Ron Muhlenkamp: What we have been saying since 1998 is that the market is priced to do 8% or 9% per year. We’ve been doing about 14% because there have been huge disparities in values. The first question I get from the media is always “Which way is the market going?” Well, which market are you talking about? We’ve had a split market for at least six years now. And the second question is “Which sectors do you like?” That game is over. We say that you want to own individual companies.

The spread between the stocks that are under-priced and those overpriced is getting narrower, so the odds of us beating the market by as much, going forward, are less. But the markets are priced to do about 8% or 9%. If your alternative is 5% [long-term bonds], then you want to be in stocks and the trick is to find the ones that we’ve been finding -- better companies that are priced cheaper than their competitors. As long as that’s true, we’re in good shape. But I can’t tell you what the number will be. Historically, we’ve been able to add a couple of percent to the market returns which is probably why you’ve hired us in the first place.

Ron Muhlenkamp: You wake up in the morning and you see the future, or you see Futures? You were about to earn your pay, Jack. Gold has been going up. The dollar has been going down. Those are the same thing. Gold has been going up in dollar prices. The dollar has been going down versus the Euro. Gold, in Euros, is about flat.

Folks any time you are talking about currency or are talking about gold, you are talking about one versus the other. You cannot talk about weakness in the dollar unless you talk about weakness against what? In this case it has been weak against the Euro. It’s been flat against the Chinese Yuan, which is actually pegged to it. So “gold up” and “dollar down” are the same thing. The dollar has been weak such that it is back to where it was ten years ago. Is it too low today, or was it too high a few months ago? My guess is that it was a little high a year or so ago, and we think that it is about fair [today]. It’s not enough off fair to give us an economic reason to bet for it or against it. What you also get in currencies, which you also get in stocks and bonds, is that the short term is always determined by the psychology. The short term is always about psychology just as the daily weather is the daily weather. I don’t have an edge on psychology. What I have an edge on is basic values, determining the basic climate and the seasons. So that’s what we bet on.

Right now the trend on the dollar is down and there are a number of people who play the trends. Chances are that they are going to drive this beyond fair value.

Perspective
Folks what you see now on the screen is U.S. personal consumption expenditure adjusted for inflation, per capita from 1950 to 2000; (click here for details). We are 2.7 times as prosperous as our grandparents were in 1950. Their income and spending was about $8,800 per person. Today, it is about $23,800 dollars per person. So all this stuff we’ve worried about in the last fifty years -- we’ve had about nine recession, we’ve had inflation, Korean War, Vietnam War... We are 2.7 times as prosperous. The 1950s flattened out a little bit, Kennedy cut taxes. The 1970s flattened out a little bit and Reagan cut taxes. So it’s pretty nearly a straight line. All this stuff you’ve been hearing about, the problems during your lifetime, this is the net of all of that. The net is pretty darn good.

When I was in school during the 1960s we were taught that the U.S. economy was growing at 4%, the Russian economy was growing at 6% and they would pass us in GDP per capita in roughly the year 2000. Somebody missed something. As long as your kids see it in their best interest to work, and as long as employers believe it’s in their best interest to hire them, we see nothing that halts that trend. That’s an amazing trend.

Anybody here start carpooling? When you start telling me that you are changing your daily patterns based on the price of oil then I’ll change what I’m investing in based on the price [of oil]. Have you noticed that everybody complains about the price of gasoline? Nobody complains about the price of beer?

Perspective
Let me explain: We’ve been asking people for the past seven or eight years, “What do you spend money on that you don’t haggle price?” And the answers were titanium golf clubs, Harley-Davidsons, Winnebago’s, etc. It was all the luxuries of life. We called them adult toys and somebody said, “You don’t mean ‘adult’ toys, do you? No, we mean adult toys… We own a bit of Winnebago. I decided that I should get to know them a little better, so Connie and I went out to see them. In this past recession, some of their competitors decided that they would cut price. Winnebago said that their customers were buying Class A motor homes, (these things average $200,000 a piece); and a third of their customers pay cash. They said that if people can pay that much in cash they are not sure that cutting the price by 10% is going to be as important to them as whether they can get 24/7 roadside service or whether we spend a little extra money on paint and fit and finish. So they put a little more money into roadside service and fit and finish. Now they noticed the recession, but not a whole lot. Nobody needs a Harley-Davidson or a Winnebago.

