What a pity a year has four quarters and not three. 1997 would have been a delight had there been less of it. The first three quarters of the year produced returns slightly above average for Levy, Harkins & Co.s eighteen year history, but the last quarter was sufficiently disappointing that we will devote the rest of this letter to it.
As you no doubt know, at mid-year a small currency devaluation in the Thai baht, a heretofore utterly obscure monetary unit that could have been no ones idea of a store of value, slowly but inexorably touched off a collapse in every other East Asian financial system. Today stock prices in dollar terms for roughly half of humanity are 50% to 90% lower, and most of the decline is due to the devaluations of currencies. The savings of middle class Asia have been savaged. In the last weeks of the old year and surely in the first week of this, the Asian despair has now overtaken equity markets everywhere.
Before we examine the likely impact of ailing Asia on America it would be well to remember American stocks have their own reasons to be suspect. Their single glaring blemish is their price. However you measure stock prices, either from where they were to where they wound up; or how they measure up to their underlying businesses, American stocks are dear. They are also well loved. Is there a saloon in America not playing CNBC at lunchtime today?
Because the stock market is binary, it either goes up or it goes down, there is always an irresistible urge to attribute its last movement to whatever was the last passing phenomenon. There is the old story of the English priest visiting an Irish village, and he is called on to assist when a young mothers time has come. He straightaway stations the husband at the foot of the bed with a lantern, and just as he is about to conclude in the delivery of the last triplet, he hears the put upon husband meekly ask, Excuse me Father, I dont mean to interrupt, but do you think its the light thats drawing them?
We hope to be a little more knowing than that confused husband. Just because Asia is a worry on everyones lips now should not blind us to the possibility that stocks may be going down because they were too high to be long supported, going down of their own accord because the motive forces that were driving them up the last sixteen years are now spent. But there can still be little doubt that the Asian collapse has unnerved investors as nothing else since the Persian Gulf War. For one thing, there is no precedence for gauging the degree Asian markets impact on our own; with the exception of Japan, they scarcely existed ten years ago. Nonetheless, three points are plain.
First, we are about at the stage where enough is enough. Last week the Singapore dollar and stock market took dives of 8% and 27% respectively. This is ridiculous. Singapore is the richest nation on earth in per capita terms and has foreign exchange reserves to match. It is a paragon of political stability and fiscal probity, all tending to show we have reached the indiscriminate stage of a panic.
Second, and closer to home for us, businesses that stand to benefit from events on the ground are finding their shares pummeled on the worlds exchanges. No case stands out in starker relief than Gulf of Canada, our largest holding. About 25% of the business is producing natural gas in Indonesia and selling it at the equivalent world price for barrels of oil. What could be more fun than watching your costs of production fall an almost instant 80% while your revenues are very nearly fixed? In Gulfs case things are even better, since the government is taking a number of measures to speed up Gulfs already prodigious growth rate. The governments interest is in capturing the foreign exchange to be had from the greater taxes we will pay, but it still bids fair to being a marvelously profitable two to three years until the inevitable inflation catches up with us. To those who are fearful of nascent civil disturbances, we can only observe that Algeria is in the midst of a mind-numbingly vicious civil war, and oil production in Algeria has risen every year for the past five. Central Sumatra, where Gulfs properties are, makes Algeria look like Central Park, it is that remote.
In the same way American International Group is the direct beneficiary of the turmoil, and yet its shares too are battered in the years first fortnight. AIG started in Shanghai and has an insurance franchise throughout Asia we could not duplicate with billions of dollars of advertising. Fortunately we do not have to, as it is immensely profitable in Asia today. And it is destined to get more so, as the World Trade Organizations agreement on financial market reform, concluded in Geneva on December 13, throws open the commercial and life insurance businesses to equal and unfettered competition. Foreign firms are now to be regulated as equals with previously protected homegrown firms in over 70 countries. With hundreds of Asian banks and insurance companies under harsh and cynical scrutiny as potential bankruptcy bait, wouldnt you rather pay your premiums to a great American name with a convenient local network? So will millions of Asians.
In the cases of both Gulf of Canada and AIG we are being punished for doing what we do, buying obviously distressed assets at prices less than what a private buyer would pay. Indeed, in Gulfs case, a quarter of the Indonesian subsidiary is public, and the subsidiary sells for more than half the value of all of the vastly larger Gulf. Since the rest of Gulfs assets are in Canada and the North Sea, and have nothing to do with Indonesia, it has left us shaking our heads at the madness of crowds. We have complained in recent letters about the dearth of value investments selling at substantial discounts to break-up value, and we cannot help noting the irony that now that we have them again in spades, it is slightly less pleasing than we had remembered it to be.
