July2009

July 8, 2009

Dear Client,

For the first six months of 2009 our average account appreciated +6.2%.

If you find yourself in a precarious circumstance that you have never known before, never imagined, and never heard of anyone else in, it seems common sense not to claim certainty in the outcome. Give or take a little, that is where the world finds itself now. There are no old-timers to ask, “Have you ever seen anything like this before?” The answer is obviously no. No one has ever seen developed economies contract like this before, nor have we seen governments make such heroic attempts at stimulus either. There is a gathering gloom that the authorities are not in control, that prosperity is not around the corner, and indeed that our previous prosperity was an illusion, built on stilts of leverage. So do we wait for certainty to reappear before we invest?

Investors pay a very high price for certainty, and it is amazing how often certainty turns out to be illusionary. Markets anticipate, they go up before good news appears and gloom dissipates. If you wait for that moment of certainty you may never invest in anything, and certainly not at an appealing price. So while freely admitting that our own myopia is at least as great as the crowd’s, what is there that we can hang our hat on?

Well for one thing, growth is hard to come by, and unless the miraculous happens that is likely to be true for quite some time. Any company showing vigorous sales and earnings gains in this dismal environment has got a lot going for it. Happily, that also describes more than half your portfolio. Akamai, Cognizant, EMC, Google, Qualcomm, and Starent aren’t waiting around for better times to roll in. They are bending the world to their will, and in the last case you are likely to see the proof all around you soon. Starent is the leading provider of equipment that allows cell phones to receive streaming video. Young people use their cell phones for all sorts of unlikely purposes, and while watching a baseball game on a two inch screen strikes us as odd, we are keenly aware that we are not the market. Video watching is an incredible bandwidth hog compared to a simple voice phone call, and every cell phone system in the world will have to be rebuilt to reflect that. Starent just had a quarter with 30% revenue growth. Wonder what they could do if the economy picked up?

That Levy, Harkins could own something with such rapid growth as Starent is another sign of the times. We never got chances like this before because prices for great growth were exorbitant for all of our investing lives. In March, growth sold for a song when Armageddon seemed a lively possibility. Even now, healthy growth rates are rewarded with lackluster multiples because people are so downbeat about our future.

Nowhere is the prevailing pessimism starker than in the Treasury bond market. One percent interest rates and less have come to seem normal. They are not. It is a bubble of pessimism. No one can live with a 1% return forever; not a person, or a pension plan, or a charity. People will come back to the stock market not because they want to, but because they have to. This is the point Warren Buffett was making in his op-ed piece in The New York Times on October 16th, and it is instructive to reflect back on what’s happened in the intervening eight months. Buffett warned that the complacency of Treasury bill holders would haunt them in the end, as inflation was a likely outcome of ultra low rates. “Quantitative easing” wasn’t even then a gleam in an English banker’s eye. Today, every central bank in the developed world is printing money like mad, hiding behind this artful construct, “quantitative easing”, and crossing their fingers that they’ll know when and how to stop the presses when the moment is right.

Even granting the Fed perfect foreknowledge, which they have most certainly not shown to here, will they have the political gumption to defy their Congressional masters at the star struck moment? The front page of Saturday, June 20th’s New York Times named half a dozen Congressmen who had made special pleadings to the Federal Reserve to lend money directly to one or more of their constituents. Every one of them got a respectful hearing, and most got money. William McChesney Martin, a central banker of sterner virtues, would have given them the back of his hand.

But this is a new age, and even as we frankly confess we have never been more uncertain how the next few years will play out, we still can tell sense from nonsense. It has got to be better to own shares in unleveraged good businesses that grow through time than to own bonds issued by governments that want to paper over every problem they come across with still more of those bonds. If you get diluted every day, you may not notice it at first, but you will eventually.

Despite everything you have read above, don’t think we are going to be set in stone, waiting for the inevitable inflation come hell or high water. With all the spare capacity and labor lying about, that could be some time indeed. It’s just that it always has paid to worry about what the crowd isn’t worried about, and frankly there isn’t anyone in the world who doesn’t know how tough times are just now. We are starting to profit from thinking about what comes next, and who pays the bill for all this stimulus. For all the talk of de-leveraging, that is about all that it has been to here, talk. Next fiscal year the U.S. government will borrow 46 cents of every dollar it spends. That is the ultimate in unsustainable, and we hope it makes you feel better that we worry about that too every day.

       Sincerely,

       Edwin A. Levy

       Michael J. Harkins