July 2001

Portfolio Comments

Market View

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Need to Diversify?

Stock Focus: Dell Computer Corp.

Portfolio Comments

Recently, three companies (not all of them held in every portfolio) announced plans to be purchased by other firms: C.R. Bard by Tyco International, Houghton-Mifflin by Vivendi, and American General Corp. by American International Group. These buyouts will cause changes in the portfolios; the changes will depend in part on whether the account is taxable or tax-deferred.

Also, several companies have spun off parts of their operations into separately traded stocks: Southern and Mirant; Lucent and Avaya; and Worldcom and MCI. In deciding whether to retain the new stocks, I will be balancing the need to keep the portfolios to a certain number of holdings against the costs of trading.

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 Market View

A curious combination has been occurring in the market this spring. Even as analysts reduce their earnings and growth estimates for companies, especially technology companies, the market has been rallying. The net result is that the expected returns on stocks are shrinking like a balloon with a slow leak.

Several well-known investors, including the oft-cited Warren Buffet (add this citation to the list), have been trying to warn people not to expect the kinds of stock returns they earned in the 1990s. Instead of 15-20% annual returns, investors should expect something like 10%. I tend to agree.

At the beginning of 2000, when everyone and his third cousin knew to invest only in technology stocks, there were many good opportunities in other sectors of the market. Today, precious little is ignored. I wouldn't say that I'm biting my nails with worry yet, but if stocks continue to climb through the summer as everyone blithely determines that stocks are the place to be, I'll be nibbling my nails like a bunny in a vegetable garden.

At least the bond market is back to normal (I use that word loosely). The yield curve has the happy, upward slope that signals life as it should be; investors get a higher interest rate for investing in longer-term bonds. No recession from their point of view. But now inflation is the nasty to watch out for (there's always something). This is why members of the Federal Reserve Board keep pointing out that there are no signs of inflation, and that any inflation will be dealt with more severely than your local juvenile delinquent.

With inflation under lock and key, and with the recent dramatic increases in productivity, optimists argue that market price-to-earnings ratios can and should go higher. Translation: we should all be willing to pay more for stocks. This is dangerously close to the new paradigm type of thinking that got technology investors in trouble last year. As Mr. Greenspan said several years ago, the road to prosperity is littered with the carcasses of new paradigms. Bond investors are telling us inflation isn't dead; and, as the latest figures demonstrated, productivity is much more cyclical than the optimists believe.

So while I don't fall into the optimist camp, I think I fall into the semi-optimist camp. The US economy, while slowing, still chugs along. US companies are reacting quickly to the slowing economy by reducing production, rather than building up large inventories of unsold goods. This should help to avoid drastic cutbacks later. Unemployment is rising, but is still below 5%. And, at this point, only energy costs are raising the red flag of inflation.

Any number of occurrences could cause investors to sell stocks, including higher trade barriers among countries; higher energy costs due to actions of the Organization of Petroleum Exporting Countries or to a mideast war; or a falling dollar, which might cause investors to look outside of the US for investments. Any of these events could happen, but none of them cause me to bite my fingernails because I don't think I can reliably predict any of them.

Other than getting slightly anxious, I really haven't changed my market view much. True, now there are fewer splendid opportunities than last year, but I continue to believe that there are good companies to buy at reasonable prices. I'm still not excited about the big companies that dominate the indexes, but across all sectors of the market, there are good companies to own that should provide decent returns over the next three to five years.

Steve TeSelle

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Written pieces are available on these financial planning topics:

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Now I remember. I think we need to diversify our portfolio.

Stock Focus

An Insight Into Dorato’s Investment Style

Dell Computer Corp.

Dell Computer Corp. is a global computer company with more than $30 Billion in annual revenue. Dell is best known for its desktop and laptop computers, but it also makes servers and storage systems.

Dell provided a spectacular return to investors in the 1990s. From a split-adjusted low of about $0.20 in 1993, the stock reached a high of 55 in 1999 - a return of more than 27,000%. Not too shabby. Since the end of 1999, the company's stock has drifted back to earth. The stock now trades at around $25 per share.

One of the reasons the stock performed so well is that Dell itself performed well. Earnings grew at an annualized rate of more than 50% during the 1990s, and at a rate of more than 80% during the second half of the 1990s. On the revenue side, Dell benefited from heavy technology spending by both consumers and businesses. On the expense side, Dell was one of the early adopters of the Internet for sales and for production, which has allowed the company to be the low-cost provider in the industry.

Since the beginning of 2000, Dell, like many other technology companies, has seen its revenue and earnings growth stall as businesses reduce their expenditures on technology. For 2001, instead of earnings continuing to grow at a 50% clip, analysts estimate that earnings will fall 10%. At the same time, analysts have slashed projected growth rates for the company as other firms try to copy Dell's business model and as Dell's margins have come under pressure due to a price war for personal computers. What looked like a reasonable price (at $45 per share in 2000) relative to growth and earnings suddenly looks less attractive.

I do not expect a return to the halcyon days of massive technology spending, however I do expect businesses to continue making investments in technology in order to compete; and I do expect consumers to continue to make investments in technology as software applications develop and improve. Both of these trends should benefit Dell. I also think Dell has a competitive advantage in its use of the Internet. The company's low cost structure should allow Dell to continue to be an industry leader. Therefore, I think Dell can attain an earnings growth rate of 15-20%.

At a current price to earnings ratio of about 30 (trailing earnings), Dell is not cheap. But the price is reasonable for a high-quality company that is a leader in its market. I don't expect Dell's price to earnings ratio to get much higher, so I am essentially counting on earnings growth to justify the current stock price and to lead to a higher future price.

Dell has a strong balance sheet, with $5 billion in cash and only $500 million in debt. With this financial position, Dell can weather an extended period of slow technology spending or slow economic growth. No analysis of an investment is complete without a discussion of the risks. The risks start with valuation. The current price is reasonable, not rock-bottom. Investors could still bid Dell's shares down, especially if the economy continues to struggle and/or businesses continue to be stingy with capital expenditures. Another risk is that Dell could bungle demand. Cisco is another high-tech paragon that was supposed to be able to respond quickly to supply and demand changes in the marketplace due to reliance on Internet-based systems. Yet Cisco recently wrote off more than $2 Billion in inventory because the company had ordered too many supplies in an overly optimistic assessment of demand. Finally, other competitors may copy Dell's Internet model, and drive prices so low that computer companies will earn a permanently lower return. All of these risks are real, but they are outweighed by the potential return from this leading computer company.

Here it comes again, the diversification argument. Dell looks like a solid choice for a long-term portfolio, but not everything turns out as we plan. I've identified a few risks, and there are certainly others that yours truly cannot presently imagine. Putting all your eggs into the Dell basket in the early 1990s would have looked brilliant; doing so in 2000 would have looked dopey. Since we're investing rather than playing the lottery, I'll stick with a diversified portfolio. As part of a diversified portfolio, I think an investment in Dell makes a lot of sense.

Steve TeSelle

Sources: Bloomberg, Yahoo, Dell, Value Line

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