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| January 4, 2010 |
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Dear Client, 2009 was a very good year for Levy, Harkins & Company. America is outraged by this. Well, maybe not all the country and not specifically us perhaps, but financial types are in bad odor. They should be. Economic distress may not have grown any worse in the last six months, but that is a far cry from prosperity. The Conference Board Index that we wrote to you about in the worst of the panic in March has just about doubled, and it still languishes at about the rate of December 1974, the bleakest nadir of what used to be called “The Great Recession”. Bankers’ bonuses amidst this pain hurt doubly; it seems to reward the wicked. In Britain, they have even invented a new tax rate designed to punish banks the government despises. Is this lawful? The public is too angry to ask or care. Meanwhile bailouts for this lot march on. On Christmas Eve the American Treasury announced it was waiving the $200 billion limit on loans they might make to Fannie Mae and Freddie Mac, essentially declaring the Treasury would simply give them whatever cash was necessary. There was no Congressional authorization of this, and up to now not even any mention something highly irregular occurred. Does Treasury Secretary Timothy Geithner now have the power to print money and hand it to people? None of his 74 predecessors thought so, but then he is very energetic. So is his counterpart at the Federal Reserve Board Ben Bernanke, who spent a large part of December testifying before the Senate Finance panel that the Fed was perfectly in control of events now, and would be in the future too, removing stimulus in perfectly measured doses, and hiking interest rates at just the right moment. It got us to wondering, “How could he know that?” After all, before the housing crisis struck, bankers assured us again and again that the housing market in the United States had never had a sweeping downturn. No one thought to ask them, “Yes, but you have never lent money like this to the real estate market either. So what good is the predictive power of the past if current practices are all new and different. Why would tomorrow look like yesterday if we are doing once in a lifetime things today?” Investors have grown numb to how many ways the government is emitting money, and just how sharp a departure this is from all previous practice. Last week the Treasury casually informed us GMAC needed some billions more, exactly how much was left vague, and the news barely made the papers. Are the Federal Reserve and the Treasury really so prescient they can be treated like this, without oversight or limit? You would not think so if you read either of two marvelous books out in the fourth quarter, Andrew Ross Sorkin’s Too Big To Fail or David Wessel’s In Fed We Trust. They are both ripping good yarns detailing just how close we came to financial Armageddon in late 2008 and early 2009. We can save you 700 pages of reading right now. Seemingly everyone in American finance collaborated with the two authors, including government officials, often times with a candor that is amazing. Here is the salient point of both books: The authorities didn’t have a clue what was going on in the nation’s banks, didn’t understand the consequence of Lehman’s collapse, and had no notion that money market funds were in distress. AIG was thought to need $5 billion to tide it through a weekend; it has now absorbed $185 billion and we still do not know if it is fixed. The authorities were constantly foisting weak banks onto bigger banks who were, unbeknownst to the authorities, even sicker. Indeed, they usually found out something was amiss at an institution after a run was three to five days underway and then their invariable solution was to tide a failing bank over to Friday afternoon, in the hope that someone would arrive with a magic potion by sometime Sunday night. Both authors get people to say shocking things about their own confusion and bewilderment. But now, at a calmer moment, Secretary Geithner and Chairman Bernanke are full of confidence in a stable future. How could they know that? They can’t and they don’t, of course. Mr. Bernanke, up for a second term, recently cleared the Senate Finance panel by a 16 to 7 vote. Reminds us of the story of the sick mayor who is told the City council wishes him a complete recovery, by a 25 to 24 vote. Chairman Bernanke still has the full Senate to get past, and how many ways will they find to pressure him to keep short term rates extremely low, to keep the spigot wide open? We do not mean to sound so awfully harsh about the authorities. They were in a tight spot. But Milton Friedman passed away last year, and he told us, “Inflation is always and everywhere a monetary phenomenon. It is too much money chasing too few goods.” It leaves us thinking the British brain box who invented the expression “Quantitative Easing” deserves both a Pulitzer Prize and hanging in the same week. If printing money was the easy way out of distress, Zimbabwe would be Utopia. It is instead Hellish. Nonetheless, two recent phenomena have sprung up in the last six