July 2002

Portfolio Comments

Market View

Dorato Services

The Library: articles by Steve TeSelle

Stock Focus: Cardinal Health

Portfolio Comments

I mention diversification every chance I get, but perhaps I should explain what I mean by this word (you can also go to "A Primer on Asset Allocation" on the web site for a more lengthy discussion).

When you own a single stock, the return you should expect to get from that investment is about what you should expect from an investment in stocks in general. You may think you're a little sharper than the other investors out there, and so you have a better stock than the average. But remember, other investors are thinking the same thing. Good opportunities are usually already reflected in a stock's price.

By putting all your hope in a single stock, you have about the same expected return (maybe slightly higher if you're sharper than the kitchen knife), but much more risk. Something unexpected can happen that will send the stock's price plummeting or soaring. So you're paying the price of a lot of risk without getting anything in return - your expected return is about the same as someone who holds a diversified portfolio.

When you own a diversified portfolio of stocks (a portfolio of 30 technology stocks does not qualify), the risk of each individual holding is offset by the other holdings, leaving you with a risk level that is about the same as the market. Once you have enough diversification to get the same risk as the overall stock market, then adding additional stocks doesn't help to reduce risk.

[top]

 Market View

The second quarter wasn't a good one for US stocks. Both the S&P500 and Nasdaq are near the levels reached last September 21, soon after the terrorist attacks. I don't think September 21 represents some natural floor on stock prices, but I do think the mood was pretty negative back then; current prices indicate how negative investors have become again.

People have been reacting to bad news coming from companies, in the form of low earnings and questionable accounting. Yet the news isn't all bad. The economy is improving: unemployment appears to have stabilized, inventories are at low levels, inflation continues to remain dormant and productivity numbers are still strong.

Essentially, investors as a whole are willing to pay less for a dollar of earnings than they were just a few months ago. If you could know ahead of time how positive or negative other investors will be, then you could move in and out of stocks accordingly. Unfortunately, I think that's an impossible task, so it's best to stick with a diversified portfolio of stocks.

After periods such as the late 1990s, in which investors focus on good news and drive stock prices up, it is not uncommon to go through a period in which people focus on bad news and send stock prices down. During these latter periods, patient investors can purchase solid companies at reasonable prices.

The dollar is getting a lot of attention. The current account deficit (we import more than we export) is large enough that most people expect this deficit to cause the dollar to fall in value relative to other currencies. You might hear that the US stock market and the dollar could plunge as foreign investors sell their US assets. Well, yes, anything is possible; but a massive sell-off is unlikely. The US still has a more vibrant economy and better long-term prospects than Europe or Japan. And the US is still one of the safest places to invest. Developing markets (for example, Brazil) may have lower valuations than the US market, but that's because they carry greater risk for investors, both in terms of shareholder protections and currency.

A falling dollar could lead to inflation, as prices of imports rise. But so far, that has not been the case. Both wholesale and retail prices continue to remain low. About the only areas of high inflation are healthcare and college costs.

As confirmation of the benign inflation outlook, long-term interest rates are edging downward. Because bond prices go up when interest rates fall, those with an allocation to bonds have happily experienced an increase in value to offset the falling stock market.

As the US economy continues to recover from the mild recession, earnings should begin to recover. And a slightly weaker dollar should serve to improve the earnings of exporters and of companies with extensive operations overseas.

I would not be surprised to see stock prices continue to languish given the current focus on bad news. Yet, at current prices, a number of stocks offer good investment opportunities. The average annual expected return for the portfolios has risen slightly to 10-14%, given the lower prices in the market. Investors who exercise patience should be well-rewarded by a healthy allocation to stocks.

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
  

[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

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]

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

Cardinal Health

Cardinal Health provides products and services to service providers and manufacturers in the healthcare industry. That mouthful translates into a variety of activities. For example, Cardinal will contract with a drug company to package and distribute a particular drug. Cardinal also makes its own products, such as surgical gloves, that it supplies to hospitals. And the company will work with hospitals to more efficiently manage the hospital's inventory and staff. The consistent theme is that Cardinal provides services and products that allow other healthcare companies to operate more efficiently.

Cardinal generated nearly $40 billion in revenue in 2001, and made a profit of just under $1 billion; this is not a business with huge profit margins. For a successful company, a low profit margin generally means the company operates in a highly competitive business, which puts pressure on management to be efficient. On the other hand, low margins keep new competitors out. Cardinal should therefore be able to maintain its position as one of the leaders in providing services to the healthcare industry.

At $65, the company's stock trades at about 25 times earnings, in line with its historic average. This means that if the company continues to increase earnings at a 20% rate, and investors continue to pay a multiple of 25 times earnings, investors should expect an average annual return of 20%. Even if the growth rate slows to 15%, causing investors to pay a reduced multiple, say 20 times earnings, the expected annual return exceeds 8%.

In many businesses, I'd get nervous paying a high multiple of earnings. But in healthcare, where the US is likely to see an increasing amount of spending for the foreseeable future, a high multiple is justified by a high earnings growth rate.

Cardinal has a healthy financial position. The company carries about $2.5 billion in debt, which generates interest expense of about $130 million - easily covered by the $1 billion in profits.

Of course, there are risks here. There could be some event that causes the US to spend less on healthcare, perhaps through price controls on drugs. Management could stumble on quality or execution. Since part of its growth comes from acquisitions, Cardinal could struggle finding companies to buy. Also, approximately 20% of revenues come from two customers; so problems at either of the two customers could cause problems for Cardinal. All of these risks are possible, but I view them as acceptable given the potential return.

I think Cardinal represents a solid investment opportunity. Even so, I would never put too much of any portfolio in Cardinal. For me, getting much above 6-7% of a portfolio is too much. While Cardinal stock has done well in the portfolios, I need only look back to my last newsletter and my interest in Worldcom to be reminded how wrong I can be.

Sources: Bloomberg, Yahoo, Cardinal Health, Value Line.