Muhlenkamp & Company Quarterly Investor Letter

The economic drivers we wrote about in the past few newsletters remain in place; (more about that in a minute). And we continue to expect volatility in stock prices, which moved up on the order of 5% in the first quarter—only to give it back in the second quarter—until the last week in June when prices moved up approximately 5% again. So year-to-date, stocks have done okay— not great—but better than cash; our performance is average. (For current standardized performance, click here. Past performance is not a guarantee of future results.)


The good news is the number of American (and international) companies with good balance sheets and strong earnings, selling at reasonable prices, several of which we own. The bad news is the number of headwinds, both domestic and international, which has slowed the current economic recovery.


The U.S. economy is growing at a subdued pace as people continue to control their spending and save more than they did prior to 2008. Because the economy is growing slowly, unemployment remains high. Employment began to pick up last winter, at about the time Congress extended the Bush tax rates for two more years. Since President Obama made it clear recently that increased tax rates are definitely on his agenda going forward, it will be interesting to see whether employers continue to hire. I believe the prospects of increased taxes, increased cost of medical insurance, and increased regulation are discouraging to employers. If you disagree, I suggest you consider hiring someone.


The current hot topic is the debt ceiling.

Our current federal government spending of $3.6 trillion ($36,000 per family) exceeds tax receipts by $1.6 trillion ($16,000 per family). Any family facing a similar deficit would prioritize its spending by cutting back on discretionary spending in order to pay the mortgage. Senator Pat Toomey introduced a Bill to do the same at the federal level, but politicians hate to prioritize, they want to have it all. So, instead of prioritizing spending, they’re warning about the risks inherent in defaulting on interest payments to the people and pension funds who own U.S. Treasury Bonds.


Folks, our politicians have made more promises than they can keep. Their assumption is that the people who produce the goods and services in our economy—and who pay the taxes—will continue to do so as we increase the burden of taxes and regulation. It didn’t work in the 1970s, and those of you who’ve attended our seminars in the past thirty years have told me it won’t work today. (“How many of you would come to work on Friday at a 50% tax rate”?)


Yet, we’ve continued to elect politicians who’ve made these promises. We’ve now reached the point where they and we must choose which promises to keep and which ones not to. The topic deserves discussing for a year or two—which we are now in the midst of—but we don’t expect to see a trend until the discussion nears a conclusion. Our Federal Reserve has been trying to “help” by keeping interest rates low and buying debt securities, but it is using monetary tools, (which is all the Fed has), when the problem is fiscal (taxes and spending). Hence, Quantitative Easing (QE1 and QE2) was ineffective in spurring economic activity. We believe QE2 may have encouraged the borrowing of money to buy commodities. As QE2 neared its end (6/30/2011), we’ve seen a pullback in the prices of many commodities, including crude oil. The Fed has said there will be no QE3. I hope that’s true. Pouring more money into ineffective programs simply wastes more money.


Meanwhile, China is raising interest rates and slowing its economy on purpose, much like we’ve done in the past. And Europe is grappling with problems somewhat similar to the U.S., but at a more advanced stage. Some countries, (not just states), are bankrupt. European banks are major lenders to European governments, putting them at risk as well. While we don’t expect a meltdown similar to the subprime lending and Lehman Brothers debacle that hit the U.S. in 2008, (partly because everybody is aware of the problems in Europe), the risk cannot be ignored. So our “watch and worry” list remains: 1. European government debt and banking problems; 2. China’s slowdown which could become a “hard landing” or recession; 3. The ongoing U.S. political/economical debate on taxes and spending. 4. We do see improvement in some U.S. states, which are coming to grips with government spending at the state level. The plusses, as stated previously, are the attractive balance sheets and current stock prices of many American (and international) companies. Our strategy in dealing with the crosscurrents has been to keep more-than-normal cash and to invest only in companies selling at modest prices with strong cash flows. We think there will be ample opportunity for more aggressive investing when some of the headwinds discussed above are clarified.


So our “watch and worry” list remains:

1. European government debt and banking problems;
2. China’s slowdown which could become a “hard landing” or recession;
3. The ongoing U.S. political/economical debate on taxes and spending.
4. We do see improvement in some U.S. states, which are coming to grips with government spending at the state level.

The plusses, as stated previously, are the attractive balance sheets and current stock prices of many American (and international) companies. Our strategy in dealing with the crosscurrents has been to keep more-than-normal cash and to invest only in companies selling at modest prices with strong cash flows. We think there will be ample opportunity for more aggressive investing when some of the headwinds discussed above are clarified.