January 8, 2013

Dear Client, In our last letter to you we quoted Martin Feldstein with an estimate that the Federal Reserves might propose a quantitative easing program that could create money at the rate of $1.5 trillion over three years.  That was 90 days ago, before the Fed got to feeling really frisky.  The program actually announced on December 12th promises to buy assets at a rate of $85 billion a month, or $1 trillion a year; about tripling the pace from what we and Professor Feldstein had already thought outlandish money printing.  Monetary milestones whiz by at a blurring pace these days. Not so much in fiscal policy, where mountains get reduced to molehills with countdown clocks going on every news station, to give high drama to low eleventh hour pipsqueak deals.  Think back to the bright hope of the Simpson Bowles Commission.  Eighteen brilliant people spending eight months thoughtfully addressing our budget woes, and coming up with a bipartisan plan by an 11 to 7 vote, to reduce our deficits sensibly.  That was 25 months ago.  We read the report at the time.  In light of what’s subsequently happened, you should severely chastise us for that.  We could not have more wantonly wasted time if we had spent a weekend tearing up the collective works of Benjamin Graham with our bare hands.  In the year that ends in September the United States government will borrow about 41 cents of every dollar it spends, and the Fed will buy up 68% of all that new debt with money created out of thin air. 1   That cannot continue and must not be stopped.  That those two thoughts can co-exist in one manic sentence is indicative of how dysfunctional Washington is now even with a new Congress, and it doesn’t look set to change any time soon.  It does put us in a mind though of the wisdom of an old friend when we were just starting in the financial business.  “Never listen to what the authorities say, only watch what they do.”  He left out the part about having a strong stomach.  But a greater point survives.  When you hear about how low interest rates prove our foreign lenders have confidence in us, don’t believe a word of it.  The Chinese stopped their net purchases over two years ago.  These low rates come from 33 Liberty Street 2 and nowhere else.  Let us all understand the inflationary storm to come comes from the exact same place. Outside of Washington things look so very different, and oh so much cheerier.  The collapse in house prices that was the proximate cause of the worst economic calamity since the Great Depression is at last behind us.  Not only is the Case Shiller Index up almost 5% year over year, but the proportion of sales coming out of distressed foreclosures and short sales is down to 22% from 30% last year.  Even better, there is less than a 5 month existing supply of unsold homes.  For Jane and Joe homeowner, this is unalloyed great news.  Unlike every soul who reads these letters, most people don’t have sizeable investment or retirement accounts.  They have their house, and a lot of worries about their future.  We hope we never go back to the bad old days when a house was also a part time ATM machine, but the psychological release in higher prices shouldn’t be discounted.  It helps the consumer enormously. Even better news is to be found on the energy front, and why this doesn’t get greater national news play is beyond us.  Each time we have written about the boom in oil and gas production here in America we have understated the case.  In the quarter ended September, Texas oil production was up 33% from the year before to 2.1 million barrels a day.  Can there be a more clapped out oil province than Texas?  People have been punching holes in the ground in Texas for a hundred years.  Yet such is the wonders of horizontal drilling, 3-D seismic, and fracking, that Texas alone is now producing as much oil as Iraq.  Indeed, in West Texas in December oil was averaging about a $15 discount to Cushing oil, which was itself selling at $20 a barrel less than Brent at Sullom Voe, Scotland.  We have so much of the stuff we don’t have the pipelines to move it around efficiently, but we will. The news is even more dramatic in the natural gas markets.  As we write this, spot natural gas is going for $3.25 a thousand British thermal units in America.  In Europe and Asia that same clean energy source goes for between $12 to $16 an MMBTU.  Natural gas makes up almost a quarter of all America’s energy needs, and that is a proportion that stands to increase rapidly. It equates to buying oil at $19.50 a barrel.  What a godsend this is to every American manufacturer, fertilizer plant, electric utility, farmer and many, many more.  We are even, though painfully slowly, working out how to use it as a transportation fuel.  New York City buses are running past our offices using natural gas every day.  Considering that an awful lot of the earth’s crust is made out of shale, America may not keep this startling advantage forever.  But it is a testimony to how naturally productive this nation is that we have gotten out to such a big head start.  And almost all the world’s oil field services companies are American firms, which partly accounts for why you own Baker Hughes right now. We ended 2012 with returns that were less than our 12.2% historical average, so in that sense the year was disappointing.  On the other hand, it had a far more than average amount of angst, with fiscal cliff, double dip, and Euro-split worries never taking an end.  Yet it still leaves us somewhat perplexed.  The stated earnings of your portfolio, and the earnings power going forward, went up much more than the quotations gained.  A good, though rough, estimate is twice as much.  So did they get cheaper or dearer?  In our eyes cheaper, though we are fully aware you can’t spend our thoughts.  Still, in looking at the tremendous cash generating powers of Apple and Google, Qualcomm and Akamai, Cognizant and Boeing, Berkshire Hathaway and Tupperware, we are left with two predominant thoughts.  The first is multiples of earnings can’t keep compressing like this forever, and in particular the best things can’t keep selling at the same pedestrian multiples as the rubbish.  Today is the first day of earnings season, and if the first reporter, Alcoa, disappoints as usual, it will be selling at about the same price as Tupperware.  This is daft, no?  Yet it leads directly to our second thought.  We have a lot of confidence about our future.  Someday we will be forced into the backwoods of world finance to find value.  But before that day comes we think we will get a large liquidating dividend for owning only the best at compressed prices.  We promise to wear a smile on that day, even if only through the morning. Sincerely,        Edwin A. Levy          Michael J. Harkins 1  Source:  Citigroup Estimate 2  Headquarter of New York Federal Reserve                                                            Levy Harkins Rates of Return                                                                 Since Inception 1980                                              Rates are Compounded Rates of Return After Fees                                                   Year End 2012……….…………….+9.70%                                                   Since Inception……………….……+12.30%                                                   15 Years Ended 12/31/12…….…….+10.35%                                                   10 Years Ended 12/31/12……..……..+8.18%    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.