QUARTERLY LETTER

Published First Quarter 2000
Muhlenkamp Memorandum 53

The Fourth Quarter of 1999 continued the patterns we have described to you over the past year. The economy continued strong in nearly all respects with GDP (Gross Domestic Product) up 6.1% for the fourth quarter and 5.5% for the year. Employment remained strong, keeping the unemployment rate at 4.1%.

Inflation remains under control, with the core CPI (Consumer Price Index) up 2.0% for the fourth quarter and up 1.9% for the year. The core PPI (Producer Price Index) was also up for the quarter and 1.9% for the year.

Despite these numbers, economists and the bond market continue to fear that the strong economy must cause increased inflation, even though Reagan and Volcker disproved this theory nearly 20 years ago. This fear drove Long-term Treasury yields from 5.4% at the beginning of the year to 6.7% at the end of the year, driving bond prices down 13% for their worst year ever. (The second worst year was 1994.) This rise in interest rates drove P/E (Price/Earnings) ratios lower for most stocks. Fully one-half of the stocks on both the NYSE and the NASDAQ declined in price, despite healthy increases in sales and earnings.

Despite this background, public enthusiasm for a narrow list of high-tech stocks drove them to dramatic price gains. In the S&P 500 Index, just 30 stocks (of the 500) accounted for all of its gain for the year, and just 7 stocks accounted for one-half of the gain.

I once commented to a friend that most people buy stocks the way teenagers buy clothes, i.e. they buy into current fads. We have seen such behavior in those stocks that caught the fancy of the public in 1999. Until mid-year there was some rationale for the price levels of most stocks, even the most popular. Lately, many prices have lost all relationship to reality. I will cite two examples that came to our attention in December.

Freemarkets is a Pittsburgh company that conducts auctions, on the Internet, for businesses purchasing parts and supplies from other businesses. Thus, it can be useful in helping a purchasing agent to do his/her job. By September 1999, it had conducted auctions for a total of 21 companies with two, United Technologies and General Motors, accounting for 58% of its revenues. UTX owns 5% of the company and could reasonably be expected to continue as a customer. But GM, at the time of the offering, had invested a sizeable sum in a competitor.

In 1998, Freemarkets had $8 million in revenues. By the fourth quarter of 1999, its revenues were approaching $5 million/quarter. In December 1999, the company sold 3.6 million shares to the public, out of a total 34 million shares. The stock had been filed to come to market at $14/share; but due to high demand it came at $48/share, and it jumped to $350/share in three weeks. At this point the market valued the company at $12 billion ($350 times 34 million shares). This for a company doing $20 million annual rate in revenues and without anything proprietary. On January 3, 2000, GM announced they were canceling their contract with Freemarkets and would henceforth do their business with the competitor in whom they had made their investment. In 12 days the stock fell from $350 to $172.

The second instance occurred when an analyst for a major Wall Street firm wrote that Qualcomm, which was priced at $500, should go to $1000/share. (The stock split 4/1 the next day.) The media immediately picked up on the $1000 price and the stock jumped to $660 (up 30%) in a day and to $750, (up 50%) in a week. The analyst's argument for the $1000 price ($250 post split) was that in the year 2010, he expects the worldwide public to buy 3 billion cell phones for an average price of $180 a piece. He further believes that Qualcomm should then sell for 60 times the resulting earnings. Folks, there are roughly 6 billion people in the world, one-half of whom don't earn $180/year. To predict that 3 billion of them would pay $180 for a cell phone in a given year is crazy. I suspect that a number of Qualcomm stockholders realized this when they saw on paper the assumptions that were required to justify the price of the stock. Since early January, it has fallen from $187 to $140 (post split).

It is always hard to say how far a fad can run or when it will stop, but they do work both ways. In Muhlenkamp Memorandum #52, we named 6 Internet stocks (America-On-Line, Amazon, Ameritrade, E-Bay, E-Trade and Mindspring) that were down 30-50% from their April 1999 highs. Despite the tech rally in the fourth quarter (in which 2 of the 6 hit new highs), the six stocks are now down 35-65% from their highs.

Meanwhile, some of the seven "security blanket" stocks Abbott Labs, American Home Products, Clorox, Coca Cola, Disney, Gillette and Pfizer) we named in Memorandum #52 have partially recovered, but the group remains down 15-40% from their highs. Of the six cyclical stocks we named (Alcoa, Caterpillar, DuPont, Goodyear, International Paper and 3M), three recently hit new highs. In fact, in recent weeks, aluminum, copper and steel stocks have been among the strong performers.

We suspect the market is beginning to pick up on the trend begun in the second quarter of 1999. We said then that, as the fear of recession disappeared, the market's focus would shift from "Security Blankets" and Internet stocks to a broader list of companies with good earnings and reasonable prices. We were right -- for three months. Then the Fed and the institutional market shifted to a fear of increased inflation based on strong growth in GDP driving up interest rates - both short-term rates and long-term rates. The retail public ignored these fears. Reflecting a continued strong consumer confidence, it continued to play the "game of the stock market", merely rotating its focus from Internet stocks to other technology stocks, primarily in telecommunications.

A number of trend following (momentum playing) professionals extended the game to the point exemplified by the two examples given earlier. These examples and the price action since year-end indicates that the "game" may have peaked although it could once again rotate to a new group.

Meanwhile, similar to Q-2/99, we are seeing strength in name cyclical stocks, indicating that some people are willing to bet on the strength in the economy. Since early December, we're also seeing strength in utilities (normally a proxy for bonds) although we haven't yet seen strength in the bond market itself. This indicates that bond investors are not yet willing to bet that inflation remains low. Since we now have nine months of data showing a strong economy and low inflation, our expectation is that the fears of inflation will soon subside, allowing interest rates and P/E's to stabilize and stock prices to reflect their earning gains of 1999 and 2000. If we are right, the strength should spread to the broad range of companies and stocks that are doing very well in this economy. This broadening of strength should also close the huge valuation gap between the largest companies (and stocks) and the small and midsize companies.

We continue to invest in good companies at cheap prices as indicated by the following table. We also continue to be bought out of a number of our holdings through mergers and management buyouts.

These buyouts confirm the values we see in our companies. It also validates that companies, at least, value themselves and their competitors much the way we do. We use these valuation methods because they have been proven reliable in all kinds of markets over a long period of time (over 50 years). Whether or not we're in a new economy is debatable, but ultimately, stock prices will reflect company values; and earnings and cash flows determine company values. So despite periodic excursions into the "growth" stocks of a given time, values in companies and stocks ultimately provide good returns.

One more point. Some of you have suggested that we should own (have owned?) more technology stocks. Our portfolio is nearly 20% in technology stocks but we're focused on those companies that benefit from a greater number of integrated circuits used in technology, and in companies with a history of good profitability. We have not invested in companies that are one of many competitors in new markets or in those with no near-term prospects of turning a profit.

Read our quarterly newsletter, Muhlenkamp Memorandum, for more by Ron Muhlenkamp.