Quarterly Letter     BACK

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:

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:

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.

 

The Importance of IRA Designations (Part 1 of 2)   BACK

In January 2003 we mailed an “IRA Designation or Change of Beneficiary Form” to all our IRA account holders and asked them to complete it and return it to us. Judging from the few responses we received, not everybody recognizes the importance of these forms.

Designating a beneficiary is your opportunity to specify what you want done with your IRA money when you die. Also, designating a beneficiary provides that beneficiary the chance to preserve the tax–deferred (or tax–free in the case of a Roth IRA) compounding of investment gains in your IRA for years after your death. Tax–deferred compounding remains a powerful advantage of the IRA, and doesn’t have to end with your death.

Your beneficiary designations should be incorporated into your overall estate plan. Everyone should have some form of estate plan, regardless of your age or how much money you have, so that ALL your money goes where you want it to go. Frankly, once you start planning and adding everything up, you may be surprised to realize how much money is in your estate. If you don’t provide direction on what should be done with your money after your death, then someone else will have to decide for you. That will probably be the probate courts. If you don’t have a plan for what happens to your money when you die, I suggest you start making one. Designating IRA beneficiaries is a good first step.

How do you designate an IRA Beneficiary?
First, if you don’t have a beneficiary designated, or you don’t know if you do, call the mutual fund, bank or broker where you have your IRA and ask what beneficiary designation is currently on file. Make this call every couple of years to verify that the correct designation remains on file. Mutual funds, banks and brokers make changes to their systems all the time and information can be lost or misfiled, making it difficult to retrieve when you need it. So ensure that your information is readily available and still correct.

To designate an IRA Beneficiary:

1. File a new IRA Beneficiary Designation Form if you don’t have a beneficiary designated; if your original information cannot be retrieved or if something changes in your life such as a new spouse, child, or grandchild that needs to be added to the form; pertinent addresses and phone numbers change; a beneficiary dies; a minor beneficiaries reaches maturity, etc.
2. If you need to file a new beneficiary designation, then request a new IRA Beneficiary Designation Form, fill it out and sign it. MAKE A COPY FOR YOUR FILES, and send the original via registered or certified mail so you have a receipt from your IRA Custodian. When you get the receipt, staple it to your copy of the forms, and keep it in a safe place.
3. Make sure your spouse, lawyer, and executor know where you keep your copies of the beneficiary forms. (This is good advice for all your legal documents such as wills, insurance policies, etc.)

What happens if you don’t properly designate an IRA Beneficiary?
According to the Muhlenkamp Fund IRA Disclosure Statement and Custodial Agreement, Article VIII, Section 5:

This means that if you die without a designated beneficiary, we will distribute your IRA to your spouse; and if your spouse isn’t living (or you don’t have a spouse) then we will distribute your IRA to your estate. Unlike the Muhlenkamp Fund, many IRA Custodians (mutual funds, banks and brokers) will skip your spouse and distribute the IRA directly to the Depositor’s estate if there is no designated beneficiary. The only way to know for sure is to read the IRA Custodial Agreement you receive from your IRA Custodian.

What happens if your IRA is distributed to your estate?
Your estate will probably have to pay income tax on the taxable portion of your IRA before any money can be distributed to your heirs. This means your heirs will probably pay income taxes earlier than they would if you had properly designated a beneficiary and they will lose the opportunity for tax-deferred earnings on that money. If you die before you turn 70½ without a designated beneficiary, then your IRA must be distributed within 5 years of your death. If you die after turning age 70½ without a properly designated beneficiary, then your IRA must be distributed over your remaining life expectancy. You should designate a beneficiary for your IRA so your heirs have the opportunity and the flexibility to defer paying income tax on your IRA as long as possible, which should be far longer then your own life expectancy.

Who should you designate as your beneficiary?
The simple answer is that you should designate whomever you want to have the money. The real answer is that it depends on your financial and estate planning. How does your IRA figure in the larger picture of your estate plan? You may want to have multiple beneficiaries; or you may want to have multiple IRAs, each with a different beneficiary. The designated beneficiary has to be an individual person, although you can name charitable organizations or some types of trusts. You have to be very careful if you try to use a trust as a designated beneficiary, and you should get legal help.

