For the first nine months of 2002, our average account declined -10.9%.
When we founded Levy, Harkins 23 years ago we emphatically stated we would not try to elicit praise by touting relative performance. We are ourselves clients as well as managers, and do not enjoy being told how happy we should be that while we had suffered losses, others had done worse. Happiness is made of different stuff than this. We are acutely aware that our responsibility is to produce positive results. Despite our continuing distaste for relative performance as a yardstick, and with some trepidation, we will point out your account has fallen less than half what the average mutual fund has experienced. The significance of this dim achievement comes from the nature of the compound interest tables. If you want to have a really good investment record, the keys are to not go out of business, and to never have a really large loss. The two are related, of course, but the second point is more subtle and telling.
Long time readers can skip this paragraph, having seen it a number of times before, but we are addicted to the parable of the two money managers. Imagine a Mr. D.L. Dishwater, who sets up a money management shop and makes a steady and dull 15% a year, every year for ten years running. It should be noted that when we first conjured this parable some years ago fifteen percent was considered a barely presentable performance, and is now seen as improbably terrific, but never mind, times change but arithmetic does not. Now across the street from Dishwater springs up a rival investment shop run by Mr. A.D. Venturesome. This fellow is a real go-getter, and he makes 20% in eight years, - it does not matter which eight, - and loses twenty percent in two years. The mind’s eye tells you their clients will be in roughly the same place at the end of the ten year period. In fact, Dishwater’s clients will be 47% ahead of Venturesome’s at the end of the decade. And now here is a sour observation on the world. It is almost certain that Venturesome will have a far larger money management business at the end of it all, since he will have attracted more of the townspeople as clients. He had bragging rights to 80% of the time, of course, and that matters far more to people than compound interest rates ever will. Large losses, like Venturesome’s apocryphal ones above, interrupt the compounding process so severely that all sorts of heroics can surround them, and still not add up to much in the balance. What we have managed to do so far in the bear market is to avoid large losses, enough so that we are keeping the arithmetic of compounding in our favor.
But what are we to make of people who sign up for investments where compounding can only work glacially, at best, and yet who take the risk of very large loss with great equanimity? We are talking about current day bond buyers, and their breathtaking courage. Bond mutual funds are this year’s hot item, the last safe haven for refugees from the stock market, eager to depart from risk just when that risk has abated to the lowest level in a decade. The maturity of choice for mutual funds, judging by the chatter in the daily press, is the middle part of the yield curve. So to pick an example, not at random but also not exaggerating the risk we are wondering about, the ten year Treasury bond yields 3.6% at this writing. Now imagine for some reason that that bond sells at a 6% yield a year from now. Perhaps something goes right in the economy, or we knock off Iraq with ease, and yields go back to about the mid-point of post-War experience. This is America, after all, and things do go more right than wrong, although admittedly, not lately. At 6% in October of 2003, today’s buyer would be sporting about a 17% loss if he needed a bid on his then nine year note. That theoretical loss is about five times more income than he could have hoped to achieve. More to the point, it is a heck of a lot of risk to take for a very paltry return. We are not making an interest rate prediction here, to be sure. We don’t do that sort of thing. But we will predict that if this comes to pass more than half the owners will comfort themselves with the thought, “Ah, well, I’m not going to sell before maturity anyway.” Twenty five years ago, hearing such inanity on a daily basis in the midst of a towering inflation, we first became friends. We had nobody else to talk to in the face of such absurdity. If you own a bond with a coupon less than the rate of inflation, you are losing money hand over fist.
Indeed, in this week’s Bloomberg market commentary, the estimable Caroline Baum reports she is in receipt of a survey of 1000 randomly selected investors who “did not understand the inverse relationship between bond prices and interest rates.” She thinks this “startling” and “about as scary as, well, investors chasing Internet and technology stocks in 1999 and 2000 without any understanding of the inherent risk.” Ms. Baum is a fine writer, and her point about a bond bubble now mirroring the previous enthusiasm for stocks is exactly the point we are trying to get across here, but we wonder if she isn’t showing a touch of naivete.
