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| April 2, 2008 |
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| Dear Client,
For the first quarter of 2008 our average account depreciated -5.37%. The first quarter of 2008 was fear filled and difficult. We lost a small amount of money and while all losses are bad, it is crucial to the compounding process to keep mistakes modest in size. These last nine months have been one long confession of error for all of Wall Street, us included, and if ever a business could be said to be in need of a dose of humility, surely one that routinely got itself leveraged 35 to 1 ought to lead the list. We learned from the Long Term Capital fiasco ten years ago that even the most brilliant ideas are crummy investments if they are leveraged enough when the tide goes out, and this remedial lesson has been painful to the entire investment community. That it is worse agony to others is cold comfort to us. Having never seen fear like this before it would be folly to assert certainty about anything, but we are duty bound to hazard the question, aren’t the authorities brewing up the next bout of inflation? Aren’t these the same policies that gave us the last two bubbles, first in internet stocks, then in housing? If everyone can borrow billions from the Federal Reserve Bank, posting any kind of dodgy collateral that comes to hand, at 2½% pretty nearly indefinitely, doesn’t this lessen the value of the dollar in the long run? We have worked hard in the last year to buy businesses that have at least 50% of their income streams coming from abroad. We are at it still, and we think it will pay off in spades when the current near hysteria wears off. In our 28 year history we have always been leery of “growth stocks” not because we have something against growth; far from it. It is just that to get a 15% growth rate you mostly had to pay a 30 multiple of earnings, and if a firm stumbles and disappoints, the result is so immoderately painful that we just couldn’t stomach it. Imagine our wonder then in telling you that you own two stocks, connected to India, that grow at 35% plus rates, but sell at multiples of about 17 times this year’s earnings. A growth rate that is twice the multiple of earnings stands the old paradigm on its head, and can probably only happen in circumstances as extreme as these. The two companies are ICICI Bank, which we have written to you about once before, and Cognizant Technology, which we have only just been buying. Cognizant is an American company, based in Teaneck, New Jersey, with an Indian workforce based on seven campuses throughout the subcontinent. This is a unique information outsourcing method, in that every client gets “two in the box” treatment, having one American representative to contact during U.S. business hours, and then an Indian agent to talk to as the data is actively being processed all through the Asian work day. At a recent dinner management told us that it believed it would have 38% growth this year, with 90% of that growth coming from existing clients. After chewing that over for a minute, we asked, “How can that be?” The chief financial officer told us, “When we get a client, we typically do one thing for them, like processing checks for a bank, or doing payrolls for a manufacturer. It takes them five years to realize we can do all their data processing for less. It is a long sales cycle.” He went on to tell us his cost advantage is more than 50% over American do it your selfers in most cases. When asked repeatedly about an American recession, the chief executive officer said he didn’t see it affecting Cognizant because, “We save people money. They need us more now.” In ICICI Bank and Cognizant we are getting Chinese growth rates at American distress multiples. Their cost advantages over American firms are so pronounced we can’t see how any U.S. firm could compete against them, so we decided to join them instead. Oddly enough, our Tupperware investment is down the same alley of thought. Yes, Tupperware. We bet you think the company is selling the same old milky white plastic that burps to American housewives, no? Well, it is and it isn’t. For one thing, 85% of its revenue comes from outside the United States, which for an Orlando based firm is about as international as you can get. Next, almost half of these sales come from beauty aids, meaning everything from lipsticks to lotions to fragrances. In the third world, direct selling by Tupperware’s 2 million strong consultants is a powerful method of distribution. As CEO Rick Goings likes to point out, 10 miles outside Jakarta or Rio, tobacco is sold by the cigarette, as in one at a time. There are no big box stores to compete with. At less than 14 times this year’s earnings when we bought it, it’s another chance to get a third world growth rate at an American multiple. It also generates cash in torrents, and is as recession proof as they make businesses. The fact that everyone thinks they know Tupperware, and are wrong, ought to make for a series of pleasant upside surprises. American Express is an international business with a valuation problem about as schizophrenic as any we have ever seen. 46% of Amex’s revenues last year came from the fees it collects from merchants and vendors every time you use the card. Wall Street loves this business, and has rewarded Amex’s two competitors in the network fee business, Visa and MasterCard, with huge multiples of earnings, each more than 30 times this year’s estimates. American Express is also in the credit extension business, this to the tune of 19% of revenues. Wall Street loathes this business, as it worries, perhaps rightly, about the credit crunch lasting longer than can be anticipated today. But demographics work on Amex’s behalf. Its average customer is many times wealthier and spends some 7 times more than the average bank credit card customer. They couldn’t be further from the subprime crowd. You can sense the frustration in Ken Chenault’s voice when he writes in the most recent Chairman’s letter, “Our business model is built on driving card member spending. Lending is a planned and profitable outcome of our spend-centric strategy..., but it is not our primary focus.” Last year Amex was “spend-centric” indeed, adding new card members at an 11% rate, while not compromising on credit worthiness. They also collected $1.7 billion in fines from Visa for anti-competitive marketing, and are still waiting to hear from MasterCard. If the sainted half of the business sold at Visa’s multiple, the stock would go up 50%, and we could throw out the other half. This would be crazy business strategy, but illustrates how punch drunk the stock market is today. Moments of great fear produce great bargains. The trick in bargain hunting lies in not shooting yourself in the foot by being too early and too aggressive. In buying stocks for you lately we do not mean to be cavalier or dismissive of the fears currently bedeviling the bond market. The deleveraging we alluded to in the first paragraph is much needed, long overdue, likely to take a while and certain to be painful. But the authorities are fully engaged, and have never been so aggressive or inventive. Betting against them when they are in this mindset has never worked before. With all the ink being spilt over our troubles, the astonishing level of interest rates often goes overlooked. No one can afford to retire with a conservative bond portfolio and hope to live many years off the income, at these rates, and particularly not if inflation stays here or worsens. Down that road lies poverty. No school, or pension plan or endowment is set to weather a long spell of these rates. Anyone with an assumed rate of return that supposes “the good old days” of 7% or 8% interest rates returns quickly is going to be sorely disappointed if current 3% rates hang around very long. It seems hard to believe, but when the current gloom lifts all sorts of people are likely to discover not simply that they should own stocks, but that they must own stocks if they are to have any chance to keep their purchasing power intact. We make no predictions as to when that day dawns, except to say that nine months is a long time for Wall Street to be paralyzed with fear. And we have some remarkable bargains when the new day gets here. Sincerely, Edwin A. Levy Michael J. Harkins |