QUARTERLY LETTER
Published Second Quarter 2003
Muhlenkamp
Memorandum 66
March 31, 2003
As I write this on March 31, 2003, the daily
headlines, every day, focus on the war in Iraq. As long as
this is true, not much else will matter in an investment sense.
But the headlines themselves, and the perception of them,
will give us great volatility. When President Bush made it
clear that action would not be postponed indefinitely, the
markets jumped over 13% (a year’s work) in just 8 days, only
to give back one-third of that in the next week.
It’s interesting to remember that we are
also at war in Afghanistan, but that it is no longer in the
headlines every day. I believe that within 5-10 weeks, the
war in Iraq will either be over or will settle into a pattern
that allows other items to make some of the headlines on the
daily news. When that happens, the markets
will respond to the following underlying factors:
- Inflation remains under control.
- The economy is expanding, albeit slowly.
- The current focus on Iraq will have
the effect of slowing, but not stopping the growth in consumer
spending. Because of this, March will have been a slow month
and first quarter earnings will be somewhat disappointing.
- Many companies are doing well with solid
balance sheets, respectable earnings, good cash flows, and
cheap prices (20% of the S&P 500 companies are selling
below 10x earnings). As investors get a little more confidence
on the war in Iraq, these stocks will do well.
- As consumers get a little more confidence
on the war in Iraq, they’ll resume their prior levels of
discretionary spending.
We don’t know precisely when these things will occur, but
we expect it to begin within 5-10 weeks.
In the meantime, people continue to focus
on the question “How low will stock prices go?” We think the
more useful question is “What should stock prices be?” We
believe stock prices are determined by the fundamental factors
of inflation, interest rates and corporate profitability (as
demonstrated in our 1979 essay Why The Market Went Down, available
on our website).
In any market, bear or bull, determining
what stock prices should be depends on some constant, underlying
questions:
In any market, bear or bull, determining what
stock prices should be depends on some constant, underlying questions:
• What’s happening to the purchasing power of our money?
• What kind of investment returns do we require?
• What’s available?
• What are we willing to pay for it?
In the following table, we have filled in our responses
to these key questions; it is likely to be more useful
to you if you fill in your own responses.
Our required equity return of 8% to Key Question
#4 is derived as follows:
2% inflation + 3% long-term debt premium + 3% equity return.
To pay 2x book value should not require paying
for inflation twice, or the debt premium twice. It would require
earning the equity premium twice, so that an 11% ROE would be worth
approximately 2x book value. Paying 2x book value for 11-12% ROE
should return to me the required 8% over time.
Note: Return on Equity (ROE) is just earnings
divided by book value (E/B), so paying 2x book value for a 12% ROE
equates to being willing to pay 16.7x earnings (P/E = P/B ¸
E/B = 2 ¸ 0.12 = 16.7) when inflation, interest rates, and
ROE are as described in the table.
Today, current inflation and interest rates approximate
the numbers in the table, and the average corporate return on equity
is 12%. So we should be willing to pay 2x book value or 17x earnings
for companies with 12% ROE. (Actually, we like to buy cheap.) If
your debt and equity premiums are similar to mine, the justifiable
P/E in today’s market is 17 – as it was in 1965 (which is the last
time we had 2% inflation and 5% long-term interest rates). Of course,
if your debt and equity requirements are different from mine, you
will be willing to pay a different price for the same company.
The average P/E on the S&P 500 is significantly
higher than my fair value of 17, but that is a capitalization-weighted
P/E. The unweighted median P/E of the 1700 stocks covered by Value
Line is 15, which is fair. We believe prices on average are roughly
where they should be.
Some people believe that P/Es must go to 6 or
7 before the market bottoms as it did in 1982. We believe it was
high inflation that drove average P/Es to 6, as explained in Why
The Market Went Down. In 1982, inflation of 8% and long-term interest
rates of 12% required equity returns of 15% and P/Es of 6x.
Today, we are recovering from a “normal cyclical
recession.” We haven’t made the governmental policy mistakes that
would give us a depression or revived inflation. So we see no economic
reason for P/Es to go to 6 or 7, and believe the secular bear market
of the 1970s is not about to be repeated.
If you are wondering why the market
has come down since March 2000, read my quarterly letter
in Issue 63 of the Muhlenkamp
Memorandum (also available on our website).
The great stock market fad, which round-tripped in only
three years, was all about hope and hype— two of the most
expensive four-letter words I know.
— Ron Muhlenkamp
The comments made by Ron Muhlenkamp in this article are his
opinion and are not intended to be investment advice or a forecast
of future events.
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Memorandum, for more by Ron Muhlenkamp.
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