private-label goods, sales would fall. In addition, P&G is a formidable competitor in almost every household product category. In order to keep up with P&G, CP will need to continue to spend on research and development to come up with new and improved products.

I’m willing to take on that risk because CP has demonstrated over time that it can respond to competition and increase earnings at a fairly steady rate. CP is the second-largest household products maker, and with their history of performance and their strong finances, I expect them to remain competitive.

I’m sure that there’s a risk or two I haven’t considered. After all, if I knew what the risks were, then I’d consider them. Rather than think that I’ve exhausted all the potential risks of an investment in CP, I prefer to diversify, so that CP represents only a portion of any account. As such, I think CP is a good investment.

Sources: Value Line, Colgate-Palmolive, Yahoo.

"I hope you don't mind. I took our stock returns for the year and bought a sandwich."

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