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Holly LaFon
Holly LaFon
Articles (8179) 

Ron Muhlenkamp Memorandum Quarterly Letter

July 22, 2013 | About:

As indicated by recent performance, stock prices are up nicely year-to-date and we’re doing well.

While the economic trends of the past couple of years continue, we’ve just seen an important change in interest rates and the bond markets.

First, the economic trends:

  • Europe is in a recession.
  • China is attempting to shift from an infrastructure and export focus to more domestic consumption, but the transition is hampered by reluctant local leaders and their interest in recent successes. The resulting stresses are making it difficult for China to reach its announced targets for growth.
  • In the U.S., growth continues to be tepid despite gains in autos and housing. First quarter GDP (Gross Domestic Product) growth was just 1.8% (initial estimates were 2.4%) as consumer spending on services is subdued.
  • Since the end of April, interest rates have rebounded nearly a full percentage point as the markets speculated on when the Federal Reserve stimulus would taper off.
Second, interest rates and the bond markets:

  • Since the end of April, 10-year Treasury yields have gone from 1.7% to 2.6% and 30-year mortgage rates have gone from 3.4% to 4.5 percent. Frankly, we think these moves are healthy as they are advancing toward normal levels. (Interest rates have been held below normal market levels by the Federal Reserve in a belief that this would foster economic growth.) Specifically, higher interest rates benefit retirees and pension funds.
  • U.S. bond markets now appear to be focusing on the likely end to stimulus and have moved interest rates higher, thereby driving bond prices lower.
  • Whatever the underlying cause, a full 1% increase in less than two months is dramatic in the bond market and potentially disruptive in the stock market. In fact, the stock market has recently sold off 5%-10% in the various indices after a strong up-move since last fall. It now seems to be stabilizing as we look forward to second quarter earnings.
In a world where the U.S. economy is growing at 2% and most other economies are also growing well below potential, we expect that the stocks of companies that can report good revenue and earnings growth will do well.

The great disappointment is that the improvements in the U.S. stock market and Federal income tax receipts (and in European bond markets) have given politicians on both sides of the Atlantic an excuse not to rein in government spending in a meaningful way.

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.

Ask Muhlenkamp

At our investment seminar on May 21, 2013, Ron Muhlenkamp presented The Big Squeeze: How taxes are squeezing your income; how interest rates are squeezing your assets. Afterwards, Ron and his Investment Analysts entertained questions from the audience. Following are responses to these and other questions that have recently surfaced. If you have any questions or comments, please don’t hesitate to contact us at (877) 935-5520 extension 4.

An archive of the seminar is available on our website at www.muhlenkamp.com.

About the global economy…

What’s happening with the Japanese economy?

Shinzo Abe became the Prime Minister of Japan for the second time in December 2012. (He was previously Prime Minister in 2006-07.) Abe campaigned on a three-part program of returning growth to the Japanese economy: reversing austerity measures and using fiscal policy to boost the economy; weakening the yen to boost exports and increase inflation; and reforming some business laws to encourage growth.

Upon election, Abe installed a new governor for the Bank of Japan (BOJ), Haruhiko Kuroda, who introduced a large program of yen creation and asset purchases by the BOJ. As a result, the value of the yen dropped from 80 yen/dollar to 102 yen/dollar, the Nikkei-225 Stock Average rose 65% from December 2012-May 22, 2013 (then dropped 12% from May 23-May 30, 2013), and the yield on 10-year Japanese bonds rapidly increased .5% in early April 2013 to nearly 1% in mid-May—still very low, but quite a dramatic change in a short period of time.

In our opinion, the problem the Japanese are trying to solve is the enormous debt burden of their federal government, currently about 240% of annual Gross Domestic Product (GDP). The previous government wanted to address the problem largely through tax increases. Abe campaigned against this, wanting to grow his way out of debt—thinking the country can generate economic growth through currency devaluation and inflation.

If Abe can achieve inflation, it will help the borrower (the government) at the expense of the saver (everybody else in Japan). Currency devaluation will help the exporter, e.g. Toyota, at the expense of the importer, e.g. the Japanese consumer and Toyota, as well. (Japan doesn’t have a lot of natural resources and must import pretty much everything.) So Abe’s hope is the debtor will be helped more than the saver is hurt.

We believe real GDP growth (net of inflation) comes from either a growing population, increased productivity, or both. Japan’s population is declining faster than its productivity is increasing, which is why it has had zero real growth for 20 years. Devaluing the currency and generating inflation won’t change that, which means, in real terms (i.e. purchasing power), the quality of living in Japan will come down. We have strong doubts that this will work out well for Japan.

For more on our thoughts about inflation, please see the question/response within the “About the U.S. economy…” section of this article.

