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| April 11, 2007 |
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| Dear Client, For the first 3 months of 2007 our average account depreciated -1.36%. We have written to you time out of mind that good management is a prerequisite for our investing in a company’s shares, and that we knew we had good to great managers in all of our investments. It was a bold statement, and might have had a bit of braggadocio thrown in. So imagine our delight in picking up the March 26th issue of Barrons’ and seeing a story headlined, “The World’s Best CEOs.” Only twenty of the thirty men listed (and they are all men….hmm) are Americans. Now imagine our surprise, and delight, that four of the anointed are in your portfolio. They are American Express’ Ken Chenault, Berkshire Hathaway’s Warren Buffett, Echostar’s Charlie Ergen, and Countrywide Financial’s Angelo Mozilo. The odds on that happening by chance in a portfolio of fewer than 20 names is just about 0. After all, these are naturally scrappy people, some to the point of pugnacity. They are not “followers”, who are simply going along herd like with some guiding guru’s copybook under their arms, and their businesses are diverse and have little to do with each other. We should hastily add that we are sort of pugnacious too, and rarely laud Barron’s for anything, so our sanctifying their anointed list has a dollop of self-interest about it. Still, they are not wrong all the time, and this time we think they got it right in spades. In the short term having the best managers doesn’t guarantee a thing. If you paid the wrong price for a stock or the cyclical Gods are against you, a managers reputation for brilliance can even grate on your nerves. But in the long term managerial smarts and decency count for a lot, and aggregated over enough diverse investments it will count for everything. Which brings us to our next point, which is that we have to be around the guys long enough and in sufficiently challenging circumstances that we can be sure of our judgments. We have to listen to conference call after conference call to do that, which fortunately our long term style allows. If you are going to be a short termer in the investing business, then you have to rely on other people’s opinions about other people’s reputations and that is like the child’s game of “telephone”; subject to all sorts of screw-ups. This is what we think our sly friend David Abrams is getting at when he says, “We believe in diversification for risk reducing, but we don’t want to diversify ourselves into ignorance.” Of course, we are also mindful that these managers have a perpetual fair wind at their backs. They run businesses that produce cash and have very effective moats around them. Buffett’s frequently stated admonition still applies, “When a management with a reputation for brilliance tackles a business with a reputation for bad economics, it is usually the reputation of the business that remains intact.” So if we have the best managers why is our performance so ordinary just now? We may have multiple sins to atone for, but the market is out of sorts with us today for something we are not giving up on. Besides good managers, we insist on businesses that produce real, spendable cash. We value a business by how much cash comes to us after all capital expenditures are made. What’s more, they have to produce cash all the time, good times and bad. This is bedrock principle here, because in a five year stretch of time, there is almost always going to be a moment when the debt and equity markets will be closed to all comers, and if you need money then what comes next is nightmarish. The compounding process is destroyed if you have to suffer through those moments, and peace of mind is given a shrewd knock too. In the current environment, of course, nobody gives a damn about this. With the notable exception of the sub-prime mortgage market, anybody can get funded for anything these days. When that’s the case, what is the point in fuddy duddy thinking like that in our last paragraph? Well, without any dire forebodings, but just as an observation, if markets tend to spasm once every five years, and we have had three plus years of good times, it’s time to try looking around corners again, no? Even if we are wrong about this, we are not wrong about what produces good long term results: that comes from never losing a lot of money when conditions turn severe. The arithmetic of compound interest is unyielding on this point. On a personal note, we know if you want to have a good long term record in the money management business, you first have to be around a long time. We are pretty intent on that. And now on a more grainy note, we are going to briefly but specifically tell you our thoughts on three of our holdings because they are in the news all the time. Despite Countrywide Financial’s Angelo Mozilo being amongst Barron’s sainted star managers he is on television almost daily as the face of all that’s wrong with the mortgage business. His company is the biggest, and that makes him fair game. But it seems unfair to us, because he has been the leading voice against sub-prime mortgage excesses for about a year now. His actions have reflected his speeches, as he has cut the volume of sub-prime loans to less than 6% of total loans held, and the mortgage business is only half of the company’s total efforts. All this fuss for an exposure that’s less than 3% of total assets? The stock sells for eight times this years earnings and the company has compounded equity at better than 20% for more than 30 years. That is some mismatch, but when the press is braying this loud these things can happen. We have described Boeing as an investment we made that was out of our style in that it doesn’t have the character of our other great businesses, but it does have the attraction of being the country’s greatest exporter, and as dollar bears we love that. We mean no knock on the good job James McNerney has done, but it sometimes seems that the management of Airbus is determined to make Boeing a great company all on their own. They seem incapable of delivering the big plane they have that no one particularly wants, and the mid-size planes the world wants they can’t make up their minds to build. Boeing was stuck for years and years at around $50 billion in revenues. Last year they did $61.5 billion, but on that they earned less than $3 billion. What you have to know is that in the plane business list prices are usually treated as an insiders joke. It is not at all unusual for a plane with a $200 million price tag to sell for $125 million. Today, however, Boeing is getting close to list prices on its future orders, which is man bites dog news. Combine this with its operational leverage as it produces many more planes and, well, we won’t say the sky’s the limit, but you get the idea. Finally, Moody’s is a great business that is getting lambasted, and justly, for its failure to sound the alarm bells louder and sooner in the excess ridden mortgage market. Perversely enough, we are likely to benefit from their failings. Every time the rating agencies mess up, there is a temporary call in the press for heads to roll. Then there is a long lasting call in the financial markets for greater scrutiny of the disappointing asset class, and who is called on to provide that greater scrutiny and at greater fees? Why, the rating agencies, of course. Moody’s is a little pricier than we like stocks, but it has also grown at a much higher pace than we ever thought likely. This is a business that the world decries and cannot get along without. The profitable part of that last sentence is the second part. We like the investments we have, and we have two new ones we hope to make that we are really enthusiastic about. Two new ideas in one quarter—why it must be Spring. Sincerely, Edwin A. Levy Michael J. Harkins James B. Lebenthal |
| Levy Harkins Rates of Return Since Inception 1980 Rates are Compounded Rates of Return After Fees 2006……………………………………….……………+14.02% Last 10 Years………………………….….…………….+14.74% Since Inception 1980…………………………………….+14.6% NOTE: The figures above represent the composite performance of all fully discretionary, balanced accounts. These figures exclude accounts managed for less than 6 months, accounts using short selling and accounts consisting only of fixed income investments, to more accurately reflect the past performance of fully discretionary, balanced accounts. These numbers are after all fees. However, past performance is no guarantee of future results. |
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