When President Nixon stood before the nation on November 17, 1973 and declared, “I am not a crook”, thoughtful people instantly surmised that something was very much amiss. Worldly wisdom teaches that men who trumpet their honesty when no one has accused them of anything are best given a wide berth. Nevertheless, an investor would have to be comatose were his suspicions not aroused by the recent mutual fund scandals, and since we have written these letters candidly for twenty years and more, it would seem disingenuous to ignore the elephant on the investment scene today. You have a right to know what measures we have in place to prevent your investments from being so casually, and apparently criminally, diluted as has been the case in a shocking number of mutual funds. We have an obligation to make plain your trust in us is justified, and indeed that we understand trustworthiness is the first thing you are buying with a money management fee.
We have always believed in eating our own cooking; all the stocks that you own in your portfolios we own in an investment partnership called The Gracy Fund. We are both the general partners of that fund and amongst the larger limited partners. But The Gracy Fund has a few defining characteristics, set up twenty-four years ago, that ought to give you much comfort.
To begin, partners can only add or subtract capital from it every six months, and that includes us. The commitment to long term investing we preach to you we practice ourselves. Next, because your money is not co-mingled with ours, there is no possibility of late day trading on dubious net asset values, which is the cornerstone of the coming prosecutions of mutual fund companies. Thirdly, our policy on buying shares alongside of you was established more than twenty years back; if we buy or sell a large block, we all pay the same price. If the trades involved are small, we go last. If it takes many days to buy something, we buy it last; if it takes days to exit, we go last. We should candidly tell you this works no great hardship on us, since we just about need a prayer meeting around here to pay up an eighth when we buy, and when we sell stocks they are often going up by leaps and bounds. But in the cases when our judgment is wrong, and being last out is painful, that is just our hard luck. We have traded consistently on this basis not because anyone ever challenged us, but because it simply ruled out the appearance of impropriety from the outset.
Fourthly, the fees you see on the back page of this year end report, one number for an advisory fee and another amount in brokerage commissions, are all the charges you pay. No loads, no 12b-1 fees, no exit fees, in short; no hidden fees of any type. In particular, there are no “soft dollar” arrangements with stock brokers, where we trade your account, generate commissions, and then the brokers pay our rent, or our computer bills, or our travel expenses. We pay our bills with our money. What Wall Street artfully calls “soft dollar arrangements” are in fact kickbacks, designed to inflate the fees investors pay to managers in a way the client cannot see, and the practice is insidious. Soft dollar payments are a scandal waiting to happen, and perhaps soon. Finally, all of the seedy shenanigans with new issue allocation, and the payoffs that go to those who have friends high up in brokerage firms, who often have private opinions of the value of these offerings utterly at odds with their public sales pitches, does not affect us or you at all. We have not bought a new stock issue in twenty years, and are not likely to do so in the next twenty. Founders of businesses only sell their interests in them when they think the time and the price is right. We trust their opinion, that it is time to sell, far more than the enthusiastic touting of a stock broker, who wants us to buy. There is a reason why brokers get paid ten to twenty times more in commissions in new issues than on standard floor trades.
We wish Godspeed to Elliot Spitzer and the newly energized Securities and Exchange Commission. Without any inside information, but with over 70 years of investing experience between us, we suspect if the authorities are serious about cracking down on investment company wrongdoing, they are likely to be much closer to the beginning of their efforts than the end. Part of our opinion comes from the disquieting observation that the necessary shame and ridicule that should come from the investment community itself seems to be wholly lacking. Early last month, First Boston issued a sell recommendation on Berkshire Hathaway. The stock traded down all day. Now a good day for First Boston is a hung jury. The Berkshire management, on the other hand, will retire the prize for selfless service to investors the day Warren Buffet and Charles Munger call it quits. Yet no one saw the inner hilarity of the one firm passing judgment on the other. In other spheres of life Paris Hilton is not called on to review Doris Day movies. Wall Street is different, and not to its credit.
We hope you do not find these comments to be sanctimonious, or delighting in the troubles of others. As we said at the top, candor compels us to write to you about an enormous problem between investment managers and their clients, and we might as well do it bluntly. However, we do not hold ourselves to be above criticism. If you can think of a way for us to report to you better or more transparently, or if there is a stronger way to relieve even a remotely possible conflict of interest, call us today. You pay us for honesty and performance, in that order, and we want to see that you get what you pay for.
In our mid-year letter to you we said, “A large part of the catch-up between our judgment of perceived value and the market price has now happened, meaning part of the juice has already been squeezed from the fruit.” Since then we are up another 15%, meaning if not yet desiccated, investment fruits today are looking anything but lush. This is not a market commentary. It is just a healthy reminder, to ourselves as much as to you, that our long term average in compounding capital is 14.9% over 24 years. If we make more than twice that in one year, we all ought to start scaling back our expectations for the immediate future. Reviewing our July letter brings up a related, but subtle point. As of June 30th our long term average rate of compounding was 14.5%. A terrific second half barely budged the cumulative average. One very poor year, though, would put a tremendous dent in our results. That is the nature of high rates of compounding; and we keep it in the forefront of our minds whenever times get really good. At those moments risk also gets really greater.
