Ken Dupre: The cut in marginal tax rates has a lot to do with today’s topic. Basically, there have been three times in the past when our politicians have cut our tax rates: in the 1920s, in the 1960s, and in the 1980s. Early in each of those decades the politicians gave us a cut in tax rates, and the net result was that, overall, the average increase in tax revenues was 5%. So it was a cut in tax rates, but the overall result was an increase in tax revenues. And this is something that we expect to see this time around. The net is that tax cuts, often times, can lead to an increase in GDP and, therefore, tax revenues for the government.

Ron Muhlenkamp: We wrote an essay about three years ago called Prosperity in which we argued that, in the US today, in both the spending level and in the earnings level at the margin, things are discretionary. Some of you have been through the thought process… Suppose you work a 5-day week. What you earn on Monday, you pay 10% in taxes. What you earn on Tuesday, you pay 20%. What you earn on Wednesday, you pay 30%, and on Thursday you pay 40%. Whatever you earn on Friday, you pay 50% in taxes. How many of you would come to work on Friday?

Everybody here, if you’re earning any money at all, is in the 40% tax bracket. Those who think that they are in the 28% bracket -- add in Social Security and it’s 42%. And then there’s 2% state and 1% local. Folks, we’ve all been in a 45% tax bracket, and…only one hand went up at the 50% rate!

As you get more prosperous, the rate at which you will continue working comes down, which is why I believe this recent cut in taxes was necessary. If you are hungry, if you are starving, you’ll work at a 95% rate, right? That’s called slavery; but even slaves will work to get fed. But as you get more prosperous that number comes down.

The timing of the tax cut was useful in that we are in the aftermath of a recession -- which is when you should have some deficit spending. But I’ve argued that we needed the cut in tax rates to keep people working three, five, ten years from now. Obviously there are folks who want a job and want to work, but you also need someone who is willing to hire them. Who’s more likely to hire your kids: somebody in the top tax bracket, or someone in the bottom tax bracket? The answer: those in the top tax bracket. They’re only going to hire them if they see the rates low enough that it pays them to do so.

Ken Dupre: There is another big piece: when it comes to the people who are rich, it is because they have accumulated their wealth over time. I mean, you have your Warren Buffets and your Bill Gates, and most of the people who are rich are already retired. Are they paying income tax? No, they’re paying capital gains taxes. And they have a lot of money put away in retirement savings funds. Who pays the taxes? It’s not so much the rich who are paying taxes -- it’s the people trying to become rich. You want to encourage the most productive people in society, the ones who are paying all the taxes. The top 40% of taxpayers pay 95% of the taxes. Those are the people who are out creating jobs, being entrepreneurs. You want to encourage those people to work as hard as you can get them to work. That’s where tax revenues are going to increase. That’s where you are going to get jobs -- and if your tax rate is too high, those people are going to decide not to work, or to work less. In the long run it actually hurts, instead of helping.

High-yield bonds are also called junk bonds. Right now you’ll probably make some decent money in high-yield bonds because the yield spread is unusually wide between the Treasury and the junk bond. But, frankly, you’ll make more money in the stocks of the same companies.

Be aware that as people get a little more confidence and they bring interest rates down, the companies will refinance their bonds at a lower rate. Just as you and I refinanced our mortgages from 11% down to 8%, down to 7%… junk bond companies will do the same thing, just as they did the last time around. They will refinance at a lower rate, which means you won’t own them any more! And they will refinance them for the benefit of their shareholders.

Most people have no business in junk bonds. If you are going to own bonds, own good quality bonds. If you want to take company risk you might as well do it in the equities where, if the company survives, you make more money than you would in the bonds.

I learned coming out of the early 1970s (after the last stock market fad) that 2–3% of management will lie to you. In fact, Business Week had an article a few months ago in which they had 12 pictures of people who were indicted, or who were arrested – or were likely to be. Twelve out of the S&P 500 is, I believe, 2 ½%. Two to three percent of the people are going to lie to you.

Recently I was asked by a reporter, “whom do you trust?” I said, “I trust 95% of the people, just like I did last year. I just don’t know which 95% they are!” That’s why you diversify.

