Quarterly Letter     BACK

Folks, our patience (yours and mine) is paying off.

Since it became clear that the war in Iraq would not be a disaster, the public has become a bit more confident on the U.S. economy and a bit more willing to invest in that economy.

As we stated in recent newsletters, we continue to believe that the economy is recovering from a “normal cyclical recession,” albeit slowly. We believe the strength and timing of the recovery have been delayed by the hangover from the stock market fad (bubble) and by the events of 9/11/01 and the litany of concerns that pummeled the American psyche since, culminating with the war in Iraq.

We believe (and pray) that the litany of concerns is now over and that the bad news going forward will be at a more normal pace. We believe that the nature and timing of the recent cuts in federal income tax rates will strengthen the economic recovery. We’ve been investing your money (and ours) in good companies that are likely to benefit as the economy strengthens and are reasonably priced, in our opinion. This has been a gradual process, which we expect to continue. The key is not to be distracted by the daily market volatility, which we also expect to continue. Patience remains key.

— Ron Muhlenkamp

Captial Gains and Income   BACK

There are two events that can trigger a tax liability for shareholders of a mutual fund: when the fund manager distributes ordinary dividends and capital gains to shareholders; and when the shareholder initiates a redemption, thereby realizing a capital gain or loss.

We prefer the latter, as it is consistent with the Muhlenkamp Fund’s objective to maximize total return. The Fund Manager’s preference is to allow shareholders to initiate their own taxable events, permitting them to pay taxes or to take a loss when it is most fiscally suitable (a particular concern for shareholders with non-retirement accounts). For instance, our Manager tries to offset gains with losses when selling securities that are held in the Fund, while trying to maximize unrealized appreciation. With a goal of creating value on an after-tax basis, the Manager monitors several issues, including economic trends and tax regulation, to determine the appropriateness of investing for dividends and interest.

To understand how dividends and interest were handled in the past, refer to our Statement of Operations found in our semiannual and annual reports. The Statement of Operations is effectively the Fund’s income statement and reveals details on how the Manager has administered income and capital gains throughout the year. In the December 2002 Annual Report, this statement can be found on page 6. *

Under the heading “Investment Income,” notice that the Fund took in $6,660,626 in dividend and interest income combined for 2002. This income is reduced by $7,279,585 in expenses that were incurred for the year, resulting in a $618,959 net investment loss. If there had been a net gain, the Fund would have been required to make a distribution to shareholders thereby creating a tax liability. Shareholders would have owed ordinary income taxes, which could have been up to 39 percent at the Federal level depending on their marginal tax bracket. Moreover, taxes would have been owed despite the fact that 2002 was a down year.

In contrast, long-term capital gains (assets held one year or longer) were taxed at a maximum rate of 20 percent. It was advantageous to obtain the majority of earnings in the form of long-term capital gains. Shareholders realize capital gains two ways:

In light of recent legislative changes, it remains our goal to grow our shareholders’ assets through unrealized capital appreciation, by increasing the Fund’s Net Asset Value (NAV). This is achieved when there is a net increase in the prices of securities held in the Fund. By focusing on increasing unrealized capital gains, our shareholders are placed in control of the timing of taxes owed on gains and the realization of losses.

— Tori Soudan

Tori Soudan works in Shareholder Services. She joined Muhlenkamp and Company Inc. in April 2002.

* To request a copy of our 2002 Annual Report, contact our Shareholder Services Department at (877) 935-5520 extension 4 or you may download a copy from our website: www.muhlenkamp.com.

For additional information on the tax treatment of distributions and redemptions, refer to IRS Publication 564. The information above should not be considered tax advice. Please consult a tax advisor for your particular situation.

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

In Memorandum 66, we began our discussion of “The Importance of IRA Beneficiary Designations”. We conclude that discussion in this edition of our quarterly newsletter.

