For the first quarter our average account gained +1.00%.
It is a modest result and we are modestly pleased. You, on the other hand, might be forgiven for puffing out your chest a bit. You have managed to avoid what Investors Daily claims is the typical loss in a mutual fund in the year to date of 9.3%. More than one client has pointed out that our berating the mutual fund boom in our client letters is rather like shouting at the church choir; you, after all, have your money here. Not investing with people whose interests are at odds with yours would seem to be the first rule of financial preservation, but it is a bit of wisdom that is only now sinking in on the average mutual fund investor. We appreciate that you have always known the difference.
We have recently become concerned that small investors may yet have to learn another reason the rich have long shunned mutual funds; to wit, taxes. If you buy a mutual fund and sell it at twice your basis cost, the taxable event is straightforward; you owe a capital gains tax on the amount of your profit plus or minus any incidental expenses that might have accrued. If you lose money, however, as all those many souls who bought last year now probably have, the tax issue becomes much more complicated. If a mutual fund has large scale redemptions, and if that fund must answer these cash calls by liquidating previously acquired stock positions that have a low costs basis, remaining shareholders are responsible for the capital gains tax even though they in fact have a capital loss. This is the worst of both worlds, and we doubt very much that the owners of last years hottest funds, now down 20% or more, have any notion that they have potentially signed up for someone else’s tax liability.
What if they were to find out? Obviously there is an overwhelming advantage to being the first to jump ship if one were to think that it will come to this, but we are aware that an outright, unthinking panic out of mutual fund shares might discomfit us too. After all, managers will quickly turn to selling their best holdings after their worst are sharply lower, and it is their best holdings we ordinarily hope we own in common. The liquidation phenomenon might as easily be an opportunity for us a threat, but it well bears close scrutiny in the months ahead.
Meanwhile, we go on happily buying shares outside the United States that fit our value profile, in the hope that trans-oceanic diversification will prove the most insulating. Guinness is exactly the sort of value we used to find so regularly in America, and now find we must hunt overseas for. A great brand name in its own right for its renowned Irish beer, Guinness also owns United Distillers, the world’s dominant spirits company (Dewar’s, Johnnie Walker, Gordon’s, and Tanqueray). We have bought it at an average of 14 times last year’s earnings. This investment would be attractive in its own right on price alone, if you did not know that Scotch whiskey sales have been trending down in America for almost 20 years in adjustment to the progressively tougher drunk driving laws. Scotch sales have now bounded ahead 6% in the last six months as zero tolerance for intoxicated driving is finally the law around the nation, and we can now fashionably hang out in cigar bars and walk home. Combined with a rationalization in taxes between wine, beer and spirits sure to come in Europe and Japan, Guinness is likely to find a stiff headwind of five years duration is now a fine quartering breeze. Schlumberger was last year’s example of a fine company emerging from a long secular struggle not of its own making, and we are hoping Guinness can be this year’s Cinderella.
If you track our individual stocks daily, you know that our decreasingly important gold shares have been quite a trial. This year’s problem is Bre-X Minerals, a Canadian start-up venture, apparently a fraud, whose shares have plunged from a value of roughly $4 billion to worthlessness in a month. We have never owned a share in Bre-X, nor does it resemble any of the shares we do own, but this tar baby is making quite a mess everywhere. This too shall pass.
Sincerely yours,
Edwin A. Levy
Michael J. Harkins