1991 was a disappointing year for us. It was only the third year in our twelve year history that our investments earned less than the appreciation of the Dow Jones Industrial average. More to the point, it was only the second time we failed to achieve our more important goal of bettering inflation by six percent or more.
At the beginning of the year we greatly underestimated the ease of the American victory in the Persian Gulf, and most particularly the euphoria occasioned by video images of our bombs flying with eerie precision straight down the smokestacks of enemy Defense Ministries. The war was a magnificent feat of arms, although we hope we are not ungracious in noting that victory seems to have very little business impact on the average American. Whatever his sins, and they are many, Saddam Hussein never made a seven year car loan or overextended a money center bank.
The war did have one remarkable financial component however; it was overwhelmingly financed by our coalition allies. Because the U.S. contributed so much to the military effort, and because much stiffer resistance was expected than met, our allies were unintentionally open-fisted with their support. America wound up reaping a one time gain of about $40 billion. The money was in foreign currencies, of course, which were immediately sold for dollars. This wasn’t just war on the cheap, this was downright profitable, and particularly welcome at a time when confidence in the dollar and the American ability to service our extraordinary foreign debt seemed near to collapse.
We remained sobersided through it all, which from that time to this has been indescribably frustrating. Part of the reason for our caution is the nature of the money we manage for you. We do not leverage your account, nor do we buy options, commodities, futures on futures, junk bonds or the now popular exotic and volatile mortgage products that cannot be described in fewer than fifty pages. Consequently there are few opportunities for truly exceptional gains, although there are unfortunately plenty of chances for exceptional declines. And by declines, we do not mean transitory diminutions in market prices, but rather permanent and unrecoverable losses.
This makes the general level of stock prices just now decidedly alarming to confirmed value buyers like ourselves who cannot justify our participation in stocks with a greater fool rationale. Indeed, the state of things and the price of things have scarcely ever been at greater odds. For example, as we write the Dow Jones Industrial average has earned for the last twelve months about $100 a share. If we imagine a rather standard post-war recovery, beginning right now, then the Dow might be expected to be earning, say, $150 a share in January next year. We have scant reason for actually believing in this instant recovery, but looking past that and supposing shares were valued this time next year at the average post-war rate of 15 times then profits, the Dow would trade at a price one-third lower than today’s. That is the sort of catastrophic decline that your account would find it difficult to readily recover from, particularly so as share prices would still then not be anything like cheaply priced.
We do not mean any of the above to be seen as our “market opinion”; we haven’t got one. We do think, however, it is a fair evaluation of the risks involved in a general portfolio of stocks. We say this in full knowledge that Treasury bill rates are 4% and the public is outraged at the prospect of earning so much less than what they have recently become accustomed to. Yet buying a Treasury Bill does not sign up the purchaser for all time at that rate. Considering the fact that a year’s interest can be wiped out in but one interesting afternoon in today’s commodity-like stock market, these newly enthusiastic mutual fund buyers must feel very desperate indeed. Which is not the attitude toward investing traditionally associated with profit.
This frenzied atmosphere would be difficult for us at any time, but it is particularly galling now because we believe we have investments of marvelous value which are easy to ignore so long as bio-technology companies with no business, and no immediate prospects of getting any, merrily double every quarter. It may come as no surprise to hear we place German government bonds at the head of that list, but clients long in the tooth may remember our investments in American government bonds of a decade ago at similar real rates of interest.* It is astonishing that the least leveraged government in the least indebted society is willing to offer 9.5% for short term money and 8.5% on longer terms when inflation is only 4.2%. All the more so as that inflation rate looks set to drop presently as their economy cools off from last years torrid pace and the sales at the bottom of a long bear market. They said the Russians were lying; they really have plenty of gold. Why, exactly, a hard pressed debtor who was scrounging the globe for fresh funds would deny having tons of the most acceptable collateral there is, was left unexplained. If past really is prologue, then gold is due for one big rally starting about now.
Meanwhile the recession goes on as before. The government pours enough fresh money into subsidizing the banking system to prevent a Depression, but the relentless contraction of that same banking system prevents prosperity’s return. Were the stock market to sell at more normal valuations, the newspapers would read far more bleakly than they do, as every new layoff and closing would be seen for what it is and not the last of its kind. Through it all brokers go on printing shares in non-companies and near bankrupts alike, secure in the knowledge that the public will take any risk so long as they don’t get that dreaded 4% for ninety days.
When speculation is the fashion and prudence is going begging, our job is to make sure our eyes don’t wander from the value field. With the markets as eager to pitch out value as they are now, it should pay us well to play catch.
Sincerely,
Edwin A. Levy
Michael J. Harkins
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LEVY, HARKINS & CO., INC.
In 1991 our average account appreciated 8 ½% from all sources, inclusive of all fees.
The statistics below are also from 1991:
GNP Price Deflator +3.5%
Consumer Price Index +4.2%
Average Treasury Bill Rate +5.4%
Standard and Poors 500 Appreciation +26.3%
Dow Jones Industrial Appreciation +20.3%
Wilshire 5000 Index +30.3%
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. However, past performance is no guarantee of future results.