April2009

April 9, 2009

Dear Client,

For the first three months of 2009 our average account declined -8.51%.

America is a sunny upland for cheerful optimists. No people cross trackless oceans, homestead in rocky New England, bust sod on the Nebraska plain, then walk over the Rockies to California who are wholly lacking in moxie. Alexis de Tocqueville thought it startling how strong a belief the average American had in a better tomorrow just around the corner, Franklin Roosevelt counted on that trait when he guided us through rack and ruin, and Ronald Reagan personified optimism in our own time. In our October and January letters we noted how uncharacteristically downbeat the population as a whole had become, and not just the batty denizens of Wall Street, who always were a very quirky subset of the citizenry as a whole. Financial types were prone to flightiness, but the people were made of sterner stuff.

Last week the March Consumer Confidence index came out, and it proved in this crisis everyone has been shaken to the core. For the months of February and March, dourness is off the charts. We mean this literally. We cannot print the chart in a standard letter page because the bottom has fallen so far from the previous data points that it can’t all fit coherently.   We can describe it to you though. The Conference Board has been asking a large survey of Americans, “What do you think of the economy, what are your job prospects, and what do you think of the future?” since 1967. They sum up the answer in one number, and publish it monthly as the most respected barometer of consumer health. Note that it is a self-administered diagnosis. The participants are asking themselves, “How do I feel?”

Will it surprise you to know it has proven to be a remarkably accurate contrary indicator? The height of confidence in the post-War years came in January 2000, which was also the top of the internet bubble. You may recall America was feeling its oats at the time. The data point was 144, a number that was almost reached at the height of the swinging sixties stock market, and again in the 1980’s just before the 1987 Crash. When people are feeling good about themselves, stock prices reflect it.

The nadir came in December 1974, at 43, when the end of the world seemed at hand and gloom was thick as pea soup. Stocks were also dirt cheap. People always make predictions about the future with their eyes squintily examining the rear view mirror. It was always thus.

Now we come to February and March of this year, and the index has hit 25.5 and 26, rendering it impossible to print without resorting to graph paper hung to the bottom of this letter. Indeed, for five of the last six months, the country has been more fear filled than any moment since Lyndon Johnson was president. Whatever your political persuasion, can the current crowd really prove drastically worse than Richard Nixon and Jimmy Carter combined? Investment professionals always claim that at extreme moments of panic, they are buyers. So far, we are feeling a little lonely. When people are this overwrought, surely there must be some good investment opportunities, no?

We got to thinking about that as we started purchasing Google last quarter. At any other moment in our 29 year history investing in high growth, highly lauded glamour names would have seemed like Levy, Harkins heresy. Google may prove bear markets have some distinctly odd silver linings. By any conventional means Google is rather cheap. When we started buying it, it was 18 times the estimate of this year’s earning, and that estimate had been scaled back drastically to allow for very little growth in this year’s hard times. The company had almost a fifth of its market capitalization in cash, with no debt, so if you cocked your head a different way it looked even better. What is wholly unconventional about Google is its record. It is spectacular. In 2002 it had $440 million in revenues and $100 million in earnings. Last year it had $21.8 billion in revenues and $5.3 billion in earnings. How does that growth rate sell at a cash adjusted 15 times earnings? Obviously the short answer is “fear”, and the long answer isn’t any more illuminating than the short answer. The management that produced that extraordinary record is still in place, and the top three fellows pay themselves $1 a year in salary. They obviously just love coming to work, and it shows.

In amassing large positions in fast growing technology companies, you may think we are changing our stripes, and making some sort of statement that we know of a sunnier future than the crowd portends. We are not. We have days when we are just as shaken as the Conference Board surveyants. But Akamai, Cognizant, EMC, Google, and Qualcomm are leading American companies that are best in class worldwide at what they do, and they have virtually nothing to do with the financial ills that have laid the economy low, first here and now everywhere else. They also have no debt, which we have long hailed as a blessing, and never more than now. In any sort of recovery their growth will re-accelerate, because the businesses were never wounded in the first place. Their stock prices were, though, and that can be to our benefit.

The same can be said, albeit to a lesser degree, for McDonald’s, Caterpillar, Danaher, Deere and Tupperware. They can’t have the explosive growth of an Akamai, to be sure, but they will have much less ground to make up when sentiment turns because they didn’t give up much ground when the winds were howling a short while ago. We don’t have to repair the businesses to prosper; we just have to have fear abate.

Finally no letter on this date would be complete without noting the rating agencies have downgraded Berkshire Hathaway. Who said Wall Street was lacking a sense of humor? The financier who navigated the financial crisis better than anyone else we can think of, and may yet bring more advantage to his stockholders from it, is being savaged by the companies who may have done the most to bring the crisis upon us. Rating agencies who thought sub-prime mortgages could somehow be bundled to produce triple A safety are eager to pass unfavorable judgment on Berkshire. Wouldn’t a better business strategy be that they just hoped we would all forget they existed? Berkshire was the Rock of Gibraltar before now, and nothing the ratings agencies can do or say is going to change that. But as a sign of the times, surely downgrading Berkshire, which barely has any debt, is about the ultimate in capitulation.

       Sincerely,

       Edwin A. Levy

       Michael J. Harkins