by Ron Muhlenkamp   

In 2007, we had a lousy year.

The transition period we’ve been discussing for two years is lasting longer than we expected, and having greater negative effect on some of our companies than we expected.

Nevertheless, the general pattern is familiar. After a period of economic and market expansion, the Fed raised interest rates to contain inflation and slow the economy. Subsequently, it has lowered rates to start a new cycle. We covered this pattern in some detail in Muhlenkamp Memorandum #84, three months ago.

As often happens in boon times, some consumers and some companies lost sight of reality in pricing their products and have since suffered severely. In 1999-2000, it occurred among technology companies; in 2006-2007, it occurred in the credit markets. The credit markets include loans of all kinds. Much has been written about the problems in sub prime residential mortgages, but similar problems exist in commercial mortgages and some corporate loans, particularly for mergers and acquisitions. In the aggregate, these problem loans affect the balance sheets of financial companies, including banks and brokers. The problem to date is that no one knows how bad the problems will prove to be, or to what degree each company is affected. So the markets assume the worst.

In one respect, it’s good to be at year’s end. In preparation for year-end reports, company management and their auditors are required to do a thorough assessment of the value of their assets and liabilities. So, some of these questions should soon be cleared up. (In the current instance, the risk might be that they over compensate and go too far.)

The second part of a transition is often a change in market leadership, and our holdings are reflecting this change. We have decreased our holdings in home builders, financials, and consumer cyclicals and have increased our holdings in capital goods and technology. In doing so, our turnover has increased this year, resulting in sizable capital gains and the resulting taxes. In our recent essay on capital gains and taxes (available at www.muhlenkamp.com), we pointed out that the goal of investing is to achieve capital gains. Folks, in this cycle, we postponed it as long as we could, and somewhat longer than we should have. (For those of you who joined us less than three years ago, we’re quite aware that you haven’t yet seen the gains that justify the taxes.)

If we’re right that the investment climate is good and the business cycle continues, we are now, once again, at the beginning of a business/investment cycle, giving us opportunities we haven’t seen in 6-7 years.

The comments made by Ron Muhlenkamp in this letter are opinion and not intended to be investment advice, or a forecast of future events.

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. Copies of past newsletters are available on our web site at www.muhlenkamp.com.