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Quarterly Commentary

July 2021

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July 14, 2021

To the friends and clients of the Harvey Investment Company:

Buyer enthusiasm continues to send the stock market higher.  The S&P 500 Index rose 8.55% in the second quarter, boosting the 2021 six-month result to a 15.25% gain.  For most investors, it has likely become a joyous trip to the mailbox each month to examine their monthly investment statement. 

As is invariably the case, many justifications have been conjured to explain the higher and higher price levels.  One we haven’t heard, or at least expressed in a way that resonates with us, is that a portfolio of excellent companies is a safe haven in the face of the grand monetary experiment currently underway at the Fed.  The Fed’s positioning both adds to and enables the expansive financial tendencies currently at work in Washington.  But no matter how it is justified, persistently rising stock prices are sweet relief in a turbulent world.

The stock market may be viewed in two ways.  In one sense, it is a wonderful gambling vehicle.   With prices gyrating daily, betting on the movements is an alluring, somewhat addictive activity.  It provides plenty of excitement---the hot streaks, the cold streaks, the fodder for lively discussion, the swearing off of bad habits, the intellectual stimulation.  It’s all there, perfectly legal, made easy by investment professionals and, as an added bonus, in a growing economy there is a wind at one’s back.  

Viewed through a different lens, the stock market offers the opportunity to profit in the development of a well-conceived, well managed business enterprise.   It is an open question as to which approach is riskier.  The renowned economist J.M. Keynes pointedly emphasized that “the forces of time and our ignorance of the future” present daunting obstacles to successful investing when a businesslike tack is taken. Keynes suggested that approaching investing as a game might be easier and more fun.  The goal of the game is to outwit other investors by divining future events accurately, and trading ahead of the crowd.   Nevertheless, the fundamental question is not an open one at the Harvey Investment Company.  We firmly adhere to the notion that purchasing shares in a company is a way to participate in its future---- a bright one if our analysis is correct.    

Albert Einstein is said to have remarked that “Compound Interest is the eighth wonder of the world.  He who understands it…earns it…he who doesn’t, pays it.”   Understanding compound interest is easy.  Assume $1000 is saved and put into an interest-bearing account; the compound machine begins its magic.  If the interest rate is 4% per annum, after the first year, reinvestment includes the original $1000 plus the $40 interest earned.  After year two, the investment is again the original $1000, the $40 earned in year one, the $40 earned in year two, plus the interest on the $40 from year one.  If the chain is unbroken for many years the results build astonishingly.  How astonishingly depends on the starting investment and the compounding time period. 

Relating this concept to the stock market is a leap, but a leap worth making.   Say a company reliably earns a  $100 million profit annually on its existing assets.  If it continuously reinvests these profits in new, also reliably profitable assets, the overall profitability of the company is ever rising.   This is analogous to the savings account in its clockwork nature.    The challenge, of course, lies in the simple terms “reliably” and “reinvest.”   Identifying reliably profitable companies that have managements both practical enough and disciplined enough to regularly reinvest intelligently, and to do so over many years, is our singular focus.  Only with such companies can the compounding process and advancing profit level remain unbroken.  

The rate of compound is a function of both the opportunities available in a company’s primary business and the astuteness of management in reinvesting the profits. In our experience, keeping the compound in tact is vital in achieving extraordinary results.  It doesn’t take much imagination to grasp the devastation severe losses visit on the compounding process.  Perhaps that is why a young Warren Buffett once said, when asked to explain his success, “Rule number one: don’t lose money.  Rule number two: never forget rule number one.”

Make no mistake, all stocks will be subjected to the turbulence created by the gambling element.   Those emotional highs and lows, the uneven nature of profit growth, and the unknowns in the future guarantee unnerving up and downs in even the most reliable of enterprises.  But when the identification process is sound, and framed with the mathematics of compounding understood, a chosen company’s stock price over time will continue its wide swings, but at ever higher levels.  It’s a winning game.   We’d stake our careers on it.  And we have.

We certainly hope you are having a wonderful summer.  You give our work meaning, and we are most appreciative of your continued support.

   

 Sincerely,

 Samuel C. Harvey