Just how high expectations are, and how influential those expectations are on the economy, came to us recently as we read again a Boeing annual. You will no doubt remember from earlier letters how little we like investing in companies with large pension liabilities. In your current portfolio, Boeing is about the only one of that kind. Let us show you what a good thing that is too. The Boeing Company has about $8 billion in equity, and a pension plan with about $34 billion in assets. Right there, you get a feeling for the size of the dog and the size of the tail. The liabilities of the plan are about $36 billion, and while that mismatch is nothing compared to the usual experience in heavy industry America, it’s not so paltry versus equity capital, is it? Yet that isn’t the part that most concerns us. Boeing has an assumed rate of return attached to the plan’s assets of 9% per year, with about 60% of those assets in stocks and the rest in bonds. Think about 9% for a moment. If there were no costs involved in administering this plan, and there most assuredly are, the stock portion of the plan will have to do handsprings just to meet that 9% hurdle rate, because the bond portion can come nowhere near 9%, given current interest rates. The company is kind enough to point out in its last 10K that if it misses that 9% forecast by one percentage point, the dollar amount comes to $4 billion. If Boeing earns the $2 a share in the current year that we think it will, that comes to $1.6 billion. In other words, a modest disappointment in the stock market is 2 ½ times what the company earns. We own Boeing because we think we must have a dollar hedge of some kind, and Boeing is the country’s largest exporter. Also, we would have to take a much larger dollar risk in foreign bonds to get the same exposure as a modest Boeing stock position gives us, and at current interest rates, foreign bonds are fraught with risk too. Still, we see the incongruity of worrying over plane orders obsessively, when it is stock prices that may tell the tale. In modern America, stock prices drive earnings at least as much as earnings push stocks.
Boeing is a compromise in what we do, proof that in the investment business some art is thrown in with the science. We own a less than great business because we think it cheap and it serves another purpose. Our Moody’s investment, on the other hand, is exactly what we do. It is a great business that, when spun off in September 2000, was selling at a good price. But what has happened in the three years and three months since we bought it is instructive. In late 2000 we thought Moody’s would earn about $1 a share in the year that was 3 months from over. This year it will earn about $2.50 a share. Did we foresee a 30% annual growth rate back in September of 2000? Never. We just knew passing judgment on other people’s bond offerings was a good business that required very little by way of fresh capital to grow. And that is just the point. Nothing like this could ever happen in what we call the “spend to survive world.” If a car company, or a steel mill, or a public utility ever had some strange set of circumstances that allowed it to grow like this, it would never be able to raise the prodigious sums of capital needed to do it. Or, if the investment scene were so frothy that such a thing were possible, then everyone else could get capital too, and the chance for permanent growth would be over before you had the chance to say “Shazaam!” Cyclical businesses can have phenomenal swings, but they cannot have this sort of explosive growth. That it comes in very lumpy fashion, in the case of Moody’s or Countrywide Financial, or Qualcomm, bothers us not a bit. E.B. White, at the end of the first paragraph of Here is New York wrote, “No one should come to live in New York who is unwilling to be lucky.” By concentrating almost exclusively on great businesses we are putting ourselves in the way of being lucky, and it keeps happening. In this form of investing, it is better to be lucky than prescient.
Our closing note is a word about prescience. We don’t have any. Many times we are asked our opinion of the stock market. We cough, and try to say something as innocent and anodyne as possible. Then people think we are holding out on them. We think it is to our tremendous advantage to know that we do not know. It allows us to concentrate on what we do know. The experience of the last two years and three months is particularly telling. On Monday, September 10, 2001 the Standard and Poor’s Index of 500 stocks closed the day at 1092. It closed the year 2003, seven days ago, at 1112. In between came a murderous attack that killed almost 3,000 people and obliterated the workplace for 50,000 others, a recession, a war in Afghanistan that did not yield bin Laden, a recovery, a war in Iraq that netted Saddam, a large sell off in the dollar, and the lowest interest rates in 50 years. If we had been granted perfect clairvoyance of these events on the night of September 10, we would never have guessed that stock prices would have been almost precisely flat. Such clairvoyance is not even to be wished for, because some of these events would be too painful to anticipate.
Yet we can tell a good business from a bad one, and we have something to say about what makes an appropriate price for them. That has been enough to make us all very respectable gains over the two and a quarter years, and, of course, twenty eight times your money over twenty four years. The next time some breathless interviewer on financial television asks a subject about the make or break importance of the day’s latest events, you might think back over the litany above, and ponder the improbability of all of that not mattering 2% to stock prices.
We recently had in a friend who is thinking of starting his own money management operation. He told us how unusual it is to have a client base that allows us to operate with such patience or to think so far ahead. We told him he doesn’t know the half of it, and for that we are deeply grateful.
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
2003………………………….………………………..+35.2%
Last 5 Years…………………………….……………….+22.8%
Since Inception 1980……………………………………..+14.9%
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.