What we’re finding, and it comes out of our Prosperity essay (click here for essay) we did a few years ago, we are more and more interested in those areas of your life where you’re spending money on things where you don’t haggle price: on the toys of adults, if you will. And that has worked for us very well.

Ron Muhlenkamp: First of all, short rates should go up. Short rates, historically, have exceeded inflation by about 0.7%. Today we think that inflation is about 2% and short rates are at 2%. They should be at
2¾ % - 3%. Now if the Fed starts raising them above 3%, then I’ll start taking a look.

Long rates have been, historically, at about inflation plus 3%. Well, the long treasury is at 5%. Inflation is at 2% -- so the long treasury is where it should be. We have been hearing for a couple years now that, “Gee, if short rates go up then long rates go up also.” Last spring, that happened. Short rates went up and long rates jumped about 80 basis points and everybody got excited. In the next couple of months, long-term interest rates gave about three-fourths of that back. Long rates have been basically flat all year. We don’t yet see a reason for long rates to go up much.

The second part of the question is about interest rate sensitive companies and stocks. A lot of people seem to believe that the only reason anybody bought a house over the past couple of years is because interest rates came down. We think people bought houses because they like owning a house. Can you tell the difference between an owner’s property and a rental property? How many of you own a home? We homeowners do things on the weekends that you couldn’t pay us to do during the week, because we own it. The real reason houses make you money when you own them is because you do all this stuff that otherwise you would have to pay somebody day-labor wages. Have you noticed that people who mow grass for a living are driving very nice pickups these days? It used to be that the guy who mowed grass had a beat-up pickup with a few mowers in the back and -- now we’re seeing 250 Fords with a trailer in the back, a closed trailer with matching paint! That says to me that this has been a pretty good business.

We think that housing starts will probably level off. The reason we own housing stocks, between 15% and 20% of the portfolio, is that they have made us a ton of money and they are still dirt cheap. We think that the big companies whose market share has gone from 10% of the market to 20%, are on their way to somewhere between 30% and 40%. We expect them to continue to get market share. They are very well-run companies. Return on equity (ROE) is somewhere between 18%-20%. They are selling at eight times earnings and as long as they continue to do well as a business, and certainly as long as their stocks are that cheap, we’ll own them. And we may buy more. Yes they’ve made us a ton of money. We’ve owned them for four and a half years and people have called us crazy for three and a half years. When they start telling me that they want to own housing stocks too -- then that’s when we’ll sell it to them.

Ron Muhlenkamp: There have been periods of years, particularly in the last 30 years, where it has been one sector then another sector. We think that game is over. Every industry that you can find has ample capacity. That means that [if a company like] WalMart is going to do well, then it is going to do well at the expense of JC Penny or Kmart. If General Motors is going to do well, then it is going to do well at the expense of Ford and Chrysler. We think that you have to pick the company who is beating their competition within their industry.

Ron Muhlenkamp: China is becoming the manufacturer for the world which means that they are selling us stuff dirt cheap. And we’re hearing a lot of rhetoric about the outsourcing of jobs to China. In the 1970s we heard the same complaints about jobs going to Japan. When I was in school in New England in the 1960s we heard the same complaints about New England textile jobs going to the Carolinas, and pointing out to the New Englanders that the Carolinas are in our same country didn’t mollify them a bit. The point is that while these changes can be upsetting to the producers, they all benefit the consumers; (see our reference to consumer spending since 1950.)

The point is that we’ve been here before, and have benefited. In his recent book Running Money, Andy Kessler argues, in reference to China, “We think. They sweat.” That’s not a bad deal for us.

Several years ago when the topic was Japan, somebody asked me “Weren’t they taking advantage of us?” I said, “They sell us Toyotas cheap and they are taking the money and buying Pebble Beach and Rockefeller Center.” Remember when that was a big scandal? Japan buying Rockefeller Center and Pebble Beach? I saw the prospectus on Rockefeller Center. They paid three times what it was worth! The Rockefellers didn’t complain! Why would the Rockefeller’s sell it to them if they were being taken advantage? They paid three times what it was worth. They paid outrageous prices for Pebble Beach. Japan has been in a funk since, partly because it doesn’t pay for their people to work more. These arguments that we’re hearing, we’ve heard before. I can’t tell you that the outcome will be the same but I can tell you that the odds are that it will be in the same range.

