October 10, 2011

Dear Client,

For the first 9 months of 2011 our average account depreciated approximately -12.62%.

European banking woes dominated every asset class in the third quarter, sending everything associated with “risk” sharply lower, and cash, German bunds, and American bonds sharply higher.  We wrote in our last letter that the expression “Greek bailout” was the misnomer of the decade.  The Greek people face austerity and privation for a very long time.  The bailout cash is going to French and Belgian bankers, circuitously to be sure, but the Greeks will touch the money for mere seconds.  How to pull off this shell game, where the French guarantee debts without the markets noticing France is already overstretched, is the conundrum.  Every 10 days or so we have another meeting, where Frau` Merkel and M. Sarkozy resemble nothing so much as two inebriates trying to hold up a lamppost.  Confidence has been badly dented, and we should have seen this more clearly 3 months ago.  Meanwhile, the continent continues casting about for a French Jimmy Stewart to restore calm.  Good luck with that.

The only place overwhelming force has been brought to bear is on the monetary front, where the world’s central banks have been printing money at a maniacal pace, and the markets are dead set in ignoring their efforts.  America leads the league on this score, as ten year yields reached 1.8% and stayed there for much of the quarter, taunting the last of the bond market vigilantes in a way that would make a school yard bully blush.  What the markets refuse to notice is that M2 has grown 10.3% year over year, M1 has grown 20.2%, and over the last quarter those growth rates have accelerated to 25% and 42% respectively.  Milton Friedman said in 1970, “Inflation is always and everywhere a monetary event.”  Rather a long time not to get the memo.  To be sure, there is a small technical factor that has slightly distorted the picture.  American banks have stopped sweeping unused cash into Eurodollar accounts to earn a few extra pennies every night in Euroland, and who can blame them for that?  This technical glitch might be distorting growth rates by a percentage point or two.  But it does nothing to gainsay Chinese inflation breeching 7%, or the Bank of England printing £75 billion more when inflation is already 5%, and interest rates are effectively zero.  Currency debauchery is a worldwide phenomenon.  Even the dour Swiss have lost their heads, as the assets of the Swiss National Bank have shown annualized growth of over 250% in the three months through August.  Central bankers manipulating markets this brazenly and on such scale has never been seen before.  It already has had weird side effects.  Ireland, the first of the Euroland countries to be bailed out, saw the yields on its 10 year bonds almost halve in the last six months, from 14% to 7.7% today.  Bond buyers are stuck judging a beauty contest with a lot of really ugly girls.

The authorities tell us not to worry about any of this.  They will ride to the rescue and slay the inflationary dragon right on time.  They are often the same people who gave amazingly candid interviews to Ron Suskind in his new book Confidence Men , in which they admit to being clueless three and a half years ago, when the banking crisis first began.  Other layers of government seem to be more knowing.  The Long Island Railroad refuses to sell a ticket that is good for longer than two weeks.  When asked why, the conductor replies, “Guess they’re planning on raising their prices again.”  That man stands no chance of getting a posting at the Fed, and mores the pity.

That we have suffered quotational losses on our holdings is vexing, but that hides the fact that these are remarkably good times to be a capitalist.  Warren Buffet announced that his Berkshire Hathaway is really cheap, that he doesn’t think you should sell it to him, but if you wanted to he would buy shares back from you at 110% of book value.  The stock promptly traded at a 4% discount to his bid.  Has anyone ever traded a used car like this, where the dealer said $10,000, and the seller said, “Ah, no, $9,600 is the most I’ll take.” ?  Financial markets can be really perverse places.

We have story after story like this.  In mid-quarter we traded shares in Western Union, the poor man’s American Express, for shares in Apple, everyone’s model of success. Western Union has debt, Apple has none, being loaded with cash, and they sell for roughly the same multiple of earnings after adjusting out Apple’s cash.  It was a switch that cried out for making.  Then Apple’s iconic chief executive Steve Jobs passed away, and we have gotten a weeklong tutorial in the vigor of American exceptionalism.  Although biologically half Syrian, he was utterly all American.  He could never have flourished to anything like the degree he did anywhere else on Earth.  Not even a college graduate, Jobs didn’t waste a minute in 56 years thinking about what he couldn’t do.  And what other society would celebrate a businessman and a capitalist like this in every magazine in the nation?

As harsh as this recession is to workers, home owners, savers, and graduating school kids, it has been remarkably profitable to large businesses.  Caterpillar Tractor is likely to have revenues about $2 billion dollars less than it did 3 years ago, and earn about $1.5 billion more.  They are doing this right in the face of steel and energy increases that ought to make it impossible, and still greater efficiency keeps coming to the bottom line.  What could they do if prosperity broke out?

There is small cap proof and large cap proof and everything in between to tempt the value investor into believing opportunities abound.  The markets have turned their faces from this in order to stare down a crisis that may very well have passed its nadir three years ago.  This moment may be giving the lie to an old Wall Street adage that markets never discount the same worries twice, but still, this level of fear can’t go on forever.

We have case study after case study in your portfolio just now, every one competing for pride of place.  Please call us up if you’re feeling blue about the world.  We just love to talk about what we’re in.  Indeed, you might well find it more difficult to get us to stop than to start.


Edwin A. Levy

Michael J. Harkins