January 12, 1999         1998 taught us all the difference between a stock average and an average stock.  The former soared and the latter sank.  As the year wore on and conditions grew more unsettled, mutual fund buyers and managers alike seemed determined to hazard their money only in the fifty names they new best.  By year end it was hard to know who was “winning” the race, investors to cash in all for index funds, or mutual fund managers to turn their actively managed funds into closet indices.  This sort of “comfort food” investing has gotten out of hand, in that the most popular fifty names now have about as much investing value as comfort food usually has nutritional value.  Yet overvaluation seems to happily and blithely co-exist with astonishingly great value in hundreds of middle size and smaller names.  And bear in mind, in a world of behemoths, anything less than five billion dollars is today a small capitalization.  We are asked again and again what we make of the fact that a large capitalization alone seems reason enough for a stock to sell at extravagant multiples of earnings.  Why does Staples, to pick a name at random, sell at ten times the capitalization of Office Max, when the two firms are in the same business, with nearly the same overall sales and profitability?     We don’t know.  Fortunately, we don’t have to know more than to avoid Staples and, perhaps, examine Office Max.  To be sure, last year all performance came through embracing the Staples of the world.  Seasoned readers of these letters do not need to hear us decry the risks involved in buying anything at 54 times earnings; nothing had better go wrong or you are out an awful lot of money.  But all would-be Cassandras might profitably better note how many ways there are to gain in a neglected Office Max, including the obvious temptation for Staples to buy it with overvalued shares, thereby doubling in size at a cost of one eighth in dilution.  When stocks are undervalued, life most often takes care of itself, meaning stocks can go up for dozens of reasons, including simple rapacious devouring by their overpriced competitors.     We mean no advertisement for Office Max.  We use it as a neutral example only because it is so perfectly commonplace.  Also, we are delighted to tell you that we do not yet own MAX because the existing discounts from value in your portfolio today are greater than this example.  Indeed, the Russian dust-up in the Fall has meant that for value investors willing to step out beyond the top 100 names there is something for everyone.  There is high yield to be had, there are great discounts to replacement values, and there are growth companies with unblemished records selling at more reasonable multiples, particularly in relation to the now much lower interest rates, than anytime in the last decade.  This last point bears repeating; growth is cheap if you do not demand an Internet connection or a top fifty imprimatur, and high top line growth is particularly valuable because it is so rare in a world of zero or lower inflation.     Amongst the reasons you own so much Echostar is because it grows faster than 5% per month; yes, per month, and we have seen no reason to trim it back whilst it is in the midst of such a pleasant binge.  Echostar, you will recall, is the owner of four satellites that can deliver 180 channels of television to your home through a DISH antenna scarcely bigger than a dinner plate at prices about a third less than the local cable company gets for much inferior service.  Almost a million new customers signed up last year while the company was still effectively banned from giving the customer what he most wants; local TV signals.  At present subscribers have to make do with network feeds from New York or Los Angeles due to archaic FCC regulations.  Three out of four customers leaving retailers without purchasing the system say they do so because they would miss local events.  Seattle natives want to watch the fog roll in on the tube, Chicagoans must see the wind blow, and in New York’s tabloid culture local television’s rule is “If it bleeds, it leads.”  There are regional differences.  Echostar has in place satellites that are already beaming four such channels to 20 markets now, but the rules in place prevent the company from connecting the customer.  They are the only satellite company with local to local ability, and they are certain to stay that way since no more licenses for this particular orbit can be issued.  Come February, these rules are due to be reconsidered, meaning growth might accelerate from here, if the rules are changed, and Echostar can take customers from other satellite providers, as well as preying on the cable companies.     Echostar is delightful to write about for all sorts of reasons, but it serves to illustrate a greater point.  Small capitalization growth can be had for a song by comparison to its behemoth brethren.  Consider the comparison between Echostar and the giant cable companies Telecommunications and Cablevision.  They sell for approximately $2800 per subscriber and are shrinking; Echostar sells at $1600 per subscriber and is adding subscribers at the rate of 75% per year.  Good as Echostar has been, Telecommunication’s and Cablevision’s shares have been slightly better; go figure.     While hardly any business has the sort of insurmountable moat around it that Echostar has, the companies in your portfolio are, almost universally, joined by a common thread.  They are very difficult to compete with.  Want to take on American Express?  If your name is not Visa or Mastercard you have no chance, and in the last quarter we were greeted with the happy news that the Justice Department has become, at last, our marketing ally, seeking to break down the cartel that bars banks from issuing AMEX cards.  If successful, the government will open up a new selling channel for AMEX in a market in which competitors sweat bullets for tenths of percentage points.  At 18 times earnings, a 15% growth rate and an unbeatable brand name, AMEX seems to us mispriced as it stands compared to a 5% Treasury bond, let alone the bizarre multiples on technology stocks that so dominate the averages today, and hardly any of whom are insulated from competition.     During the last quarter we purchased Ethan Allen, a nifty example of about everything we want in a business.  As the only nationally known home furniture chain worth the mention, Ethan Allen presents the consumer with what she wants in a package other retailers can’t match.  Since Ethan Allen makes 90% of what they sell, they are responsible for their own quality control, and can guarantee reasonably acceptable delivery times, neatly knocking off two bedeviling problems for the shopper with one stone.  Plus, the strength of the brand name gives the consumer confidence the store is going to be there in a few year’s time, and the simplicity and continuity of the line reassures the shopper that when something wears out, she can replace it with a matching item three years hence.  Even after a decade of greater than 15% growth, without a down quarter, Ethan Allen only holds a 2% share of the furniture market.  When asked about overseas expansion, Farooq Kathwari, president and guiding light for eleven years, dismisses the idea, saying, “For us, America is an emerging market”.  And we think he means that optimistically.     We will end with a commercial announcement; you may have noticed there are some real estate investment trusts that have crept into your account through the second half of the year.  While we claim no particular expertise in the field, it is amazing how many listed stocks there are with greater than 9% yields in a world that is supposedly yield famished.  As this year goes on we are likely to be naturally adding to this list but if you have a bond portfolio that now provides too little income you might want to call us for a peek at an attractive alternative.     Wishing you and yours all the best in the New Year, we are      Sincerely yours,      Edwin A. Levy      Michael J. Harkins Levy, Harkins & Company 570 Lexington Avenue New York, NY  10022 212-888-3030 FAX 212-888-7146 -------------------------------------------------------------------------------- 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% 1998 ......-3.77% 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. This is a 15.0% compounded growth rate over the 19 ½ years since inception.