Jan2009

January 5, 2009

Dear Client,

2008 was the worst year in the American stock market since 1937. Around the rest of the world it was generally worse. That we were caught up in the maelstrom is particularly vexing considering how often we sounded warnings in these letters. In the letter of July 6, 2005 we wrote, “The mortgage market has us worried.” We went on to explain what was wrong with “interest only” mortgages that re-set after three years. “It makes us uneasy because we are not convinced the majority of buyers and re-financers know what they are getting into.” They didn’t know in spades, and the housing fallout is all around us. Of course, it took two years from the time we wrote this for any obvious manifestation to appear, and in investing being early and being wrong are often the same thing. Likewise we warned of the dangers inherent in credit default swaps in our letter of October 9, 2006, when we wrote, “this market doesn’t yet have a history, but it has the feeling of providing (insurance) cover for risk taking no one is properly aware of.” In the London offices of AIG, management took on incredible risk, the New York office was oblivious to it, and the firm collapsed. The U.S. taxpayer has now lent AIG the staggering sum of $150 billion, and still counting. So why didn’t we better heed our own warnings?

We don’t have a good excuse, and we won’t make a bad one. It would have required a really lurid imagination to foresee all of what has transpired in these last 18 months, but we certainly could have done better, and we know it.

The good news--and there is good news--is that value abounds everywhere, and we are in position to take advantage of it. How do we mean this?

Well, for one thing, despite the quotational carnage reflected in the stock prices the actual underlying businesses in your account continue to earn money. If the fourth quarter wasn’t so hard to look back on and predict, we would almost hazard a guess that the full year’s earnings stream for our portfolio in 2008 will prove to be about even with earnings from 2007. That is quite a mouthful considering how steeply the worldwide economy fell off through the autumn. We have carried on for years about how important it is for us to own businesses with sound balance sheets, real free cash flow, and never a need for trips to the debt markets. Every thing you own has survived that test, meaning we can come back quickly because the businesses never got hurt severely. Indeed, your largest holding is the chief vulture at this bloodletting.

We mean Berkshire Hathaway, of course, and its suddenly hyperactive Chairman, Warren Buffett. His biography has spent 13 weeks on the New York Times bestseller list, and his stock could not find a bid amidst the panic in mid-November. So the reading public finds him a fascination for his $45 billion net worth, and the investing public thinks him a damn fool for doing the very thing, i.e. buying assets when they are being thrown away, that made him his billions in the first place. He details in his editorial in the New York Times of October 16th just why he is buying stocks, and says in part, “Today people who hold cash…feel comfortable. They shouldn’t. They have opted for a terrible long term asset.” We would add that in the fourth quarter the Treasury’s Bureau of Engraving gave an order to KBA-Giori, the Swiss maker of currency presses, for new presses that can print money at three times the speed of the existing machines. Let each man draw his own conclusions on that data point.

Even a Billionaire Can’t Afford Treasury Bills

The fear that your bank could be the next to tumble so unhinged markets that for four months Treasury bills have traded at barely above 0%. Think for a moment what $1 billion yields at 2 basis points, which is where the 30 day bill spent most of December. It’s $200,000 or something like $125,000 after taxes in New York City. To get any sort of return that would produce an acceptable lifestyle requires going out the yield curve, and here we wonder whether people paying record prices for Treasury bonds understand just how far out on a limb they are climbing. At year end, the ten year bond yielded 2.25%. If yields were to go back to where they started 2008, which was 4%, an historically low number, a current coupon ten year bond would depreciate by about 17%. This is not to imagine prosperity, just something akin to near normalcy. Then an investor would be faced with a painful choice about his bonds. If he sells because prosperity seems around the corner, he takes a painful loss to buy stocks that are likely to have appreciated mightily on the way from a 2% to a 4% world. Or does he hold on to the Treasuries, garnering only 2.25% for the next 9 years, in a world that might just have quite an outbreak of inflation in store? This is what our sage friend Paul Isaac means by “return-free risk”, and there is an incredible amount of it in the bubble that is the Treasury market just now. These people can’t be thinking clearly about how recently oil was $140 a barrel and gasoline was $5, can they?

Yield famine is not just an American phenomenon. Today the Bank of England cut its base rate to 1 ½ %. That is the lowest rate in the Bank’s history, and the bank was founded in 1694. When someone tells you this crisis is outside recent historical experiences, they really mean it. Even the other great value moment since the Great Depression has a telling difference. In 1974 shares were this cheap, and perhaps statistically cheaper. But interest rates all through 1974 and 1975 were between 7 and 8.5% on the ten year U.S. Treasury bond, as the authorities were mindful of clamping down on inflation. Bonds proved then not to be as good investments as equities but at least they were reasonable. In America we are sprinting to print money, and while the rest of the world is behind, it is only because we have outdone ourselves. So what is the reasonable way forward?

