January 8, 2008
2007 will go down as the year the “know your customer rule” got turned on its head. A collection of financial engineers, each of them smarter than the next, has foisted a credit scheme, first on America and now the world, so lacking in accountability and transparency six months of paranoid fear has transpired and no one is the wiser for how much risk really is in the system. Outside of paying the engineers large fees, was any greater good ever likely to be served here? We doubt it. But is it possible the worst of the fears are overblown?
We think that is not only possible, but highly likely. Everyone in America hasn’t turned into a deadbeat, and even if the national quota of honest dealing with creditors were set to take a dip, the new bankruptcy law of October 2005 is likely to cause many a second thought. The new law treats deadbeats far more like indentured servants than the “walk in the park” treatment the previous law allowed. But that still begs the question, why the extreme fear in the bond and stock markets, and when does it pass?
Perhaps the most noteworthy part of the subprime mess is how long it has terrified markets. Six months is an eternity for Wall Street to be focused on any one problem, and “subprime” was voted word of the year by the American Dialogue Society. A little perspective is in order here. If half of all the subprime loans made go bad, and the dwellings sell for half the face value of the mortgage, the system-wide losses come to about $300 billion. That’s almost exactly the same amount that the Savings and Loan bailout cost from 1991 to 1995, and the country and financial system is vastly bigger today. Then again only 16% of subprime mortgages are late paying so far, let alone in default, so is it likely that current fears are exaggerated? We might also note that in 1991 interest rates were twice as high as they are now, and with commodity prices doing what they are doing, there is today an absurd degree of return free risk in American treasuries. Yet they are lusted after for their “safety”, and stocks are shunned.
The troubled mortgage world has a glaring internal inconsistency that has set us to thinking. Any reasonably credit worthy borrower, with a good history of honoring obligations in a timely way, a salary adequate to meet his mortgage payment and a sensible loan to value ratio, can get mortgage money to make a purchase or to re-finance. We are not talking paragons here either. We mean a 20% down payment and 30% of income going to debt service. A thirty year mortgage costs this fellow around 5 ¾ to 6% around the country. These are historically low rates; and, so long as he is willing to document all this, he will have his pick of lenders. Yet mortgage pools cannot find a bid, even on exclusively prime mortgages of the type we outlined above, and they are regularly offered at rates of return three times and more than the happy homebuyer above has to pay. This is not sensible, but it is a measure of how deep the panic is in the financial markets today. And this is not just a picture of distress, it may also prove an opportunity to make a lot of money.
But in the short term we must still ask ourselves, will the extraordinary fear on Wall Street just now spread to Main Street? Can a deep recession be ahead as fear radiates everywhere? The commodity markets themselves are not flying recession flags at all. From copper, the metal with a PhD in economics, to oil, to industrial items without futures markets, the basic stuff of production is strong. This is not a prediction, but we will make the observation that we never saw a business contraction where the price of raw materials didn’t sell off heavily first. Commodities think prosperity is just around the corner.
In 28 years in business, we have lived through four recessions, and always prospered because we remembered that lower interest rates fix many ills, and betting on America pays off again and again. Here are five stocks we have been buying recently with great potential.
Cameco is one stop shopping for a nuclear power investment. They own 31% of North America’s biggest nuclear power plant, they refine and enrich more fuel than anyone else, and they produce 20% of all the uranium in the world, while laying claim to 40% of the world’s uranium reserves. If we are ever to be serious about global warming, or weaning ourselves from our oil addiction, or even just addressing our surging power needs, nuclear is sure to be a large part of the mix. There was a tremendous glut of uranium on the market at the beginning of this decade as old Soviet era nuclear warheads were dismantled and fed to power plants. Bombs refashioned into fuel still make up 40% of the uranium market, but the last of them will be disposed of in 2012. This is a long lead cycle market, and the price of uranium has shot to $90 a pound in anticipation. Cameco sells its metal under long term contract, which last quarter went for about $52 a pound. They have a lot of profitable catching up to do just to get to current prices, which will prove cheap if the 3 year long jam on plant approvals ever gets broken.
Carmax is the used car dealer with the heart of gold. They know how skeptical you are of that, and are bluntly candid about conquering your skepticism. Their idea is wonderfully straightforward, “treat your customer fairly”, and through no haggle loans and straight condition reports they achieve it. Consumer Reports fairly glow over them, and the sincerest flattery is their growth rate, which has been 16% since Circuit City spun them off in 2002. There was a hiccup in the last quarter tangentially due to the credit crunch, but since they are not in the car loan business it shouldn’t bother them much going forward. They have only 3% of the U.S. market for used cars now, and are likely to gain share rapidly as they take their fairness concept nationwide. After we started buying, Warren Buffett joined us as a shareholder. Didn’t move the stock an inch, which tells you how glum the stock market is now.
ICIC Bank is India’s second largest banking institution, and they do everything, corporate, retail, foreign exchange. India has a growth rate that rivals China’s over the last four years. But its stock valuations are much closer to what a value investor can understand. ICIC sells at about a 25 multiple to this year’s earnings, it has been growing faster than 30%, and similar Chinese banks trade at multiples two and three times more. India, China and Brazil are the great growth stories of our time, and while we have tried indirect plays on this in the past with holdings like Nike and Fluor, ICIC is a chance to own the real thing.
Burlington Northern is America’s second largest railroad, and all railroads are stealth energy plays. It is far more fuel efficient to ship goods across the country by rail than by truck, railroads always had an edge in manpower costs, and now the two together mean market share gains for rail over truck for as long as we can see. However, Burlington is the energy railroad because it controls access to the Powder River coal fields in Wyoming. A ton of American coal, transported to an East Coast port and shipped to Europe, arrives there at a BTU cost less than half of an equivalent barrel of oil. America is the Saudi Arabia of coal, and a great deal of it will have to come through Burlington.
We have lived through tough times before, most notably in 1998, when distress was just about this intense, but we don’t know that even those values were as good as this, particular compared to a bond market than offers much lower returns now than then. American Express today sells at 12 times earnings, the business is twice as large as it was in 1998, and the absolute stock price is just about the same. General Electric is about in the same boat. These companies have nothing to do with a housing crisis, but are tarred with the same brush. In the aftermath of that distress, the rewards coming out of it were remarkable as we more than doubled our money in the following year. In 28 years at this we have compounded money at just shy of 14% a year, and with our stocks at current prices our chances of doing that again for the next few years have rarely been better.
Edwin A. Levy
Michael J. Harkins
Levy Harkins Rates of Return
Since Inception 1980
Rates are Compounded Rates of Return After Fees
Last 10 Years………………………….….…………….+13.31%
Since Inception 1980…………………………………….+13.70%
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.