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April 23, 2020
To the friends and clients of the Harvey Investment Company:
One month ago, we reported to you our thoughts on the nature of the market panic the unfolding COVID-19 epidemic had engendered. We also speculated on what the future likely had in store for investors. At that time, markets were in free fall, and, though there was a notable recovery toward the end of March, the S&P 500 index still declined by 19.60% in the first quarter.
At this writing, the panicky selling that ensued as the scope of the epidemic came clear has subsided. Resignation has set in as America adapts to business lockdowns and social distancing. Even shocking unemployment reports and business indicators have been taken in stride.
The working assumption for most companies and investors is that second quarter business conditions and corporate profits will be horrendous, the worst on record. The thinking is that conditions will gradually improve as the year progresses, with a full recovery next year. It’s anybody’s guess whether this projection will, in fact, occur, but its adoption has given comfort to Wall Street if not to the millions who are out of work wondering what’s in store for them.
With the chaos and uncertainty that currently exists, it seems a good time to review our investment goals for the assets you have entrusted to us. We will also review the program we employ to achieve those goals. Our goals and our program derive from a set of core beliefs that shape the actions we take.
Perhaps our most fundamental belief is that one’s savings and investment portfolio should be a source of comfort, and certainly not of anxiety. We are fortunate to operate a sized business that allows us to spend plenty of time coming to understand clients for the unique individuals they are. We are careful to structure each portfolio in a way that takes into account the client’s income needs, risk tolerance, and any meaningful personal preferences.
Another cornerstone belief is that to achieve distinctly superior returns we must focus on the long-term factors that drive enduring business success. We must avoid being swept up in the guessing game of what the period just ahead may hold. For us, long term means 5 to 7 years. Such a time frame allows good business decisions at a company to take hold and diminishes the effects of short-lived business conditions and investment fads.
Often clients come to us with existing portfolios assembled elsewhere. In these cases, we work around existing tax implications, taking care not to create senseless tax liabilities. Clients also come to us under widely varying market conditions. Hence, portfolios get built differently, reflecting the circumstances existing at that time. In short, ours is not a pure investment vehicle like a mutual fund or hedge fund. It is customized in each individual case.
Our primary goal for the equity portion of our accounts is, at a minimum, to match the performance of the S&P 500 index. We also want to build into the portfolios the chance of an extraordinarily good result without increasing the risk profile inherent in the portfolio.
Our plan to accomplish these goals is reflected in the structure of the part of the portfolio devoted to common stocks. In the initial stages of building the portfolio, we generally devote approximately 65% to large, well-established companies. They will have billions of dollars in revenue, high profit margins, strong finances, and experienced management. Customarily, they will generate revenues reliably in good times and bad. Highly cyclical businesses dealing in commodity products will be avoided. Our hope is that this portion of the portfolio will act as a firm ballast in tumultuous markets and produce annualized returns that are modestly ahead of the market.
We hope to fill the other 35% of the portfolio with medium sized companies, which we define as companies earning less than $500 million in net income. We want these companies to have established track records of profitability that extend back ten years or more. We want stellar finances, market positions that are well defended against competition, and, most importantly, first class management teams. In most cases we will meet face to face with the CEO or CFO of the company.
We incorporate these mid-sized companies in the portfolio hoping that occasionally one will string together a long period of 15%+ earnings growth. Such growth can, in turn, produce a startlingly good investment result. It is our opinion that such exceptional growth is more likely in smaller companies that are at an earlier stage in their development. Profit growth at 15%+ that goes on for a decade or more is rare. When it happens, in our view, certain preconditions almost always are present. By identifying companies possessing these preconditions and including them in your holdings, we hope for a few investment “home runs”.
To say that today’s economic, financial, and investment conditions are out of the ordinary is laughably understating the case. In fifty years, I have never seen circumstances that so defy measured analysis. Even so, we are quite comfortable continuing to manage your assets as just described. Underpinning our strategy is a primary assumption---a first rate manager will adapt to circumstances never contemplated, see the enterprise through the storm, and pick up where he or she left off to build a prosperous future. In the tempest of swirling change, we want to cast our lot with persistent, determined management teams.
In closing, we urge you to call us if these volatile markets have you worried or if you just want to review your portfolio. Perhaps your goals are altered in light of the unwelcome visitation of COVID-19. We want to know. Connecting with you to understand what’s on your mind is the best part of our job.
Sincerely,Samuel C. Harvey