Most people name their spouse as the primary beneficiary, and their children as contingent beneficiaries. If your children are minors, you can make a custodial account under your state’s Uniform Gift/Transfer to Minors Act (UGMA/UTMA)1 the contingent beneficiary. (You could use a trust for the continent beneficiary instead of the minor’s UTMA, but as I said before, get legal help if you are using trusts as IRA beneficiaries. It is tricky.) Naming your children as contingent beneficiaries gives your spouse some flexibility upon your death, and also protects your heirs if your spouse dies before you and you die before updating your designated beneficiaries.

What about estate taxes?
Used properly, your IRA accounts can be used to take advantage of law currently exempting one million dollars per person from federal estate taxes. (This is sometimes referred to as the Unified Credit, or the Applicable Exemption Amount; and the amount changes each year. See a good estate planning attorney for more information). My wife and I are sheltering the first two million dollars of our estate from federal estate taxes by moving all the non–IRA assets into a testamentary trust and the IRA assets into a UTMA for our daughter (and no, we don’t have an estate that large, but we have hopes—someday, someday…).

So at my death, my life insurance proceeds and non–IRA assets are put into trust, and my IRA goes to my wife. If my wife dies before I do, we have the same arrangement in place but the money moves from her to me. When the surviving spouse dies, the IRA assets go to our daughter and non–IRA assets go into the Trust. If we die together, my will stipulates that I died first so our executor can establish an order of death to use in moving assets. So when my wife and I are both gone, our daughter will have an IRA and a trust that she inherits. She controls the IRA at age 18, and she controls the Trust at age 35 (more on control issues later). This arrangement should be sufficient until we have more than two million dollars in our estate, or until our daughter turns 18, whichever comes first.

Part 2 of The Importance of IRA Beneficiary Designations leads us into a discussion on estate planning. We will continue our discussion in Memorandum 67.

— Anthony Muhlenkamp

(Footnotes)
1 See http://fairmark.com/custacct/cust101.htm for a brief overview of UGMA and UTMA custodial accounts.

The above discussion is based on Anthony Muhlenkamp’s specific situation and investment objectives. It is not intended to be investment advice or estate planning advice. Please consult your investment professional and/or tax adviser for advice concerning your particular circumstances and for any updates to the tax law.

For more information about the Muhlenkamp Fund, including risks, fees and expenses, please call (800) 860-3863 to obtain a prospectus. Please read the prospectus carefully before you invest. Mutual fund investing involves risk; principal loss is possible.

The Muhlenkamp Fund is distributed by
Quasar Distributors, LLC.

Announcements   BACK

The Wall Street Transcript 
Ron Muhlenkamp is featured in the February 2003 Money Manager Interview section of The Wall Street Transcript. The 8-page interview text gives a more in-depth look at Muhlenkamp & Company’s view of the current investment climate, our investment process, and some of our holdings.

Click here to view a copy of the transcript here.
Note: you will need Adobe Acrobat Reader installed to view this document.

Appearances   BACK

Pittsburgh Chapter NAIC, April 26, 2003
Four Points Sheraton Pittsburgh North
Exhibit booth open 8:00 a.m. to 12:00 noon

Las Vegas Money Show, May 13-15, 2003
Bally’s/Paris Resorts, Las Vegas, NV
with speakers Ron Muhlenkamp and Anthony Muhlenkamp
Exhibit booth #513

Back to Basics: How to Make Money in the Current
Investment Climate, June 3, 2003
Four Points Sheraton Pittsburgh North
with Ron Muhlenkamp
2:00 p.m. and 7:00 p.m.

Los Angeles Chapter, NAIC Compufest, June 27, 2003
Anaheim, CA
with keynote speaker Ron Muhlenkamp

Visit www.muhlenkamp.com or call (800) 860-3863 extension 4 for more information

Published April 2003.
© 2003.   All rights reserved.