at his own protracted funeral.”
The Earl of Rosebery, on Randolph Churchill’s last years.
Yet we must be alert to the likelihood that the end of bin Laden is not the end of the problem. On this score, the judgment of Berkshire Hathaway’s Warren Buffet is unsettling. In a highly unusual letter to shareholders in mid-November, Buffet wrote of his insurance business, “We…included coverage for terrorist acts in policies covering other risks and received no additional premium for doing so. That was a huge mistake.” He goes on to say, “We continue to bear huge quantities of risk for which we received no payment.” He goes still further, and speculates on the outcome to the insurance industry had the attack on New York been nuclear, a particularly unwelcome thought if you spend your days perched over Lexington and 51st Street, as we do.
We need hardly tell you what respect we have for Warren Buffet’s thinking; a glance at your own portfolio will tell you that. Moreover, Buffet is long accustomed to his every word being weighed for meaning around the world. He does not vapor idly in print. What is more, his assessment of risk seems to be rippling down to his fellow underwriters. If no one who can afford to make it good is willing to write insurance coverage against future terror attacks, then that is a market judgment we need to spend some time wrestling with. Obviously such uncertainty makes the multiple we are willing to pay for any income stream lower than before. It also almost guarantees greater volatility, because there are really only two ways we can prevent terror. We can look to turn America into a police state, carefully monitoring the whereabouts of everyone and everything. That would destroy what we most wish to save. There is much fanfare just now over airline security procedures, which while welcome, is a bit like locking the barn door after the cow has kicked the fence down. A little of this can do no harm, but an America of real restrictions on personal freedoms in unthinkable.
The other alternative is to actively go after terror wherever it takes us, to take the President’s words literally when he said, “From this day forward, any nation that continues to harbor or support terrorism will be regarded by the United States as a hostile regime…The only way to defeat terrorism is to…destroy it where it grows.” This means far more volatility is likely in store for us as investors.
More volatility because we will not win every battle as quickly as we did the first. Will we have to re-shuffle our allied coalition every time a new threat is addressed? Count on it, American resolve against terror will upset some of our erstwhile enemies. Also, some of our enemies are our ostensible allies. There are regimes that smile on us in the American daytime, and train their youth to hate us by the light of their own day. Think Saudi Arabia, Pakistan, and Qatar, home of the al-Jazeerah television network. But the Saudi Arabians have oil and the Pakistanis have nuclear weapons. When America shifts from coddling these states to confronting them, the stock market is likely to have more than a few tremors. An oil embargo, for example, even if it were brief, has been a bugaboo to the financial markets for thirty years. That we are nowhere near as dependent on Saudi goodwill as we once were might take some time to seep into the collective consciousness.
Yet the greatest upset in the coming year may well be simply in how different an activist war against terror is compared to the Cold War that we had grown used to. In that forty-five year showdown, deterrence worked because the opponent was rational. The Soviets wished to conquer the future; they did not wish to retreat into the stone age past. Islamic extremists are something new under the sun. As Thomas Friedman has put it, “They hate us more than they love their own children.” People who launch attacks on us, and then gather their families about them as they prepare to meet their makers, are strange but formidable foes. We have recently re-read the Nixon-Kennedy debates, since they were a defining moment in that other fight against an evil ideology. When the Soviets were our opponent we needed only to contain them. This opponent we must go and root out, and our task seems more complex. Of course, present problems always loom larger than past ones. When John Kennedy said, “I look up and see the Soviet flag on the moon”, he could not have guessed how exaggerated his fears would seem 40 years later. What is remarkable in the Nixon-Kennedy debate was how blind both men were to their own society’s advantages. In four hours, over four nights, they mentioned “free markets” once, and that was disparagingly. Just as Kennedy and Nixon were blind to the attractions free markets would have for people waiting in endless lines for everything, our current government and elites have a blind spot when it comes to democracy. They don’t know how good it is. They do not see that democratic India tolerates dozens of differing ethnic groups and religions, and undemocratic Pakistan breeds hatred for all but one, and the difference is democracy. We are told in every establishment quarter today that Islamic states are not “ready” for democracy. You were born ready to live under democracy.
The American elite had clearer vision at the end of the Second World War. As that conflict ended, the first country we imposed a democratic framework on was Italy. To the rest of the West, Italian democracy seems to take place in a revolving door. In the 56 years since the War’s end, Italy has had 38 prime ministers. One was murdered and found in the trunk of a car. Virtually all of them have had “failed” governments in the sense that they fell far in advance of the end of their parliamentary term. No people regularly shows less civility to their political opponents or less respect to their democratic institutions. Democracy cannot find flintier ground than Italy. And yet Italy works. It is peaceful, prosperous, and delightful. It is a threat to no one but dieters and the unfashionable. Italy is democracy’s greatest triumph, because it shows its inner strength.
We invest from the bottom up. It is uncharacteristic of us to go on at any length about anything other than the business prospects for our current holdings. This time is different. Peter Bergen’s book Holy War, written before the September 11 attacks, is amazingly clear on how many dozens of outrages were committed before this last, and how resolutely they were ignored. America will come to grips with this now and impose democratic norms in the Islamic world, or we will be struck again and again. Afghanistan is only the end of the beginning. As investors, we don’t expect to hear the all clear siren for quite a while.
