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Ron Muhlenkamp Q4 Letter

October 31, 2012 | About:
Holly LaFon

Holly LaFon

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For over a year, we’ve been discussing Europe, China, and U.S. Politics as the major drivers of the markets. On September 7, 2012, we published a Market Commentary, headlined “Threat of European Banking Crisis Recedes.” In it, we discuss the Outright Monetary Transactions (OMT) program, introduced by the European Central Bank (ECB). We think this program makes credible the ECB’s promise to do all it can to keep the Eurozone together. And we believe this action mitigates some of the risk of investing in U.S.-based international banks. As for China, we continue to monitor the country as its leaders turn their economic focus from building infrastructure toward ‘building the consumer.’ We don’t think that China has turned the corner.

We think some of the uncertainty surrounding U.S. levels of taxation and regulation will be resolved when we find out which direction the voters choose for the U.S. on November 6. In the meantime, on September 13, in addition to keeping short-term interest rates near zero until mid-2015, the Federal Reserve announced a third round of Quantitative Easing (QE 3). The Fed has stated it will purchase $40 billion worth of mortgage-backed securities every month until unemployment declines to a reasonable level. We don’t think these purchases will help lower unemployment much, and contend that keeping interest rates low is hurting the retirees/savers in this country. Further, past attempts to reflate the housing market and spur the economy through record-low interest rates and quantitative easing have not been very effective. (Mortgage lending in 2011 declined to its lowest level in 16 years, according to a report from federal regulators.) What we do see is that the Fed’s actions are boosting the equity markets. The DJIA (Dow Jones Industrial Average) hit an annual high after the Fed’s announcement.

We continue to believe the Fed is attempting to fix a fiscal problem (i.e. too much government spending) with monetary policy (i.e. pouring money into the economy). Bernanke, the Fed chief, states “The weak job market should concern every American.” He’s exactly right in this regard, but it’s our belief that hiring will pick up only after the matters of increased taxes, regulation, and healthcare insurance are clarified. (In fact, Bernanke has urged Congress to address such concerns.)

Meanwhile, U.S. Gross Domestic Product (GDP) growth hovers at 1.7 percent. A number of bellwether companies, including FedEx, Intel, and Caterpillar have all revised guidance downwards in the last few weeks. If the automatic tax increases and spending cuts slated for the end of the year occur on schedule, we think it will be a 2%-4% hit to GDP and likely trigger a recession. It is also possible that equity markets, in responding to the latest round of QE, have gotten too far ahead of the economy. If the economy doesn’t follow, we expect the markets to correct.

The comments made by Ron Muhlenkamp in this commentary are opinions and are not intended to be investment advice or a forecast of future events.

A Ronald Muhlenkamp-esque screen: Quality companies with high return on equity

The following abridged article was published by Stockopedia, a web-based resource for investors. Per its website, “Stockopedia Features covers in-depth stories on strategies, companies and themes that are relevant to online investors. Investing is hard work. We don’t try to over-simplify complex concepts— we prefer to try to help you navigate the detail.” The complete article can be found at www.stockopedia.co.uk/content/a-ronald-muhlenkamp-esque-screen-quality-companies-with-high-return-on-equity-67781/. We think the article does a good job of outlining our investment process.

A Ronald Muhlenkamp-esque screen: Quality companies with high return on equity

Wednesday, August 29, 2012

Ronald Muhlenkamp is the founder and president of U.S. fund management firm Muhlenkamp & Company. After setting up in business in 1977 he rose to prominence with a successful investment strategy that continues to seek out good quality companies with strong profits at an attractive price.

Background

In his book Ron’s Road to Wealth: Insights for the Curious Investor, Muhlenkamp describes beginning his investing career in 1968, just as the bull market of the 1960s was about to run head long into the bear market crash of 1973-1974. That collapse triggered a market-wide rethink on investment knowledge and conventional wisdom and led Muhlenkamp to begin an extensive study of fundamental and technical investment management philosophies.

His research led to a proprietary method of evaluating both equity and fixed income securities, which his firm continues to employ. He is a regular fixture as an investment commentator in the media and produces numerous articles and newsletters covering a wide spectrum of investment topics.

Investment strategy

Muhlenkamp’s strategy looks for companies with a high return on equity (ROE) at a reasonable price. ROE is basically a measure of how much profit a company earns in relation to the total amount of shareholder equity found on its balance sheet. Muhlenkamp likes this measurement over other growth indicators because a company whose ROE is higher than its growth rate is likely to be generating lots of cash. While companies can be responsible for spending cash in fruitless ways, Muhlenkamp figures that lots of free cash flow means the stock is in control of its own destiny—so it’s a useful starting point.

