July 3, 2012
To the friends and clients of the Harvey Investment Company:
The behavior of the U.S. financial markets in the second quarter of 2012 was largely shaped by two factors. Early in May, financial updates from several bellwether companies indicated a slowdown in the growth rate of industrial activity in the U.S. At the same time, though foggy as always, reports on the Chinese economy also suggested a decline in its growth rate. The booming Chinese economy has been a rampart of growth globally so this was especially unsettling news. And there is Europe. The mighty struggle to bring viability to the European Union operating under the common currency made little headway until the last day of the quarter when a seeming breakthrough was unveiled. In its EU summit the last week of June, EU leaders introduced what appears to be a Fed-like banking regulator which touched off explosive rallies in global stock markets. Notwithstanding the quarter-end market updraft, every European economy is experiencing at least modest recessionary conditions further exacerbating worries about earnings growth for corporate America. The steady drumbeat of deflating news explains the drop in stock prices this quarter. The S&P 500 fell 2.75% but remained ahead by 9.49% for the year. Interest rates in the U.S. Treasury market dropped to astonishingly low levels with the sour news. The 1.7% rate on ten year Treasuries reflects both unusual structural factors in the modern financial world and a bundle of fear as well.
Looking ahead, the Big Top comes to town in the third quarter. By that, I mean the full fury of the Presidential election will be upon us. In the side rings will be partisan wrangling on issues (the fiscal cliff, raising the debt ceiling, what to do with the Bush tax cuts, etc.) that must be confronted by year end. Along with the financial drama in Europe, it should be quite a spectacle. It would be nice to sit back, relax, and enjoy the circus. But, alas, our well-being is too tied to the developing events for us to be anything but on edge.
To an amazing degree, the financial markets display alternating waves of euphoria and bouts of despair as the global financial news as unfolds daily. Perhaps this is to be expected in light of the media’s moment-to-moment updates and their tendency to sensationalize every development. We are not immune to these emotions, but we work very hard to compartmentalize them. We constantly remind ourselves that even as the noisy macroeconomic news moves the markets, beneath the surface our company managements go about the business of effectively executing their plans, thinking about growth, and how best to deploy the profits they earn. We are long term shareholders of our companies. A review of a favorite passage from Ben Graham explains best why we doggedly cling to this identity no matter how nasty the periods we encounter.
When I think of the written works that reflect the deepest understanding of how to succeed in equity investing, always at the top of my list is the simple two-page postscript to Benjamin Graham’s great work The Intelligent Investor. What appears to be merely a light hearted wrap-up to a classic work is actually a story packed with insights that hold the key to achieving great wealth in stock market investing. The postscript recalls (without naming names) a particular investment made by a well-respected investment partnership and how, after many years of employing tried and true tactics, profits from this single investment, in which the partners eventually abandoned their iron discipline, far eclipsed everything else they had previously accumulated.
In recounting this story, Graham says there are several morals in plain view. Then he writes, “Another, not so obvious, is that one lucky break, or one supremely shrewd decision---can we tell them apart?---may account for more than a lifetime of journeymen efforts. But behind the luck, or the crucial decision, there must usually exist a background of preparation and disciplined capacity.” The partnership to which the postscript referred was Graham’s own, operated with Jerome Newman. The crucial investment was in the formation of GEICO.
Our interpretation of the lessons to be taken from the postscript naturally is colored by forty years of investing in common stocks. The message, as we see it, is that good investment habits and the consistent application of common sense to the task will likely produce satisfactory results that are nicely above average. To produce stunning results and to build a great fortune requires something more---luck. Some years ago, after much reflection on the subject, we came to the conclusion that we should make a formal effort to position a portion of clients’ assets in situations where good fortune could befall them---to stand in the path of luck, so to speak. The challenge is to do so without abandoning good habits and discipline, which, in fact, Graham and Newman maintained in their GEICO purchase. We believe our program accomplishes this difficult goal.
Over time, we will make many decisions and buy many securities. Our expectation is that the vast majority, close to 100%, will experience spurts of profit growth interspersed with long periods when profit progress is labored. We hope that the total group profits will grow at a somewhat faster rate than the average company, and that the stock performance for the group will reflect as much. But simple observation indicates that every once in a while, the stars align in a way that allows a company to grow at greater than 20% year after year for a decade or more. It is our thesis that this seeming miracle only occurs when certain ingredients are present at the starting point. An important element of our strategy is to find and purchase for the portfolios we manage companies that possess these ingredients. It just takes two or three investments in a lifetime that defy the odds to turn a solid investment performance into an eye-popping one.
A company whose value grows at 25% per year will double in just a shade longer than three years. Were it able to grow at this rate for fifteen years (an exceedingly rare occurrence) the investment would double approximately five times. If this were to unfold
in a smooth, orderly manner an investment of $50,000 would progress over the fifteen years in the following manner.
First Double: $50,000 to $100,000
Second Double: $100,000 to $200,000
Third Double: $200,000 to $400,000
Fourth Double: $400,000 to $800,000
Fifth Double: $800,000 to $1,600,000
When we get questions on why we don’t sell when we see troubling economic trends that suggest an inevitable market plunge or when it seems obvious that it’s time to take profits, the answer is the above table. It is emblazoned on our brains.
As always, we are truly grateful for your ongoing support. You can be sure that no matter how high the hopes we hold for the equity investments we make, we will always demand a substantial margin of safety when purchasing securities in case our expectations are off the mark.
Sincerely,Samuel C. Harvey