In fact, most business managers are honest. You’ll find that as you go along. Of the ones who have been crooked, many of them are going to jail. You haven’t seen anything about corporate malfeasance in the last six months. Last year, it was huge headlines. But I believe that people are gaining confidence and that it’s being solved in the normal process, so we think that fear of malfeasance will dissipate. And we passed a law, Sarbanes-Oxley, which was a political response to peoples’ fears.

If you list 100 people whom you know, 2–3% are probably habitual liars. And they’re probably rather entertaining at a party. But that doesn’t mean you want to give them your money.

What we try to do is make sure that the people we are investing with, we trust. Nevertheless, we are going to be wrong with 2–3% percent of them. But that’s why we diversify.

As a benchmark, the top 50 companies in the S&P 500 have a 20% return on equity, which makes them Cadillacs in my lexicon, and a 20 P/E. So they are Cadillacs selling at Cadillac prices.

We’re buying Buicks at Chevy prices. And we will do that year-in and year-out. Now, the level of a fair price slides up and down the scale. When inflation changes, what we’re willing to pay changes.

Ron Muhlenkamp: Inflation is a matter of printing money. In the 1960s we could do it because we lent money to the rest of the world. Today, if there’s a hint of inflation the dollar tanks.

Ron Muhlenkamp: No. But every country in the world has found that it can’t get away with printing money. Frankly, the world markets make sure it doesn’t happen.

Ron Muhlenkamp: They told us in November of ’01 that the recession had started in March. It bottomed in December. And sometime in the next year they’ll tell us that it bottomed in December of ’01. The point is that they don’t tell you until it’s too late to do you any good.

In mid-1991, Connie and I were at a reunion at MIT. I caught up with an old classmate, who is the chief economist at DRI, (Data Resources, Inc.). They own Standard & Poor’s and other things. At the time treasury bonds were at 9%, and he argued that with the deficit, interest rates had to go up. I said, ‘With the incentives that are going on and with inflation coming down, interest rates will come down.’ In June of ’91, treasury interest rates were at 9%, and by year-end of ’93, they were at 6%.

Recently, in the Sunday issue of the Pittsburgh Post Gazette, this same economist was quoted as saying that he didn’t expect to see government surpluses again in his lifetime. Of course he’s my age, (I’m 59), and he’s reflecting what he was taught in the 1960s. This is what he’s been taught. He’s got his PhD in economics. My advantage is that I’ve only had two courses in economics. I haven’t had to unlearn as much because those two courses were dead wrong. If you go back to my textbook, it talks about inflation being cost-push and demand-pull. Well no, what we’ve proved, what Paul Volker proved, is that inflation is monetary. In 1964, I was taught that the US economy was growing at 4% per year and that the Russian economy was growing at 6% per year, and that (in roughly the year 2000) they would surpass us on a GDP per capita basis. Well, folks, somebody missed something, right? The economics I was taught was all nonsense. The last 30 years has proved it. But if you are a tenured professor, or an economist, or have a PhD, it’s kind of hard to agree with that.

You would think that the chief economist at Morgan Stanley would be the most free market man in the world. But he uses language that comes straight from Karl Marx. He’s been wrong for 10 years. In the middle of the 1990s, he was expecting recession; he was expecting labor strikes. He was saying that the worker isn’t keeping up with the economy. I said, ‘With unemployment coming down, if it’s a union shop, all the worker has to do is go over to the bulletin board and upgrade his job.’ And he said, ‘Well, that could affect it, but I see no reason to change what I learned in grad school 30 years ago.’ I said ‘Man, you’ve wasted 30 years.’

There have been some fascinating experiments in economics in the past 30 years and they have disproved what I was taught. The only advantage I’ve had is that I’ve only had two courses, so I didn’t have as much to unlearn. I spoke at Pitt last week for a portfolio management class –- a professor asked me to talk. Anytime I talk to a college class the first thing I tell them is, ‘’Be aware that half of what you have been taught is total nonsense or backward.’ Every professor agrees with that. I assume that each professor thinks that it’s the other professors who are teaching the stuff that is nonsense or backwards, or they’d change. Well, the arithmetic that I was taught still holds up. Two and two still equals four. But the economics I was taught has all been proven nonsense.

