For the first nine months of 2004 our average account gained approximately +10.72%.
Well, more than not, but then, not quite either. What we mean, of course, is that while our books are kept to the penny, the standard of value they are kept in has begun eroding at an alarming rate. The government says we are wrong about this; that the All-Item Consumer Price Index rose at a 2.7% pace for the last twelve months, a gathering, but still benign reading. They are not trying to be taken seriously. The housing portion of the CPI, the largest single constituent part, is calculated using a bizarrely complex construct that postulates the sum you would have rented your house to yourself for had you decided to be your own landlord. You are always magnificently generous, and have barely raised prices on yourself for many years, says the government.
Meanwhile another part of government, the Office of Federal Housing Enterprise Oversight, is responsible for being the watchdog of Fannie Mae and Freddie Mac, the overextended and over-expanding quasi-government enterprises. They need to prove they have not been engaged in reckless real estate lending far outstripping the actual rise in the housing market. No problem. The government announced September 1st that house prices increased 9.4% in the second quarter compared to the same period a year ago, a comforting uptick from the 8.3% increase recorded in the first quarter. We are no doubt committing lese` majeste` just by keeping score, but if America were to use this number, simplifying and making the Consumer Price Index far more accurate at one stroke, we would also nearly double it. The authorities would find that inconvenient, and very expensive, since the cost of living adjustments made to Social Security recipients would balloon the federal deficit mightily. Obfuscation and inaccuracy has an honored role amongst government accountants.
We have gone on in recent letters at some length about inflation being considerably worse than is popularly depicted because it goes right to the heart of our relationship with you. We have no business taking full credit reporting returns to you we know to be partly inflated, and therefore illusory. Unfortunately we haven’t the resources to accurately track price changes ourselves. Yet we do have the intellectual resources to know how to think about this.
Many years ago, long before the height of the last great inflation, an insightful commentator named Ray de Voe of Legg, Mason cheekily invented a “Cost of Living It Up” Index. It was champagne and caviar and Concorde flights. Also suites at the Ritz in Paris, private school tuition in New York, and golf club memberships in all the best resorts. Will you be surprised if we tell you it always far outstripped the official inflation rate? It also far better described the actual conditions facing the moneyed classes Mr. de Voe worked for, as he well understood. While the items he picked were often light-hearted, Mr. de Voe’s underlying point could not be more serious. You did not send us your money from a trailer park, you are not paying us fees in order to be consigned to one some years hence, and the government is describing that life and no other. Mr. de Voe stopped keeping his index some years ago, after Paul Volker nearly ended inflation and with it the crying need to gauge its true, but obscured, rate. However, we talked to Mr. de Voe recently. He said he wished some young and energetic type would take up his cause again, because we certainly need it. He also allowed as how he thought the real rate of inflation was two to three points higher than the stated CPI, and that gets us about exactly to the 5% level we posited a couple of paragraphs back. Even more instructive, it was surprising how many of the items in a modern “living it up” calculation stayed the same from twenty and thirty years ago. Except, of course, the Concorde is no more. Wonder what the “hedonic” adjustment is for that?
We are not writing a Jeremiad against this particular government. It has always been thus. Consider that the base year for the CPI is 1983, and the index started at 100. It is 189 now. If you are pack rats like us, and can actually look at your 1983 checkbooks, the inner hilarity of this less than doubling of official prices is instantly apparent. If you do not want to bother, we can point out one of us joined two golf clubs exactly 20 years ago, and their entrance fees have climbed eight times and six times in the interval. That simple observation better describes our worlds, and yours too.
To repeat our last letter, however, just because you need better investment results in a gathering inflation does not mean you are going to get them. Rather the obverse pertains in real life. Prices are the lights that illuminate a market economy. Inflation dims them so that we are all left in the inefficient dark. And, of course, when the authorities get serious about ending inflation, then it’s really lights out.
We have done what we can to own only those companies that have some pricing power and that can hold their own in an inflationary storm. American Express is an example of what we mean. Your Amex bill inflates pari passu with Ray de Voe’s “Cost of Living It Up” Index, and thank goodness for that. We have made no effort to outwit inflation, by buying every business that makes some product likely to soar in price. That smacks of market timing to us, and the authorities are not calling us the day before they get serious about ending inflation with a “sell” recommendation, now are they?
We want to go on owning great businesses at good prices because it works over the long term, it’s working splendidly now, and it is a reasonable, and natural, inflation hedge. Also, our style produces much less by way of capital gains taxes, particularly of the punishing short term variety, and that factor assumes an outsized importance in an inflationary world. It does you no good to keep ahead of the Federal Reserve’s depredations if the Treasury Department gets all the gains.
We want this letter to serve as a warning that our returns are not as good as they look, and nobody else’s are either. Also, if this keeps up, some part of our current success is coming at the expense of a nastier tomorrow. And finally, as stewards of your wealth, we are supposed to know the difference between the real and the illusory. Inflation is fool’s gold. We want you to know we know that.
Sincerely,
Edwin A. Levy
Michael J. Harkins