Oct2008

October 13, 2008

Dear Client,

For the first 9 months of 2008 our average account depreciated -18.25%.

“In my adult lifetime, I don’t think I’ve ever seen people as fearful economically as they are right now.”
                                           Warren Buffett in an interview with Charlie Rose

In the ten days since Warren Buffett said this, markets have worsened considerably. Share prices are down sharply worldwide, credit markets are almost completely frozen, and the traditional fear gauge in the United States, the Vix index, is at all time highs, and by quite a large margin too. All of the authorities’ attempts at assuaging the fear, from the Congressional authorization of the $700 billion mortgage flotation, to the weekend rescue of European banks, to last week’s interest rate cuts, all have come to naught. The markets are saying this time it’s different, and a return to prosperity is far away. Are they right?

It would be real foolishness to say out of hand they are wrong. These are truly extraordinary times. In the last hundred years, we only have two periods to compare to this, and they are unhappy comparisons. There was the 1929 to 1932 “break”, which segued to the Great Depression, and the 1990 Nikkei crash, which led to Japan’s lost decade. That is a small sample size to make sweeping generalizations, but two things are clearly different this time from those. One difference is valuation. Stocks were about 100 times real operating earnings in both 1929 America and 1989 Japan, and the public was wildly in love with their shareholdings in each case. The U.S. stock market is about 15 times normalized earnings now. The other crowning difference is the attitude of the authorities. The Ministry of Finance and the Bank of Japan were at best indifferent to the plight of the Japanese financial woes in the early 1990’s. The Hoover era Treasury and Federal Reserve were actively hostile to banks, allowing thousands to fail and reducing the money supply by a third. American policy in 2008 couldn’t be more different from that of 1929.
At the beginning of this year the Federal Reserve had a balance sheet that footed to about $750 billion. It was doling out credit in small dollops. Ten months later, the Fed looks like nothing so much as a fireboat in New York harbor on the fourth of July. Money is spraying everywhere, direction matters little, and volume pumped is all. On Thursday the Fed will likely report its balance sheet has doubled, to $1.5 trillion, and is almost certain to top $2 trillion by year end just off the continuation of current measures. Add in the Treasury’s $700 billion bank rescue package, and the $350 billion or so on stimulus packages past and future, and about $2.5 trillion of economic stimulus will have been implemented in eight months time.

Over the weekend just past, European and Asian central banks made a similar
u-turn as the stalwart German Chancellor Angela Merkel went from “Never!” in her policy against bank bailouts to, “Ok, 400 billion Euros.” in approximately 72 hours. We are not making light of the Chancellor’s plight. All around the world governments and monetary authorities are panicky, and they are now making ground breaking policy day to day, hoping to find the magic bullet. Fear clouds everyone’s vision, but in this dire market, vision has foreshortened to the vanishing point. So, where are we likely to be a year from now?

In a recession, quite likely, because this has been such a shock to the system. So the companies we own had better be able to weather that. Nike, McDonalds, and Qualcomm have all reported record results recently, and expect to keep doing so as they are leaders in their markets they cannot be displaced by competition anytime soon. Caterpillar, Deere, and Boeing are industry leaders with immense backlogs, and while some of those orders may get cancelled, people don’t walk away from big deposits with nothing in return without thinking about it long and hard. Also, most of those orders are from abroad, and are soundly financed. Boeing said late last week for example, that it hasn’t lost one order yet from the effects of the credit crunch. Even if some cancellations loom, Boeing, Deere, and Caterpillar are priced as though no one is ever going to fly, eat or dig again. Somehow or other they will.

Berkshire Hathaway, our largest holding, also stands to be the surest beneficiary from all the bloodletting. People come to Berkshire with lush investment proposals not simply because they want money, but also because they want the seal of approval that comes from Warren Buffett’s imprimatur. Add to that, Berkshire’s biggest insurance competitor, AIG, is in rapid forced liquidation. Berkshire has the field to itself in large property and casualty insurance, in municipal bond insurance, and in large re-insurance policies. Buffett and his team are not shy about charging high premiums for their services, and operating income is likely to soar as the fee increases make their way to the bottom line.

Up and down our roster, the firms are performing well. Cognizant is still nabbing outsourced computer work at a 30% + rate because companies need the cost savings that come from Indian back office efficiency. Tupperware is making women prettier and keeping food fresher. The month before last Enerplus increased the already hefty dividends it pays us by almost 10%, and sold a property on such favorable terms the dividend is likely secure for quite some time regardless of market condition. Yet we know as well as anyone that on days like Thursday and Friday value has no standing with anyone, the urge is so strong to “get me out.” Why then take the risk of ownership?

For one thing, because we think the worst may be over. While predicting market bottoms is worse than a waste of time, identifying them after they’re past can be profitable, and if last week wasn’t the end of the world we could see it from there. Also, the governments pouring money into banks do not have it lying at hand. They have to print it, and while that process is just getting underway the inflation that will come in its wake is going to be either large or really big. The curious role that Ben Bernanke has played in the rescue has gone largely unremarked. While Treasury Secretary Hank Paulson is mostly front and center, he is going to be gone soon, and the Fed Chairman will be around for a long time. Hiking interest rates is always hard to do once the inflationary consequence of a bailout becomes plain, but how much harder will it be when the architect is called on to begin dismantling his own creation? This is a conflict of interest of great proportions that has gone unnoticed until now.

Bull markets need cheap values, easy money, and fear. We have all these in abundance now. We are in a treasury bill bubble and when it bursts, stocks will be seen to be much better values.

       Sincerely,

       Edwin A. Levy

       Michael J. Harkins