What’s happening with the Chinese economy?

We believe it continues to expand. The Chinese leadership has targeted GDP growth of 7.5% for this year, and, unsurprisingly, it looks like they will meet it. The Chinese leadership has also stated it wants to shift from an “infrastructure build-out” growth model to a consumer-led growth model. Doing so will neither be easy nor quick; movement in the new direction has been slow.

Clearly, Chinese demand for industrial commodities has cooled and, since China had been the growth driver for many materials industries, we think commodities and basic materials will do poorly. We continue to look for companies that meet the needs of the Chinese consumer.

What’s interesting is we’re now seeing estimates that within three years (2016) the labor cost in China will be as high as labor costs in the U.S. We’re starting to see outsourcing return to the U.S. As Chinese labor costs go up, (family planning laws have had a dramatic effect on its workforce), robots—jiqiren in Chinese, literally “mechanical people”—have proliferated in China, many of them homegrown.1

About the U.S. economy…

Inflation has been added to the checklist of things you routinely monitor. If inflation does increase, how will it change the portfolio? What will you do differently?

Historically, when the Federal Reserve (Fed) printed money faster than our economy was growing we got inflation because the velocity (turnover) of money was fairly stable or gradually expanding. In 2008, however, velocity fell through the floor, which is why the Fed doubled the size of its balance sheet. (Those of you who have been listening to us for awhile know that we didn’t fear inflation for the past several years because much of the money the Fed printed was to offset a collapse in the velocity of money.)

One of the triggers that tell us the velocity of money is picking up is an increase in commercial and industrial loans. Because businesses are becoming a little more willing to borrow and banks are becoming a little more willing to lend, inflation is now on our red flag list.

As consumers, most people think of inflation in terms of price increases. As investors, we think of inflation not as prices moving up—but as the value of money shrinking. Inflation eats into the purchasing power of our income and assets. Today, we can’t protect the purchasing power of our assets against 2% or 3% inflation with cash (T-Bills, CDs, and Passbook Savings) or even long-term Treasuries.

We believe that by investing in companies with strong balance sheets and free cash flows, we are better able to protect the purchasing power of our assets. Such companies, however, must also be able to adjust for changes in the inflation rate.

Knowing that if we have a gradual rise in inflation—if it moves up at a rate that companies can respond to based on sufficient demand—companies can, in fact, offset inflation. But there are two qualifiers: it has to be gradual and businesses have to see enough demand in the economy to offset it.

Remember, inflation normally drives up interest rates, which would normally drive down P/Es (price-to-earnings ratios). However, if a company’s earnings grow faster than its P/E goes down, the stock price should go up. (Obviously, if earnings do not grow faster than a declining P/E, the stock price should go down.)

To learn more about how we price the markets, refer to Ron’s essay, Why the Market Went Down.

Are low interest rates pushing us toward a stock market bubble?

Currently, the Fed is buying $85 billion of Treasury and mortgage bonds each month to put downward pressure on borrowing costs. This has had an effect: first, it’s achieved the intended purpose of keeping interest rates low; second, it has bolstered the stock market—all that money has to go someplace. But evidence that low interest rates have helped the economy is much harder to find.

Specifically, low interest rates encourage people who manage hedge funds to borrow and to buy securities, commodities, and other financial instruments—which, in fact, the Federal Reserve is encouraging. The Fed wants to get the stock market up! Remember, you can lift the stock market for a period of time by feeding it money, but, sooner or later, it responds to the underlying values of the companies represented by the stock.

Because we think stock prices are fair—and that the market will be driven as much by the Fed and investor psychology as anything else—we’re trying to be more nimble. We’re a little quicker to sell; we’re a little quicker to raise cash.

Is it good stewardship of U.S. resources for companies to export natural gas?

Crude oil has long been transported by ocean tankers, making a global market possible. Natural gas is more difficult to transport because it must be liquefied for tanker transportation and then re-gasified for pipeline delivery somewhere else. (Currently, North Dakota captures and sells roughly 70% of the natural gas it produces and flares the remaining 30% because it doesn’t have the pipeline infrastructure.) The cost of liquefying/transporting and re-gasifying is on the order of $6 per thousand cubic feet (MCF)—on top of the price of natural gas at $4 per MCF.

Some industry leaders, including T. Boone Pickens (Founder of BP Capital) and Andrew Liveris (CEO of Dow Chemical Company), have spoken out against exporting. We think they’re being short-sighted; they already benefit from saving $6 per MCF on the transport. We think a global market for natural gas could materialize in about five years as more tankers and terminals move natural gas between markets and continents. So far, our federal government has approved two natural gas export terminals on the Gulf Coast; twenty more applications are pending. Canada, Australia, and East Africa are also among the places seeking to export natural gas to markets like Japan (where prices are $14-$15 per MCF) and Europe (where prices are $10-$12 per MCF).