What’s happened in basic commodities is China is buying to build their infrastructure, and some commodities tend to be in short supply. I spent an hour at noon today listening to people in the transportation industry. We had people on the phone from Burlington Northern Railroad and the topic was container cargo. Of course they come over by ship, primarily from Asia. There is a bottleneck at the port of Los Angeles. I don’t know if any of you have seen the container port out there. If you go out to see the Queen Mary then you have to pass by the container port. The biggest container port in this country is in Long Beach, outside of L.A. Well, it goes from ship to train to truck to get delivered. The container port is at capacity. The trains are at capacity. The truckers are getting so tired of waiting there that we are having a shortage of truck drivers. If I were a blue collar guy looking for a job, this is where I’d look. We have a shortage of truck drivers. They are finding that they have to be far more flexible. I don’t know if any of you have ever worked for a railroad, but flexibility is not their strong suit. Flexibility has been a strong suit of trucking companies. What they are finding is that shipping and railroad companies are starting to adopt trucking company mentality to have a little more flexibility. Some of the questions are, “Should we be taking some of this freight through Oakland? Should we take some of it through Seattle? Should we take some of it through the Panama Canal, into East Coast ports?” Well, it turns out that the Panama Canal is almost at capacity. The trick is that we have this shortage, but I can’t find a way to make money on it! The railroad and the shipping companies can raise their rates a little bit, but if the trucking companies can’t haul it… So I have identified the shortage -- but I am having trouble finding a way to make money on it. Long answer to a short question but that is the kind of stuff that’s going on out there.

Anthony Muhlenkamp: That depends on the manager. How good is he? What have you hired him to do? Do you think you know more about it than he does? If you know more than he does, then yes, limit his flexibility. But if you don’t, hire a guy that can go anywhere and make the best investments. It depends on what you have hired him for and what you want to accomplish. We’re not in the mutual fund marketing business. We’re in the profession of investing other people’s money. The Fund happens to be a nice way to hire us to do that.

In the meantime…Folks, I’ll ask you: What’s the purpose of Social Security? To keep old people out of the poor house? Kind of an insurance plan? How many of you own a house? You have fire insurance? You want to collect? You paid in all those years, aren’t you entitled to collect? An insurance plan says that a few people can get a lot more out than they put in. That’s an insurance plan.

How many think that Social Security is a pension plan? A pension plan says that you put money aside and it grows and that becomes your pension. That’s the way corporate pensions work. That’s the way private IRA’s work. If Social Security were fully funded that might make sense. But it’s not fully funded. If companies ran their pension funds the way the government runs Social Security the executives would all get thrown in jail. Social Security has simply been a transfer plan. Yet it’s sold to the public as either an insurance plan or as a pension, which are two very different things.

In my mind what President Bush is talking about is taking the pension part out of it and allowing us to do that ourselves, and keeping the insurance plan. So that if we fail to do that ourselves there is still a backup. I don’t think that anybody says that we shouldn’t have something like Social Security in place to keep old people from being destitute. Eighty percent of us are capable of funding our own retirement if you give us the chance and allow us the money to do it. So what I think he’s doing is splitting those two apart and I think it would be an easier sale if he did that.

We mentioned earlier that people have three working speeds. When you are working for yourself you will do it better and you will do it more effectively than if the government does it for you. The difficulty is that it takes a lot of power out of some people who work for the government and who work for the Social Security Administration. Incidentally, folks, the people over sixty don’t have a problem. There are ample assets and flows coming in. The nice thing about Social Security is that all the retirees for the next thirty years are already working and all the workers for the next twenty years are already born. So it’s pretty easy to predict the numbers for the next twenty or thirty years. Those numbers say that for people over 60, ample funds will be there. The plan runs out of money in about 2034. And for people in their 30’s and 40s, the promises will not be kept -- and Congress knows this. And they expect to hear from the 40-year olds who say, “Fix Social Security.” What they are afraid of is the people over 60 who say, “Oh, don’t touch my Social Security.” The only way it’s going to happen is if you -- people over 60 -- tell your congressman “We understand the numbers, you have got to fix it for our kids.” That is the only way it’s going to happen. Right now that’s on the table in Washington D.C., so now is the time to update your numbers, form your opinion and let your congressman know. Long answer to a short question.

