QUARTERLY LETTER
Published First Quarter 1999
Muhlenkamp
Memorandum 49
1998 was a challenging year in the investment
markets. We got it partly right and partly wrong.
The markets started the year very strongly.
In the April 1998 Muhlenkamp Memorandum, we wrote:
"At year-end, we judged U.S. stock
prices to be fair based on 1997 earnings. We now judge prices
to be fair based on 1998 estimated earnings. Since it's only
April, there is ample time for a normal (5-10%) market correction
this year. We don't expect a decline greater than 10%, because
the trends in GDP and inflation remain positive. In summary,
prices are fair; the long-term and intermediate-term trends
are positive; in the short-term we expect prices to be volatile."
Generally speaking, we got the economic
part right. GDP growth remained positive and inflation continued
to decline. We said that you didn't want to be a U.S. producer
selling to Asia. We also said the U.S. consumer buying from
Asia was in good shape. So, the broad-based economic numbers
we got right.
We failed to foresee the dramatic decline
in the prices of world tradable goods including; oil, grains,
metals, paper and chemicals. The prices of these goods fell
much faster and much farther than we anticipated. The stock
prices of companies serving these industries also fell farther
and faster than we anticipated. That hurt us - specifically
in the stocks of oil service companies and manufacturers of
farm equipment. We also failed to foresee the default by Russia
on their government debt, and the impact that had on the investment
markets. The Russian economy and Russian debt are very small
parts of the world economy and world investment markets, but
Russia's default was the first default on debt by a government
in many years. It had a dramatic effect on the worldwide debt
markets. This effect was greatly magnified by the widespread
ownership of emerging market government bonds by hedge funds,
which bought them with borrowed money.
In August and again in October, we witnessed
the selling of securities regardless of price. We believe
this selling was done by hedge funds that received margin
calls on their portfolios in August, forcing them to sell.
They then received redemption requests by their investors
at the end of September forcing them to sell again in October.
This forced selling drove market prices of both bonds and
stocks down dramatically in August and October. This selling
engendered a climate of fear and uncertainty in the marketplace.
This fear and uncertainty manifested itself in several ways.
First, of course, it resulted in the selling of securities,
regardless of price. Second, it fostered a preference for
only the highest quality bonds (U.S.Treasuries) and for the
highest quality stocks. Third, it fostered fears of recession.
Headlines of the time speculated that we must have been facing
serious economic problems for the markets to be so weak.
But economic data confirm that the economy
remains quite healthy. As the data continue to come in, we
believe that confidence in the economy and in secondary stocks
will recover and that values in the marketplace will once
again reflect corporate values. In the fearful time of August-October,
value didn't matter. Those folks needing or wanting to own
securities were only interested in owning those perceived
as the highest quality, which we call "security blankets."
In the bond markets, only Treasury bonds were good enough.
Treasury bond prices went up, all other bond prices went down.
In the stock market, only two sectors did well: the biggest
and the best.
The S&P 500 is capitalization weighted.
The big companies are weighted heavier than the smaller companies.
In fact, the top 10 stocks (of 500) equal 21% of the index.
As a result, the S&P 500 did 28% for the year even though
the median (one-half did better, one-half did worse) price
range of the S&P 500 was 3.5%. The S&P 500 is composed
of the largest stocks. Mid-size and small stocks did worse
than the median S&P stock. So why didn't we own more of
these big stocks? In a word - price! The average stock in
the S&P is priced at 30 times earnings (P/E=30). The top
10 have an average P/E over 50. Our holdings have an average
P/E of 15.
Historically, lower P/E's have protected
investors in declining markets, especially if the decline
was sizeable or protracted. In 1998, the decline was sizable
but short-lived. At any rate, our lower P/E's didn't help
us this time. Investors paid up for "security blankets,"
not value. We believe this is changing as investors gain confidence
that their economic fears won't be realized. This is seen
by the markets' response to Brazil's recent floating of its
currency. The real sign is that the investors' attitudes have
changed. After months of fear that Brazil would devalue (or
float) its currencies, the market's response to the reality
was one of relief. Markets in Brazil and in the U.S. went
up. We suspect that the different response was due to:
- The action was long feared/anticipated
- therefore, not a "surprise."
- It didn't trigger margin calls in leveraged
portfolios, which would have resulted in further selling.
- Nervous holders of securities had been
recently "washed out" in the August-October period.
As the data continue to come in showing
the U.S. economy doing well, inflation under control and corporate
profits in decent shape, we expect investors to broaden their
list of acceptable stocks to include good companies at favorable
prices, such as those we own.
Read our quarterly newsletter, Muhlenkamp
Memorandum, for more by Ron Muhlenkamp.
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