In 2004 our average account gained approximately +17.1%.
We began Levy, Harkins in October of 1979, and the record you see from our many letters starts from January 1980, because the Security and Exchange Commission quite properly frowns on fractional accounting for start-up money management firms. So now, with 25 years behind us, it might be time for a reflective look back at what we have done and how you have fared.
There are two things to know about our start. We had only two pools of capital. One was the Gracy Fund, which we restricted to ourselves, our families, and three other families we had long done business with. The other pool was Levy, Harkins & Company’s separate accounts, which were open to all. These two pools of capital were extremely shallow in fact, although we could have drowned in the oceans of promises that were made and never kept from would-be clients just before we left Bear, Stearns and AMR Management respectively. For our first five years every day was St. Crispin’s day, because we were so very few a band of brothers. We indulge in this nostalgia now to make a salient point. There is no survivorship bias to infect the rest of our comments. We did not have 10 incubator funds that were started at the same time, and these are the two that worked. We have not merged our firm with other firms and their records, and this is the pastiche that survives. The same two names on the letterhead are also the two fellows that sign this letter, and produced the record. These three traits are unheard of in the mutual fund industry, where so many records seem to be manufactured out of whole cloth by people who were nowhere on the scene through most of the record building.
With that long preamble out of the way, how have we done? Over 25 years, after all fees, our firm has compounded money at a 15.1% annual rate. This compares to a 13.5% annual total return for the Standard and Poor’s Index, and a 14.5% total return on the Dow Jones Industrial Average*. Bear in mind that an index fund typically consumes about 20 basis points in re-balancing costs to produce the index average, meaning our lead over “average performance” is 180 basis points or 80 basis points depending on which index you thought most important back in 1980. To put the same facts in a different way, after fees a dollar invested with Levy, Harkins from 1980 to December 31, 2004 is worth $33.33, versus $22.69 with an S&P Index fund or $27.05 with a Dow Jones Index fund. We want to say, in the same breath that we recite our past record, that we have real doubts about our future resembling our past. Stocks are much more expensive today than they were in 1980, interest rates are much lower, and the percentage of national output going to rich people through their stock holdings has never been greater. Thus, the SEC’s standard warning about past performance being no guarantee of future success should be heeded in spades these days.
Yet we take you through this past because we want to say something about the future. So far it has been worth it to pay us a fee to actively manage your money. The results are almost half as much more, or about a quarter more, as the stock averages have grown, and stocks have been the best asset class we know of over the quarter century. We should stipulate here that our intention, then and now, has never been to beat a stock average. We set as our goal the beating of inflation by six to eight points, and while we have many times pointed out that the official inflation indicators are scarcely credible measures of your experience with the declining value of money, still we have handily bested even Ray Devoe’s “Cost of Living It Up” index by a very wide margin. This remains our goal going forward.
The stock averages are mighty difficult competition, partly because, as Jeremy Siegel of the University of Pennsylvania has observed, there are very few twenty year periods in which stocks do not outperform all other asset classes**. Also, the stock averages are far less “passive” than they look. The Dow Industrials has had 21 changes to its 30 stocks since we began in business, and the Standard and Poors’ turnover has been similar. Moreover, there is a subtle survivorship bias in the stock indices themselves that is profound over time. Society always picks the hottest index to compare investment managers to. If we were writing this letter in 1990, we would have to have included the MSCI Index, which overweighted the Japanese stock market, hot for 40 years. Then the Nikkei went from 39,000 to 11,000. Today, nobody knows where to find the MSCI Index in the local paper. Indeed, for its first fifty years of existence, General Electric contributed more than 50% of the performance in the original Dow 12 Index. If he hadn’t had the prescience to include GE in his index, Charlie Dow might have been replaced in the annals of Wall Street legends by some guy named Smith.