Ken Dupre: I think that when you start talking about deficits, there are two pieces of it. One is tax revenue, and the other is tax spending. If you want to encourage people to work more and to pay more taxes, you find out that it’s important to not have too high a tax rate. You want a lower tax rate because it will increase your revenues. The other important piece is tax spending. You want spending that is going to produce and create good value for you -- not just spending for whatever it might be. In the political arena the Republicans suffer from that just as much as the Democrats. So we’ve got half the package, with having the tax cuts in order. Now there’s the other half yet to be done, and that’s the spending.

Ron Muhlenkamp: Let’s bring it home. Connie and I have been married 40 years. We’ve had deficit spending 18 of the 40 years. Five years when I was in school, eight years when the kids were in school, three years when we bought houses, two years when I started the company. I don’t regret borrowing money for any of those purposes. But I will not borrow money to buy a new car. I will not borrow money to take a vacation. Every now and then I will borrow money for an investment, but I will not borrow money for things I think will depreciate. In your own lives, it’s not whether you borrow money -- it’s what you use it for. Ronald Reagan borrowed money to get the economy moving again. It boomed. We had 20 years of prosperity. And he borrowed money to end the cold war. Most economists will agree that when you are in a recession, you should borrow money; there should be a deficit. You should have surpluses when you are in boom times. And I think we’ll probably get there in a few years. The problem isn’t whether you borrow money -- it’s what you do with it. That’s true for you personally. That’s true for our government. The flip side of this, as Ken just said, is what do we spend it on -- and is it productive? The deficit itself is not the key. We went through this argument 20 years ago! And the economists still haven’t learned. They’re making the same arguments that they made in the early 1980s.

In Japan they have a fair amount of deflation because, frankly, they are afraid to inflate. And their economy is moribund. We’re watching for deflation, but we see no signs of it. The government is printing money at about an 8% rate, which, unless they stop some of that up, will become inflationary. So far it hasn’t been a problem because people haven’t been in a hurry to spend money. But as this economy comes back, we expect them to sop up some of that money or we’ll start worrying about inflation.

Ron Muhlenkamp: Not a lot.

Ron Muhlenkamp: Fine. Three weeks ago dividends were a negative because they were taxed at a higher rate. Today they are almost as good as capital gains. Both rates are at 15% now. There still is a modest attraction to capital gains because we can defer it. I want to make money after inflation and taxes. If I can defer the taxes, it’s even better.

What we have really learned over the years is that you’ve got to take what the market gives you. If the good companies are paying dividends, fine. If the good companies don’t pay dividends and are buying their own stock, fine. We want to know that their earnings and their cash flow will support what they want to do. Then we try to get to know management to make sure that they don’t do something dumb. But to pay dividends or to buy their own stock, if they are cheaply priced, either of those is good.

Ron Muhlenkamp: No.

It looks like Bush Jr. learned from not only Reagan, but from his father. So far we think that what he’s done has been pretty good. The remaining big problem out there is Social Security and that probably won’t get addressed unless there is a second term.

Ron Muhlenkamp: Well, to call that today is kind of dumb. We expect to learn some stuff between now and then. I have tried to make this clear: I don’t know how to predict the future. I never have and nobody else does, either. We spend our time trying to understand the present. When we wrote Why the Market Went Down in 1979, it was to explain things that had already happened. We have not told you that P/Es are going to stay at 17. We’ve told you that if inflation stays at 1½% and ROE stays at 13, P/Es should stay at 17. I don’t know what the future will bring. I spend my time -- we all spend our time -- trying to understand today. Everybody wants to predict tomorrow. Most of them don’t understand today; maybe they understand yesterday. To make a call a year and a half out… We expect to learn some things between now and then and to adjust to whatever it is that we learn.

Ron Muhlenkamp: $820 million (as of 6/3/03).

Ron Muhlenkamp: Certainly not before $3 billion. When I start having more money than I have ideas, we’ll do it then. Right now, we’ve got more ideas than money.

Ron Muhlenkamp: It depends on whom you ask. All the rating services are in the marketing/publishing business. They think that they have to create their own categories to add any value. If you look at what we’ve done and what we own, we don’t care about market cap. If you look at the details you will see that we are usually about a third large-, a third mid-, and a third small-cap. And if the small-cap stuff doubles in price, then all of a sudden, we look like a large-cap value fund.

