Dear Client,
It is three years in a row now that we write to report a small loss to you. This is disappointing, the more so as it exceeds the number of losing years we had had in the previous twenty. The losses, taken together, are sufficiently small that they do no serious damage to the process of compounding. Also, they are much less than average experience. But taking joy in the suffering of others is a disreputable pleasure; worse yet, it does not pay any bills. You did not initially hire us, nor have you paid the last three years fees, to lose anything. Investing is foregoing current pleasure to enjoy future gains. Gains, pleasure and enjoyment are all in woefully short supply. We are to blame for this; and we shoulder the blame both as clients and as managers. We are losing money along with you, and our own account balances make dreary reading too.
The country went through a spell of mass hallucination three years ago without equal in our lifetimes. Everyone was going to get rich from the stock market without ever having exhibited a single capitalist virtue. There was no thrift, there was no patience, there was no prudence; and lust, greed and envy were on display everywhere. We wrote when the mania was in full flight that we did not think the country was on the road to riches. What we did not adequately appreciate, although we used the expression at the time, was how deep the cycle of cupidity amongst the capitalists had become. It is clear today that tens of thousands of people knew about and actively took part in the Enron and Worldcom frauds, the Tyco and Adelphia criminality, the routine flotation of worthless new issues at gargantuan prices by dozens of investment banks, and the quarterly racing to inflate revenues and depress legitimate costs that went on at seemingly half the businesses in the country, all to meet expectations that never should have been raised in the first place. If you were not a part of it, you were apt to underestimate the shocking pervasiveness of this culture of criminality. Not one company that you were invested in over the last three years has reported a loss due to improper accounting or odious behavior. We have had our reverses, but not of that type. Still, the blow to confidence has been severe, as it should be, and as we should have better anticipated.
Even so, you have grown intrinsically richer in a few ways you might not have suspected, and although there isn’t much to show for it in your monthly statement just yet, the power of compounding continues to work its powerful magic. We mean simply that on the whole the amount of free cash being thrown off by the companies in your portfolio has expanded, in many cases quite considerably, over the last three years. With interest rates sharply lower, the fundamental value of what you own has grown, although not in the opinion of the market, which is reflected in the quotes. But if we keep getting the value right, the quotes will follow.
Echostar is a prime case in point. At December 31, 1999 the Dish Network had 3.4 million customers paying Echostar about $44.50 a month for their satellite television reception. Today the company has almost 8.2 million subscribers, and they pay about $49.50 a month. Over the three years the company’s costs went up in advertising and marketing, to get the new subscribers, and in building and lifting three additional satellites, to provide spare capacity and deliver more local channels. But revenue growth has far exceeded cost increases, so that free cash flow is today about triple what it was three years ago. In that time Charlie Ergen, Echostar's owner/operator, has attempted to buy Direct TV, his still slightly larger competitor, and been rebuffed by the federal authorities. A telling measure of the man has come in the three weeks since Ergen has had his hopes disappointed. He has announced the repayment of almost half the debt of his company. This is man bites dog news. When managements amass a war chest to make an acquisition, and the purchase doesn’t come off, they rarely give the money back. They contemplate other acquisitions, they suddenly discern other worthy investments that had somehow eluded them before, or they announce stock buybacks conveniently timed to go off just after large stock options packages have been approved for the management’s benefit. Money sticks to professional managers. It is only owners who think to send it back to their other fellow owners. This Ergen has just done, voluntarily, and it is a telling commentary on his opinion of the lasting profitability of Echostar, and his confidence that it will throw off loads of cash from this point forward, that he has done so. Three years ago the stock was exactly twice this price. The intrinsic value, by which we mean the cash we can take from this business, has tripled. Now what? Obviously, we do not know exactly, but rapidly rising cash flows do eventually attract admirers, no matter what the distractions, and there have been distractions aplenty for investors in the last three years.
We mentioned a moment ago that interest rates have come down over the last three years, and have they ever. Short rates have been more than halved, from 5 ¾ to 1 ¼ for treasury bills. Ten year rates have also dropped, from 6.4% to 4%. All stocks are theoretically more valuable because of this, since the discount rate on future cash flows is less punishing. But some firms have profited directly. We are now in a bond bubble, and it has led to a strong housing market, and a boom in re-financing of old mortgages. We have had two direct stakes in this trend: Countrywide Credit makes mortgages, and then sells them off as quickly as possible. Fidelity National checks that the title to property is legitimate, and insures the buyer and mortgage company that this is so. Countrywide has seen its earnings go from $3.52 a share in 1999 to about $6.35 this year, and its book value nearly double, from $21.72 to $39.15. Will the re-finance boom march on forever?
Of course not, but if the able founder of Countrywide, Angelo Mozilo, produces only half the rate of return on equity he has previously generated, we own a very cheap stock. He would be crestfallen if a halving of returns came to pass, but even if they did the stock would likely trade higher. The market is in such suspense as to when the re-finance boom will be over, almost any event will bring relief. In like fashion, Fidelity National earned $1.88 a share in 1999 and should earn more than $5 a share in the year just ended. Fidelity sells at a price that is not much above what you could liquidate the company for, and it continues to provide an enormous stream of income. If the earnings fall considerably in a rising rate environment, and we anticipate no such thing, still we will see an earnings yield of about 8% on the stock which is twice as much as the ten year rate on bonds. These two stocks have margins of safety stapled to lush opportunities.