Anthony Muhlenkamp: Dad said something before about definitions of risk, right? What’s interesting is that we’ve had a few people say that we should open another fund, but nobody has ever asked for our second best ideas. Presumably we already own the best things that we can find so that if we opened a second fund I’m not sure that it would own anything any different. So it would be the same risk and the same reward. The point is that Charles Schwab and Morningstar’s classifications are based on some assumptions that we don’t agree with. One is that they assume that Beta and Standard Deviation are the only measures of risk. Two, they measure us against “different people” in our same category. Well, I don’t like how they define the categories, so I don’t agree with that. So, by the time you run through Charles Schwab and Morningstar’s risk-reward calculations, frankly it’s an opinion. It’s presented as a fact, but it’s an opinion.

Ron Muhlenkamp: The reason they call us “high risk” is that they equate volatility with risk and they think that we went up too fast. If any of you think that we went up too fast, I can’t help you. The presumption is that we will then go down too fast, but that is not necessarily true.

Anthony Muhlenkamp: First of all, how many of you believe that your money knows how old you are? And if it did know, would it care? So this distinction between “younger than forty” and “older than forty…" Who cares?

What we try to do is three things: 1. not lose your money; 2.earn you a decent return; and 3. help you to sleep at night with the process. It turns out that all my clients are interested in those three things. Whether they are two years old or ninety-two years old, none of them want to lose money, all of them want a decent return and they want to sleep at night with the process. What we do is broadly applicable. The problem is, of course, that we are unconventional.

We introduced you to our Shareholder Services team. These are the people who help with questions like:
“Should I fund an IRA?”
“What are the rules for IRA’s?”
“How much should I save?”
We can either help you with that or introduce you to people who can help you with that. Frankly a lot of these questions are pretty straightforward to answer. Any financial plan I’ve ever seen assumes a rate of return on your money, right? Well, figuring out how much you have to save and what rate of return you have to get and where that will put you in twenty or thirty years, that’s pretty straightforward. Knowing how to invest to get that return is a little interesting and that’s what we get paid to do. The rest of that is useful, but a lot of people can do that for you. If you’ve got a financial plan in place and it’s not working it’s probably not the plan that’s bad, it’s that the execution may be suffering and we can help you with that. But if you are less than forty and you want to figure out how much you have to save in order to retire at age sixty-five, yes, we can help you with that.

Ron Muhlenkamp: We really don’t have a time horizon. We sit down and say, “What do we think this company is worth? Are the things they are doing sustainable? ” If we can get if for a third less than it’s worth, then we get excited. We’ve owned some things for thirteen years. We owned Fidelity National Financial for a $1.50 per share starting in 1991 and it’s now at $36 [per share]. As long as the company does what we expect it to do, and the price remains reasonable, we’ll hold it. If the company disappoints, it gets sold. If things happen on the price that we don’t quite understand, it’s likely to get sold too. But if we think the company is going to grow at 15% and it grows at 15% -- and stays cheap – 15% percent is a pretty good return. The P/E (price-to-earnings ratio) doesn’t have to move up. If the P/E gets ahead of itself then we’ll sell it. But as long as the company fulfills our expectations and the price remains cheap we’ll hold it.

Ron Muhlenkamp: Ron Muhlenkamp: 2004 will end in about thirty days, twenty-nine, make it. I don’t know how to predict the future! Nobody else does, either. What I’ve learned over thirty-five years is that you don’t have to predict the future. If you have some idea of what is happening in the present that is sufficient. We spend our time trying to understand the present. Everybody wants to predict the weather of tomorrow. Most of them don’t know what the climate or the season of today is. Odds are that tomorrow will be a whole lot like today. Yes, we have seasons in the marketplace just like we have seasons in the weather. We do spend a fair amount of time, every now and then, asking if the climate has changed, because every once in a while you get a chance at that. We concluded this time around that it wasn’t changing. We’ve said that stocks are priced to about 8%-9% per year, but that’s over a period of three to five years.

My father was a farmer. He farmed on a four-quarter cycle. When we invest, the market runs on a three- to-five-year cycle. I fully expect that one year in five we are going to lose money. If I knew which one, we would avoid it, but I don’t. My calendar isn’t that good. Stocks are priced to do 8%-9% over a three-to-five-year period. Since you can get 5% on bonds, we’re willing to live with that volatility. But I don’t know how to predict the future.

