For the six months ending June 30, 1998 our average account gained +.0016%.
Last quarter we wrote you and said, “If shares are to have much further buoyancy, the economy must accelerate or a decline in interest rates must justify higher multiples.” Both conditions were satisfied, with a half point drop in rates and an economy growing faster in the quarter than at any time in the decade. Shares, on the other hand, marked time. Asia was once again the reason, as fear went from the general to the highly specific; Japan’s recession is considered the underlying culprit behind the entire region’s depression, and bad banks are Japan’s particular bete noir.
That Japan has bad banks is undeniable; that this is news is flabbergasting. Every client in our firm was invested in puts on the Japanese Nikkei index in 1989, ’90, and ’91, and this was hardly clairvoyance on our part. The Japanese banking system was then overloaded with bad real estate loans against which they held precisely no loss reserves. We sold the last of these puts in 1992 with the Nikkei at prices not far from here. To be sure, real estate prices have gone much lower in the intervening seven years, as every talking head relishes revealing each morning on television’s ubiquitous stock market warm-up shows. But reserves have been established, and the problem, at long last in the open may in fact be well on its way to resolution.
Which only begs the question, how could a problem that is now nine years old create this many column inches of news, this much fear? We think the fears of a systemic meltdown are overblown, that they are creating marvelous opportunities in individual stocks, and that to have your pick of Asian stocks in an environment with every market down between 50% and 90% in dollars is the chance of a decade. We are also acting aggressively to take advantage of unreasoning panic in severely depressed markets outside Asia, and think that by this time next year we stand an excellent chance of earning rewards at least as great as our pessimistic foray in Japan produced nine years ago.
Our most recent acquisition is the charmingly named Asia Pulp and Paper. In a corporate world that can turn the universally recognized Guinness into the indecipherable Diageo, Asia Pulp and Paper is to be commended for its nomenclatorial candor alone. It is the largest paper maker in the Orient outside Japan, and stands a fair chance of being the most profitable one in the world this year. Its headquarters are in Singapore, its books are kept in American dollars, its forests are overwhelmingly in Indonesia, and its customers are even more overwhelmingly everywhere else. The spectacular devaluation of the Indonesian Rupiah, from 3,500 to the dollar last fall, to 15,000 to the dollar now, has upset the markets terribly, but increased the profitability of this company amazingly. As the management put it at the end of the last quarter, “We are experiencing peak margins at trough prices.” So a recession for everyone else in this business, in particular the mills in Scandinavia and the southeastern United States, is turning into a bonanza for Asia Pulp because their costs are so drastically lower than anyone else’s. To be sure, this is a temporary phenomenon, since great devaluations bring great inflations with them. But it gets them through the rough part of the cycle with high returns on capital, a rapidly expanding capital stock, and a chance to be the dominant player in an important industry in the world’s fastest growing region. We don’t dwell on what the next boom holds in store for them, since it seems so far off just now, but “even better” is the most modest forecast. Companies this vigorous don’t often sell at six times this year’s earnings, as Asia Pulp does today, and nothing like it has been on offer in America for a long time.
Hurricane Hydrocarbons is another company aptly named, this one for its ambitions. As a virtual start-up two years ago, Hurricane set out to be the largest oil producer in the central Asian republic of Kazakhstan. If you know that its competitor in that regard is Chevron, you get some idea how ambitious Hurricane is. Hurricane’s production in the first quarter grew 30%, reserves grew even faster, and the stock sells at a barely recognizable three times cash flow. Exotic geography ought to account for some discount in any natural resource, but the extreme nature of this one should not go unnoted. Major oil companies with finding costs for oil of $4 a barrel or less take every opportunity to trumpet that fact in their annual reports. The industry’s average in its exploration efforts was $5.77 per barrel found for the year just ended, according to the Oil and Gas Journal. You can buy Hurricane, with hardly any debt, at the equivalent of 55 cents per barrel. Why do oil companies send exploration teams all over the world when they can call their local stockbroker and buy oil at 90% discount to their best efforts? Perhaps they won’t forever.
Nowhere is Asian angst more obviously overdone than in the shares of Telebras, the Brazilian phone monopoly. First, as you may have noticed on your own, Brazil is not part of Asia. Secondly, the government of Fernando Cardoso has for the last four years pursued policies directly at odds with those of Asian governments, most notably avoiding foreign debt. His reward has been to see the monopoly he is anxious to sell off drop to the lowest valuation amongst major telephone companies, now at 9.5 times this year’s earnings. This in a telephone market expected to double in the next 3.5 years. There are now 19 foreign companies registered, at considerable expense, to participate in the bidding for the government’s 20% share of Telebras on July 29. Here’s hoping they are open fisted when they get to Sao Paolo.
Lest you think we have lost our native caution around Levy Harkins headquarters, we are drawing a second lesson from Telebras, above and beyond our obvious delight in owning it. We cannot overlook that when American mutual fund managers are wounded in one part of the world, they think nothing of indiscriminately selling other businesses thousands of miles away, even continents away, which they had only shortly before believed to be fancifully linked. And in the sentence just preceding, “think nothing” is the phrase to be dwelt on. We continue to swing from faintly to fairly bullish on American stocks, but were something ever to go wrong here, we suspect the overseas sell off is giving us fair warning as to how calm and discriminating mutual fund managers will be on getting redemption calls. “Not at all, not for a minute, and not in anything” is the obvious answer.
It isn’t every day that we get to lower the average enterprise value of our portfolios, diversify, lower our risk, and quite likely increase our odds considerably for having a solid second half. If it didn’t seem presumptuous, we would end on something about no wind so ill it blew no one any good.
Sincerely yours,
Edwin A. Levy
Michael J. Harkins