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| July 3, 2007 |
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| Dear Client, For the first six months of 2007, our average account appreciated +0.90%. The first six months of this year were a struggle, and while the same thing happened last year and we wound up all right, surely it would be a pleasure to start a year out gangbusters and keep right on going. We take your vigorous agreement as a given, and hope to get on it first thing next year. As to the rest of this year, we have every reason to think we own great value, but goodness the investment business can be exasperating. Many times we have admired your patience with us, and we salute you again. As large owners of Bear, Stearns we have been reflecting lately on the wisdom of the old adage, “Only get your name in the newspapers at your birth, on your wedding, and in your obituary.” Every day another barrage of invective is printed about Bears’ misadventures in the hedge fund business. While these stories are not inaccurate, we do think they are misleading, and we are going to take a couple of paragraphs to tell you why. But first a bit of confessional full disclosure. We like these people personally, and one of us (Edwin) worked there for twenty years. We do not think that clouds our judgment, but you should know it anyway. So what’s good about Bear, Stearns? Well, for one thing, they are not really in the hedge fund management business. It is at most tangential to their overall efforts, and the pre-tax loss of $35 million that has been incurred from the dissolution of two of their funds is embarrassing, but to a firm that will make about $400 million net of taxes in this quarter (August), it is barely significant. “Aha”, say the Doubting Thomases, “But it is indicative of much worse to come in their mortgage broking, and that makes all the difference in the world.” We are agnostic as to whether the sky is going to fall on the mortgage markets; we just don’t think it is going to hit Bear, Stearns in the head if it does. They are brokers, not owners, except in the sense that you need some inventory to trade, and even that they partially hedge. To be sure, volumes are likely to go down, but then again spreads are likely to widen, and that is where the money is. A friend of ours who is an accomplished distressed debt investor enlightened us the other day when we asked him whether he was tempted to start investing in any of the mortgage pools yet. He said no, he wasn’t, and the reason had nothing to do with price. The impediment was that with so much information about the individual mortgage pools available, he didn’t think he could staff up fast enough and develop models sophisticated enough to take advantage of whatever opportunities were available. We repeat, this is a talented guy with a great record. If he finds it daunting to enter this space then there really is an effective moat around it. It took us years to discover that the time to buy insurance companies was just after they had been stung by really heavy losses, because weak competitors would be knocked off the field and rates would skyrocket. The current circumstance isn’t exactly the same, but it rhymes. Mortgages are always going to be an outsized part of the bond market, and Bear, Stearns knows better than anyone else what their proper pricing should be, and therefore how to trade them. Indeed, in all the storm and chaos about Bear’s present embarrassment an important point divulged in a conference call Friday, June 22nd went right over the markets’ head. The chief financial officer said he didn’t think any of this would have a significant impact on this quarter. His voice wasn’t trembling when he said it either. As participants exit a business they never should have been in, Bear Stearns won’t simply survive; they will thrive. There will also be no newspaper story when they do so. Exasperation is in the voice of Angelo Mozilo when he speaks of his business, Countrywide Financial, and the sub-prime mortgage business. Sub-prime represents 3% of his assets, and it seems to be the subject of 97% of the questions analysts throw his way. Why is Countrywide viewed in the stock market as an oversized Savings and Loan Bank, when Mozilo explicitly rejected that model 37 years ago when he founded the business? Hard to say. Countrywide is the country’s leader in originating mortgages and then selling them. They are gaining market share again as some 60 competitors have gone by the wayside. To be sure, with median prices for homes down slightly and sales volumes lackluster, Countrywide faces a headwind. But 9 times earnings for a business with this record, and ancillary businesses that are now half the profits growing at 15% plus? We suppose headwinds can turn into hurricanes, but that’s not usually the profitable way to bet. If you think we are frustrated at owning a collection of businesses that are doing well while their shares languish, you should read the shareholder letter from General Electric’s Jeffrey Immelt, dated February 9th, 2007. A friend suggested we would like Immelt’s candor, and he was so right. Immelt opens by expressing frustration that in the five years he has run the company the earnings have doubled and the price of the stock has gone nowhere. He has reacted to this by persistently buying more himself. Our kind of guy. He goes on to project likely growth rates for each segment of his varied empire. In a post Sarbanes-Oxley world this is sticking your head in a noose, and since the man has lawyers, he must also have an awful lot of confidence. Not to keep you in suspense, but between the yield on the dividend and the growth rate sought for the businesses, he’s promising a total return right around our historical average. We would love it if our future looked just like our past, hence the quick decision. But we would be remiss if we didn’t tell you how much we admire his candor on the crucial issues that have long mattered to us. He says that profit must be measured by excess cash that a business legitimately throws off. Immelt writes, “our average ‘hold’ of a business is measured in decades.” He describes the pitfalls of making acquisitions, the barriers to temptation he has built for himself, and this, “There is no deal heat in my conference room.” All this and a triple A rating at 15 times next year’s likely earnings? GE is huge, but so are their ambitions. The Greenbrier Companies is not the operator of the Appalachian resort spa. The Greenbrier in your portfolio manufactures, refurbishes, and leases railroad cars. The first of these business, bending metal into intermodal flat cars and hopper cars, is a so-so business: cyclical, competitive, and subject to gross margins in the single digits. However, value managers are always looking for the diamond-in-the-rough. Hidden beneath this homely manufacturing business are two terrific Levy, Harkins’ type of operations. First the repair business; the moat in this business is the need for a geographically diverse network of field shops. Greenbrier’s rail repair shops are located in quintessential railroad depot towns: Kansas City, Oklahoma City, and the like. Recently they added a company named Meridian to this operation. They bought it for a song as the company had recently emerged from bankruptcy with a lean asset base and revised union contracts. The repair business is steady and margins reside in the upper teens. The leasing business caters to the major railroads. Union Pacific, Burlington Northern and their ilk would much rather use their limited capex budgets on new rights-of-way and more efficient locomotives. If a demand surge tightens their railcar capacity, they turn to Greenbrier’s fleet. In this business, Greenbrier enjoys gross margins in the mid-50’s and capacity utilization above 90%. Pre-tax earnings are roughly split equally between the three businesses. Wall Street has been fixated on the manufacturing business, giving the company’s shares an attractive price for us to own the more valuable other two-thirds of the earnings stream. In an age of high energy prices, railroads are an unexamined marvel. A ton of freight moves 410 miles on a single gallon of diesel fuel on an American railroad.* A long term trend to shift freight traffic to rails from highways will keep demand strong for all Greenbrier’s businesses. Value investors live between Scylla and Charybdis. If our stocks are going up very rapidly we fret that all the value is disappearing and how will we ever manage the risks? When the businesses are flourishing and the shares are floundering we hate that too. The wonderful thing about owning businesses that throw off excess cash is that eventually, even if it’s just through the simple mechanics of buying out disgruntled shareholders, the markets come to admire the flowing cash, and the hiccups fade into obscurity. Sincerely, Edwin A. Levy Michael J. Harkins James B. Lebenthal |
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| *Source: Norfolk Southern |