 |
 |
 |
 |
 |
 |
 |
 |
| October 9, 2006 |
 |
| Dear Client,
For the first nine months of 2006, our average account appreciated by +3.0%. We are long term investors. We intend to stay long term investors. But once upon a time in the not so distant past one aspect of the long term seemed more predictable than now. Whether or not a business had a moat around it, - that is, was it hard for a competitor to chip away at a firm’s margins or market share? - was a fairly predictable phenomenon. The exact depth of a moat never was known too exactly, otherwise the Justice Department might come snooping around asking awkward antitrust questions. Still, seasoned investors were sure to agree amongst themselves that some industries really punished new entrants, and others would always be bedeviled by them. Warren Buffett once famously remarked that if given $1 billion and told to go compete with the “Wall Street Journal” he would have to, albeit reluctantly, give the money back and say, “No thanks.” The Journal’s niche was just that clearly marked. Now, of course, he says, “If the internet had been invented first, do you think we’d have newspapers today?” That is really a mouthful, because if you knew the name of any town or city’s big newspaper 50 years ago, chances are it’s the same name today. Yet virtually all of them are under such a state of siege today that you are unlikely to know half their names five years from now. We sold Gannett some months ago and chalked it up only as internet road kill. Subsequent thinking has us wondering more and more about that. With money so very easy to come by, and every sort of scheme getting funded in the private equity market, if not the public markets, maybe moats can be bridged with bricks of cash? It is feeling that way to us, and it leads to two disparate ideas. One is that the companies that truly do have moats are worth even more than we all thought, scarcity value being what it is. The second thought is that you had better be checking the first proposition on a daily basis. All sorts of competitors may have snuck up on you in the night. As the old saw goes, “You are not paranoid if they really are all out to get you.” Worst of all, such a long stretch of easy money hasn’t just made competitive conditions harder. Easy money also increases risk. Perhaps the best way to measure risk is the new, arcane, and explosively growing market in credit default swaps. These are bets that a borrower will not go bust over a specific number of months or years, rather like a life insurance contract on a corporation, or so we are told by their promoters at the major investment banks. What they leave out is that insurance companies are heavily regulated entities, frequently examined by state commissioners, and the credit default market is regulated by no one. There isn’t even a theory in government as to who should monitor them. Worse yet, the premiums that are being collected on this so-called insurance is the lowest in “history.” We write history in sneer quotes here because the whole point is this market doesn’t yet have a history, but it has the feel of providing cover for risk taking no one is properly aware of. Not to worry, we have been told, because sophisticated back-dated models allow the ratings agencies, mostly Moody’s and Standard & Poor’s, to determine what would have happened and how many losses would have occurred had they been in place in the past. This is a little like declaring Alex Rodriguez lost the game for the Yankees in the sixth inning when he didn’t get a walk, the next Yankee up hit a homerun, and the team loses by one. The fallacy lies in thinking the opposing pitcher, the opposing catcher, or their manager would have done nothing differently if A-Rod were on first, while it is almost guaranteed they would have done everything differently had that been the case. Credit default swaps give us the creepy feeling that not only would everything be different if they didn’t exist, but many things would be opposite. Projects wouldn’t be built, houses wouldn’t be so large, acquisitions would not be made, and on and on. And such a radical change in conduct can be guaranteed safe at the cost of a handful of basis points? Puts us in mind of the wry wisdom of Paul Samuelson, who said, “The problem with history is that we have only one sample of it.” That all the risks inherent in capitalism can be taken out of it at the cost of a few dimes per million at risk is a loopy and dangerous idea. This bears vigilant watching. Not to end on such a gloomy note, we recently spent the day with Angelo Mozilo and his team from Countrywide Financial. It is a pleasure to write about him. There may be more hard knocks to come in the housing market; indeed, we would be surprised if there weren’t. But Countrywide can be trusted to tell it straight. As Mozilo himself says when asked about a soft landing in housing, “In 30 years in this business I’ve never seen one.” That sentence neatly illustrates the man. He makes a great effort to explain a complex business in a plain way, he follows the spirit of full disclosure and not just the form, and every time he has ever been asked a question that stumps him on the many conference calls we have listened in to, he invariably says, “We’ll have that on the next call,” and he always does. His genuine devotion to the American homeowner got us to ruminating that at most times and in most places if someone had more guns than you, he owned your house. Even in America, Hollywood has made countless Westerns with this grim observation in mind. Around the world, that has changed quickly and profoundly. Roughly a billion people, in China and India and Russia, are getting the chance to own their own homes for the first time. It is uplifting, it is a way of creating untold wealth for these people, and it plants capitalist roots in society far deeper than any others. It also leads us to ask, to the varied and knowledgeable readers of this letter, “Anybody know the Chinese Countrywide Credit, or the Indian Angelo Mozilo?” Finally, after ten enjoyable years at beautiful 570 Lexington Avenue, we are moving. We have just plain outgrown this space, as there isn’t space to put another person or box. We have signed a new lease on much more space at 366 Madison Avenue, at the corner of 46th Street. Building has started, and while we hope to move in before year end, we know better than to count on anything this size ever going smoothly. If we have a day or two when we are hard to reach or slow getting back to you, we want to apologize in advance. Come see the new digs at your leisure. Sincerely, Edwin A. Levy Michael J. Harkins James B. Lebenthal |