The third, and most obvious point about the current Asian turmoil, is that in times of panic horizons shorten to the moment by moment, which is not how you make money. Where will the world be one year from today? Well for one thing, it will be a place with a hell of a lot more money in it. Central banks everywhere have opened up the spigot, and American Treasury officials are seemingly on every outbound flight accompanied by their IMF opposite numbers. Money supplies are growing faster than planned around the world, including, praise be at last, Japan. And this gives no effect to the staggering amounts put forth by the International Monetary Fund, soon to approach a total of $200 billion, or as much as was spent in the entire savings and loan crisis. We know how stimulative that proved to be here, and in a years time the same process will be at work out there.
And the headline grabbing involvement of American officialdom conceals the point that American banks have surprisingly little at stake directly, in all perhaps $28 billion, less than either Europe or Japan. But with each new round of loan re-structurings comes a negotiation for greater capitalist freedoms in the affected countries. Neither the Japanese nor the Europeans have the moral standing to lecture about the need for greater labor mobility, or financial reporting transparency, or the evils of outright government subsidies. Americans play the leadership role because they can, and it is well to remember they also get to write the new rules in ways most favorable to us.
Investors invariably overestimate the ill effects of currency devaluation on economic activity. Think back to September 1992, when Great Britains slavish and foolish devotion to a pegged rate between the pound and the German mark produced a bear market in stocks, 12% interest rates and at least as much public agonizing as the Asian crisis today. George Soros, the man who broke the Bank of England, led a speculative attack on the pound and the fixed rate was sundered. Today Britain has the lowest unemployment in Europe, the most vigorous economy, and a stock market more than twice the then price. Soros is still waiting for the editorial to appear in a major U.K. daily,
Dear Mr. Soros,
You were right and we were wrong, thank you very much.
This is the same George Soros, by the way, who can be seen on the cover of last weeks Financial Times happily shaking the new president of Koreas hand as he prepares to invest $1 billion at the knock down prices now prevailing.
It is not that we mean to minimize in any way the pain that has been inflicted by this turmoil, or the potential of more to come. It is just that we do not yet think that the cries of Deflation Ahead that we hear all around us quite make sense. Deflation? We are overlooking the unpleasant fact that 500 million people who were experiencing negligible inflation in mid-summer are now facing rates greater than 30%, and every soul amongst them is deeply surprised. This is the nature of inflation, not one man in 1,000 sees it coming; a particularly odd fact considering how commonplace inflation is through time. Secondly, conditions are so very different in America than elsewhere. Here credit creation is buoyant, Americans are about to re-finance their homes in record numbers, and the unemployment rate is so low that we could not withstand another year of job growth like the last one without overheating. And stimulation is what we are going to get, since the Congress and the President have already begun competing to see who can spend the nascent surplus faster through tax cuts and new social programs.
These are large magnitude items. The $25 billion swing in our net export position with Asia is a small one by comparison. To be sure, if China is cut off from credit the same way as the lesser East Asian nations we will have a different opinion quickly. China is a great power, however, and had a rather prominent role to play in the last presidential election. We are unlikely to treat her with the same sort of benign neglect we showed Thailand at the beginning of this difficulty.
Despite our exasperation with them at the moment, we like our stocks, and are more comfortable with them than we have been in any recent year. High anxiety, low interest rates and shares selling for less than break-up value is how we have compounded money at better than 14% a year for 18 years. And while we have never made an issue of this, it also has led to low volatility and a very modest tax rate. Moreover, we do not like bonds at such very low rates. We will not take you again through the arithmetic of bond yields during times of very low rates*, but bonds appear to us to be an extraordinary risk with a negligible reward.
If the tone of this letter seems in any way that we are too sure of ourselves, dont you believe it. We are sufficiently concerned that we are going to break with our usual practice and write you again next month when the dust may have settled.
Wishing you and yours a happy and healthy New Year, we are,
Sincerely yours,
Edwin A. Levy
Michael J. Harkins
*The curious can refer to the January 1995 letter.
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Performance for Levy, Harkins Since Inception
1980 . . ..+26.11%
1981 . . . .. .+8.10%
1982 . .. . .. ..+34.98%
1983 . . ..+14.32%
1984 .. ..+15.13%
1985 .. . . +22.79%
1986 .. ..+13.08%
1987 .. . .+10.02%
1988 . . +2.02%
1989 . .. .+17.02%
1990 .. . . ..+8.75%
1991 . ... ..+7.32%
1992 .. .. . .+2.00%
1993 . .. .+22.80%
1994 . . -4.19%
1995 .. .+27.00%
1996 .. .+27.30%
1997 .. . ..+5.60%
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.