January 11, 2000
The investment business has its ups and downs. Last year was about as uppish as we ever expect it to get. What does it mean that three or four years’ returns came to us all in one year? Warren Buffett has frequently said that he would prefer a lumpy 15% return through time than a smooth 12. When it comes to deep theorizing, that’s about as far as we get. We would like to add, however, that it is very important to us that you understand we did nothing out of our ordinary practices to achieve these returns. Our risk profile, either as we see it, or as an academic would see it, barely budged from what it has been through our twenty year experience. Nonetheless, we are utterly certain there will be no repeat. These two notions are not at odds, despite initial impressions, if we spend a moment detailing what went right with our two biggest investments.
When we first began investing in Qualcomm, about this time last year, it was selling at around twenty times earnings. We had been, for many years, very skeptical of the new standard of digital wireless phones the company had been proposing, first because a European standard already appeared to be firmly entrenched, but also because we had the opinion of an outstanding professor at a leading American university that Qualcomm’s CDMA standard would never work as advertised. The density of calls the system claimed to handle was said to be in conflict with the laws of radio propagation. But it is one of the astounding traits of turn of the century American entrepreneurialism that the laws of physics seem to be treated like ten-pins, there just for the knocking down.
We were amazed to discover in late 1998 that the system worked in Seoul, Korea, in Hong Kong, and then finally in Los Angeles. There are no places on earth with denizens more addicted to cell phones than these three, and so we were persuaded scientific cavils could be dispensed with. The company, however, was barely making money for its efforts. In order to win over skeptics like us it had been forced into manufacturing every single part of the system internally. Mass manufacturing electrical goods in San Diego is no one’s idea of a fun outing. The financial documents made plain that if it could simply stop losing money on the most onerous parts of its business, the making of base stations, then the shares would be trading at a mere ten times earnings.
This is where we entered. What came next was wholly, and marvelously, unexpected. In March, Ericsson, one of the two big European competitors, capitulated after a ten year fight, bought Qualcomm’s money losing infrastructure albatross at a walloping great price, signed licensing agreements validating the strength of Qualcomm’s patent position, and set up standards for the next generation of cell phones that entrenched Qualcomm. If Irwin Jacobs, the CEO, had taken the rest of the year off we would still be signing his praises. Instead, he went on to display in September a system for hooking your computer up to the internet that will be wireless, and that will allow you to pull a PC out of a box and be on the web three keystrokes later. No cable modems, no ISDN lines, no world-wide wait required. This will be on sale everywhere by year end, and an early prototype can be seen in the cell phones we both carry.
Qualcomm may be standing astride the choke point of the most exciting and ubiquitous technological changeover in the last century, and it was at a knockdown multiple twelve months ago. We are not going to stop looking for the next one, but the series of events detailed above seem so improbable even in retrospect, that we would not advise holding your breath waiting for the encore. When we said a year and a half ago that the Asian crisis was a blessing in disguise, some of our clients remarked that it was very well disguised indeed. The size of the blessing, as it turns out, is what was really obscured.
Going forward, this investment needs to be watched like a hawk. It sells at 100 times earning and has generated unthinking enthusiasm from the hyper-thyroid day trading crowd. Yet the cell phone market is 50% bigger than the PC market, and Qualcomm’s position to it seems eerily like Microsoft’s position in the earlier revolution. Also, the Jacobs family has now whittled away the unprepossessing manufacturing businesses masterfully, leaving nothing but a jewel of a software business in its place. We wrestle with the merits of this now over-sized investment by the hour.
Echostar lies in another realm entirely. While brilliantly guided in fact, it is the very definition of an ideal business; no one needs to do anything very smart every morning in order for outsized returns to pour in before supper. Great businesses are often said to have protective moats around them. This one’s a nearly impenetrable 24,000 miles. Indeed, even if someone had the gumption to try competing with the two rival satellite broadcasters now, the government will not grant another license. Think about that for a moment. Since Chief Justice John Marshall struck down the steamship monopoly of Robert Fulton, the federal government has been out of the business of granting exclusive charters to businesses. The sole exception was AT&T, and that business was heavily regulated for the first half of its life, and forced to forebear subsidized competition throughout the second half. There are no such fetters on Direct TV and Echostar, and they sate the national obsession for television. Lest you think “obsession” too broad a characterization, we would point out the average Echostar customer watches 52 hours of television per week. Considering there are only 168 hours in a week, Charlie Wilson clearly got it wrong, the business of America isn’t business, it’s TV watching.
