July2008

July 7, 2008

Dear Client,

For the first six months of 2008 our average account depreciated -11.71%.

This is a hard time to be an investor. Inflation is not now a forecast, or a lurking threat; it is a here and now torment at every gas station and supermarket check out counter. And the bond market offers no relief. Yields on short dated paper are far less than any realistic estimate of an honest inflation rate now prevailing, and longer dated bonds, with slightly greater yields, carry risk that we find simply unconscionable. A bond investor loses purchasing power either way, but long term holders stand to lose a lot of capital too.

Recent news on the inflation vs. interest rate front has grown even grimmer. Fannie Mae and Freddie Mac, the government sponsored mortgage behemoths that between them own or guarantee almost half of all residential mortgages in America, have seen their stock prices collapse. This makes it impossible for them to raise capital. They are desperate for capital as Congress chides them to grow faster, as they are the only aggressive bid in the secondary market for mortgages. Without fresh capital, some way will have to be found to prop them up. They are not only much too big to fail, but much of their debt is owned by foreign governments, most notably the Chinese and Russian, who reportedly were assured by various American Treasury Secretaries that these were suitable investments for their dollar surpluses. The dollar would be sent reeling even further, even faster, on the foreign exchange markets if a whiff of default were scented. So who pays for this fresh mess?

American taxpayers, to be sure, but anyone with a dollar in his pocket is thoroughly at risk too. A 2% Federal Funds rate is clearly and powerfully inflationary, and the Federal Reserve cannot raise it at least until the Freddie and Fannie fiascos are behind us, and that will take some while. Accelerating inflation is the near certain result.

Equities are the asset class designed to beat inflation, but the first half has seen heavy going on that front. In the last six months anything that can be labeled a “financial stock” has been punished and guilt by association has come to rest in some odd places as all sorts of unlikely companies are now deemed “financials.” We sold Carmax, a used car dealer with the industry’s best business plan and rapidly gaining market share, because even though it turns its inventory 11 times a year, it still has to finance itself over that 5 week hump. The market is unforgiving of that, though one day we would like to return to this stock. General Electric was thrown into the same pot, even as its large infrastructure businesses are likely to boom over the next five years. GE Money is a bugaboo now, and the future can fend for itself when investors are as spooked as they are today.

Berkshire Hathaway neatly illustrates just how spooked they are. With a $35 billion cash hoard and taking in something like $1 billion a month, Berkshire is the most likely beneficiary of a credit crunch. The knowledgeable and energetic Warren Buffett has been creating his own monoline insurance companies, scarfing up distressed bonds at big discounts, and helping other people take over whole corporations willing to pay him fat fees for his legitimately triple A rated balance sheet. He will come out of this as he always has, much richer for other’s distress, but this seems doubtful to a scared and scarred Wall Street.

You don’t need us to tell you what a marvelous history Berkshire Hathaway has had over the years. But there were always three nagging worries: How was Warren feeling, what could he do with the money, and where was his stock selling in relation to the underlying intrinsic value? A baseball fan himself, Buffett might think he’s going three for three every day the credit crunch goes on.

There are many disconnects between logic and stock prices today, but it has been really odd watching the prices of grains soar to record highs while the price of John Deere stock sells off. Most commodities can go in any direction at any time, but grains are a little different. Once a growing season is ruined, there is nothing to do but wait around for the next one. Once stockpiles are very low, prices are sure to be very high, until they are rebuilt. And give farmers this sort of income, and they will buy farm implements. Deere’s results are going to be very strong for a long time, and sooner or later so will be its stock price, but it’s exasperating in the meantime. We mention it as much to tell you how daft things are, as for anything else.

Qualcomm is one of our largest holdings, thank goodness, and it is proving how some great stories survive any storm. The next time someone walks into you on the street because they are watching TV on their cell phone, or taking pictures, or text messaging madly, sigh with a little less exasperation. You are making money out of this boorishness, as Qualcomm is the undisputed leader in 3G mobile phone technology, and gaining market share in gobs in a market still growing. One measure of their dominance is that they still get over $200 per phone in a line of chip sets they first introduced five years ago. This is unheard of in the telecom industry, where prices almost always drop relentlessly. Qualcomm keeps adding so many new applications that prices stay up and volumes explode, an unusual and advantageous position. It also makes more than half its profits from outside the United States, which is a virtue we prize more and more by the day.

To end at the beginning, these are hard times. Yet one of the oddities of hard times is how often investors seek to protect themselves against lesser risks, while ignoring the greater ones. Inflation is a clear and present danger. Looking out longer than a week, it is what investors should be worried about. It has been 25 years since Paul Volker slew the inflation dragon, and we have been living off that legacy for a generation. Since debasement is always the future of a fiat currency, it is decidedly odd that every next bout of inflation comes as a “surprise.” Short term volatility is the price stock investors pay to ward off the certain losses bond investors will incur in the long term. We can’t claim this volatility is pleasant, but it is providing us with some marvelous values which we are eager to exploit. In 28 years at Levy, Harkins volatility has been our friend, because we buy companies with rock solid balance sheets that prosper when times get tough. They will again and so will we. We last went through a bout like this in late 1998, and what came next was a cornucopia. People are forgetting, in America surprises are usually not negative.

Sincerely,

Edwin A. Levy

Michael J. Harkins