months to make us think inflation is still coming, but maybe these Goldilocks moments can linger a little longer. The first is the turnaround in the energy outlook, scarcely remarked upon and all the more interesting for that. Think back to the summer of 2007, with oil prices $145 a barrel and the hopelessness of peak oil our only prospect. Then in November 2007 the Brazilians announced the discovery of the Tupi Field, which they have now identified as the Campos Basin, and one of the biggest in the world. This oil is frightfully hard to get at, under more than 10,000 feet of ocean, then under 10,000 feet deep in the earth, and more than 180 miles offshore. It is very expensive to produce, but the costs of getting it are highly front-end loaded. Once Petrobras says, “Start” it is very difficult to say “Stop”. Even more remarkable is the Marcellus gas play here in the shale of the Eastern U.S. It is reached by a new form of drilling technology, and has led the Energy Department to increase its estimates of onshore U.S. natural gas reserves by 35% in two years. Shale is found all over the world, and no other country has even punched a hole with similar technology in the ground to look for it yet. Finally there are the remarkable events in the north end of the Persian Gulf. At an OPEC meeting two weeks ago in Angola, Iraq declared it will increase production by 10 million barrels a day in ten years time. Can they? They have signed seven oil majors up for the effort, and that was a stumbling block that took six years to lift. And the Iranians are in near revolution, giving hope that benighted place might at last leave the rogues’ gallery of nations. The supply side of the energy market has hope today, where it had none two years ago. Reminds us of the old adage in the commodities market, “The best cure for high prices is high prices.” On the demand side for commodities there is only one question. Whither China? Europe and North America haven’t used more of anything in years, and aren’t likely to in the next decade ahead. Marginal demand was in China, and that’s what moves prices. And China looks increasingly dodgy to us. Some of you will remember how we benefited greatly by the share price collapse in Japan in 1990. We were a little early, to be sure, but the payoff made up for it. Now look at the similarities. In Japan, you needed an in with the LDP to get a loan, but with that nobody asked many more questions. In China, it’s the PLA; same difference, with a lot of extra guns. Business Week tells us in the January 11th edition that the average apartment in Beijing now goes for 80 times the average workers’ annual salary. Floridians know that is not sustainable. For the first time in Chinese history, housing, at least in an economic sense, is in over supply. Whole neighborhoods stand vacant because buyers can’t be found, and banks are holding these loans. Sound familiar? China has long been considered a dead certainty by people who have never been there and do not understand the culture. Think how invulnerable the Japanese were twenty years ago, and then if you know of a cheap put on China, give us a call. If China has a comeuppance like Japan, the world may prove a poorer place, but we can make a lot of money. We want to end this letter as we began, assuring you that we know just how miserable the economy is. When Warren Buffett said in March, “The economy has fallen off a cliff” he proved right, and climbing back is hard, steep work. Cliff faces are also dangerous places, and we are collectively going to be living on one for at least the rest of this year. But we ought to share a moment of quiet pride in what we have done as managers and you have done as clients. We have outperformed the major stock averages almost double, and the bond market by a margin that doesn’t need mentioning. We told you the companies whose shares we were buying were still thriving, and that their plunging share prices were good for us all at that moment, and would reverse eventually to our benefit. That is the essence of value investing. You stuck with us, and for that we are grateful. Now we own the best of the best and while they too can get overpriced, they can’t do it without making us a profit first. If we are right to fear inflation as we do, then many comforting bromides get turned on their heads. Cash turns out to be amongst the worst investments, for any month you do not make money is a step backwards. The investments we own now spit out cash at prodigious rates, and are likely to outpace any gold brick ever mined. Sincerely yours, Edwin A. Levy Michael J. Harkins Levy Harkins Rates of Return Since Inception 1980 Rates are Compounded Rates of Return After Fees 2009 +40.54% Last 15 Years +11.96% Since Inception 1980 +12.4% NOTE: The figures above represent the composite performance of all fully discretionary, balanced accounts. These figures exclude accounts managed for less than 6 months, accounts using short selling and accounts consisting only of fixed income investments, to more accurately reflect the past performance of fully discretionary, balanced accounts. These numbers are after all fees. However, past performance is no guarantee of future results. |