Echostar grows at 60% per year, sells at a modest premium per subscriber to shrinking cable companies, and would be less than 30 times earnings were the accounting normalized. This leaves us in the incongruous position of hoping the stock just doesn’t go up too fast, thereby tempting us to do something really foolish and sell it. That we have done such things before never seems to make us proof against selling too soon again.
In our last letter to you we extolled the investment merits of Berkshire Hathaway. The stock spent the quarter shuffling its feet aimlessly, until the last weekend of the year, when Barron’s weighed in with a cover story asking, “What’s Wrong, Warren?” and wondering how America’s most renowned investor could have “stumbled so badly”. Buffett is about even on the year, which might go some ways toward telling you just how over the top expectations are in the investment world today. Buffett doesn’t need our defending him, but as we buy more of his company’s shares at a big discount to the intrinsic worth every week, we keep hearing the words of our friend Shad Rowe, the Texas philosopher and value investor, who likes to say, “It’s been my experience people don’t generally alternate between smart and dumb.” Buffett has been smart enough to compile the greatest retained earnings hoard of any company in the United States. As for the editors of Barron’s well….
No fin de siecle investment letter could be complete without a passing mention of the Internet mania. How out of control is this phenomenon? Well, it is entertaining to watch the ABC television network demand upfront cash payments from dot.com companies wishing to advertise on the Super Bowl broadcast. The companies are judged not credit worthy for million dollar bills by their suppliers, but regularly accorded billion dollar enterprise valuations in the stock market. In our long experience, creditors always get it right in their jousts with stock jockeys.
Five years after the internet revolution fully took shape, America, as a society, has poured as many IQ points into the search for a vigorous on line business success as was ever marshaled in the lunar project a quarter century ago. Anyone who has read Michael Lewis’ new book, “The New, New Thing”, is in no doubt of the astounding brilliance of the people promoting these new enterprises. With the marginal exception of AOL they all lose money, most at accelerating rates. This suggests there may not be a profitable business model to be found, else these people would have found it. In that case, there is over a trillion dollars of market capitalization standing out in thin air. Its collapse might prove unpleasant all around.
1999 marked our twentieth year in business and we would like to end this letter on a reflective note. We have run balanced accounts, always with a considerable income producing component, since before the Reagan revolution, before the fall of communism, before Jeff Bezos was a Time magazine subscriber. We have compounded money in that time at better than 17% a year after all fees. Over twenty years, that works out to better than 25 times your money. The trick lies not in having great years; everyone has some of those. Compound interest works only if you have no big down years, and this we have avoided. Maybe this skill will come into play again sometime. To be sure, we do not expect the next twenty years to yield results as good as this. The economy can’t grow fast enough, and interest rates will not fall through zero, which is what they would have to do to match the previous experience. Still, we have one great advantage going forward. The specialization of the investment world had grown laughably rigid. If you are a technology investor, woe betide you if you buy a newspaper stock. You will have your money managers’ epaulettes torn off your shoulders, or at the very least money withdrawn from your mutual fund, because you have committed “style drift”, and this is generally considered unpardonable. Praising rigidity is rank foolishness, and it will end sometime, but it is in full-throated roar now.
To invest is to choose, and after twenty years of trying a little of everything under the sun, we think flexibility and breadth of experience is an asset. At the end of the next millennium, when we all will likely next be in a reflective mood, we hope this observation will have borne out.
Meanwhile, for this year, we wish you and yours a happy and healthy new year.
Edwin A. Levy
Michael J. Harkins
LEVY, HARKINS & CO., INC.
In 1999 our average account gained +159.73% from all sources, inclusive of all fees.
The statistics below are also from 1999:
*GDP Price Deflator……………..…………….………….+1.4%
*Consumer Price Index……………………………………+2.6%
Average Treasury Bill Rate…………….…………...…….+4.6%
Standards and Poor 500 Appreciation…………….….….+19.5%
Dow Jones Industrial Price Appreciation………….…….+25.2%
Russell 2000 Index……………………………….……...+19.6%
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.