April 4, 2013

Dear Client,

For the first quarter of 2013, our average account gained approximately +5.6%.

Monetary mileposts have gone past at blinding speed in the last five years.  We are now on the, “We don’t like you!”, standard of central banking after the last few days of the first quarter when insured deposits on two Cypriot banks were not honored.  After famously castigating America in the wake of the Lehman Brothers failure with, “Europeans wouldn’t let a dry cleaner fail,” the European authorities decided they wouldn’t honor deposit guarantees with people they, well, didn’t like.  The line remained blurry, of course.  If you like cucumber sandwiches with the crust cut off and I like pulled pork, do I get to not pay you?  That is unclear at this writing.  So was the size of the Cypriot haircut on those the Europeans didn’t like.  It went from less than 10% to more than 60% in the space of 2 weeks.  That this is unfair is manifest.  That it is stupid as policy is equally plain, as it saps confidence at a delicate moment for no real money gained.

And the confusion goes on.  Today “der Speigel” quotes Jeroen Dijsselbloem, the Dutch Finance minister and architect of the Cyprus plan, as saying the Cypriot model is the new template for all troubled European banks.  Commenting on the unwisdom of annunciating that policy clearly to Spanish and Italian account holders, Spiegel goes on later to call him “Dusselbloem”, which has the dual benefit of being pronounceable and meaning “Dimwit flower” in German.

Monday’s Time magazine has an interview with Christine Lagarde, head of the International Fund, with the exact opposite view, saying Cyprus is a unique case, a one-off not to be repeated.  Espousing European unity, she is quoted as saying, “Europe is only half-built and half safe.”  Two policies everyday seems like a lot.  By the way, Time runs a picture of Ms. Lagarde at a recent IMF meeting in Japan with her fellow finance ministers.  By our count, the picture holds 26 men and one woman.  If you are looking to build consensus, perhaps that’s not the way to go.  But there is no doubt the confusion is troubling all sorts of people.

We have said in letter after letter that central bankers are pursuing never before seen policies, taking risks no one knows how to gauge.  In recent days the pace has quickened, unbelievably, as Japan, Europe, the Bank of England and the Fed have all openly avowed they would like higher inflation rates.  If you have been around for more than twenty years you have to rub your eyes as you read the papers.  Inflation was so hard to kill last time.  Can it really be such an effort to re-start?  And with prices already rising to boot?

We start the year’s buoyant first quarter behind the averages by a few percentage points, and that is annoying to us, as we might suppose it is to you.  But we’d like to beg a word in our own self-defense.  This past Thursday the first quarter closed with the S&P 500 Index at its all time high, just slightly bettering its close in the first days of the fourth quarter 2007.  From then to now came the second worst financial crisis the country has ever known and a dreadful recession.  Taken from September 30, 2007 to last Thursday at quarter end, Levy, Harkins is ahead 25% and the S&P Index is 2.5% higher.  To be sure, the dividends on the S&P have to be thrown in to make the comparison fair, but then so do index fund expenses and re-balancing charges.  Net of it all, our lead is about 12 percentage points, which is worth having over the 5 ½ years but the lesser part of the story.  The bigger story is that we went down less and bounced back faster through all the dreadfulness.  That means you were much less likely to pull the rip chord on your parachute, guaranteeing you the Earth bound returns of Mr. Bernanke and not the newly regenerated stock market.  You also went to bed knowing every night if the commercial paper market stayed closed forever it wouldn’t impede Tupperware in the least, but GE might miss payroll.  That felt a lot better, and that counts for a lot too.  We stick only with companies that generate high cash returns without using significant leverage to do it.  It is surprising they are not better loved right now compared to run-of-the-mill dross, but then a sound night’s sleep is a charming dividend in its own right.

Going forward we like our chances.  In a world that is still a mess America is clearly leading from the front.  We have been writing about the energy boom for three years now, and our hopes have been exceeded all the time.  We seem to be adding oil production at the rate of a million barrels a day per year.  With coal exports and perhaps natural gas exports we might be looking at energy independence by the end of the decade.  Amazing, that.

What is almost equally amazing is that credit spreads have come down all the way to the levels of 2005-2007.  We caught ourselves ranting the other week about the foolishness of investors being willing to take such risks again so soon after epic punishment, when we caught ourselves mid-rant and thought, “Ranting is not what we are paid to do.  Making money is.”  Days later we were buying shares of Kohlberg, Kravis and Roberts.  Considering what we have had to say about leveraged buyouts over the years this purchase is either beguiling flexibility or rank hypocrisy.  We will let you decide.  But the company was selling as if it should just be valued at its existing cash and investments, that is, as though the underlying business of making new deals is valueless.  We may not know what that worth really is, but if we were getting it for nothing, that’s the right price.  Especially at a time where the deal business is hotting up.

“Something for nothing” seems to be the theme around here these days.  In a yield famished world how long will it be until investors discover that Apple, Qualcomm, Tupperware, McDonalds, Walmart, Boeing and KKR all yield at least more than half a point more than U.S. Treasuries?  They are all likely to increase those dividends in the near future.  Ignoring these world beaters is decidedly strange behavior on the part of the rentier class, but it ought to pay one big dividend to us when Wall Street comes to its senses.  We can’t wait for the moment.

Sincerely yours,

Edwin A. Levy

Michael J. Harkins