Letter - October 2005





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The recent catastrophes on the US Gulf coast, Katrina and Rita, have prompted us to think about catastrophes in general. Should events like 9/11 or the twin hurricanes unduly alarm investors? Are they really as isolated and improbable as we sometimes think?

As we think back over the last eighteen years, the series of extraordinary events is itself extraordinary. October 1987 brought the Black Monday stock market crash. The one-day 23% decline would be the equivalent of a 2400-point decline in the Dow Jones Industrial index today. The 1980s ended with a full-scale real estate collapse, forcing a $175 billion bail-out of junk bond financed savings and loans institutions. Since 1991 we have been embroiled in five wars. The millennial year started with a stock market bubble and ended with another crash far more damaging than the first. Acts of terrorism against US and other Western interests have claimed thousands of innocent victims. The events of 9/11 brought war to the US homeland, shattering a false sense of security for all Americans. Finally, hurricanes Katrina and Rita brought widespread destruction and suffering to the Gulf Coast. Oil prices spiked to all-time highs with spot shortages calling up grim memories of the 1970s.

If asked in 1986, we would have said that the probability of any one of these high-impact events happening was low. Yet history demonstrates that high-impact events have a high probability of occurring, though it is impossible to predict exactly where, when, and how they occur. Shocks to the system are the norm, not the exception. History is stormy not tranquil. Yet despite the shocks, the American people and the American economy have proved resourceful and resilient, and the stock market has reflected this. With dividends reinvested, a $1 investment in the S&P 500 at the end of 1986 (i.e., before the 1987 crash) was worth almost $8 by the end of September 2005, nearly a 12% annualized return. Events of the moment rivet our attention. But the market adjusts and moves forward. Phil Herzig, who saw clients prosper through these and many earlier crashes since founding the firm in the late 1950s, was fond of saying, “The end of the world only happens once.”

More insidious than sudden shocks, in our opinion, is the regulatory creep that saps the vitality of what John Maynard Keynes referred to as the “animal spirits” that drive prosperity: entrepreneurial spirit and risk taking. Class-action legal suits with sky-high plaintiff awards do more than punish the improprieties of a small minority of corporate managers. They hurt the retirement funds of innocent shareholders (who ultimately pay far more of the awards and fines than the errant managers). And they discourage appropriate risk-taking by honestly run businesses. How many life-saving drugs will never make it to market because the catastrophic cost of making a mistake?

When some latter-day Edward Gibbons chronicles the Rise and Fall of the American Empire, we suspect his emphasis will not be on the dramatic events of the day -- market crashes, hurricanes, terrorist attacks, and the like -- but on the slow creep of regulatory and legal burdens that discourage risk-taking, raise costs and pressure the profitability of American business, that engine of our prosperity.


We have been surprised that our clients have done so well so far this year relative to the paltry returns of the overall market. The S&P 500 with dividends reinvested increased only 2.8% through September 30. However, the first three weeks of October have been brutal. As of this writing, hard-won gains have been paired back putting the S&P (though not yet our clients) barely at breakeven. We try to remain cautious, keeping new positions relatively small. Cash balances will likely increase as we sell more than we buy. We are becoming uncomfortable with price volatility as the cycles for real estate and natural resources may be coming off their peaks. As for the next great investment idea, we don’t see it yet.

As always, clouds obscure the economic horizon. The Fed is worried about inflation. Long-term interest rates have begun to move up a little. Most of the blame for recent signs of inflation is placed on the price of oil. However, we are concerned about the possibility of deflation as well. Consumer debt is high and housing prices are down in the hottest markets. High oil prices may act as a tax, draining dollars out of consumers’ pockets and weakening demand for other goods. Some fear the Christmas season will be a wash-out. Does $40 in the gas tank mean $20 less to spend at Wal-Mart?

We are watching gold prices for a clue to the inflation/deflation outlook. The price of gold has approached an eighteen-year high, though the charts give scant indication as to whether the next move will be up (inflation) or down (deflation). Ominously, gold is appreciating against the euro and yen as well as the dollar, suggesting world wide inflationary pressures. Business meanwhile continues to be surprisingly good. Retail sales and employment have stayed unexpectedly strong in the face of the destructive weather. While the hurricanes destroyed a tremendous amount of wealth, business should generate extra income from the rebuilding of the Gulf Coast.

We traditionally close our letters with a discussion of our thinking about specific stocks in our clients’ portfolios. However, new compliance requirements limit our ability to do so for the time being. We are in the process of conforming to new regulations and will be able to communicate our thoughts in future letters. We hope that clients will contact us directly should they be interested in specific actions on their behalf.


Tom Herzig


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