January 8, 2001

The social object of skilled investment is to defeat the dark forces of time and ignorance which envelope our future. J.M. Keynes

Ignorance had quite a year.  The distinction between revenues and profits is ordinarily grasped by a child on a hot summer’s day at a lemonade stand, and then remembered for a lifetime.  The year past saw half a generation of mutual fund managers learn that basic lesson and more in a remedial class lasting from April through to today.  No barrier to entering a business means no high returns from that business.  A return on capital, or even just the return of capital, is good.  Revolutions eat their children; technical revolutions will eat your children’s college funds with even greater voraciousness if you let enthusiasm get the best of you.  All of these simple lessons of investment life were forgotten in February, and Wall Street’s poor memory was ruefully regretted by December.     The slump we are now in should be laid directly on Wall Street’s doorstep.  The public, however, does not deserve to get off scot-free from last year’s speculative stock debacle either.  Without thinking highly either of business or of patience, investment riches has long been the public’s self-assured end.  Life is not likely to work like this.  Indeed, expectations for investment returns remain way too high, and this continues to trouble us, not least because we are expected to produce those returns.  Society is likely to get bent out of shape in a great many ways so long as ownership is thought entitled to 15% growth in a system that grows but 5 per cent per year.     To seize on just one ugly contortion, heaving free or nearly free money at entrepreneurs in any business, in order to capture a brief period of high returns, is far more likely to produce many years of losses and no moment of pleasurable profit.  It is one of the paradoxes of investing that too high equity prices are almost guaranteed to ruin the underlying businesses, as well as crushing the hopes of the shareowners.  We write this with beet red faces, since about five years ago this lesson got re-learned right here at Levy, Harkins.  We invested in the AMC movie chain, theater owners with a new idea to make movie-going far more enjoyable than the established multiplexes.  Almost immediately after our investment came a deluge of capital from the leveraged buy-out houses looking to cash in on the innovation.  We owned the original innovator, an eighty year old business, run by the best guy in the business.  It did us no good, as the money flowed in to the good operators, the poor ones, and everyone else beside.  Today there is not a movie theater in the country not in bankruptcy or at death’s door.  This is a business that survived two world wars, a depression, and the coming of television, all prosperously.  But there was no effective way to batten the hatches once the storm of Wall Street money started raining down in earnest.  This is part of the reason it is so much better to be hated by the Street than caressed.  George Soros goes so far as to build an entire social theory out of this observation, that stock prices create the future as much as they are influenced by the future, calling it “reflexivity”.  It is enough for us simply to remember that the wise man never wishes for his stock price to go “too high”.     With our AMC mistake, we saw firsthand the catastrophic outcome of over-investment in as stable a business as movie theaters.  What odds do personal computer makers, or telecommunications licensees, or internet startups have, in the aftermath of a spending binge?  The last three are all last year’s darlings as investments, and are businesses with a large number of rapidly moving parts, any one of which can twirl and take your head off at any moment.  If you look at your portfolios today, you will see all the issues have two things in common crucial to investment success.  First, they all have effective moats around them, impediments to someone else emulating their success.  If you launch your own satellite to compete with Echostar, you go to jail.  If you violate Qualcomm’s patent portfolio, you are fined and perhaps jailed.  Want to compete with USA Today?  Prepare to lose money for fifteen years just as Gannett did.  Businesses with moats, and managers who understand the importance of daily digging, are the key to superior returns.     The second crucial attribute all of your investments share is that they do not need access to the outside capital markets; not stock sales, bank debt, or bond issuances.  We can go on for quite some time with stringent credit conditions, and your underlying investments will thrive.  If we cheerfully agree to ignore the egregious internet, technology and telecommunications sectors, capital hogs all, it is still true that something on the order of 75% of Standard and Poors companies need periodic trips to the capital trough.  Most businesses are worth much less if they are cut off from the capital markets, if only because their growth is so impaired.  Your portfolio grows internally.     And grow it most certainly did in 2000.  While we had our worst quotational loss in twenty-one years, we are profoundly grateful at the large increase in value the businesses achieved on the year.  Echostar added almost 2 million subscribers on a base of slightly more than 3 million, and declares that it is ready to do about the same this year as well.  If we normalize its earnings to allow for the amortization of new customers, rather than the instant expensing of these costs, the shares now sell at twelve times this year’s earnings.  That is unlikely to be the stock market’s final verdict by year end 2001.  