April 2002

Portfolio Comments

Market View

Dorato Services

The Library: articles by Steve TeSelle

Stock Focus: Worldcom Group

Portfolio Comments

All the portfolios have some exposure to the utility, energy and telecommunications sectors. All of these areas have been affected by investor fears over accounting issues, and by supply and demand issues due to the state of the economy.

Accounting concerns include several issues, one of which is the use of off-balance sheet financing as practiced by Enron and Arthur Andersen. In plain language, Enron put obligations to pay and debt somewhere where most folks wouldn't find it, which made the company look financially stronger than it really was. Apparently, Enron engaged in these activities in a deliberate attempt to confuse investors, and with transactions that involved their own corporate officers. Other companies, such as El Paso Corp., used off-balance sheet financing, but with third parties, and with assets that generated cash flow to repay the debts.

Prices for natural gas, electricity and telecommunications services have fallen as the economy has slowed. While I don't expect the economy to roar, I do expect it to at least purr, which should lead to more stable pricing in both energy and telecommunications.

I continue to hold stocks in these industries, such as Worldcom, El Paso Corp., and Mirant. I believe these stocks currently hold good return potential.

[top]

 Market View

The US economy appears to be emerging from a recession, dated by the powers-that-be from March 2001. The fourth-quarter growth of Gross Domestic Product was first reported to have inched up 0.2%. Within a month, that number was revised to more than 1%. More revisions wouldn't be surprising; this number gets revised more than a childhood story, so I don't put much faith in the precise number. The point is that the economy is probably not contracting at a 1-2% rate, as it was in the fall of 2001.

As I wrote in the last newsletter, even though the economy is recovering, the rate of GDP growth is likely to be more in the 2-3% range over the next several years than in the 5-6% range that we saw in second half of the 1990s. Business spending on technology, which drove business investment in the 1990s is unlikely to return soon to the levels of those halcyon days. Businesses will invest again, and especially in technology, but not at the frenetic rates of a few years ago.

Consumers are not likely to spend wildly either. Aside from September 2001, the American consumer has continued to spend at a fairly steady pace, which means there's no pent-up demand to boost growth coming out of the recession. Rather, there's a higher likelihood that the US consumer will keep spending in check as the unemployment rate rises and the stock market continues to move sideways.

With moderate growth should come tame inflation. The Federal Reserve, while no longer cutting short-term rates, does not see a high risk of inflation. Bond investors seem to agree. Intermediate and long-term interest rates on US government debt haven't budged, neither up nor down. Bond folks are good indicators of inflation fears because the value of bonds is hurt by rising inflation.

Of course, bond investors have been fooled before. After a long period of low inflation in 1950s and 1960s, bond investors were blindsided by the high inflation of the 1970s. Still, they're pretty good watchdogs for inflation.

Some folks are raising the issue of Greenspan's eventual retirement. After all, he's been Chairman of the Federal Reserve for 15 years. Given his track record, any change would probably cause some uncertainty among investors, if not indigestion. I don't think his retirement is imminent, but the possibility is a salutary reminder that unsettling changes can occur at any time.

Given the moderate growth scenario that I think is most likely, and given that stock prices haven't changed much from the end of the year, my outlook is pretty much the same as in the January 2002 newsletter: I continue to believe investors are well-served by a healthy allocation to stocks, with expected returns in the 8-12% range.

I am concerned about the prices of stocks overall, as investors still seem to be pricing in a more robust recovery than I am. But even in a high-priced market, there are a number of stocks that offer decent expected returns over the next several years. As has been the case for the last several years, technology stocks continue to sell for higher prices than stocks in other industries, relative to earnings. Some of the best investment opportunities are in sectors such as finance, manufacturing, and utilities.

As always, I recommend investors stick to their long-term asset allocation strategies and retain a diversified stock portfolio.

Steve TeSelle

[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
  

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?

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.

Notice of Form ADV:

By regulation, Dorato must notify clients at least once a year of the availability of the Form ADV, which is a detailed description of the firm. If you would like a copy of the Form ADV sent to you, please Contact Dorato.

Regulation S-P:

Annually, Dorato is required to send clients a written statement regarding the firm's privacy policies. This statement is included in client statements at the end of the year. Dorato also posts this policy statement on the web site.

Stock Focus

An Insight Into Dorato’s Investment Style

Worldcom Group

Worldcom is a world-wide provider of telecommunication services, which includes voice, data and internet traffic. In 2001, Worldcom issued tracking stock for the domestic long distance portion of its business (Worldcom MCI). The remaining parts of the company, including data, web hosting, and international operations, trade under Worldcom Group (ticker WCOM).

WCOM Group generated more than $20 billion in revenue in 2001, and made a profit of about $1.4 billion. At $7.50 per share, the stock currently trades at about 10 times projected 2002 earnings. The telecommunications industry is undergoing turmoil as the tremendous capacity expansion of the last several years, combined with a recession, has translated into falling revenues and profits for telecommunications providers. Yet prices should rebound as weak companies go out of business and as the economy recovers. Earnings are expected to grow at 10-12% annually over the next several years.

As WCOM's stock price has fallen from $60 a share to $7, the debt to equity ratio has deteriorated. The company now has approximately $20 billion in stock value for $30 billion in debt. Even so, WCOM should not be lumped in with weaker telecommunications companies. WCOM has positive cash flow and positive earnings. True, much of WCOM's cash flow goes to capital spending, but capital spending can be cut if tough economic times continue.

I think investors have fled from WCOM not only because of pricing and economic worries, but also because of accounting concerns raised by other companies. Investors have become worried about Qwest's aggressive accounting for revenue and Enron's off-balance sheet financing. In March, WCOM announced that the Securities and Exchange Commission has asked the company for information regarding its accounting practices. This raises the specter that WCOM will have to restate earnings; however I think WCOM's stock price more than reflects this possibility. When other investors are running away from an industry, it is often a good time to see if there are some good companies selling at low prices.

As usual, there are risks to an investment. The risks specific to WCOM include a continued poor market for telecommunications companies and management bungling. If pricing for telecommunication services remains tight for a couple of years, WCOM will find it increasingly difficult to meet debt payments and raise money for new initiatives. Though not as strong as the Baby Bells, WCOM is in a stronger financial position than many of its competitors, and should be able to hold on until pricing recovers. Also, management could make poor decisions that would drive consumers to other providers. However, WCOM's management has a proven track record and a solid line of businesses, so I think this risk is minimal.

I thought WCOM represented a good investment opportunity when the stock sold for about $40 per share. Not exactly keen foresight on my part. Fortunately, this is one of a portfolio of companies, so the horrible performance was offset by solid returns elsewhere. Once again, diversification has its benefits.

Steve TeSelle

Sources: Bloomberg, Yahoo, Worldcom, Value Line.

You know, from this angle, it doesn’t look half bad.