For the first 6 months of 2003, our average account was up +15.35%.
The New York Post reported recently on the work habits of the chief investment officer of a $57 billion money management organization. It seems he starts every Monday listening to the recorded call giving the details of Wal-Mart’s sales for the previous seven days. The ritual decides, he says, whether he will start the week as a bull or a bear. “It tells you what the consumer is really thinking, how confident they really are. In this business (investing), we can get so caught up in looking at the forest we forget to look at the trees.” Does the gentleman above have 52 opinions a year? Does he move all $57 billion in accordance with each of them? The article doesn’t say. The Post, famed for its’ in depth coverage of the zany, bizarre and just plain scurrilous, clearly has done its duty just by printing this. It is up to us to offer the commentary that if this hyper-thyroid case is serious, he is a menace. But he is not atypical; the financial press now offhandedly refers to money managers being paid on monthly performance. Who is more to blame for this foolishness, the clients who put such credence in short term results or the investment managers who gull them into it? Hard to say.
The point to this little parable is that we are the other guys. Around this shop, turnover seems to be measured in geological units. This makes us complete failures in the vim and vigor contest the financial press, the cable news outlets, and the New York Post all enthusiastically sponsor. However, make no mistake, we salute the industry of the fellow quoted above. The point of this letter is that lethargy can be rewarding if you are in a profitable rut.
This is not a bad moment for reflection on investment styles. Stocks are hardly cheap, but after the mad enthusiasms of three years ago, this seems a welcome respite. Most investors, to be sure, are still nursing painful wounds from the burst bubble, but they have at last stopped throwing babies after bathwater. Good companies suddenly have higher stock prices, but mad cap business plans without an underlying rational still can’t get funded. Blessedly, there has not been a terror outrage in some time either. Since the financial business always goes from pillar to post it’s fair to ask, where are we now?
First, at Levy, Harkins, we are not very far from new highs. This is particularly gratifying, since we have written for so many years that the essential element in compounding is to never have a very heavy loss. When your performance matches your rhetoric you may simply be lucky, but you are most assuredly relieved. Having thrown brickbats for years at managers who take excessive risks with their clients’ assets in the hopes of embellishing their own records, we are pleased we now do not have to play catch with our own darts.
Next, it’s not a bad moment to define what a “profitable rut” is. Levy, Harkins has been open 23 ½ years, and we have compounded money over that time at 14.5%. That means that after all fees an initial dollar invested with us has grown to $24, over the course of the 23 years. We have done it with the same personnel, and with the same style, although there was one notable mid-course correction. That change had to do with our dawning realization, about ten years ago, that it was better to own a great business at a good price than to insist on paying a great price for any old business that came along. If you insist on paying great prices for stocks you are going to wind up with a collection of dreadful, capital consuming businesses. Benjamin Graham left this part out of the bulk of his writing, but trust us, after many years of owning knitting mills in South Carolina, defense contractors on Long Island, auto parts suppliers all over the place, rarely do people sell you a business at much less than net-net working capital without it having some truly disfiguring warts. Moreover, there is a larger element of the “greater fool” theory at work in this style than we had initially grasped. Nobody but a very great fool indeed pays you book value or a decent multiple for a clothing mill in the American South. The buyer can only be a man who has never heard of India, and he is likely to find out about their greater comparative advantage faster than you can sell him all your shares. You are, after a fashion, sitting in front of a honey trap with poisoned honey as the bait. Worse yet, the bait tends to evaporate, because bad businesses consume cash.
Today, we stick to great businesses. A great business throws off a stream of cash such that if you spend every penny of its profits in a given year, when you come back the next year there is not only a business, but there is a chance that it is a bigger business. This is at odds with the great majority of businesses listed on the stock exchange, which spend to survive. If they do not spend great sums every year, often as great as profit and depreciation combined, on new plants or cutting edge research or cost saving devices, then they find themselves out of business in short order.
It is not the point of these letters to produce an accounting text in installments, so we will not take you through chapter and verse of what is a depreciable asset or the persistent biases to be found in capital expenditure projections. Just bear these two things in mind. A business that throws off cash is rarely confused with one that consumes it. An experienced investor just doesn’t get this sort of thing wrong. And secondly, stocks sell about at the same multiples whether they produce cash or consume it. This second thought would be astounding if you were not already familiar with the financial press or television. As it is, when was the last time you heard a talking head ask a subject, “Is this a good business?”, or, “Is there a protective moat around these high returns?” You have never heard this on television because investment professionals do not think this way, so swept up are they in examining tree bark, like the fellow quoted at the top of this letter. If you rarely mis-identify a good business from a bad, but you are frequently wrong about the immediate outcome of current events, many of which are fiendishly complex and subject to manipulation by people who know much more than you, does it not make sense to stick at what you are good at? This is what we do, and sticking to our knitting works to our great advantage over long periods of time so long as we pay reasonable prices.
It is on that note we wish to whistle a little caution. Our recent letters to you have lamented that our investments were doing well but the stocks were sleeping. All of a sudden that is not true, and long time clients know we accept lumpy returns just as gratefully as well-mannered smooth ones. A large part of the catch-up between our judgment of perceived value and the market price has now happened, meaning part of the juice has already been squeezed from the fruit.
Another worry is also bedeviling us. In order to value a stream of earnings you have to have a discount rate in mind. Ordinarily, we take the ten year treasury bond rate as our rough guide post without a second thought. Plenty more thoughts are now in order. America, and indeed much of the world, may be swept up in a bond bubble. We have listened to the recent warnings about the perils of deflation, issued as the price of almost everything around us vaults higher, with growing jaundice. When the authorities wish to pursue policies that would be condemned as reckless on their face, they often issue warning of dangers the rest of us cannot see, and intimate that their greater knowledge gives them greater vision. At the moment, the Federal Reserve seems to be campaigning in the next presidential election 16 months before it is to be held. That is a long time to be running the monetary spigot flat out.
Yet even if we take their deflationary alarm bells seriously, their prime example is looking decidedly suspect. If we are not to look like Japan, maybe it would serve us well to look at Japan a little more thoroughly. Japan has had modest deflation. Indeed, last month interest rates on Japanese government paper of ten years’ duration made an all time low of 47 basis points. That is not a typo. A ten year bond (#250) traded well above par with a coupon of ½ of 1 percent. As we write, that same bond is quoted at 95 bid. How would you fancy that? In less than a month an investor has lost more than he stood to make in an entire decade of coupon clipping. This is indeed what our sly friend Paul Isaac refers to as “return free risk”. It may be endemic to most of the Western world’s financial systems, and we have a weather eye cast on it. If interest rates are artificially low, and set to go substantially higher soon, then our current degree of comfort in our investments is misplaced. All stocks are interest rate sensitive when rates go up, and ours are no different. Still, in twenty three years there has always been something to worry about, and much of it was much scarier than this.
This letter wouldn’t be complete without our acknowledging our record wouldn’t be what it is without your patience, faith and good sense. Our clients allow us to look much farther ahead than any similar organization, and for that we are deeply grateful.
Sincerely yours,
Edwin A. Levy
Michael J. Harkins