January 10, 2018
At year end, 2017, our average account gained approximately +29.13%.
It was a good year for stocks; and the world owned bonds. The moneyed classes have been in thralldom to bonds for so long, eight years and counting as we write, that half a generation of investment managers with arguments from past letters, has been brought up to think this is a normal interest rate world. There is a great risk in this, because for most of us what we see as “normal” determines what we think and do next. At risk of wearying you, we will only say this is not a normal interest rate world. The most recent Grant’s Interest Rate Observer points out that a month ago Portugal issued to rapturous reception 5 year notes with an initial yield of 1.1%. Portugal is barely an investment grade credit, and only a few years back it put the “P” in the acronym “PIGS”, for European governments who couldn’t pay their bills. But through the miracle of Mario Draghi’s policy of having the European Central Bank buy everything in sight with Euros freshly minted for the purpose, Portugal’s ongoing economic problems disappeared with a wave of his hand. These notes float, so perhaps an investor may do a little better before his parole board lets him go after his 5 year sentence, but we wouldn’t count on it.
The reason for that is to be found on these shores. The American Treasury yield started the year at 2.40%, and ended it in the self-same spot. In between came President Donald J. Trump. Many Presidents have taken credit for economic vigor they had little to naught to do with. They didn’t Tweet. If you have been reading Mr. Trump’s thousands of tweets roughly every fifth one lauds the stock markets’ fresh gains, and deposits all credit on his own doorstep. Federal Reserve watching financial writers used to murmur in wonder amongst themselves whether there wasn’t a “Greenspan Put” artificially propping up the stock market. Wonder no more. No one has ever invested his ego more in the wanderings of the Dow Jones Industrial Average than President Trump, and the tweets are there for all to see. And Mr. Trump still has a majority of Fed Governors yet to propose after Jerome Powell gets confirmed in the New Year. “Fed Watchers” are un-employed people who still have offices. Real Estate developers with heavy debt loads personally like interest rates low, and so interest rates shall remain.
Quantitative Easing has wreaked havoc on all the plans of those who would be prudent, and nowhere was that on fuller display than at the last “Grant’s Conference” in October. The endowment managers for Rockefeller University, the Ford Foundation and Bowdoin College were all guest speakers. We would like to say upfront that these are talented and well-meaning investors, but it was fascinating to listen to what they had to go through to achieve a 7% assumed rate of return on the money in their care. We live in a world without a bond in it, East or West, that yields 7% or more with a margin of safety in it. Then came question time, and watching their body language was even more telling of their distress, and worth the price of admission on its own. They find that 7% somewhere or professors get laid off, scholarships shrink, and perhaps their own salaries disappear. These talented professionals will do what they must do. Even eight years in it brought home the fact that most people are buying stocks because they have to, and not because they want to. Before this is over, this too shall change.
Now seems a good moment to pause and talk about risk, before we get to the sunny news of what went right. In investing, risk is almost always something you feel before you see. Many of you have noted we did very little trading last year, even for us. What you did not notice, because you couldn’t, was how we did not purchase Celgene, Teva Pharmaceuticals, Western Union or Dave and Busters. All came recommended by impeccable sources, who in times past have made us a lot of money. All seemed extremely promising as we picked up annuals. They seemed like value investing stalwarts with prices that were just unduly beaten up. But in each case further reading made us just doubtful enough to pass on hazarding your money, and ours. As has been attributed to Churchill, “Nothing is quite so invigorating as to be shot at and not hit.” As you have no doubt worked out on your own by now without benefit of a Bloomberg machine, all went down quite heavily. You can watch financial television long after the cows come home, and they will not point out that not following one of our theories with your money over a cliff is a very pleasing virtue. Not losing is the hidden, and all powerful, secret to successful investing. We had extremely few losers last year, and that counts for a lot. Moreover, a handful of very small stocks that come to us from a very talented source did flounder, but the businesses flourished and now early in the New Year so are the stocks. It is not intuitive that staying your hand is a great way to make money, but it is.