“There are ample domestic supplies of natural gas to meet future demand without significant price increases,” the Bipartisan Policy Center2 wrote in its May 20, 2013 report. While it’s clearly a wait-and-see situation, we think higher production rates can accommodate foreign demand without negatively affecting domestic prices because of the technology-led energy boom.

For more about our thoughts on natural gas, please see the question/response within the “About the markets…” section of this article.

To learn more about Ron’s thoughts on the stewardship of U.S. companies, please refer to Ron’s essay, How We Benefit from Free Trade.

About the Markets…

You’ve stated that commodities are leveling off; i.e. they are not a ‘good buy.’ Is this true of gold and silver, too?

With China making a push toward more consumer spending and less infrastructure spending, along with Europe slowing down and the relative strength of the U.S. dollar, commodity prices have come down. This applies to all commodities, all the way from steel to copper—basically the hard commodities—and, lately, gold along with that. (Actually, gold has been declining for the past 18 months. The trouble with gold and silver is that they’re “half religion.” Some people buy them for non-economic reasons.) As a result, we do not own any material stocks or basic material stocks.

Have you identified a theme or trend on which you are focusing?

There are two areas where we are bullish: natural gas and biomedical technology.

Natural GasThe price of energy in this country is coming down big time, driven partly by natural gas, but also by horizontal drilling for crude oil in North Dakota. (We think there’s a decent shot, within five or ten years, of cutting the cost of energy in this country in half.)

Natural gas is selling on a British Thermal Unit (Btu) basis at about one-third of where crude oil is selling. We think the price of natural gas stays about where it is at $4 per million Btu because it’s profitable for many gas fields. It should also be profitable for a whole lot of companies to convert from using crude, diesel, and gasoline to using natural gas at these prices.

We think the next area of opportunity is in transportation, particularly over-the-road trucking. We’ve invested in companies that drill for the natural gas and those that service them. We’re also invested in companies that modify truck engines to burn natural gas, as well as companies that are building and supplying the fueling stations.

Biomedical Technology

Advancements in biomedical technology are changing how we provide healthcare in the U.S. While in the early innings, the healthcare industry is evolving from the traditional model of going to the doctor to diagnose our symptoms and treat our illness, toward a model of screening, prevention, and early intervention; i.e. personalized medicine based on one’s genetic makeup.

The healthcare industry is getting better at understanding the causes of disease—and using that knowledge to not only improve treatments, but to identify those individuals more at risk.

We’ve invested in companies that bring innovative genetic testing to the field of medicine, allowing earlier diagnosis, prevention, and treatment, along with companies that are working to develop biopharmacologic medicines to more effectively treat cancers and viruses, two growing areas of biotechnology. …And we think the long-term return potential is significant.

Has your stock selection process changed over time?

Our stock selection process continues to be “bottom-up” and we remain steadfast 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. Here’s 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 Outright Monetary Transactions (OMT) program was announced back in September 2012, we concluded the likelihood of a European banking crisis had receded. We decided it made sense to own the banks we had identified at cheap prices, so we invested. So far, those investments have worked out very well for us.

Our portfolio is now dominated by large, U.S.-based companies that we believe have rock-solid balance sheets and strong free cash flows—companies we believe can survive a period of lackluster earnings, should that take place. For some of the companies we own, the dividend yield is better than the bond yield of the company. We like financials; we believe natural gas-related companies have great potential; and we think biotechnology companies are singing.

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


2Founded in 2007 by former Senate Majority Leaders Howard Baker, Tom Daschle, Bob Dole, and George Mitchell, the Bipartisan Policy Center is a non-profit organization that drives principled solutions through rigorous analysis, reasoned negotiation, and respectful dialogue.


Nikkei-225 Stock Average is a price-weighted average of 225 top-rated Japanese companies listed in the First Section of the Tokyo Stock Exchange. The Nikkei Stock Average was first published on May 16, 1949, where the average price was ¥176.21 with a divisor of 225. One may not invest directly in an index.

Free Cash Flow is a measure of financial performance calculated as operating cash flow minus capital expenditure. It represents the cash that a company is able to generate after laying out the money required to maintain or expand its asset base. Book Value (BV) or “Book” equals total assets minus total liabilities. It is the owner’s equity in the business, often quoted as Book Value/Share. Price to Earnings Ratio (P/E) is a valuation ratio of a company’s current share price compared to its per-share earnings.

Book Value (BV) or “Book” equals total assets minus total liabilities. It is the owner’s equity in the business, often quoted as Book Value/Share.

Price to Earnings Ratio (P/E) is a valuation ratio of a company’s current share price compared to its per-share earnings.

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