If my wife also dies while our daughter is still a minor, then my brother (who is our executor and trustee/custodian of our daughter’s accounts) will:

Who controls the Inherited IRAs?
When my daughter turns 18, my brother is relieved of his custodial duties for the Inherited IRAs and my daughter takes control of the Inherited IRAs, renaming them the “Daughter Muhlenkamp beneficiary of the Wife Muhlenkamp IRA” but keeping her Social Security Number on the account. She can then take as much money out of her Inherited IRA as she wants. For many people, this is a scary idea and one reason they shy away from naming minor beneficiaries of IRAs, even using the UGMA. My wife and I have decided that we would rather my daughter have the money than the U.S. Government. She’s likely to be more responsible with it than they are (no matter how irresponsible she turns out to be). This is why my brother has discretion over how much to take out of the Inherited IRAs before she turns 18. He may decide to empty out her Inherited IRAs before using funds from the trust and spend the money on her if he doesn’t think she will use it wisely when she turns 18.

I don’t intend to imply that everyone should follow the plan I outlined above. I am trying to illustrate how the designated beneficiary for your IRA can and should be incorporated into your own estate plan. Start by making sure you have designated beneficiaries on file, then ask what happens to your IRA if you die, if your spouse dies, if you have more kids, etc. Who gets the money? Will they have to pay income tax? Will they have to pay estate tax? How much? Why? Can you avoid, defer or eliminate the tax? As you ask these questions, write down your answers and make the necessary changes to accomplish your goals. Do some reading, consult some experts, and every couple years check to make sure that the situation, the laws, or the taxes haven’t changed and rendered your earlier decisions obsolete, or even dangerous.

— Anthony Muhlenkamp

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.

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

Resources
1. The current “IRA Disclosure Statement and Custodial Agreement” from your IRA Custodians.

2. IRS Publication 590, Individual Retirement Arrangements, Department of the Treasury, Internal Revenue Service, 2002. http://www.irs.gov/formspubs/index.html.

3. Natalie Choate, Life and Death Planning for Retirement Benefits, Fifth Edition, 2003. http://www.ataxplan.com/index.html.

4. James Lange, “MRD Defenses”, “Lange’s Cascading Beneficiaries Plan”, http://www.rothira-advisor.com/index.htm. (The “Cascading Beneficiaries” article is very interesting, but be careful when using a trust as a beneficiary. It is easy to foul up.)

5. Donald R. Levy, Steven G. Lockwood, and Gary S. Lesser, Individual Retirement Account Answer Book, Ninth Edition, 2003. http://www.aspenpublishers.com

Tax Cuts and Their Effect on the Economy   BACK

Understanding how people work
My observation is that there are five speeds at which people work:

High taxes have two big negative effects on productivity: encouraging those who are working in 4th gear to switch to neutral because the incremental after-tax income is not worth the effort; and encouraging people to work in an unregulated, illegal, underground economy.

If the goal of government is to grow the economy and increase the wealth of its citizens, motivating people to work at their highest gear possible is key.

What does the evidence suggest?
The UK Turnaround
A decade ago the unemployment rates in the United Kingdom and in the Euro-zone were equal at the rate of 10%. No more. Present day: UK = 3.1%; Euro-zone = 8.7%. In addition, the standard of living in the UK is rising faster than that of its neighbors. Since 1991, real per capita incomes have risen 29% versus 20% in the Euro-zone. [1] Why?

The UK has persistently pursued pro-growth and pro-competitive economic reforms with respect to budget restraint, privatization, and pension reforms. Further, liberalization of a host of rules and regulations in the labor markets, foreign trade, etc., have yielded superior job conditions and prospects. The Euro-zone is slower to adopt the reforms that the realities of global competition increasingly require. With what we see, they are likely to stay that way.

Kennedy’s Cuts In 1962, President Kennedy sponsored legislation to cut income tax rates by 20% and corporate taxes by 10% “to increase incentives and the availability of investment capital.” After these tax cuts became law, the economic growth rate expanded from 4.3% to 6.6% and the economy created more than 1 million jobs over the following four years. Kennedy’s explanation? Our practical problem is not between a tax-cut deficit and a budgetary surplus. It is between two kinds of deficits: a chronic deficit of inertia, as the unwanted result of inadequate revenues and a restricted economy, or a temporary deficit of transition, resulting from a tax cut designed to boost the economy, increase tax revenue and achieve – and what I believe can be done – a future budget surplus. [2]

Past Tax Cuts
There were three times in the last 100 years when marginal tax rates were dropped significantly: in the beginning of the 1920s (Coolidge), the 1960s (Kennedy), and the 1980s (Reagan). After the drops in tax rates, “real” (inflation adjusted) income for taxpayers grew at a 6%, 5% and 4% rate respectively. During these periods real tax revenues climbed 33%, 33% and 28% respectively. All three times demonstrate that a decrease in tax rates leads to an increase in “real” incomes and a real increase in tax revenues.

