Current Letter

October 3, 2017

 

Dear Client,

For the first three quarters of 2017 our average account gained approximately +18.70%.

It has been, so far, a solid year financially.  The economy is growing, corporate profits are up almost exactly in line with stock prices, and at Friday night’s close the 10 year Treasury bond yielded 2.31%, just where it was at year end.  So far stocks have been treading water on a rising tide.  Looking forward, equities remain a much better deal than bonds.  The Wall Streeters who engage in clairvoyance think the Standard and Poor’s Index will earn about $145 a share in 2018, and it closed Friday at 2,519, for a multiple of 17.4 times earnings.  That is just a guess, but it is what the world trades off, and 1 divided by 17.4 is 5.75% as an “earnings yield”.  That is 2.5 times better than you do with a Treasury bond, and the bond has utterly no inflation protection.  Watching politicians compete this last week over who could give away tax cut candy fast enough has left us shaking our heads over the devil may care prices of bonds.  President Trump’s tax plan reform, at 9 pages, isn’t even a proper table of contents to a serious plan.  It is also nothing like the Reagan tax cutting experience of 1986.  Every detail was spelled out in that bill, and none are in this one.  In this bill, every existing deduction is up for grabs, and grabbing is what lobbyists are good at.  And markets are fearless about the prospects for inflation?  This puts us in mind of the certainty in 2007 that house prices could never go down.  After that canard was exploded in March 2009, we heard John Paulson at a Grant’s Conference.  He casually told a ballroom of financiers at the Waldorf Hotel that he made the trade of the century because a real estate debacle was priced as a zero probability event 2 years before, and zero as a price made no sense to him.  He then confessed he made 500 times on his best investment in credit default swaps, and the room gasped.  Over any reasonable length of time stocks are a good inflation hedge, and if they are paying us to own them with this earnings yield it makes them near to irresistible.  Zero is just the wrong price to pay for an inflation hedge in these conditions, and consequently the world is lapping stocks up here, there, and everywhere.  Spain is up 10% on the year, and it is coming apart.  Mr. Market wants stocks.

But then again, are all stocks worth your money?  A brilliant new study by Professor Hendrik Bessembinder of Arizona State University gives off a resounding “No!” for an answer.  He found only 4 percent of all publicly traded stocks account for all of the net wealth earned by investors in the stock market since 1926.  50 stocks account for 40 percent of the gain.  The rest of them can be charitably described as “blah,” not beating Treasury bills.  Will it surprise you to learn that we are bringing this up because many of the stocks in Bessembinder’s Hall of Fame you already own?  The list looks just like those cash generating worthies we have been banging on about in letter after letter.  At this moment, according to Bessembinder, Apple has generated more profit for investors than any other company since 1926, and we own plenty of it.  Alphabet, Walmart, Berkshire Hathaway and Boeing all make the top 50 list, and we own all of them.  And our portfolio doesn’t have 25 names.  This is a remarkable overlap, and it doesn’t count McDonalds and General Motors, which we sold not long ago.  Companies that earn profits, not just GAAP earnings per share, but honest to goodness money that you can take from the business without impairing it in the least, are worth more than their run of the mill brethren.  Much more.  And we have reasonable hopes that PayPal, Cognizant, Akamai, and Nvidia will all make the list of the sainted 50 in 2095, if only we can stay around that long.  This is all detailed in the Sunday New York Times of September 24th, and it warmed our hearts, because it endorses a strategy we have been hammering at for ages now.  Not all earnings are created equal.  Some are near to worthless, others worth their weight in gold, and all sell for the same price.  That is because every business school graduate is taught it isn’t worth it to parse the difference.  We say it is, and we still have a clean field ahead of us with nothing much by the way of competition in this belief.

So we will end on the note that active money management, and the security analysis that goes with it, could not be more out of favor.  This pleases us no end.  Yet how odd is this moment?  Every baseball team has a geek who knows to the decimal point how many pitches each batter on his team has seen all season, and on every other major and minor league team as well.  If his analysis of perhaps 5,000 ballplayers gets his team five extra wins in 162 games he gets a cushy job, a big contract, and loads of fun travel.  Every basketball team has a geek who knows where every shot was taken by every player on every team on three continents.  Sports research gets rewarded, and stock research goes begging, and this makes sense?  And oddly enough Warren Buffett has recently become the champion of this know-nothingism.  We pointed out in our April letter how Buffett identified great managers in his speech at Columbia University in 1984 titled, “The Super Investors of Graham and Doddville.”  We checked up on those investors in January of 2005, and they were still doing great 21 years after his speech.  And as of this moment they are all still going strong.  So what accounts for Buffett’s sour mood on active management now?  Well, we are all human.  And one of the least remarked on traits of Buffett’s astonishing career is that he hasn’t gotten paid in 50 years.  All that wealth without a paycheck.  We mean this in Wall Street parlance.  He hasn’t gotten a stock option or carried interest in all the time he has run Berkshire Hathaway, and nobody ever notices.  Indeed, the Berkshire proxy often reads as though it were written by Woody Allen in his funny years.  Last year Buffett paid himself $100,000, the same amount for all 50 years running.  And in tiny type he confessed he sometimes uses the postage machine for personal letters and the phones for personal calls.  So he wrote the firm a check back for $50,000 in reimbursement.  We are not kidding.  Makes you wonder where he is calling.  But if the old bromide is true that we are all human, even Warren, it will make clear why his nose might be a little out of joint comparing his net worth to everybody else’s.  Particularly those denizens of Wall Street.  They got paid and he didn’t.  That might be the burr under his blanket.

Sincerely yours,

 

Michael J. Harkins