While Muhlenkamp has conceded that his methods have required tweaking in response to changing macro conditions over the years, the ultimate aim is to find companies with strong balance sheets, low debt and strong cash generation as measured by ROE. In an interview with Steve Forbes in 2011, Muhlenkamp said he looked to buy these companies when they are cheap “and then hold them as long as they fulfill our expectations”. According to the American Association of Individual Investors, which has scrutinized Muhlenkamp’s approach, he derives a required equity return by taking the inflation rate and adding a premium for either bonds or equities. “This required return is then used to arrive at a required return on equity and, ultimately, the maximum he is willing to pay for earnings,” AAII says. In the 2011 Forbes interview, Muhlenkamp said his firm’s average holding had a P/E of 10 and had a return on equity of about 18%.

When it comes to buying and selling, Muhlenkamp doesn’t attempt to time the market when making purchases, preferring instead to focus on determining a fair price for the stock. However, he does track the market when it comes to unwinding his positions and opts to sell stock when the fundamentals no longer meet his criteria or if the share price disappoints for unknown reasons.

Investment formula

Muhlenkamp’s methods were analyzed by Ludwig B Chincarini and Daehwan Kim in Quantitative Equity Portfolio Management: An Active Approach to Portfolio Construction and Management. At Stockopedia, we have taken that model to produce a version of the Muhlenkamp screen. Here are the criteria:

  • ROE (Return On Equity) % > 14
  • ROE % 5 year Average > 14
  • EPS(Earnings Per Share) 5 year CAGR % > 0
  • EPS Growth % Trailing Twelve Months (TTM) > Industry Group Median
  • P/E< Industry Group Median • Price-to-Book< 2
  • Net Margin % > Industry Group Median
  • Debt To Assets< Median
  • Free Cash Flow > 0
What to watch

Muhlenkamp’s fund produced impressive results for many years until the mid-2000s and he has stressed that his tactics have had to change over time. While he was lauded for skipping the hysteria surrounding the dotcom bubble, some commentators think Muhlenkamp began buying stocks too early in 2008, only to see their values fall further. For investors following his techniques, timing stock purchases is obviously a key factor. More generally, using ROE as a measurement of performance can risk overlooking the issue of debt (which ROE doesn’t account for). Muhlenkamp is wary of companies with debt anyway but investors using this screen should note the risk.

Further reading

Ron’s Road to Wealth: Insights for the Curious Investor, Ronald Muhlenkamp

How We Plan to Make Money in the Current Investment Environment, Jeff Muhlenkamp

Quantitative Equity Portfolio Management: An Active Approach to Portfolio Construction and Management, Ludwig B. Chincarini and Daehwan Kim

Steve Forbes Interview

AAII on Ronald Muhlenkamp

Ask Muhlenkamp

About the economy…

What is the “fiscal cliff” that politicians and pundits are referring to? “Fiscal cliff” is the expression used to describe what the U.S. faces at the end of the year when the terms of the Budget Control Act of 2011 go into effect at midnight on December 31, 2012. If no interim actions are taken, the sunsetting of the “Bush tax cuts” will take place and the 2% payroll (FICA) ‘holiday’ for employees will expire.

The ending of the FICA holiday will directly reduce take-home pay by 2 percent. The ending of the Bush tax cuts, (which include a federal tax rates increase, an increase in taxes on capital gains or qualified dividends, and a lowered maximum for estate and gift tax exclusions) will raise taxes on the average wage earner by $2,000-$4,000 per year for a total decline in take-home pay of 5%-6 percent. When you recall that the last recession was caused by a decline in consumer spending of 5% in the fourth quarter of 2008, you will understand our concern about the “fiscal cliff.”

What do you see going on with energy?

In the U.S., we believe cheap natural gas is here to stay. This is a big change, and we are already seeing it in a couple of places. In addition to lower home heating bills, cheap natural gas has prompted a huge shift by electric utilities from coal to gas, driving down the price of electricity and coal while producing less CO2. Natural gas has also been widely adopted by the waste removal industry; most new garbage trucks are natural gas powered. Further, natural gas continues to make serious inroads in public transportation.

