QUARTERLY LETTER

Published Second Quarter 2000
Muhlenkamp Memorandum 54

The past three months have seen big changes in the securities markets, some of which we have been anticipating for the better part of a year.

We have been saying for a year that the market’s fear of inflation was driving up long-term interest rates and that the majority of stocks would have trouble doing well as long as long-term rates were rising. From late 1998 through January 2000, long-term Treasury rates rose from 4.8% to 6.7%. Since late January long-term rates have fallen from 6.7% to less than 6% even as the Fed continues to raise short-term rates. We judge this action to indicate that the fear of rising inflation is dissipating. As a result, financial stocks (banks & brokers) particularly the biggest and the best, have demonstrated strong performance.

We have also been saying that as long as the popular speculative stocks were uniformly in up-trends, there would be little incentive for the public to look elsewhere for investment ideas. That momentum has now been broken. The initial hint occurred in early March when Palm, Inc. (maker of the Palm Pilot) was spun out of 3COM. The stock came public at $48, rose in trading to $160, but closed below $100. The market took greater note of the decline than the increase. In short, the stock failed to match the hype, often a sign of a top.

More importantly, biotech stocks, which had been the speculative leader since Thanksgiving, corrected 35% in the first two weeks of March. Since then, many other speculative stocks have joined the crowd on the downside. Momentum is now driving down the same stocks it drove up. Our suspicion is that it took a lot of "New Economy" believers by surprise and it will take a while to sort through the rubble.

Meanwhile, the economy (old and new) is doing just fine, thank you, exhibiting strong growth with modest inflation. We see no evidence that inflation is about to pick up substantially or that we are about to enter a recession. As investors, we monitor the risk of inflation and recession as the two big risks to our assets. In the recent 18 months, economists, the Fed, and the markets have reacted to fears of both of these risks but neither has become reality. While a third shoe can always drop, only the fear of war carries the impact of recession or inflation, and it looks unlikely.

While the Fed has the capability of creating a recession, recent action in the markets suggest that they will take an even more gradual approach. To the extent that Mr. Greenspan and company have been battling "irrational exuberance" and the "wealth effect" their fears too should now be dissipating.

So where are we today? The American consumer and the American economy are in good shape. Fears of rising inflation and attendant long-term interest rates have peaked. The bubble in speculative stocks has popped. Most companies are doing quite well and are reasonably priced. We are finding more and better values than any time since late 1994. We think it’s a good opportunity to put your money to work in those values.

As investors seeking good values in common stocks, it is necessary for us to have a consistent method for valuing companies. The method we use is based on the methods companies themselves use in allocating capital, either in making capital investments or in purchasing other companies. When we are successful in finding such companies, we are often bought out of our holdings by corporate management or their competitors who see the same values that we do.

Many investors also look at the actions of corporate insiders to gauge whether the current market price is a good price to buy or sell a company. The logic is that insiders have the most knowledge of how well a company is doing, so their investment actions toward its stock should help other investors evaluate it.

In the current marketplace, we see many companies where management is buying up stock with their personal and/or corporate funds. The table below lists some of these companies, which we own, along with some that we've been bought out of in recent months. A number of the buyouts were at prices approximating our evaluations of the companies, which, we believe, validates our appraisals.

We would contrast these actions with the heavy insider selling reported in the high P/E stocks. When we see corporate insiders putting their money on the line in opposition to the general public, we re happy to place our money on the side of the insiders.

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