Ron Muhlenkamp: I’m not sure the housing market has been showing gains. I know the housing stocks that we own have been showing gains. We’ve owned housing stocks for about four and a half years now and we’ve been called crazy for three and a half years. NVR is at $690 per share our average cost is about $74 [per share]. A lot of people say, “Gee they ran up. It must be a bubble.” Number one, it has been a pretty good period for housing. The big surprise to us, when we started buying housing they were selling at four times earnings. I fully expected that in the recession earnings would get cut in half so that effectively we were buying at eight times earnings. The big surprise in this recession was that housing didn’t get cut in half, partly because interest rates came down.

What’s also happening in housing is that big companies are getting market share from the little companies. Up until this cycle I’ve never owned much housing stock because every home builder competes with what I call the “neighborhood man with a hammer.” We all have neighbors who like working outdoors, who like swinging a hammer. They hire a few friends, they work sixty or seventy hours a week and it’s hard to compete with them. What’s becoming more and more important in housing is to get a permit to build the house. The guy who likes to swing the hammer doesn’t like standing in line at city hall to get a permit to swing the hammer. So as a consequence the top ten home builders in the country, which as of ten years ago had 10% of the market, now have 20% of the market. We see nothing that will prevent that from going to 30%-40% of the market. These are now well run companies. The last time around they use to tell you how many houses they were building and they used to build them on “spec” -- they don’t do that anymore.

NVR nearly went bankrupt. NVR doesn’t even buy land anymore. They just option it. So you now have companies that are run as companies. They’re getting market share. Their ROE (return on equity) is 18% or 20%. We think this is sustainable because they are doing good stuff and the stocks are still at eight times earnings. So there are probably bubbles in some neighborhoods, like parts of California and parts of Long Island and everybody assumes that if these neighborhoods slow down that the building of houses is collapsing.

Any of your kids not want to own their own home? Even if I show them that it’s much cheaper to live in an apartment -- that’s half the size of the house they want. People want to own their own home. We don’t think that housing stops. We think that it flattens out from here. We don’t expect boom years, the next several years. We do expect the big companies to continue to get market share from the little companies and as long as they are selling at eight times earnings we’ll own them.

NVR accounts for about 12% of our gain this year.

Anthony Muhlenkamp: The IRS Publication #590 states that a couple that is married, at age 67, one has about 20 years to live. Actually, that would be the wife, but that’s just the price we pay. Ideally, we all want our nickels to run out with our last breath, if we’re not interested in leaving anything. If you can tell me exactly when that last breath will be, then I can figure exactly when your nickels will run out. But over 20 years, that’s a long time.

Think back over the last 20 years, it’s been kind of interesting. At a 20-year life expectancy I would argue that you are a long-term investor. If you read The Basics (click here for essay) we make a pretty good case that with any money that has a horizon greater than three years, you’re a long-term investor. So let me ask you this: How many of you want to live another three years? How many of you want your money to be around longer than three years? See? Even if the lady says that she doesn’t care if she lives, she wants her money to be here. Just in case. So at age 67, if you fully expect or want to live -- or if you want your money to last -- then you want to do the best you can with your money. So the proper allocation for a person is, where am I going to do the best and how do I know?

Would I change your allocation? I don’t know what you’ve got. Your allocation should be 100% wherever you think you can get the best returns on average over the next three years – on average. One of the things you might do is to take your financial plan and use it to create a statement of investment policy. My statement of investment policy, my criteria for investing is as follows: I expect Dad to grow my assets by 5% or 6% after taxes and inflation, on average over any three-year period. I’ve learned that the markets are volatile so I’ve learned to accept losses of up to 20% in any one year out of three -- but I do not want to accept losses two years in a row. Is that a useful criteria for someone age sixty-seven? Maybe. I’m interested in any allocation that will satisfy that. And since I don’t know how to allocate it, I’ve hired him to worry about it. If he decides that he can earn me that return by putting me 100% in government bonds, swell. What I heard him say is, “Not today.”