Qualcomm’s cellular phone technology was deployed in 90 million phones last year, almost double the number from the year before, and despite all sorts of random setbacks.  Asiasat, Countrywide Credit, Ethan Allen, and Gannett all had earnings increases of fifteen percent or better, and each sells for less than 2/3 of the stock market’s average multiple.  These are superior businesses and their modest prices will make them superior investments in the years to come.     Notwithstanding the fine performances of the businesses you own, their value has increased even more in our eyes because interest rates have dropped so dramatically in recent months.  Bond yields are, on average, down by a quarter year over year, making them poorer competitors than ever to sensibly priced stocks.  On this score, we cannot help noting how firmly settled American public policy is on one point.  Bond holders in America are casually brutalized, and their interests subordinated, at any and every convenience.  Consider the statement below which accompanied the Federal Reserve Board’s recent reduction in the Fed Funds rate, which we have edited slightly.  It illustrates a general point:                                   “These actions (the interest rate cuts) were taken in light of high energy prices                                     sapping household and business purchasing power.  Moreover, inflation pressures                                     remained contained.”     To the best of our knowledge this extraordinary statement has gone unremarked, which may be the most remarkable part about it.  If you are living off a bond’s income, what you need in the face of rising energy prices is more income.  What you get from the stewards of America’s standard of value is the back of their hand.  Bondholder’s interests are the first sacrificed in America.  This was so at the country’s creation, and is likely to be so forevermore.     In the long run stocks are bonds, but they are bonds with a peculiar twist.  They have no stated coupon and no stated maturity date.  This uncertainty creates the short term volatility for which the stock market is notorious, but which properly ought to be seen as our best friend.  Indeed, were we at all confident that the sorts of panics such as we are now in would regularly re-occur, we would be much more sanguine about our ability to keep generating the kinds of returns we have realized over twenty-one years.  Stock sell-offs are rarely worse than exasperating.  The great danger in life is having many more years left to live, and no income on which to live it.  With all the creative ways society has to suppress the common man’s daily experience of inflation, most of us manage in our investment lives to worry most about what matters least.  Volatility is a bother for weeks, poverty is a torment for years.     If we are right in thinking that persistent inflation is a far more real and present danger than two quarters of recession, one of which may have already arrived, then it is surprising that there are so many fine businesses on offer with good managements and strong finances.  If you normalize the earnings of Echostar and your real estate investment trusts in the way we think better reflects economic reality, then the average multiple of earnings in your portfolio is about 14 times.  To state this in its inverse relationship, you have an income stream currently yielding about 7% and growing.  That this is so while interest rates continue to plunge perplexes us.  We do not think these depressed values can long endure, partly because of our knowledge of the inner workings of the money management business.  There isn’t an institution we know of, not a pension plan, a hospital endowment, a college fund, that has an assumed rate of return anywhere near the current 5% or less yield of government bonds.  Their budgets are all predicated on investment returns at least two to three percentage points more than the bond rate.  Money managers who promise less will typically get one respectful meeting.  After that, a board is faced with the prospect of laying off doctors, teachers or librarians, or the much more palatable prospect of sacking the money manager and replacing him with a far more optimistic soul.  The pessimist gets it in the neck every time, and it is the primary reason why lower bond yields invariably, but with a lag, precede stock market rallies.  These forces may not be as reliable as the laws of physics, but they do cause us to be fairly optimistic about our chances in the new year.     In twenty-one years we have compounded unleveraged capital at a rate of 16.4%.  That is a rate greater than all but roughly twenty-five companies in the Standard and Poors 500 index have compounded their equity capital over the same period.  We think about the relationship of our long term performance and the long term return on capital of the companies in your account all the time.  They are inexorably linked, and are the chief reason we harp on the competitive advantages of each stock we are in letter after letter.  The television, on the other hand, blares its opinions eighteen hours a day on which direction stock prices will be an hour hence.  In twenty-one years we have never known in which direction the next one thousand point move in the Dow Jones will be.  We do know the direction of the next ten thousand point move, and that ought to be good enough.     Wishing you and yours all the best in health and happiness in the New Year, we are,         Sincerely,     Edwin A. Levy    Michael J. Harkins _____________________________________________________________________________________________________ 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% 1999 .+159.73% 2000 . . .-12.00% . 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.