Harris Associates L.P.

We won’t spill a great deal of additional ink doling out the blame for today’s credit panic. In previous communications we’ve highlighted a host of villains: Greenspan’s rock-bottom interest rate policy; investment bankers’ poor underwriting standards, asleep-at-switch credit rating agencies; unqualified borrowers; unscrupulous mortgage brokers and lenders. How about the regulators, who not only failed to identify the growing crisis, but also may have made things worse (e.g. the SEC’s decision in recent years to allow the investment banks to take on more leverage, as well as FASB’s strict mark-to-market requirements)? And then there is Congress (and all those lobbyists) who pushed the envelope for Fannie Mae and Freddie Mac:

In a move to help increase home ownership rates among minorities and low-income consumers, the Fannie Mae Corporation is easing the credit requirements on loans that it will purchase from banks and other lenders. The action…will encourage those banks to extend home mortgages to individuals whose credit is generally not good enough to qualify for conventional loans. (New York Times, September 30, 1999).

It sounded so simple, so innocent. Who could argue with making it easier for more families to own their own homes? As American as cherry pie, right? And even for those who highlighted the obvious risks of such policies, who would have imagined it would turn into the serious mess we find ourselves in today? In any case, the police lineup of guilty parties would stretch a country mile. As history has shown, and as we have argued before, a bust is generally caused by the preceding boom. In this particular case, disturbingly, the culpable evidence is clear-cut, unforgiving and brutal.

We readily admit our own mistakes, too. In retrospect, our initial read on the growing symptoms of a credit crisis was generally accurate. As we first discussed in our client letters in late 2003, we identified a bothersome lack of differentiation – and lack of compensation for shouldering extra risk – across both the fixed income and equity markets. Equity valuations appeared quite compressed, and this led us to emphasize stronger, safer businesses that seemed to offer a better risk/reward tradeoff. In 2006 we chided others who utilized excessive leverage in search of a few extra basis points of return in an attempt to keep up with the Joneses. While this caution proved frustrating to some of our clients, many of these portfolio positions have provided relatively good shelter from the storm in the past few months.

But in hindsight, we could have done a better job. Our willingness to accept better “relative” risks has proven humbling as the crisis engulfed a wider group of businesses than we could have ever imagined. Even well-capitalized companies with seemingly stable business models have succumbed to the harsh realities of a financial system so interconnected and complex that only the very strongest inspire confidence. The lessons learned from the demise of Long-Term Capital Management (1998) and Amaranth (2006) seemed to imply that the collapse of the occasional over-leveraged structure could be benign. But in fact, those events – as well as the collapse of several other hedge funds over a year ago – were more like canaries in a coal mine. The financial system was telling us, among many things, that there was way too much leverage underneath the surface. As the crisis unfolded in the next several months and touched the large bank and investment bank sponsors of these exotic bets, it should have become even more apparent that the financial world – the hedge funds, the sponsors, the banks, the insurers – were all hostage to a credit market that needed to reduce leverage quickly. But there were few well-capitalized buyers for the assets that needed to be sold, save governments, for such a massive, simultaneous deleveraging. In such a world, even the best businesses are suddenly vulnerable, and in hindsight, portfolios can never be positioned conservatively enough.

It has also been humbling to watch the crisis unfold from our natural, fundamental perspective. While our portfolios generally own better-than-average businesses (many with robust, global franchises trading at significant discounts to our estimate of intrinsic value), it’s clear that in the short-run the market reacts more to regulatory missives, political posturing and raw emotion. As of quarter-end, the S&P 500 is off more than 25% from its peak a year ago, an eye-opening markdown from levels we frankly found attractive back then. Clearly, an economic slowdown is likely nearer, deeper and more meaningful than considered a year ago, but with low-teens P/E ratios in late 2007, we would have argued overall market risk was modest. Even with meaningfully lower forward earnings estimates today, the market’s current valuation – in the context of low interest rates and falling commodity prices – seems cheap compared to across-the-cycle earnings levels. More importantly, if our own intrinsic value estimates are anywhere near the mark, our portfolios now trade at more attractive prices than we can ever recall. For historical perspective, the last notable episode was late 1999 when most investors were liquidating the shares of perfectly fine businesses in a mad dash for hot technology stocks. The circumstances today are clearly different, but the discount to value – right now near 50 cents on the dollar – is worth highlighting.

The crisis, however, is real and it is big. The rapid implosion of so many substantial financial institutions has been jarring. When Lehman Brothers – the smallest of the independent investment banks – finally succumbed in mid-September, its total assets of $640 billion were about double the total for the 700 banks the RTC shut down in the early 1990s. And each “episode” in this crisis has created further problems in the financial landscape few ever imagined, from SIVs to auction-rate preferreds to simple money market funds. Each time, the Treasury and the Fed have responded with creative fixes to address the most proximate weaknesses in the system, but investor confidence has been rattled, understandably. Unfortunately, there is not yet any concrete basis for believing this pattern is at an end.

While it seems that the entire front page of every major newspaper has been devoted to covering the markets and political bickering in excruciating, painful detail every day, there are, in fact, a few positives in the external environment that may provide some comfort. First, energy prices are falling rapidly. As we argued just last quarter (“And This Too Shall Pass”), for a number of reasons the near-term fundamental support for elevated energy and commodity prices was deteriorating. Since then, spot oil prices are down about 30%, and consumers and businesses are starting to see some much-needed relief. Second, interest rates remain low. Real interest rates (i.e. adjusted for inflation) are at a 28-year low, and falling commodity prices and a slowing world economy may reduce some of the risk of rising inflation in the future. Low rates are wonderful for businesses considering capital investment or financing inventories, as well as for families who plan to finance a home purchase (although frankly, the supply of lending funds – as well as the demand for those funds – is quite weak right now).

But even we have to admit, stocks could get even cheaper before they rally. That’s not because we expect the long-term fundamental picture to deteriorate more than already expected, but because it is so difficult to gauge investor confidence in a crisis unlike anything we have seen in several generations. Politically, everything seems upside down: free-market loving leaders at the Treasury and the Fed scream the loudest for government intervention and assistance, and a Republican administration amasses ownership stakes in private enterprises like some two-bit dictator! Of course these rescue efforts are a direct result of regulatory and industry machinery that was established decades ago and is ill-suited for today’s complex markets (an overhaul is likely once the dust settles). So with a global banking system undergoing triage and plenty of skepticism over not only government’s proper role but also its capability to create a more stable investment environment, it’s exceptionally difficult to say the coast is clear. We are certainly encouraged by the basic strength of our portfolios today. Fundamentally, we see plenty of cheap stocks: from current levels, we see opportunities for capital appreciation over any reasonable investment time frame. Psychologically, we are also enticed by an equity market that has delivered a total return of -10% since March 2000; rising pessimism and investor weariness suggest there could be plenty of room for positive outcomes. Emotionally, however, we admit to some caution and patience because today so much rests on political and regulatory outcomes – as well as investor confidence – that none of us can really predict. Perhaps this humility is a good sign: the bottom of a bear market generally occurs when no one is really sure it will ever come. The past year has been filled with all sorts of negative surprises. Sometimes, however, good things can happen at the unlikeliest moments.