If you are a value investor today there is something for everyone, but for the first time in our careers there are glamorous high growth businesses selling at Ben Graham multiples. We have been buying shares in Akamai, the leading provider of ultra-fast internet connections in the world. This stock once traded at $300 when it was little more than a good but money-losing idea in the founder’s Cambridge home. It now sells at $15 a share, which is about 10 times this year’s earnings, with 30% of the price in cash and virtually no debt. Wall Street’s mood swings really are prodigious. Not only does Akamai have an amazing record of 30% plus growth, right up to the most recent quarter, but it is also benefiting from a hot new application on the internet. If you know a friendly teenager, they can show you how to stream video to your computer and watch anything, current TV shows, ball games, new movies, old movies, --almost anything, and pay nothing for it. Some of it is legal, some of it is not, and it is all changing so fast in a confused mass that the authorities and the content-providers are always far behind. The point is that streaming media is a bandwidth hog of mammoth proportions, such that if everyone wants to do this, and you are a fiber optic company, or a cable provider, or any big net service user, you are going to call Akamai to get your system running faster. Without Akamai or someone like them, your internet connection will crash from overuse, and Akamai just about owns this business. You might have thought, with our style, that we were somehow allergic to fast-growth investments. We never truly were, except that they came at such high multiples of earnings that we hated the risk. But a pedestrian multiple for a terrific opportunity is the byproduct of this much fear.

We have recently been buying shares of EMC, which is something of a misdirection play on the same theme. EMC’s basic business is supplying computer memory storage. Their systems work with anybody’s hardware and software, and there is a real advantage in the marketplace to being an independent supplier when so many technology managers want to get away from being slaves to their dominant hardware provider. Joseph Tucci, the longtime CEO, has exploited this niche adeptly, and at 12 times earnings, with a fine record and a strong balance sheet, we would be thinking about EMC in any environment. But EMC also owns 85% of VMware, a leading edge participant in cloud computing, which is another hot way to use the internet more efficiently. VMware traded over $100 a share a little over a year ago, when its hyper growth commanded a hyper multiple of earnings. It now trades at $26 a share, which is still a 30 multiple, and too rich for our blood. Except, that it represents about 1/3 of EMC’s market capitalization, meaning we get a big participation in VMware’s hyper growth at a price that is more to our tastes. Why isn’t this arbitraged away? When Wall Street goes through the wringer like this, all sorts of obvious things get overlooked.

In a similar vein, if you had nothing to go on but the stock price, you might have thought that Tupperware had a derivatives trading book as a sideline operation. It doesn’t, and we are not looking to start rumors, but it illustrates a point. In the worst of the panic, Tupperware traded to 6 times earnings, which is equivalent to a 16% bond return, and it grows. The panic was over dodgy credit practices. What has that got to do with Tupperware? About 85% of the revenues are from outside the United States, and in the third world countries where it sells most of its beauty aids and kitchen goods, nobody has a credit card. They don’t exist, so all the party participants settle in cash at the end of the night. We heard the CEO Rich Goings ask repeatedly, “Why is my stock going down?” Mr. Goings says he doesn’t know what a collateral debt obligation is, and in the long run that has got to do him some good, although the whole experience was unnerving in November.

We are bottom-up investors because we can be far more certain of what makes a good business and a great price than we ever can be sure of what macro-economic event will come next. We know people who claim to know more about the future than we do about the past, but they are not usually money makers in the stock market. Still, recent events are so worrying and so very out of the ordinary that placid complacency in the face of such worldwide tumult would be damn foolishness. A look back ten years ago might give us a better vantage point though. At the end of 1998 the S&P 500 Average stood at 1229. It closed last week at 903. The Western investing world has already had our lost decade. Investing has been miserable for a long time now. At Levy Harkins on the other hand, we compounded money at 8.8% over the same period, although admittedly not lately. This time really has been different, but it felt about this awful in the beginning of 1975, and that led to the best quarter century anyone has ever known. We do not truthfully know what’s in store this year, let alone the next 25. We will hazard this much though. If prosperity returns, even just in a modest way, inflation will be right behind it. Federal Reserve Chairman William McChesney Martin used to warn about how hard it was for a central banker to take away the punch bowl just as the party got to be fun. Ben Bernanke will be tugging on an ocean. If printing money was a painless way to solve economic woes, somebody would have thought of it already.

Wishing you and yours all the best in the New Year, we are

Sincerely,

Edwin A. Levy

Michael J. Harkins