The difference in cost between natural gas and diesel fuel are huge, creating a large economic incentive for companies that burn a lot of diesel, (pressure pumping in the gas and oilfields, long haul truckers, etc.), to switch to natural gas. We are interested in owning companies that enable the switch; we think they have the potential to do very well going forward. Companies that are able to apply horizontal well drilling and fracking technologies to other resource fields around the globe are also interesting.

About the Fund…

Within the Fund’s top ten holdings, what are the best performers and what are the laggards this year?

We are pleased that a number of our top ten holdings have done very well for us this year.

Let’s first examine Alliance Data Systems Corporation (ADS), a company that mines credit card data and produces targeted marketing campaigns for its customers. Since our purchase in 2011, ADS is up approximately 50 percent. While not particularly cheap on an earnings basis, (selling at 16 times 2012 estimated earnings), ADS has free cash flow of 14 percent. Over the past three years, ADS has put its cash to work by repurchasing outstanding shares and by making select acquisitions to round out its service offerings.

Also up approximately 50 percent, is Sonic Automotive, a domestic auto retailer, selling primarily foreign cars. There are now fewer auto dealerships as a result of industry consolidation. Sonic has done a good job of reducing expenses and increasing productivity, thereby positioning it for strong performance as car sales rebound.

Other top ten holdings have lagged the market this year, but we continue to have confidence in their potential.

Two in this category are J.P. Morgan and Intel.

J.P. Morgan’s reputation was a bit tarnished earlier in the year as a trading scandal hit the company. We owned shares before then, and added to the position as prices dropped. We believe it remains a premier banking company—and with operations in 60 countries, we think J.P. Morgan’s global marketshare is poised to increase as a result of the European debt crisis.

While J.P. Morgan suffered as a result of company-specific events, Intel is suffering from a decline in the sales of personal computers. While in the short run we acknowledge that PC sales are declining, we believe Intel is making innovations in the manufacturing of microchips that others can’t. With an ROE averaging 25% and a P/E ratio averaging 10, Intel matches our definition of “a Cadillac company at a Chevy price.” Further, with a 4% dividend yield, Intel provides better income than most corporate bonds.

Has your stock selection process changed over time?

Our stock selection process continues to be ‘bottom-up;’ we remain steady in our pursuit of owning good companies at cheap prices. Once we have identified companies that meet our selection criteria, we edit from the ‘top-down,’ applying our macroeconomic lens. As an example, we had identified a number of large banks selling at very attractive prices, but had held off purchasing them because of their exposure to European banks. When the OMT program was announced, we concluded the likelihood of a European banking crisis had receded, and it now made sense to own the cheap banks we had identified, so we invested.

Coming out of a recession, we would normally focus on company earnings. Coming out of the 2008-09 recession, we were more cautious. Our portfolio is now dominated by companies that in our opinion have rock-solid balance sheets and strong free cash flows—companies we believe can survive a period of lackluster earnings, should that take place

Year-End Tax Planning

To our Clients with separately managed accounts:

It will be helpful for us to know if you have a tax-loss carryforward from 2011. If you reported a tax-loss carryforward on your 2011 income tax return, please let us know the amount so that we can incorporate this fact into our tax planning for your account during 2012.

Should you decide that you wish to take capital gains in 2012 and pay taxes at the current rate, rather than defer to later years and possibly pay a higher rate, let us know. We don’t claim to know what future rates might be.

To our Fund shareholders:

The Muhlenkamp Fund currently anticipates a capital gain distribution for the tax year 2012. Currently, the realized capital gain (subject to distribution) is on the order of 5%, although this could change if the market becomes more volatile. We also anticipate an income dividend of less than 1 percent.

There are a couple of other things to note about any distribution from a mutual fund. The distribution will come to you in one of two ways:

  1. You will receive a check for the amount of the distribution.
  2. If you have elected the Automatic Reinvestment of Distributions, you will receive a notice of the purchase of additional shares for the amount of the declared distribution.
In any case, the share price, or net asset value (NAV) of the Fund will drop by the amount of the distribution. If you reinvest the distribution, you will have more shares at the lower NAV for the same dollar amount. And, for taxable accounts, the distribution will be reportable on your 2012 tax return.

Any tax or legal information provided is merely a summary of our understanding and interpretation of some of the current income tax regulations and is not exhaustive. Investors must consult their tax adviser or legal counsel for advice and information concerning their particular situation. Neither the Fund nor any of its representatives may give legal or tax advice.


Rating: 4.2/5 (9 votes)

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