For the first nine months ending September 30, our average account was down approximately -16.00%.
The third quarter of 1998 was as difficult a period as any in our eighteen year history. Russia defaulted on $70 billion in debt, a Greenwich hedge fund defaulted on $125 billion in debt, and the financial markets have been in a headlong panic ever since. That a little known hedge fund could create losses to overeager lenders much greater than a nation that spans half the globe is weird and eloquent tribute to how enthusiasms can get out of bounds in financial markets. The unwinding of Long Term Capital’s convergence trades has been a painful irony, since it has punished the prudent more than the imprudent. The firm’s style was to search out genuine value in over-looked securities, a generally laudable pastime we are wholly sympathetic to. But leveraging value 50 to one on margin is an act only a Noble Laureate or two could have been comfortable with. The result has been mortifying to us, and now to them also.
None of this is to take the spotlight off the fact that we performed poorly. In eighteen years our clients have always known us to shine in hard times. That this time has been different is keenly felt around here, but we have sound reasons to believe we can restore frayed confidence in the next six months. To be candid, we were caught off guard by the severity of the decline in the average share price while bond prices are booming. There is no previous history of this happening in the United States, and it is directly at odds with what is going on in the developing world, ostensibly the cause of our upset. In Russia, Asia, and South America government bond rates of 50% or more prevailed throughout the quarter, and their stock markets were decimated, understandably. Who wishes to hazard any risk in stocks when 50% rates are available, and what business can prosper in that atmosphere? Yet why are our shares so damaged with rates at a decade’s low 4%?
Rank fear is the clear answer, and it can be seen most clearly in the market for puts on the major stock indexes. Not only are volumes of puts extraordinarily heavy, but the prices investors have been willing to pay for risk protection are the greatest they have been since the 1987 crash. Indeed, in duration this extraordinarily intense urge for risk insurance is about to surpass the trauma of eleven years ago. There are no guarantees in financial life, but this condition works heavily in a buyer’s favor. Here’s why.
If everyone in California suddenly decides within a month’s time that they must have earthquake protection, rates on that insurance are sure to skyrocket, just as they have in the put market now. But the increase in premiums says nothing about the likelihood of the big one striking; that unhappy event will come when it will come. Not so in financial markets, where the sellers of the put insurance instantly lay off a large part of their risk in short positions in actual shares. This derivative selling temporarily depresses prices worse than they would have been, but also acts as a powerful cushion underneath the market if it goes on long enough.
You might have been wondering, who then have been the buyers to absorb all this fear driven selling? This is a comforting question. For the past six weeks corporate insiders, that is directors and officers of corporations, have been buying their own shares at a pace not seen since the fall of 1990. To be sure, in that experience their buying lasted four months; but it also presaged an eight year bull market.
We doubt very much that the insiders are unaware how badly their businesses will be battered from the overseas turbulence. They are just likely to be more aware how much benefited they are from a decrease in interest rates of about one quarter. Not a quarter of a point, mind; we mean their entire interest bill will be a quarter less as soon as markets quiet down. This is not only good for business in America, but is likely to become an overriding concern to institutional investors in another month or so as they think in more immediate terms about their 1999 budgets for universities, hospitals, museums and the like. Their bond portfolios are yielding them somewhere between a fifth and a third less than they did this time last year. Considering how frightened the Federal Reserve Board is, finally, the yield famine is likely only to get worse. It is not in the nature of institutions to cut budgets back by such large amounts when, by allocating a larger share to equities, some part of the pain can be postponed. A glance at the exploding volumes of cash directed currently at money market mutual funds reassures us that were the current gloom to ever lift, the system still has enough candlepower to light the darkness.
A brilliant friend of ours frequently observes that when a security is overvalued only a handful of things can bring it down, but in times of undervaluation dozens of forces work to drive it back up. We reflect on this when we think about what private businessmen would pay for the shares in our portfolio were control positions freely for sale. An example of how disparate the two values are in our favor occurred in the quarter, when the privatization of Telebras, long delayed, finally went off. The Brazilian government sold its 21% interest in the phone company, with its 51% interest in the voting shares, in twelve separate pieces to twelve separate bidders. All the usual suspects participated; MCI, and Telefonica de Espana, and Nippon Telephone, etc. When it was over, the twelve pieces sold separately commanded a combined price of $294 per reconstituted share. Those are the same shares you see languishing in our portfolio at just over $70 now. This is some measure of how unreasoning the terror in overseas markets has become. We do not remember, even at the depths of distress in 1982, ever being able to buy a dominant company with a modestly leveraged balance sheet growing 30% per year at 6 times earnings. Nor can we recall being able to purchase for a quarter what a large collection of immensely sophisticated buyers just paid a dollar for.
We do not mean to lightly dismiss the continuing overvaluation in the largest and most popular sectors of the market, nor the obvious difficulty that America and the world faces for whatever length of time we are now going to have to do without a president. But sometimes the prices of individual businesses overwhelm all else, and your largest holding of the quarter falls into that category. Echostar Communications is a direct satellite broadcaster to backyard antennas. It is the newest and most advanced entrant into the only real competition cable-TV has. It is also the last entrant, ever, as the necessary satellite geography is all spoken for. Echostar has been growing 5% per month from the time you’ve owned it, and it is an astonishingly profitable business, since now that the last satellite is in place, every new subscriber costs nothing to service beyond the initial cost of getting a dish in his backyard. So here is a business with a moat around it, a near perfect cash flow profile, and a 5% per month growing rate. Yet a Bloomberg machine reveals only six analysts cover it. That is how easily billion dollar businesses can go unnoticed in the financial world just now, and is a powerful opportunity for us.
Sincerely yours,
Edwin A. Levy
Michael J. Harkins