For the first nine months of 2001, our average account declined -10.5%.
As it is but three weeks since we wrote you last, we will keep this regular quarterly comment briefer than you might otherwise expect. We do not mean to minimize today’s momentous events, but if we keep just to what we know it makes for much shorter correspondence. We thought three weeks ago that the level of fear at the moment the stock exchange re-opened was unsustainably great. As it turns out the market, as we write this, is barely lower than it was on the day before the attack. It is a different, and much nastier world, to be sure; but the future cash flows from businesses do not change that much whether we are at war or at peace. When current events are as spectacular as this, it is hard to remember just what the markets are designed for. A stock price is an estimate of all the future cash flows of a business discounted by an interest rate. The future looks grim at the moment, cash flow-wise and otherwise. But interest rates are as low as they have been in a quarter century, and that has made all the difference. Isn’t it amazing how markets, even in the most extreme circumstances, can exhibit an equilibrium hardly any of the participants feel?
In our past few letters we have repeatedly emphasized that your portfolio contains no business that requires periodic infusions of new capital to grow and prosper, let alone merely survive. Since this emphasis is producing markedly better than average performance, we think repetition of this one point, ordinarily noisome in a correspondent, is acceptable now. They can close the financial markets to new issues for a very long time, and you are all right. That is not true of the great majority of American businesses, which always need access to fresh capital often to survive, and certainly to grow. In tough times this distinction makes a lot of difference. The key to compounding is never taking a big loss, and big losses are ahead of you if you desperately need money when no one is willing to give it. Independence on this score helped us mightily.
You also own two businesses that are likely to write out the biggest checks to victims of the World Trade Center ever written in the insurance industry, and both stock prices are climbing, as they should be. Berkshire Hathaway and AIG are the property and casualty companies with the largest exposure to the disaster. Do not grow alarmed at this fact. Berkshire’s Warren Buffett has estimated his part of the loss at $2.5 billion, which he can easily meet out of his $62 billion in book value. You might also bear in mind the pay outs will take place over many years. For AIG, the loss is borne even more lightly, at less than $1 billion out of $43 billion in equity. So saying, since when are losses good?
The bane of the insurance business are underwriters without much intention or ability to pay, who are forever underpricing their policies in order to take in current income. That the regulators allow this “let tomorrow take care of itself” attitude is truly shocking, and one of the last great citadels of collectivist thinking, in as much as state governments always ride to the rescue when insurers go bust. This catastrophe is too big for government forbearance, and as a great many underwriters exhaust their ability to pay claims, the remaining insurance issuers will raise their prices for a decade and more. Berkshire is likely to recover in price increases over the year ahead what it pays out in total claims. We trust Buffett will know what to do with the added premiums realized over the rest of the decade.
You own two other stocks that particularly thrive in a time of low interest rates. Countrywide Credit accounts for about 7% of all the mortgages written in America, by far the dominant position in the industry. The urge to re-finance at these low rates is very strong, and amounts to an unannounced rolling tax cut as homeowners each make their own decisions on when the long term savings are worth the immediate costs. The biggest immediate cost in re-financings, it may surprise you to know, is title insurance. Fidelity National provides that, and with a third of all the title insurance business in the country, it too is number one in its field. This is a marvelous business, since it is a practical impossibility to get into it without having an encyclopedic data base on each local market, and after you had that you would still need to establish contacts with local real estate agents to sell your product. No one has made a fresh start in this business for over twenty years, and we expect nothing but consolidations in the years to come.
Countrywide and Fidelity National are “cyclical growers,” in that their growth comes in great lumpy spurts, and then subsides for the rest of the business cycle as the rest of the country prospers and interest rates rise again. However, they do not give back the gains in good times, and over an entire cycle achieve very acceptable returns on capital. They do all that for us, and provide a hedge in hard times for some of the inevitable knocks we are going to take in our other holdings. They have performed their role admirably in these difficult days.
There is no investment that will be a successful hedge against repeated attacks on all we hold dear, and we would not look to mislead you for an instant on that point. We have to count on America being struck again, and admit we have no adequate method to plan for it. But in thinking about our current condition, the example of Pearl Harbor comes back again and again. The Japanese achieved a tremendous tactical victory (the sinking of seven battleships was an unthinkable enormity at the time) by taking advantage of our openness and innocence. They did not know until too late what a strategic defeat it was for them. They goaded into war an enemy they could not realistically hope to defeat; an enemy that couldn’t seem to rouse itself to fight for its own vital interests.
Osama bin Laden hates us for what we are, not for what we have done. But these evil deeds have united the world as nothing else has in our lifetimes. He has compelled decent people everywhere to declare in full voice their support for democracy, the rule of law, prosperity and the rights of women. He’s bitten off way more than he can chew.
Sincerely,
Edwin A. Levy
Michael J. Harkins