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October 15, 2021
To the friends and clients of the Harvey Investment Company:
The stock market hit a speed bump in September as the S&P 500 declined 4.65% for the month. When combined with the July and August results, the Index was virtually unchanged for the full 3rd quarter. To put that in the context of recent history, the S&P had risen consecutively in the five prior quarters. Through August, the Index had jumped 80% from the 1st quarter of 2020 when panic induced selling drove the market lower.
The easiest explanation for the recent change of trend was a rise in long-term interest rates. But that is only a part of the story. The sanguine assumption that the economy would recover swiftly from the shut downs last year has proven to be true. With it, however, an array of knotty complications have surfaced, the most visible being widespread shortages of goods that are vital to sustaining an expanding economy. Anyone looking to buy a new car recently can attest to the empty dealer lots as evidence of something amiss.
Other bugbears are spooking the market. How onerous for investors is revised tax policy going to be? How will the wide philosophical gulf dividing the major political parties be resolved? Will inflation prove “transitory” as advertised by the Fed? Have the rock bottom interest rates engineered by the Fed created a stock market bubble? As always, conjuring things to fret upon comes easy.
In last quarter’s letter, it was suggested that, in addition to providing an efficient way to participate in the long-term growth of enterprise America, the stock market also offered an excellent vehicle for gamblers seeking daily action. Despite their very different aims, at times it is difficult to distinguish one group from another. The challenge calls to mind Supreme Court Justice Potter Stewart’s struggle to precisely describe obscenity. He wrote, “I shall not attempt further to define the kinds of material to be embraced with the short hand description and perhaps I could never succeed in doing so. But I know it when I see it…“ And, indeed, gamblers are out in force in today’s markets.
Benjamin Graham, revered for the classic investment guides he wrote 75 years ago, struggled for decades to describe the distinction between investment and speculation. He clung tenaciously to defining an investment operation as “…one which upon thorough analysis promises safety of principal and an adequate return. Operations not meeting these requirements are speculative.” As is the case with most of Graham’s aphorisms, this one is packed with wisdom. Namely, achieving outstanding returns safely depends on systematically stacking the odds of success heavily in one’s favor.
And that is how we see our job. We do not offer thrills or fodder for cocktail chat. We do not attempt wild master strokes to produce big scores while ignoring the dangers involved. Our primary aim is to build substantial wealth for our clients by reducing the chance of severe losses to a negligible probability. We respect the math. Losses kill performance. Taking care to minimize losses, while superficially appearing defensive, in our case is an offensive tactic. If this seems like having your cake and eating it to...well, that’s the point.
We adhere to well defined criteria in our search for investment situations that suggest significant upside returns. Here are the key guidelines we follow:
- We restrict ourselves to businesses that operate in markets that have well established leaders or markets that lend themselves to the establishment of niche dominance. In immature industries there are free-for-all battles for market share where the shake out produces winners while the losers are sidelined. We stick to industries where the winners have been established and vicious pricing wars for share have ceased.
- We look for companies that have been reliably profitable for a decade or more and have generated clearly superior operating margins and returns on capital for seven or more years. We want there to have been ample time for potential competitors to enter their markets to try to take them down. If such efforts have produced no success, there must a crucial business advantage that is keeping competition at bay.
- We believe winning is a habit and that there are individual CEO’s and business teams whose ultimate success is inevitable. Business leaders leave footprints along the way as they move through their careers. Knowing where to find those footprints is a skill learned over time. Reading them to effectively predict the future is intuitive, more art than science.
Once a business situation meets the stringent tests we apply, we must determine a sensible purchase price. There are many views on how to establish this price including simply being resigned to paying the current price. For our purposes, extracting risk, casual acceptance of the going rate is not enough. At all costs, we wait out emotional waves of ebullience or despair. Rationality should rule. Also, we respect historical valuation standards and are not swayed when unusual financial behavior suggests those fatal words, “it’s different this time.” Most important, we want to produce safe, double digit returns for our clients both in year one and over time. Our analysis doggedly avoids making heroic assumptions to get the outcome we desire.
As far as generating action, its feast or famine with this approach. When markets are tumbling and fear is in the air, our criteria are met across a wide spectrum, and we should be busy buying. Otherwise, we concentrate on our work and pick our spots. Experience has shown that within the first year of acquiring an account, a new client’s portfolio is substantially built, and a valuable long-term asset is added to their financial profile.As always, we appreciate your ongoing faith in us. We will work the program as described. We are confident that the results will be quite satisfactory.
Sincerely,Samuel C. Harvey