This issue of “survivorship bias” goes right to the crux of what ails the efficient market thesis that overwhelms academic investment thinking today. The leading light of this school, Professor Burton Malkiel of Princeton, never mentions the frequent changes in the indices, or that other indices have known popularity, in all 423 pages of his recent eighth edition of “A Random Walk Down Wall Street”. He does say over and over again that it is a waste to pay fellows like us a fee for active management, because you would be better off with an index.
People who write every 91 days understand better than most that there is a fair bit of hubris involved in taking on Professor Malkiel. His book has been out thirty years, and it is in its eighth (8th!) printing. If there has ever been a clamor for the second edition of the Levy, Harkins letters, it has managed to elude us up to now. Still, he threw the first punch, and now we would like to show that the central tenet of his book is ridiculous.
The professor says that we got lucky. In a financial system as big as ours with thousands of money management shops, somebody is going to have a record better than the averages, even over 25 years, and we just happen to be it. In a chart on page 290 of his book, looking back at almost 200 mutual funds, he implies that the odds on our success til now were about 5 in 197, or not even 3%. Three in a hundred should remain our odds of outperforming over the next 25 years.
Maybe he’s right about us being just lucky. But his idea looks decidedly loopy if you know Warren Buffett took the Professor on in a speech he gave at Columbia University over twenty years ago, which he published in Hermes magazine under the heading, “The Superinvestors of Graham-and-Doddsville.” In his speech of May 1984, famous throughout the value investing world, and utterly obscure without it, Buffett pointed out that Benjamin Graham, the founder of the value style of investing and Buffett’s original finance professor at Columbia, only hired four people to work for his investment firm, Graham-Newman, in its entire history. After Graham-Newman was wound up in 1957, three of those hires went on to manage their own firms; Walter Schloss, Tom Knapp, and Warren Buffett. All three subsequently enjoyed phenomenal investment success by the time of Buffett’s talk in 1984. Let us stop here and ask, what are the odds that three guys at an obscure shop should just get lucky beyond the bounds of any lottery ever known? Then in 1969, Buffett decided to close up shop, and he handed his investors over to Bill Ruane at the Sequoia Fund. Guess what? Ruane was lucky too. So that by 1984, each of these four managers had records of at least 25 years length that were far better than chance would allow. But this is 2004, so what is our point in bringing up some moldy magazine with an obscure story?
Just this. Buffett identified in 1984 nine investment records in all that were stellar, and were all directly related to value investing, the idea that you should only buy stocks for the long term that sell at significant discounts to the worth a knowledgeable buyer would pay for the whole business. You should throw in a sizeable margin of safety, meaning make it a really big discount. Then throw out every other idea, meaning turn off CNBC, and leave it off. So, how has this lucky group done since they were identified as lucky twenty years ago?
Tom Knapp went on to manage Tweedy, Browne, which today runs three major pools of capital; a global mutual fund, an American mutual fund, and the original partnership Buffett quoted. There has been no reverting to the mean for Tweedy, Browne. All three branches of the firm have outperformed every reasonable bench mark known. Bill Ruane’s Sequoia Fund is still around, and while it hasn’t taken in new investors since 1982, as of the third quarter of 2004 it has handily outperformed the S&P Index 15.5% to 12.8%. Walter Schloss compounded money from 1983 to 2001 at a rate of 15.2%, when he closed up shop at age 86. You might note that Schloss was 68 at the time Buffett mentioned him in 1984, and he worked most of the next 18 years as a one man band without a successor, meaning not one consultant in the country would have hired him, and doesn’t that say something about consultants?
