For the first 9 months of 2003, our average account was up +22.35%.
The dyspeptic have an advantage on Wall Street. If you are cranky and hard to please at the best of times, you are less likely to get swept up in enthusiasms when the good times roll. In the stock market the good times are starting to pick up speed, but it leaves us more nose out of joint than you might imagine. When we told you for the last three years running that your portfolios showed very modest losses but that the underlying businesses were experiencing immodest growth, we actually meant it. While that was going on it was a source of great comfort; rather like knowing a well is re-filling at great speed. Now the stock prices are going up faster than the businesses are improving, and interest rates have been rising. That is like draining a well in a drought. In our last letter to you we noted the threat of this saying, “much of the world may be swept up in a bond bubble.” Ninety days later long rates, the ones you use to discount stock prices, are substantially higher, leaving us to chew on the fact that financial bubbles pop without a sound. You only know they are really over long after they were really over. But around the world the signs for the bond market are not good. Remember the Japanese fellow we wrote to you about in July who bought the #250 Japanese government bond, a ten year note, at an interest rate of one half of one percent? That bond was sold to the public at 100 on June 3rd and is quoted at 92 bid today. In just over 4 months the buyer has lost 60% more than he stood to make if he holds the bond for the full ten years. And we know, from long experience in other bear bond markets, he is likely to say that holding on is his very intent. Every generation needs to learn for itself that your first loss is your best loss after you have caught yourself in a really foolish blunder.
As churlish as we are about the excesses of the bond market, it has not stopped us from profiting handsomely from the mortgage re-finance boom. We wish we could claim perspicacity; that this represents a Levy, Harkins market timing coup. Alas, it was no such thing. We just recognized a few years ago that Countrywide Credit was a good business, with all those cash generating virtues we’ve preached in prior letters. And how hard a thing was that to spot? About as difficult as opening to its Value Line page and reading from left to right. In 1987, Countrywide had a book value of $2.54. Then Angelo Mozilo went into overdrive, brokering mortgages and securitizing loans, capturing market share from bankrupt savings and loans. Fifteen years later the book value is just over $50 a share, and it is all in cash and securities, not dubious bricks and mortar values. Twenty times your money in 16 years and never a write off, Mozilo is our idea of a hero.
However, the Countrywide story is also a short parable in how our investing style is so at odds with the prevailing sentiment. Throughout the year we have been told again and again that when rates went up, the re-finance boom would end, and Countrywide would have at least three quarters with earnings that were lower than the previous years’. We didn’t bat an eye. If the current price of the stock made it cheap in relation to next years’ earnings, why would we sell it? And yet, what we heard again and again from stock brokers is, “How could you own this?” Momentum investing treats stocks as though they are the shadows of businesses playing on the wall of a distant cave. There is hardly a real connection between one and the other. Value investing treats stocks as private partnership interests with some nifty employment contracts thrown in. We get to “hire” Angelo Mozilo on terms Levy, Harkins could never get him to work for us. But through the miracle of a NYSE listing, he works for us today. Who would fire a guy like that just because he produced a slightly less spectacular year next year? Not us.
However, to return to our original point, Mozilo is likely to face a much tougher environment next year. It is an unnoted irony that the major powers of the earth, who are barely speaking to each other on diplomatic issues, are in lockstep in economic ones. The U.S., Britain, France, Germany and Italy are all running government budget deficits at 3% of their output or better. That is quite a change from three years ago, and if it is worrisome for us, it is downright alarming for them. We have a growing population and economy. The Europeans have a shrinking population facing imminent, unfunded retirement. Around the world the monetary authorities are flooding the systems with money. Some, like the Federal Reserve, have even taken to hypothesizing novel and vigorous new methods for inflating away our sorrows.
This is not the time to own a long dated, fixed coupon asset. Which is a pity for us. For twenty three years Levy, Harkins has always had a balanced approach to things, owning either bonds, or converts, or foreign bonds; anything to produce some stable income. You may have noted we sold the last of our real estate investment trusts in the last quarter, and do not intend to replace them with bonds anytime soon. When we last owned American long bonds they were widely derided on the covers of financial magazines as “certificates of confiscation.” A twenty year bull market has dulled all appreciation of the riskiness of bonds, just as the risk reaches threatening levels. Short term paper, while posing less risk, offers quite literally no reward. And it isn’t quite riskless either. When we started in business, almost twenty four years ago now, we couched every discussion about return with a warning that returns could only properly be thought of in after inflation terms. If you made 3 percent in a six percent inflation world, you lost money. Worse yet, if you said, “But I am holding these bonds for the long term,” you were locking yourself into an awful experience that was likely to accelerate. We have the uneasy feeling we may be dusting off those quarter century old warnings any minute now. Still and all we are making good money today, and we are thirteen months away from an election. The authorities do not like making abrupt changes in the run up to elections, so this golden moment, between reflation and inflation, might last awhile.
Sincerely,
Edwin A. Levy
Michael J. Harkins