America has always brutalized bondholders; the country was founded on it. Washington and Jefferson were amongst the very largest landowners in Virginia, and deeply indebted to British bankers because of it. When the revolutionary war broke out, the Virginia House of Burgesses decreed that any citizen could discharge his debts to the English by paying the Burgesses directly. Since at the time (1777) it looked like we were going to lose the war, the Continental dollar traded at 5 pence on the pound sterling. Washington, Jefferson and the rest, facing hanging in any event, took advantage of discharging their debts at one twentieth their real values, and to the wrong creditor to boot. To this day English historians maintain the cause of the War of 1812, thirty years later, was an attempt to claw back this swindled money, which had been explicitly promised them in the Treaty of Paris that ended the Revolution (1783). Americans, then and now, are blissfully unaware that a bondholder had been mugged. And by heroes, too.
The history lesson is by way of pointing out how little changes in our attitude toward debt. When you attempt to describe to a German banker how an American mortgage works, in particular the-heads-I-win-tails-you-lose element implicit in a penalty free re-finance option, he thinks you are a wandering loon or his English has broken down. He thinks no banker would take such a bad deal. What he does not realize is that no other people would think to treat the banker this way in the first place.
Which brings us to another point that we will only touch on briefly, but may soon be worth longer examination. How is it every corporation in the country is deemed suspect and doled out credit in eyedroppers, and every residential borrower is seen as a walking gold standard? We know that a house is good collateral, but cash is pretty good collateral too, and we used to make people put up 25% of the purchase price of a house with it. Now they put up less money, the price of the house has gone up, and the rate the borrower pays goes lower and lower. Does this add up? Or is this the sort of thing that only happens when people are terrified of stocks and feel they have no other choice with money? The bond bubble is a topic of more than passing interest, but we don’t need to go nearly that far afield to point out plenty of signs of revulsion to the stock market.
About five years ago we came across the Munder Net-Net Fund advertised in the newspapers and were delighted. We had not been able to find stocks of small companies selling at less than their current assets minus their current liabilities and minus long term debt (that’s the “net-net” part) for some time. That there could be a mutual fund full of them was more than we could hope for. One stop shopping! Alas, it was more than disappointing to discover the “net” referred to was the Internet, the Munder Fund was stuffed full of the zaniest Internet speculations all but a madman could imagine, and the name was nothing but a cynical reference to a rock solid investment style made famous by Benjamin Graham. Professor Graham would have given the back of his hand to these hypesters.
Fast forward five years. After the collapse of the Internet boondoggle the Munder Fund is the hat size of a pinhead, but there are now all sorts of companies selling at less than their net-net working capital, and some look to have favorable prospects to boot. This is for practical purposes like buying options for nothing, and having the comfort of knowing you could kill the underlying company and still make a profit. We have no intention of going overboard on any one of these issues; hence there is no point in describing each of these investments in turn. Each will be only tiny positions at their biggest. But they are beginning to show up in your portfolios, and if Mr. Market remains on suicide watch very long, in James Grant’s marvelous expression, you are likely to see quite a few of them. Tax selling season in a bear market may be a trying time for investors everywhere, but we don’t intend to let the opportunities that can be grasped in such a moment slip through our fingers with our tears.
So to end where we started, we know you invest money to make money, and not to lose less. To that end the companies whose shares we own must prosper and the market must agree with our judgment of their worth. You can see by your account balance that we and the market are out of sorts with each other just now. But there is no doubt how the companies are doing in the main: they are prospering mightily. While no one is wholly immune to the current stagnant business climate, collectively they are returning our faith in them with interest. And because no letter from us would seem at an end without some mention of Echostar, we would reassure you that despite the breakup of the proposed merger in the headlines just now, the company is growing just fine. It would have been nice to own all of the sky over America, but Charlie Ergen is finding ways to make his slice bigger than his competitors, and if he keeps doing that the wisdom of it will out. Every day Echostar gains market share, literally getting a larger piece of America’s upside, and that has always proven to be profitable.
Sincerely,
Edwin A. Levy
Michael J. Harkins