For the first nine months of 2005 our average account gained approximately +2.30%.
When you are awaiting word in the college application process, you are always hoping for a thick envelope. Rejection comes in skinny little form letters, while acceptance arrives fat and heavy, in envelopes redolent with course catalogs and tuition plans. The investment management business is different; you should always be hoping for a skinny envelope. Excuses consume acres of print, while outperformance explains itself. We were down the first two quarters of the year, and suitably loquacious. We are now outperforming the Standard & Poors 500 Index by a little, and the Dow Industrials by a little more, and so intend to be suitably terse in this letter.
Our slight outperformance shouldn’t mask a walloping big mistake. We have not owned oil stocks this year, and that has been a very big gaffe. For the first nine months the energy sector of the S&P Index is up 39.96 percent. Without this remarkable boost from 10% of the Index, the S&P would be down 1.3%, rather than ahead, in terms of total return, by 2.8%. This is a very big swing, and there are some reasons to think it may not be over. In the Spring of last year, crude oil inventories were at a very low level in the U.S., roughly 250 million barrels. In the last 18 months, they have been restored to roughly 325 million barrels, before hurricanes began playing Hob with America’s major source of domestic supply. This is the sort of cycle-timing we have moved so far away from, and it would be disingenuous of us not to note that our attitude can sometimes let juicy opportunities go by.
Worse yet, we intend to stick with our knitting, even after acknowledging in the paragraph above that the worst of the oil shock may not be over. We throw this hostage to Fortune because we have been reading Matthew Simmons’ new book, “Twilight in the Desert.” Simmons’ book examines what we know, what we don’t know, and what we have reason to be suspicious about in the reserve calculations of Saudi Arabia’s giant oil fields. The world is already pinched with hunger for Saudi oil, and in the next five years Saudi growth is what the world is keenly counting on. Simmons doubts this growth is feasible, and his doubts are not of the typical economic know-nothing kind so common at commodity tops, but rather a closely reasoned set of geological assumptions that may prove uncomfortably right.
We know one thing with certainty. We do not have the intellectual resources to weigh his arguments in the balance, and then hazard a large amount of money on our judgment. We can’t tell an oil field survey from an aerial view of San Diego. Most of Wall Street is in this boat with us, but has an amazing propensity to convince itself otherwise.
Our other conviction is that we stand a nice chance of prospering even without clairvoyance about which rocks sustain the best oil pressures. Witness the fact that we are slightly ahead despite the worst market timing blunder in the last five years. We own good businesses with great cash flow characteristics that have been growing nicely throughout this economic recovery. We have a reasonably easy time identifying them, and we know something about what price to pay for them. Since mistakes are always going to happen in the investment process, we hope it is instructive to point out what happens with our style when we get it cyclically very wrong. The results are slightly better than blah. We leave it to your own imagination as to what happens to people who get cycles wrong and own poor businesses. Timing markets, of course, is also really hard, and has not gotten any easier in recent years with dozens of broadcast channels pumping out non-stop advice 168 hours a week on just that subject.
Meanwhile, on a related front, the October 3rd issue of Business Week notes that this year America is likely to borrow 6.4% of its total economic output from abroad, next year they hazard the prediction that this imbalance will top 7% of our output, and want to know how long this can go on. They even print a chart showing how this trend has grown from a relatively minor problem in 1995 at 1.5% of GDP, and extrapolate where it might get to in three years time. Children read these letters; we are not going to reproduce the chart, as it is not fit for family viewing.
The size of the American trade deficit has been a bugaboo of ours for many years, which is partly why we are quoting Business Week, so that it doesn’t seem as though we are the lone alarmists. The late economist Herbert Stein was fond of pointing out, “If a thing can’t go on forever, it will eventually stop.” This problem has persisted so long that it seems to have defeated Stein’s tautology. Yet it is what has gotten us to buy Nike this quarter, and we hope to find more ways in every quarter to shield ourselves from a coming dollar devaluation we can just feel in our bones. Nike gets 53% of its revenues from abroad, and that number has been increasing for years. It is the world’s dominant clothing and shoe manufacturer, and it does it without owning a single factory. That is a really neat trick, and getting other people to commit capital to building a physical plant that is sure to obsolesce, while you reap ever fatter margins, is the business strategy Phil Knight invented more than twenty years ago. We salute him for it, and now we join him in it.
Finally, because we have two sizeable positions directly tied to the housing market, Countrywide Financial and Fidelity National, we read every “Housing Bubble” article we can get our hands on. Our hands are full, the “bubble” having become a popular press sensation, but we would like to utter a modest demurrer. We have watched, with widening eyes, the government response to the hurricanes’ damage. Leaving aside the competence issue, and focusing only on cost, we have gone from a forecasted federal outlay of $50 billion, then $150 billion, now $250 billion, all in a month. This is 7/8 the size of the previous estimate of the federal budget for the year, and it is not offset by a spending cut or a tax increase we can name. Can we really treat the credit of the United States like this without repercussion? We ask because we owned bonds twenty years ago when the creditworthiness of the United States was very much under attack, and we remember bond market vigilantes, and Blue Dog Democrats, and angry Republicans assailing Bob Dole as, “the paymaster of the welfare state.” Perhaps our hearing is gone, but the howl from the usual watchdog groups seems very dim indeed. If that’s the case, then maybe the collapse to come isn’t in the housing market, but in the value of the dollar. It would have as precedent the history of every fiat money regime that ever existed; a history that has the remarkable ability to always take us by surprise at each repetition.
Sincerely,
Edwin A. Levy
Michael J. Harkins