Regarding the second part of that question, you’ve got to take money out of your IRA because you are 70½ -- that’s the law. And because you take money out of it, you will pay income tax on it or you will go to jail or you will pay big fines. Nothing says that you have to spend the money that you pull out of your IRA and paid taxes on. If I’m 70½ and I have to take $20,000 out of my IRA, I’m going to do that and I’m going to pay the taxes. If I only need to spend $3,000, I’m going to take the remaining $17,000 and put it into my non-IRA account and save it for later. That’s all you have to do. You don’t have to spend it. You do have to pay taxes on it when it comes out.

Ron Muhlenkamp: We own a bit of UT StarComm, which is a telephone company in China. We own just a little bit of TelMex, which is a telephone company in Mexico. We own a certain amount of CeMex, which is a cement company in Mexico. And we own some SanteFe Aventis, which is a drug company out of France.

Any time you invest in other countries you pick up two additional risks. You pick up accounting risk, and we had more accounting risk in this country than we thought we had, and you pick up currency risk. Currency risk in the last year or so has favored going overseas and I checked the paper today and international funds are up about 16% this year. Well, we’re up ~19% this year, so I’m not sure it would have added. We’re finding enough good values in this country, where we know a little more about it than we do overseas. If we weren’t finding good things here then we’d take a harder look. There are various ways to do it. One of the ways is to own foreign companies, another is to own domestic companies that do business in foreign countries. One thing that we added a fair amount of is Johnson & Johnson. We are starting to see decent values in the big blue chip companies and they tend to do more international [business.] There are various ways of playing that besides owning overseas stock.

Anthony Muhlenkamp: Can I tell my story about buying Grandpa’s farm? Grandpa had a hundred acre farm in Western Ohio. Farmers in Western Ohio normally grow corn and soybeans, right? Well, I’m a city kid. Let’s pretend that Grandpa retires and I buy the farm. Grandpa hands me the keys, says, “Good luck, don’t call me. I’m retired.” He doesn’t want to hear about farming. In the spring of the year I’m out there planting and I’m planting corn and soybeans. A guy drives up in a pickup truck and says, “What are you doing?” I say, “I’m planting corn and soybeans.” “No, no!” he says. “Remember the flood last year? We are going to get floods this year. You ought to diversify your acreage and plant something that grows good when it’s flooded. Rice grows good.” Now I’m a city kid. Can’t call Grandpa and my cousins won’t answer the phone. I’ll tell you why in a minute. It sounds good and he says, “Not the whole hundred acres but maybe twenty percent, plant rice.” “By the way,” he says, “It just so happens that I’ve got all the rice you need in the back of my truck. I’ll let you have it, cheap.”

The next week I’m out there planting rice and a guy drives up and asks, “What are you doing?” I answer, “Planting rice.” “No, no, no,” he says, flood last year, drought this year. You ought to plant something that grows when it’s dry. Just to diversify, try cotton.” And it just so happens that he’s got a pickup truck full of cotton seed that he’ll let me have, cheap.

The next week, “No, no, no.” the third guy says, “The acidity of the soil has changed and here are the studies proving it. “Tobacco,” he says. Now folks, can you make money growing tobacco in this country? Sure. Rice? Yes. Cotton? You bet. In Western Ohio? Not on your life. So come fall, what do I have? Twenty acres of corn, twenty acres of soy beans... sixty acres of nothing. I’m diversified. Am I still in business? Why didn’t my cousins answer the phone? They wanted to buy a farm, cheap. That’s what Dad talks about with the climate. If you don’t understand the climate you are farming in, you’ll plant any crop that someone tells you will grow.

Ron Muhlenkamp: What Grandpa did, actually, was to call another city friend of his to come out in October and said, “Look at this corn crop I’ve got! I’ll sell you this farm. Look at how this corn grows!” So the guy buys his farm and plants corn in October. What most people do in investing is to wait until October, to see how well things have gone up. Then they buy into the market. Two years ago when I told people that things were cheap they wouldn’t send us money. Now that we’re up 70% in two years they are sending us a lot of money. Our challenge is getting them through a flat period, maybe a down period.

There are three things that you learn farming in Ohio and Pennsylvania. The second thing you learn is that crops don’t grow every month; they only grow half the time. The third thing you learn is if you don’t plant them, they don’t grow at all. You all know the first thing you learn. You learn to recognize “BS” at a very early age. Those three observations have done me more good than the Harvard Business School. And you already knew them.