Now in praise of some of the winners. Boeing was the Dow Stock with the biggest percentage gain last year, it should have been, and was one of our largest holdings throughout. It is also a near perfect example of what we have come to call, “The New American Manufacturing Exceptionalism.” That is a mouthful, but the theory makes us money, so perhaps a lack of brevity can be forgiven. Boeing rapidly increased production throughout the year while simultaneously announcing the workforce would shrink from 150,000 to 130,000 employees. How did they manage that? Well out-sourcing helps, and the blockbuster hit plane the 787 is made all over the world. But experience counts too. The first half dozen planes, wings, and radars in aerospace are science experiments, with workers virtually hand making them. And with cost estimates that are just wild guesses. A few years in and an invention becomes a production item. That is where the money is. Again, intuitively people want to buy when the new aero-space science is so exciting. Experience has taught us to wait a bit; the money comes in the boredom. And almost all of Boeings’ exploding growth is coming back to us in dividends and share buybacks. Bless them.
Nvidia was another big winner for the second year in a row, and here we must blush and confess, it still really is mostly a science project. Jen-Hsun Huang and his team are the original investors of the Graphic Processing Unit, a special semi-conductor that competes with and defies the far more popular Central Processing Unit. For the longest time Nvidia stood alone, with a promising technology that nobody wrote programs for. Then the game boys obliged with fancy computer video games, and it has been off to the races ever since as we find out what else GPU’s can do. So far Artificial Intelligence, Autonomous Cars and Bitcoin and its ilk have all been within its grasp. And there may be plenty more where that came from. GPU’s process data in a completely different way from standard chips, so there may be some extremely valuable intellectual property that has still to be asserted here. For those of you who are old enough for this analogy, think analog vs. digital from 30 years ago, and one company owns digital just about outright. This is where we may be in Nvidia. The stock is up phenomenally, but then again it illustrates something of the still tame tenor of this bull market. Nvidia sells at about 38 times our estimate of this year’s earnings, which is a steep price and especially for us. On the other hand, it is also growing at about 38%. One times the growth rate doesn’t sound nearly so pricey, and is why we are still investors, even after foolishly selling some much lower.
The bull market in stocks has gone on for so long, and we have done well enough, that we are constantly fielding the question, “When is this over?” Bull markets do not waste away due to old age. The ancient truism is they die in euphoria. Yet even this is only half true. We had an old friend and mentor, Jack Nash, who warned us that bull markets came with the seeds of their own demise. Higher stock prices demanded an even greater money supply just to buy the Nth share at the higher price. Then too, as bull markets went on, new companies came to market to cash out startup investors, and old companies issued secondary shares to fund new plant and equipment, and to take on new employees. My how times have changed. With private equity and venture capital firms chock-a-block full of new cash, there are half as many stock exchange listings as there were 20 years ago. A new listing, which was the raison d’etre of the stock exchange for centuries, is so passé now. With stock buy backs and dividends thrown in, today the stock market is a cash producer, a cash generator, not a cash consumer.
Finally, with the world so enamored with bonds it goes unremarked that in Europe and America the headline inflation rates have grown positively perky. And long bonds are completely unprepared for the change. Stocks are the world’s great safe haven from overly promiscuous central banks. Warren Buffet has been telling all and sundry this for a few years now, including yesterday on live TV. Yet utterly worthless bitcoin has been getting ten times the ink in the popular press than the rising prices of shares in companies that do precious things for their customers, over and above enriching us, their shareholders. Worrying about inflation, that 5,000 year old scourge, seems way more sensible to us than fretting over when the next 5% pullback comes in the stock market. Worry about inflation even a month too late and you are likely to feel the sting for years. In stocks you get an inflation hedge; in bonds you get to play inflation’s victim. That is the point of this rather long letter in one sentence.
Wishing you and yours all the best in the New Year.
Michael J. Harkins
Levy Harkins Rates of Return
Since Inception 1980
Rates are Compounded Rates of Return After Fees
Year End 2017 +29.13%
Since Inception +12.41%
20 Years Ended 12/31/17 +11.01%
10 Years Ended 12/31/17 + 8.76%
5 Years Ended 12/31/17 +13.03%
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.