1994 was a struggle. Our average account lost money for the first time in our fifteen year history. We did not lose much, but we long ago forswore comparing ourselves to other balanced account managers and trumpeting our relative out-performance, so the end of a winning streak that started in the Carter years came as a blow. Still, our spirits are better than you might think, as we ended the year with more optimism than we began it.
We feel as though we are living in the mirror image of the early years of our firm. America and the world in 1980 were coming to the end of a fifteen year cycle of inflation. Hundred dollar barrels of oil seemed near enough to touch, and real estate was as much a religion as an asset class. Business Week told America that financial assets were “certificates of confiscation”, and Wall Street had investors ready for a 20% consumer price index. It never came to pass.
Graybeard clients will remember we started having our doubts about inflation in late 1980, and by mid-1981 we were loaded to the gunwales with bonds, partly because conditions had changed, but mostly because prices were amazing. Ronald Reagan broke the labor movement by dismissing the air traffic controllers union. At the same time, Paul Volker was imposing a policy of rigidly tight money and daring Congress to impeach him. Those were changes in policy that everyone marveled at.
Still, by itself the change in conditions would never have convinced us to be so heavily committed to long-dated Treasury bonds. It was the prices that prevailed simultaneously for bets against inflation that drove us to act, and that still seems unbelievable even today. Although we went through a good few months of pain in 1981 and 1984 because we were fully committed too early, the simple arithmetic of our investment was a constant source of comfort. As we told so many of you at the time in letter after letter, at 15% interest rates, bonds had to go down more than 15 points in a year to lose us money. And if they did, they would subsequently be yielding 18%, and that would surely be enough to stop inflation in its tracks and reward your forbearance and ours richly.
What a difference a decade makes. In 1994 the gathering storm of inflation was already splattering its first great drops while Wall Street was doing a lively trade in sun visors. To put this plainly, conditions have changed from those that brought on our much beloved 3% inflation rate. Four years into a recovery, politicians of every stripe want to cut your taxes, and most of them claim the cuts will pay for themselves. This marvel is called “dynamic scoring” amongst those who lust for the Presidency and deja voodoo for those of us who remember the clobbering the bond market took when Mr. Reagan first proposed “self-financing” tax cuts in 1981. If you are tempted by today’s higher yields to buy a bond, you might take a glance at a bond chart from 1980. After having gone down sharply for over a year, bonds rallied in the fall of 1980 at the prospect of a dramatic Republican victory. Victory came, and with it Mr. Reagan’s first supply-side tax cuts, and the decline from Inauguration day to the eventual bottom was almost 25%. We know Mr. Gingrich is trying hard to convince us that this time it’s different, but still, he’s no Gipper.
To repeat, times have changed. American bankers no longer live in fear of a midnight knock on the door from a regulator, Japan isn’t in depression, the labor force is as close to full employment as it has been since the height of the Viet Nam war, and the profitability of large corporations today guarantees pricing freedom. Like a blinking hostage who doesn’t quite realize he’s been set free in the daylight, Fortune 500 companies have been raising prices lately and marveling at the pleasantness of it all. By year end they will be rapacious.
The greatest change almost goes without comment. In the 1960’s, Africa was the developed world’s playground for basic commodities of every type. In the waves of chaos that swept the continent at the end of colonial rule, the industrial base that produced those raw materials was haltingly, but effectively destroyed, contributing mightily to the inflationary impetus running all through the 1970’s. The world could not replace an Africa quickly. Today, not one investor in fifty knows that the old Soviet Union was by far the world’s largest energy producer in the late 1980’s, dwarfing Saudi Arabia, and that today oil production in the newborn CIS is half of what it was just five years ago. Indeed, the place is in such chaos that knowledgeable experts can be wrong in their estimates of current production by 10% and more, and have no fear their reputations will suffer. Internal demand in Russia has collapsed even faster than the industrial base is wearing out, so the effect on prices has been small. But the world will not lose a supplier of basic goods the size of Russia without eventually feeling it. Still, for a value investor, it isn’t just a lifting tide and freshening breeze that makes you want to go sailing. The price of the boat really matters. And this is what excites us today; inflation-worthy craft go for a song.
We would like to break with our usual practice in these letters and tell you a stock story, but not because we are “recommending” it in some fashion. We don’t do that, and this small company comes with all the very considerable risks attendant with a small natural resource concern. It is, however, simplicity itself and will illustrate a point. You may have noticed we have been buying you recently a very small position in a $.50 stock on the New York Stock Exchange called Campbell Resources. Campbell has a gold mine of long standing production north of Montreal, and a prospective mine in Mexico. It also has $27 million in cash and so little debt that we think the market value of the mining equipment would about equal it. Campbell has 120 million shares outstanding, meaning it sells for about $60 million. It is also earning money at the rate of about $3 million a year, so subtracting the cash from the market price we are buying the gold portion of the company at perhaps 10 times earnings, giving no account to the fact that they are exploring for gold, so far successfully, with a $6 million exploration budget that is fully expensed. It is amusing to reflect that the management of this company could do a leveraged buyout of the public shareholders and not lose a single night’s sleep under about any gold price or interest rate scenario we care to name.
No such thing is going to happen, of course, and we are not broadly hinting otherwise. But gold shares have not traded at 10 times earnings in living memory, and indeed at perhaps half that price if the yearly increases in reserves are given a cash value. Moreover, Campbell is not even necessarily the cheapest investment we have; it comes to mind first only for its simplicity and, of course, for the fact it is a fifty cent stock trading on the NYSE. It is the ordinariness of these valuations right across the inflation spectrum that excites our interest. We own oil rigs at about a quarter of replacement value (Reading and Bates), California real estate at a fifth of pre-cash prices (Catellus Development) and oil companies at a third of what major producers typically pay for individual wells (Gulf of Canada).
At the bottom of the market for financial assets in 1974 Warren Buffett said in an interview in Forbes magazine, “I feel like an over-sexed man in a harem.” Twenty years later we are much too politically correct to repeat that sort of thing ourselves, but, - well, you get our drift.
Wishing you and yours a healthy and happy new year, we are,
Sincerely,
Edwin A. Levy
Michael J. Harkins
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Note: At your request, you are entitled to receive from us a copy of Part II of SEC Form ADV.
LEVY, HARKINS & CO., INC.
In 1994 our average account lost 4.19% from all sources, inclusive of all fees.
The statistics below are also from 1994:
GNP Price Deflator………………………..……………….+ 2.3%
Consumer Price Index………………………………….…..+ 2.7%
Average Treasury Bill Rate…………………….………….+ 3.9%
Standard and Poors 500…………………………………….- 1.5%
Dow Jones Industrial……………………………..………..+ 2.1%
New York Composite………………………………………- 3.1%
Nasdaq Composite………………………………………….- 3.2%
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.