We try to own good companies; we try not to pay too much to get them. It doesn’t matter what the market cap is. The rating services don’t call us and say, ‘What do you call yourselves?’ They tell us, ‘you are a mid-cap fund or you are a multi-cap fund.’ Only recently has multi-cap become a part of the lexicon. It’s probably because they realize that we do have some large-cap stuff in the portfolio and we do have some small-cap, so maybe, they broadened their definitions a little bit.

So, for my daughter who is 4½ and my grandmother, who is 80, those criteria suit them both. Our portfolio, for them, will look the same. If grandma said, ‘Don’t ever own tobacco stock,’ we would adjust for that. We report to our clients every quarter in writing. They get a confirmation of every trade we make. They get a monthly statement from the broker. We report our performance quarterly, and I follow that up with a phone call. Three or four times a year you should be hearing from us. In between, if you have questions about what’s going on in the world, or the headlines are scary, we expect to get a call from you. When the bear market hits, as in 2002, and all you have is our performance, that’s not enough to maintain the relationship. That’s what this is about tonight. So that you can say, ‘I’m glad that I was with you last year, even though you didn’t make me any money. I knew you were holding the course.’ Well, here’s what we’ve been doing. We hold equities for a reason. We spend a lot of time talking to our shareholders and clients. If you don’t get enough communication, we expect you to call us and say that you want more.

Ron Muhlenkamp: There is a little bit of re-education going on. Some people have been trained by the brokerage community to believe that if you’re not trading for their account then you’re not paying attention to it. We spend our time trying to make sure that the investments are right. What’s been interesting in the last couple years is, and if you track our newsletters or you come to these seminars, we’ve been on the same path for about three years now, expecting the economy to come out of a normal cyclical recession and to benefit from that. We think it’s been delayed. Our turnover, historically, has been on the order of 15% – 20%. Last year it was probably less than 10%. In the last two months our investments have been paying off big time, but we own the same stocks we owned last year. And last year the public sold them down, and now they are buying them up.

Tony Muhlenkamp: As long as the companies are doing well and the economy is doing what we think it should be doing, then we are pretty patient. There is a great tendency, if you have been a client of a broker and you are not seeing any trades to say, ‘Gee, aren’t you paying attention to my account?’ Well, folks, trades cost you money. If what we own is good then there is no reason to trade it. You won’t hear from our analysts, and frankly you shouldn’t, because it is their job is to pay attention to the companies. But, the shareholder services group, my group of people, frankly that’s what we’re there for. We’re picking up the phone, and sometimes we may call too much. But the idea is, if you’ve got a question for us or we’re doing something that we can help you with, we want to be available. That’s what all those people are there for, so that you can get the help when you need it.

Ron Muhlenkamp: No. We don’t promote the purchase of any stock. We have had our own mistakes. Enron was not one of them.

Tony Muhlenkamp: That is going to depend on what interest the debt is costing you and what return you expect on your IRA. If you can borrow money and keep the cost at 3% and put the money in an IRA making you 8%, that’s a good idea. If the debt is costing you more than you can get on the IRA, then pay off the debt. And if you need help with that, call me and we’ll go through it.

Ron Muhlenkamp: There might be a difference between commercial and residential construction. My guess is that they are probably stable. There are three parts to construction: the real estate, the labor, and the materials. Materials are fairly stable. My guess would be that the labor is fairly stable. My guess is that it’s going to be fairly site-specific on the real estate. Now if you are fixing up an old house, say, on a farm in Butler County--that can be expensive!

This document must be preceded or accompanied by a prospectus. Please read it carefully before investing.

Opinions expressed are those of Ron Muhlenkamp, Jack Kunkle, Ken Dupre and Tony Muhlenkamp and are subject to change, are not guaranteed and should not be considered a recommendation to buy or sell any security. Please consult your investment professional and/or tax advisor for advice concerning your particular circumstances and for any tax advice.

Mutual fund investing involves risk. Principal loss is possible. Small-and mid-capitalization companies tend to have limited liquidity and greater price volatility than large-capitalization companies. The S&P 500 Index is a broad based unmanaged index of 500 stocks, which is widely recognized as representative of the equity market in general. One cannot invest directly in an index.

As of 6/30/03, the Muhlenkamp Fund’s top ten holdings were:

Fund holdings are subject to change and should not be considered a recommendation to buy or sell any security.

Quasar Distributors, LLC, Distributor. 07/03