Who will benefit the most from a tax cut?
According to Webster’s, “tax base” is defined as “the wealth within a jurisdiction that is liable to taxation.”

In 1979 the top 20% of tax filers paid 67% of all income taxes. In 1999 the top 20% paid 79% of all income taxes; the top 40% paid 94% of all income taxes. That leaves the bottom 60% paying only 6% of income taxes. If there were any cut in income taxes (and the top 40% are the ones paying the lion’s share), by definition, the majority of the tax cut would go to the top 40%.

Yes, the remaining 60% will see a reduction of taxes through a decrease in tax rates, child tax credit, and elimination of the marriage penalty, but the greater benefit will be realized by the 40% who pay 94% of all income taxes.

Are taxes too high?
From 1998 to 2001, tax revenues as a percentage of GDP (Gross Domestic Product) ranged from 19.9% to 20.8%. This is the highest tax burden for four collective years in our history. Compare this against the following 2-year periods:

At our investment seminars we regularly ask: “Suppose you work a 5-day work week. All wages earned on Monday are taxed at 10%; all wages earned on Tuesday are taxed at 20%; all wages earned on Wednesday are taxed at 30%; all wages earned on Thursday are taxed at 40%; all wages earned on Friday are taxed at 50%. How many of you would work on Friday?” In the past six years exactly 8 hands have gone up — among several thousand people.

Consider the implications. What if the top wage earners decide not to work? With the top 40% of income tax payers paying 94% of all income taxes, does it not make sense to encourage your top taxpayers to work more? If you had a partner who paid you 35% of all he/she earned, wouldn’t your best interest be in having him/her earn as much as possible? Might you even lower the tax rate to keep them working fulltime?

Tax cuts, where will the money go?
Regardless of your tax bracket, there are four possibilities for tax cut money. The first possibility is to spend it. This directly helps the economy. The second and third possibilities are to pay down debt or save it. These actions free up capital for banks to loan, so businesses or other people can spend. Paying down debt or saving the money would also help neutralize upward pressure on interest rates due to any increase in government borrowing.

The last possibility for tax cut money is investing for the future productivity growth. This takes the form of investing in companies through IPOs, bonds, stocks, start-ups, etc. This type of investing leads to two major employment benefits: investing in new jobs directly and investing in capital improvements. Note that investors will do this to the extent that they believe the returns on capital are greater than that available on treasury bonds.

So the basic choice is spend now for a bolstered economy or invest now to increase future economic growth. The key is realizing that the money does not disappear or just sit: people will spend it; the bank will loan it to someone who will spend it; or it gets invested into more, higher paying jobs.

What do intuition and psychology have to tell us?
People feel that they have more opportunity to become rich in the U.S. than in any other country in the world. In our capitalistic democracy, the more productive you are the more you tend to get paid.

Do you want a tax system that encourages people to be productive or one that promotes complacency (Euro-zone)? Without proper incentives, there are few reasons to work harder or smarter. Do you want to live in a society that encourages people to dream, create and contribute — or one that encourages people to put in their time and just get by?

— Ken Dupre, CFA
Investment Analyst

Footnotes
1 Straszheim Global Advisors
2 Investors Business Daily, June 6, 2003

Announcements   BACK

Investment Seminar Follow-up
During the month of June, Muhlenkamp & Company hosted investment seminars in Pittsburgh, Los Angeles and San Diego. Ron Muhlenkamp delivered the same
presentation, Why the Market Went Down, on each occasion. To ensure all shareholders and clients have an opportunity to benefit from what took place, we are making available a CD-ROM containing the slides and commentary, along with audience-asked questions and our responses. Contact Shareholders Services at
(877)935-5520 extension 4 for your copy of the CD and/or copy of the original 1979 essay. These materials are also available on our web site: www.muhlenkamp.com.

Appearances   BACK

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

Published July 2003.
© 2003.   All rights reserved.