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| April 12, 2006 |
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| Dear Client,
For the first quarter of 2006, our average account gained approximately +4.80%. We had an investment mishap last month that we would like to tell you about as quickly as possible. We own collectively about 11% of American Bank Note Holographics. This is one of two companies that make the hologram security stripe that you can see running across the back of any Visa, MasterCard or Amex card in your wallet now. American Bank Note Holographics recently developed a new product, marketed as Holomag™, that promised much more encoded information to the retailer, making it much harder to counterfeit a credit card, or to use if stolen. In an age of rising concern over identity theft, it seemed to sell itself, so that all three major card issuers began switching to it in the fourth quarter of last year. Even better, because Holomag was Bank Note’s alone, it was selling for a premium price and with much higher margins to boot. This was enough to move the stock from $4 a share, where it was most of last year, to over $6 a share this year. Then disaster struck. In February, Visa informed Bank Note that in about 2 out of every million transactions, when the merchant swiped the Holomag through the cash register, a static electric charge caused the register to crash, much like a computer crashes, and it took roughly two minutes to re-boot the register, leaving the customer angrily twiddling his thumbs. It also left us scratching our heads, since every computer around us crashes a lot more often than that. However, by March, Visa had decided the problem was so severe that they ordered all 24,000 banks in their system to abandon the new product and switch back to the old, less profitable hologram. Bank Note says it is working on a second generation product that will prevent static discharge from ever happening again, and notes MasterCard and American Express are using Holomag without complaint. Will Visa relent and come back into the fold? At 37% of Bank Note’s revenues last year, this is devoutly to be hoped for, although the companies are also threatening to sue each other. Will Amex and MasterCard have the patience to wait out this seemingly small glitch? We do not know, and can only tell you we are willing to wait a while to find out because the company has no debt, it is still profitable, and sells at a price that suggests patience may be prudence. Still, we can’t help noting ruefully that in small but promising positions like these, it is wise to sell when you can, not only when you want to, because we sometimes own enough to get in our own way. Finally, none of our comments are meant to chide or find fault with Ken Traub and his team, who were as shocked as anyone by this turn of events. This was an act of God; they happen sometimes. On a different front, it is years and years since we have written anything of a general economic opinion that might influence our actions in your account, and that is a good thing. We are still of the opinion that those who pronounce on the economy and its “necessary” effects on stock prices should be required to wear tall conical hats with stars and moons on them, so that we might all better keep track of who’s who. Nonetheless, and with a nod to the notion we may soon need a trip to the hatters ourselves, it has struck us that we may know one economic statistic that actually matters, and that merits paying rapt attention to. It is the stated Chinese inflation rate. We write “stated” in such an arch manner because we are well aware Chinese wages and prices have been rising at a greater than 10% rate for more than 2 years, highlighted by Business Week most recently, and the Chinese government has been steadily denying it. This is utterly unsurprising, as our own government behaves much the same, we have long decried it, and the unreality of our government’s Consumer Price Index follies will no doubt produce plenty of fodder for many more of these letters. The Chinese circumstance is of interest first because the reality disparity is so great. The Chinese government is claiming inflation is less than 1%, and authoritarian governments really cannot afford to be laughed at. Secondly, the situation is increasingly unstable. Every night the Chinese central bank finds itself buying roughly $1 billion in U.S. Treasury notes from citizens legally without rights to hold any foreign currency. The Bank buys these dollars with Yuan that it creates out of thin air, and therein lies the problem. It is the real source of the gathering Chinese inflation, and while it seemed of no great moment five years ago, when there were so many people still coming out of the hinterland to join the capitalist revolution, those days are rapidly drawing to a close. Also, the number of dollars that need to be purchased every night has been growing explosively, and we say this in full knowledge that President Hu will be here next week, checkbook in hand, buying everything American with reporters in tow. It won’t change a thing. The Communist Party has its own reasons to be terrified of inflation. They remember the last inflation played a big role in bringing them to power. In Barbara Tuchman’s book Stillwell and the American Experience in China, she says that by the end of the Second World War almost half the tonnage America was flying over the Himalayas to aid Chiang Kai-shek’s government was currency, printed in Virginia, of all places. It created virulent inflation, and that, as much as any military reversal, brought down the Nationalists. Inflation may become the mechanism by which America’s profligate trade deficit becomes a Chinese domestic problem, and this, far more than Congressional threats to impose tariffs, will grab President Hu’s attention, and force him to act. The endless attention paid to the Fed’s every whim bemuses us, because it is the wrong central bank to be scrutinizing. The Chinese central bank has all the money; they are the ones to watch. When will they act, how far will the dollar fall, and what do we do about it now? We don’t know exactly, but we do own Boeing, America’s largest exporter, and American Express, Nike, Moody’s and Qualcomm partly because of their large foreign exposure and their opportunities to grow abroad. That may not be enough, and we are hawkishly watching this situation every day, while also trying to be mindful that when it comes to inflation, people have a history of deluding themselves that is quite spectacular. Finally, two of our larger investments are acting a little perkier, and they are doing so right in the teeth of a popular foolishness that has irritated us from time out of mind. We are referring to Bear, Stearns and Countrywide Financial, two “interest rate sensitive stocks” that by popular lights ought to be taking it on the chin, and have in fact been rising. The irritant here is first the notion that there is some stock somewhere that is not interest rate sensitive. Any future stream of income is worth less now if it is discounted by a higher rate of interest, and that is what a stock price is supposed to reflect. They are all interest rate sensitive stocks, and they always will be. But stapled to this conventional stupidity is Wall Street’s preposterous convention of according outrageously high prices to any stream of income that grows with stairstep certainty, even if it grows very slowly, and giving knock-down valuations to vigorous growth that comes in fits and starts. This has caused the management of many a firm to massage the numbers to satisfy Wall Street, oftentimes sacrificing growth in the process, and it is utter lunacy. Angelo Mozilo is one of the two original founders of Countrywide Financial. Last year the firm earned 2/3 as much as American Express, and no one had ever heard of Mozilo thirty years ago when he was just a fledgling California mortgage broker from the Bronx, so obviously the growth has been phenomenal. It has also been lumpy, and Mozilo does nothing to hide the fact that he does not know very much about what next quarter will bring. When he makes forecasts for the year, he does so with wide enough latitude to account for the world being a very uncertain place. This commendable behavior is rudely treated with a 9 multiple of earnings for a company that has long had a growth rate twice that. James Cayne, the chief executive officer of Bear, Stearns goes Mozilo one better. He doesn’t even get on the quarterly conference calls, meaning he can’t put himself forward as the Wizard even if he wanted to. Bear, Stearns has high returns on equity, fairly sizable moats around some of its major businesses, and a great track record. Yet because it will not make precise claims about its unknowable future, it perpetually sells at a modest multiple. When we say that if you throw away an obsession on short term results, and embrace behavior likely to prosper over the long term, you are greatly increasing your chance for ultimate success, Countrywide and Bear Stearns is what we are getting at. It also ought to be obvious to all. That it is not is our great good fortune. Sincerely, Edwin A. Levy Michael J. Harkins James B. Lebenthal |