On the business front, two trends stand out. One is how nicely the businesses you own performed. You sustained only a small quotational loss on the year because on the whole, and despite the recession and the effective closure of the capital markets for most of the year, your businesses prospered. You can read below about some of the individual performances. We would only note with quiet pride how marvelous it is that America could have so many businesses that grew in value in the midst of so horrible a year.
The business world has a counter-trend going however that alarms us. The accounting trade has come off the rails. 2001 saw the biggest corporate loss ever, as JDS Uniphase lost $57 billion, a sum equal to almost a fifth of all corporate profits expected in the United States. JDS is a small company that makes exciting gizmos for fiber optic networks. In its entire history to date, it has had revenues of $5.7 billion dollars. In what sense, therefore, could it have possibly lost $57 billion? The question is nonsense, of course. It couldn’t and it didn’t, because the transactions it pursued in order to acquire the third largest book value in U.S. industry were shams. But follow through the logic of what comes next. Take the case of Nortel, which lost half as much as JDS in the second worst beating in business history. Still left with some positive equity, if Nortel sees any improvement in its business cyclically, then its return on invested assets will skyrocket. Indeed, future earnings themselves will be overstated, since it will not be properly booking depreciation on past capital expenses. Despite this, in any kind of economic recovery, Nortel will look like a highly successful enterprise with excellent return on capital. JDS, if it survives, will have towering returns on capital. Yet the experience of anyone who has contributed actual money to these enterprises over the last three years will have been ghastly.
We have often written to you in the past about the limitations of the accounting conventions to capture accurately and completely the value of the cash flows in our own holdings. Sometimes we thought we had a pearl when the accountants thought we had a stone. But in accounting for technology concerns today, up and down are often confused. If a catastrophe is, after the passing of one year, accounted a triumph, count on more catastrophe. This discomfits us even more than the Enron disaster, because fraud has always been with us, but the institutionalization of lying is a real threat to the business culture. We used to say we did not invest in technology firms because we did not understand the business; now we cannot understand the numbers. In as much as technology shares make up about a quarter of all stock valuations, they are just so much fallow acreage for us.
At Moody’s, by contrast, accounting is simplicity itself. Moody’s gets paid for delivering an opinion on the creditworthiness of any large issuer selling a bond or a stock. After an analyst renders his judgment, Moody’s gets issued a check. If it doesn’t clear, he richly deserves to be fired. Beyond such charmingly straightforward accounting, Moody’s is a fine business. If bonds are to be bought by mutual funds, they must by law be rated by one of three agencies, and Moody’s is the largest of the trio. This gives them a protected niche in the financial world, a moat around their superior returns, if you will, and a fair degree of pricing power. When interest rates go down, borrowers come out of the woodwork. If inflation breaks out, people need money for working capital. With ever more complex derivatives trading in the U.S., and the extension of the brand aboard, the business of getting paid for an opinion has never looked better.
The fourth quarter saw us buy shares of Boeing for you. As a business, building aircraft is not up to the standard in the rest of your portfolio. It is cyclical, capital intensive, and not our general style. Yet there are only two large plane builders in the world, and one of them is pursuing a strategy that is seemingly far out of date. Airbus, the misguided competitor, has already invested an enormous amount of capital in making a new plane, the A380, which would be by far the largest built. If it is ever built, it will be a double-decker throughout, and carry almost 600 passengers, roughly 50% more than a Boeing 747. Massively bigger wings means exponentially explosive fuel loads were this plane hijacked and crashed. In light of recent events, we doubt the viability of this project. Consequently, Boeing may have the market for ultra-large jets to itself for far longer than anyone now expects. Note, we pass no judgment on when the flying public will go back to flying. At very low interest rates, the present value of the income stream that will come to Boeing when travelers return was not nearly as diminished as the stock price was at the time of our buying, and that was enough for us to act.
Finally, you might doubt the authenticity of the signatures below were you to get a Levy, Harkins letter without a bouquet to Echostar. In October, Echostar upset the year-long negotiation between General Motors and News Corporation by making off with DirectTV literally in the middle of the night. It will be a year from now before we know whether Echostar gets regulatory clearance to complete this transaction. The issues are complex, and the consolidation in the parallel world of cable television complicates the handicapping odds for a satellite merger. In the end, if the deal goes through, Echostar grows at a slower, but more certain rate. If it is blocked, they will have tied up Rupert Murdoch’s twenty year quest for a satellite platform for at least another year, and taken most of this year’s growth in the business for themselves. While all this is hashed out in the newspapers in the coming year, you might bear one thing in mind. Charlie Ergen, Echostar’s chairman and half owner, was so eager for this deal to happen that he pledged his entire ownership stake behind it, in a guarantee to General Motors that would have left him nothing personally for twenty years’ labor if the resulting business had performed poorly. Contrast that behavior with the typical option fueled avarice of the run-of-the-mill corporate executive, and you will better understand why we have your money, and ours, with Charlie.
Wishing you and yours all the best in the New Year, we are
Sincerely,
Edwin A. Levy
Michael J. Harkins
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Levy Harkins Rates of Return
Since Inception 1980
Rates are Compounded Rates of Return After Fees
2001………………………….………………………..-3.53%
Last 5 Years…………………………….……………….+17.5%
Since Inception 1980……………………………………..+15.2%
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. These numbers are after all fees. However, past performance is no guarantee of future results.