Dear Client,
For the first 6 months of 2002, our average account was down -3.10%.
When Richard Nixon declared, “I am not a crook”, sweat poured from his chin and his assertion did not enhance his reputation for veracity. Indeed, it only proved once you are in that position, nobody is re-assured, and you’re a goner. Today, every chief executive in America feels himself to be under the same klieg lights Mr. Nixon found himself under, and what is he to say? All protests of probity are being met with derision, because the perfidy of the recent past is just so shocking. Worldcom claimed a $5 billion phone bill wasn’t an expense, but a capital improvement. Would you ever think of listing your phone bill as an asset on a mortgage application? Gemstar claims unpaid royalty payments on patents that have been disallowed by two courts should be treated as current revenues, but the legal expenses to pursue its case are amortized over many years. Who has the nerve for this? Half the fiber optic carriers claim gains from selling non-existent capacity to other fiber optic companies, while they hemorrhage actual cash. The annuals should come with large warning disclaimers, “Do not do this at home,” because we are certain if you buy and sell your car a thousand times with your brother-in-law, and then ask the bank for a big loan in consequence of your new found prosperity, they will be measuring you for a suit with the pinstripes sideways. How did we get to such lawlessness as a staple of corporate culture?
We haven’t got a particularly good answer, other than the standard observation that shareholders do not have nearly enough power in corporate governance, and managements have much too much. On that score, we think we see some rays of light, as there are many rapidly converging forces that may put an end to back-slapping boardrooms. One simple one is the fear of God put into independent directors as they watch the cost of directors’ and officers’ insurance skyrocket. If you are paying three times more this year than last for supposedly the same risk, the real magnitude of that risk is likely to sink home right quick. Another, of course, is the government. The president proposes doubling the jail terms for corporate malfeasance, and naming a Justice Department SWAT team to go looking for miscreants. The prospect of federal agents storming corporate board rooms may concentrate the mind wonderfully. In one quarter we have gone from sleeping enforcement to guns drawn compliance checks. We cannot remember a greater shift in any government policy in a shorter period of time.
What brings us to hope there is some light at the end of this dank tunnel for investors is that there is now an end date attached to the corporate cleanup period. By August 14th, every public company with annual revenue greater than $1.2 billion, about 950 in all, must have its chief executive and financial officers sign an acknowledgement that they bear responsibility for the accuracy of its books. The Sergeant Schultz defense, “I know nothink,” that we derided Enron’s Jeffrey Skilling for in our last letter to you, is out. If we double the penalties for frauds, as the president proposes, and make this affirmation the basis for fraud, as the Senate proposes, then we may have gone some way down the track for reform.
As for more law beyond this, we are skeptical. The surest way not to be cheated in business is to only do business with people who are unwilling to steal. If larceny is not in your heart, you do not go around the live long day reciting the penal codes to yourself as a necessary reminder. On the other hand, lest you think us naïve on this point, may we remind you that the old Soviet Union made a shocking number of business practices illegal, with trips to Siberia, and meetings in Lefortovo prison, and bullets to the back of the head, all part of the penal code. Everyone cheated anyway. Our system really is grounded in morality, and there is no unplugging it possible.
Thankfully, we have gone half the year so far without any complaint about the ethics of any manager in a business you own. Our investment style, of owning only businesses we understand and avoiding the frenetic day trading that has swept most of the mutual fund industry, means we get to meet with most of the managements in your portfolio every quarter. If they were to start giving us incomprehensible answers to workaday business questions, it would give us the hives. On this score, the number of investors who now openly admit they never understood the business of Enron, let alone the footnotes, is befuddling. If you don’t understand where the cash flows come from, how on earth do you put a value to it? The head of Alliance Capital, who told the Wall Street Journal this past quarter that he relied on the friendship of Ken Lay and had never read the financial statements, really ought to think about hiring a keeper. He doesn’t belong out alone.
We make no guarantees that we cannot be fooled by a miscreant too. There is no investing without being partially vulnerable on this point. But we have done all we can to make it less likely. Warren Buffet owns 36% of Berkshire Hathaway, the Hagedorn family owns 40% of Scott’s, and Charlie Ergen owns 50% of Echostar. None of these people ever sell shares, and so if they are cooking the books, we at least have the satisfaction of knowing they are poisoning themselves. Buffet, in the most extreme example of probity we know of, goes so far as paying himself and his partner a mere $100,000 a year, an amount they have kept stable for 21 years. Buffet should just declare his work a charitable act and have done with it. Moreover, if we take into account the average tenure of the managements in your portfolio, they have been around typically for more than ten years. Angelo Mozilo has run Countrywide Credit honorably and profitably since he created it 26 years ago. If he is now going to turn out to be a cheat he has had the weirdest apprenticeship we can imagine.
We write so bluntly about this because the moment is so deeply paranoid that we want to give you some assurance that we are properly suspicious. Of course, the greatest damage from this season of perfidy may very well come from remedies, at least as much as the disease. The political climate may be changing in ways we haven’t caught up with yet. In this regard, we cannot imagine anyone putting the risk more succinctly than James Grant did in the June 27th issue of Grant’s Interest Rate Observer (212-809-7994), “The social contract implicitly struck in a capitalist society is that the rich can become as rich as they want so long as the poor can become rich too. The contract is violated when the rich take what isn’t theirs. The political significance of the scandals of greed…is that the rich have yielded to avarice. May not the poor then give in to envy?”
We have built a twenty-two year record by ignoring almost everything that wasn’t directly to do with the price of individual securities and their relationship to the prevailing interest rates. Even this year that has stood us in good stead. Every now and then, though, the rules do change. We are aware of that and wondering whether this isn’t one of those times.
Are the politics that have protected and promoted capitalism for the last twenty-five years now irretrievably shattered? We don’t know yet, but we are willing to entertain the thought. Still and all, at the moment it does seem to us a more sensible thing to own shares of proven companies at eight and ten and even fifteen times earnings we think we can count on, than to own bonds at less than 5%. If you commit your money for years at a low interest rate and you are wrong, it can take you many years to realize just how disastrously mistaken you were. Inflation always creeps up on investors at the beginning, but comes galloping at them by the end. Considering how much stress Alan Greenspan is under just now, to keep the money flowing and to stem the bearish tide, price stability must be the very last thing on his mind.
Sincerely,
Edwin A. Levy
Michael J. Harkins