As good as these two have been, they are not our champion bond market investment. That honor goes to Moody’s, which we have owned slightly less than three full years. Moody’s judges the creditworthiness of bonds and their issuing institutions, and it has reaped a skullduggery silver lining. With confidence lying shattered on Wall Street, either you pass muster with the two major ratings agencies or you go wanting for funds. Judging others has never been more profitable, and Moody’s earnings have grown from $.95 to $1.80 in three years. And these are earnings of the type we so desire; they are real spending money. When you hire a new credit analyst you give him a desk, a chair, a phone, and precious little else. Hence, Moody’s never spends more than 10% of its earnings on capital expenditures, which are themselves right around depreciation. Real profits are spendable profits, and that is what Moody’s produces and what we want. Moody’s does not need to commit big slugs of new capital today just to stay in business tomorrow. Long experience has taught us that a rapidly rising stream of earnings on a very modest incremental investment is as rare as hen’s teeth and should be prized accordingly.
Spiraling profits ought to produce growing mountains of cash. When they do not it is time for accountants to check in with managers. But we as investors have a terrific advantage if we care to grasp it. We can avoid from the outset all businesses that show a voracious appetite for more capital, even when they claim great financial health. Michael Thomas once famously characterized the oil business as, “All good news, no money.” So it is in every extractive business we have ever come across, with our foray into gold a decade ago an example of remedial tuition. Next year will always produce the gusher, the strike, the motherlode, if only we can come up with more money now. This appetite for capital is shared with the airline industry, the automobile business, cable TV, computers and technology, electric utilities and transportation industries.
Look at that list of industries. They make up about half of the $350 billion or so in profits generated in American business every year, and we aggressively avoid all of them. If you do not consistently get more money from an investment now, then you must trust in the assumptions and estimates that the managers of an enterprise are making regarding the future cash flows to come from whatever they are plowing our money into. And there is one thing to know about payday in that distant world to come; it will look nothing like the world we are in.
Cash-in-hand businesses are different. When Bear Stearns claims its book value went from $25.80 at the end of 1999 to $37.60 at year end, we do not have to wonder what they mean by this. There is a quote at the end of every day for everything they are in, and that is what they mean by it. Whether their earnings will go up by 30% in the next three years, as they have in the last three, is uncertain. But at least we know where we are today. When Gannett’s earnings went up by 33% over the last three years, its debt was also going down by a third. This goes hand in hand, as no one ever paid off a creditor with a projection. It takes cash to do that, and a rising ability to produce it is what you have been getting out of the portfolio of stocks we took you through above. That these companies have been able to grow cash earnings through a recession and a collapse in the new issue and corporate debt markets is the surest testimony to what first class organizations they are.
Even with seventy years of experience between us, we misjudge businesses too. So it was with McDonald’s, which you do not see in your list of shareholdings because we finally came to our senses. As the business got harder the management got thicker. McDonald’s could throw off oceans of cash if only someone could convince the management they are not in a growth business anymore. No amount of tinkering with the kitchens or the menus is going to produce a fresh stampede of diners when the country is already there more than we want to go. In speeches, the managers seem to grasp the point; then the corporate imperative to never return money when there is an empire waiting to be gilded takes over.
We have hung on to American Express despite only modest growth in its earnings and despite its losses in the junk bond market. Make no mistake, the write-offs in the investment division, which are of the type always described as “one time changes”, are very real losses. We are bemused by the glossing over of awful mistakes in the allocation of capital as “one time”. After all, you are only dead one time too, and that doesn’t seem to befog anyone’s judgment that it really isn’t a very good thing.
American Express is at core a very good business, and the new manager, Ken Chenault, comes from the travel and charge card side of the business we admire so much. The dreadful blow that has been dealt to the travel business will abate in time. The share of mind that American Express occupies when you want to go somewhere or buy something is likely to be even greater when it does.
We can cheerily go on at much greater length about the progress your investments have made in the last three years while their stock quotes were grudgingly edging lower. Qualcomm has tripled the number of users of its CDMA phones and AIG has seen its earnings rise 57%, and both stocks are down. Wall Street’s mood changes are ferocious. But ours aren’t and to your credit, yours aren’t either.
We take you through chapter and verse of the last three years’ rising cash flows because, to paraphrase Robert Browing, cash is the C-major of investing life. There are high notes and low notes, but sooner or later we get around to asking, “What’s been heard from cash flow?” If you painstakingly read the daily financial press you may very well doubt us on this. Everything imaginable is regularly said to impact stock prices. Even the anticipation of a leaf falling in a distant forest finds its echo in today’s stock trading, at least amongst those who have to say something about prices every hour. Don’t you believe them. Newspapers need acres of inked space. You want a rising flow of cash. Our job is to first provide it for you, and then to look back to see if our fellow investors admire what we’ve done. For three years now, the enterprises have been growing, but admiration has been hard to come by.
Is past prologue? We have no idea. Indeed, as to short term forecasting we have a special window into the wisdom of Sam Goldwyn’s observation about the likelihood of a movie being a hit. Sam said, “Nobody knows nothing.” We spend a huge amount of time each quarter listening to corporate chiefs of our investments, competing investments, and prospective investments, all holding forth to a breath-bated crowd on what the next quarter will bring. It makes us cringe. When it comes to the future, people don’t know half of what Goldwyn thought they knew. We know that the last three years were hard. If an enterprise is bigger and more valuable today than it was before, that is quite a feat. In virtually every investment you are in, we are sure that the cash generating ability of the enterprise is greater or at least equal to what it was at year end 1999. In many cases, they are amazingly better values. Your money, and ours, lies with people who have done remarkable things. We like our chances in almost any conditions, though a rooting interest in mankind, if nothing else, makes us hope the next three years are better than the last three.
Wishing you and yours all the best in the New Year, we are
Sincerely yours,
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
2002………………………….………………………..-6.0%
Last 5 Years…………………………….……………….+14.8%
Since Inception 1980……………………………………..+14.2%
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.