Then there are the separate records of Charles Munger and Warren Buffett, who combined to form Berkshire Hathaway. Their stock is $86,000 a share as we write and was about $1,400 a share when Buffett gave his lecture. You do the math***. Two of the other fellows honorably mentioned grew so rich so rapidly they retired from running public money and no longer produce public records. Lastly, the Washington Post retirement plan has been so overfunded it regularly sends back checks from the plan to the corporation, which happens in corporate America about as frequently as snow in hell. These fellows all just got lucky again? You might consider this. Tom Knapp retired from Tweedy, Browne many years ago and Ruane, Cuniff has hired a fair number of younger investment managers. Yet these firms haven’t skipped a beat. So these lucky people know other lucky people on sight, and they hire them immediately? How do they do that? Indeed, in what way are these lucky luckies lucky? Are they all 6 feet 6 inches tall, with 25 inch waists and long flowing hair? Prodigious athletic skills perhaps? Er, no. No, no. They aren’t much to look at at all. They win no other of life’s lotteries, they are just lucky with money, or so the professoriate would have you believe.
There is no point in a further discussion of the statistical improbability of Professor Malkiel’s central tenet. It does not pass the laugh test. Perhaps the most important point to be retained in this discussion is that Professor Graham died in 1976, so none of his acolytes has had a chance to consult with him for twenty eight years. Professor Malkiel, on the other hand, is alive and well and dominates debate today, meaning no younger professors can challenge him so that science could move along. Two weeks ago, David Abrams of Cambridge, Massachusetts was here, and we talked about the incongruity of so many noted successors of Graham having success, and no obvious failure in the lot. David is a brilliant manager in his own right and we asked him why there is no intellectual progress. His blunt reply was, “Actually, I think the collective intelligence of Wall Street is diminishing.”
Getting the conversation back to ourselves, it is crucial to note that Levy, Harkins was nowhere mentioned in Buffett’s 1984 talk. We were, in corporate form, four years old at the time. So were we just lucky? Surely that is a lively possibility, both statistically and intellectually. There is, however, a subsidiary point in our favor, and it is central to Professor Graham’s thinking. For the first fifteen years of our history the stock market went up almost all the time. In the last ten years, it has gotten harder, and the last five years have been, historically and in other ways, brutal. Maybe the comparisons from these briefer subsets are telling. In the last ten years we have compounded money at an 18.3% annual rate, and the S&P compounded at 12.1%, giving us a lead of more than 6% per annum. In the difficult last five years, the S&P declined at an annual rate of -2.4%, and we appreciated at a +4.8% rate, or a difference of better than 7% per year.
We hope this is what you hired us for. It is one of the peculiarities of the investment business that everyone occasionally has stellar results. That does not ensure success. The real trick is to have no serious down years, so that the process of compounding is not seriously threatened. Benjamin Graham made this point over and over because he knew the compound interest table backwards and forwards. It is only left for us to say that value investing also is in harmony with investors’ life cycle needs, in that it is always easier for an institution or an individual to fund themselves when times are good and stock prices are high than it ever is when conditions are depressed. People focus on how much money they have every day. They might better focus on always having it.
Which brings us to a very brief discussion of our immediate future. Stocks are high, our stocks are high, and bonds sell at prices guaranteeing risk without any hope of reward. In our next letter to you we will focus exclusively on the nuts and bolts of the stocks we own, in part because we just so enjoy writing about the business characteristics within our existing portfolio, but mostly because if our future is at all to resemble our past our current investments had better be extraordinary enterprises indeed. Even with that, we should note after more than a 50% gain in the last two years their endearing traits are hardly unadmired, and if you see us raising cash in your account it’s likely not because we are less in love with the businesses, but rather we are a wee bit sour on their prices.
Wishing you and yours the best in the new year, we are,
Sincerely,
Edwin A. Levy
Michael J. Harkins
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* Source: Bloomberg, Dow Jones and Standard & Poors
** Real estate is sometimes cited with comparative advantage, but without note of leverage, which we are forbidden in Levy, Harkins.
*** It is about a 23% annual return, which is just too gaudy to put in the body of this letter. They were also leveraged, which complicates the math but does not materially alter the point.
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Levy, Harkins Rates of Return
Since Inception 1980
Rates are Compounded Rates of Return After Fees
2004…….…………………….……..……………+17.1%
Last 10 Years…………………..………………….+18.3%
Since Inception 1980……………….…….………+15.1%
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.