Quarterly Letter     BACK

The economy continues to expand.

In the past 12 months GDP (Gross Domestic Product) grew by 4% after growing by 3% in 2002. Capital spending and payroll employment, both of which lag the economy, have bottomed and are now trending up. The unemployment rate has declined from 6.4% to 5.9% in the past six months. So, in my opinion, the economy is firmly on a recovery track.

We are, of course, still hearing negatives. Some people seem to think that all economic data must exceed the old highs before they’ll admit that things are improving. That’s like saying that daily temperatures must match those of last July before concluding that winter is over. Such a stance makes no sense economically and will cause many investors to miss the largest part of a market upswing.

There are negatives, of course. There always are. The biggest negative is that our politicians continue to spend money like… politicians (thereby outspending teenagers and drunken sailors).

At our recent seminar, we received a number of questions about the federal budget deficit, inflation, and the trade deficit with China. These topics are also getting major play in the media. It’s as if we learned nothing about these topics from the inflation of the 1970s, the budget deficits of the 1980s, or the trade deficit with Japan in the 1970s. (We have included a number of these questions and our response in an insert in this Muhlenkamp Memorandum.)

It appears prices of most stocks and bonds have returned to near fair values after suffering from the triple whammy of recession, psychological hangover from the fad (or bubble) prices, and the psychological damage from the 18–month litany of ills from 9/11/01 through the Iraqi War. We believe this triple whammy has now worked its way through the markets, although some lingering effects are bound to crop up from time to time.

Thus, the markets remain volatile. While not unscathed, we have come through this period in good shape. The challenge now is to differentiate among those companies that are best serving their customers in a fashion that provides net income and cash flow. We are spending our time and effort accordingly.

—Ron Muhlenkamp

The USA PATRIOT Act and its Effect on Financial
Institutions and Investors   BACK

Congress created the USA PATRIOT Act of 2001 “To deter and punish terrorist acts in the United States and around the world, to enhance law enforcement investigatory tools, and for other purposes.” The acronym stands for Uniting and Strengthening America by Providing Appropriate Tools Required to Intercept and Obstruct Terrorism. The Act has ten titles which include, for example, “Protecting the Border,” “Improved Intelligence,” “Enhanced Surveillance Procedures” and “Enhancing Domestic Security Against Terrorism.” As investors, the title that affects us directly is Title III, which is the “International Money Laundering Abatement and Anti-Terrorist Financing Act of 2001.” The U.S. Treasury Department and the Securities and Exchange Commission (SEC) issued regulations based on this part of the USA PATRIOT Act. All financial institutions were to begin compliance with these new regulations on October 1, 2003.

Included in the Treasury & SEC regulations are guidelines to establish a Customer Identification Program (CIP) to be used in account opening and maintenance procedures. Using CIPs, investment companies should be able to determine with reasonable belief that they know the true identity of each “customer.” The CIP should include steps to reject and return the investment if the applicant’s identity is unable to be verified. Also included in the regulations are guidelines to establish procedures to identify money laundering and terrorist financing. By identifying these illicit activities, investment companies can obstruct and possibly help to intercept terrorists or individuals engaged in money laundering activities.

Muhlenkamp & Company, Inc. has designated an Anti-Money Laundering (AML) compliance officer to adopt and implement procedures necessary to enforce the new regulations within the Company. However, since Muhlenkamp & Co. acts only as investment advisor to its Fund, the Fund’s transfer agent, U.S. Bancorp Fund Services, LLC, processes applications and transactions for all of our direct shareholders according to the established AML rules. The Anti-Money Laundering Program for our privately-managed accounts and indirect fund shareholders is practiced by the affiliated financial intermediaries that house each account.

All financial institutions had to appoint a compliance officer and establish their own Customer Identification Program. Upon receiving a completed account application, the applicant’s name must be checked against lists provided by Federal government agencies of known or suspected terrorists. Financial institutions also have to make sure that the information on the new account application is legitimate. This is done by running a crosscheck of the applicant’s identity information against a database designed for this purpose. Some of the information that is checked includes the applicant’s first and last name, social security number, street address, and date of birth. Everything should agree with the database information; if not, the applicant’s identity must be further researched. If unable to verify the applicant’s true identity, the financial institution must reject the application and return the investment. Also, financial institutions must monitor existing accounts for suspicious activity that might suggest money laundering.

How will all the new regulations affect you? If you are opening a new account, you may spend a few more minutes filling out your account application. Our mutual fund account application now requires a permanent street address rather than just your mailing address. It also requests your driver’s license number to do an additional crosscheck of your identity information if something is not consistent with the initial data check. In case you are wondering, it is not used to check your driving record: we do not have access to those records and do not need them for our purposes. Another effect of the new regulations is additional expenses for the investment institutions that house your accounts. These expenses are a result of the extra procedures, database searches, and additional monitoring done in order to comply with the new regulations. The costs may be passed on to you in higher fees.

Although the enactment of the PATRIOT ACT resulted in the request for additional personal information, the release of this information to nonaffiliated third parties is guarded by Title V of the Gramm–Leach–Bliley Act. The SEC created provisions under this Act that require companies to adopt and practice a privacy policy that restricts the use and sharing of nonpublic personal information. The provisions also require companies to adopt procedures and implement safeguards to protect the records of its customers from unauthorized access. This Act is still in effect and we still follow all of the guidelines included in The Muhlenkamp & Company, Inc. Privacy Policy and the Wexford Trust Muhlenkamp Fund Privacy Policy. These policies explain that “we do not disclose any nonpublic personal information about our current or former clients/shareholders to nonaffiliated third parties, except as permitted by law.” Copies of these policies can be requested by calling (877) 935–5520 ext. 4 or viewed on our web site, www.muhlenkamp.com.

—Michelle Orphall

Sources:
The USA PATRIOT Act, is available on the website of the Electronic Privacy Information Center: http://www.epic.org/privacy/terrorism/hr3162.html

Federal Register / Vol. 67, No.141/ Tuesday, July 23, 2002 / Proposed Rules (Pages 48318-48328)

Customer Identification Programs for Mutual Funds

 

Fraud   BACK

In a courtroom, witnesses must raise their right hand and swear to tell the truth, the whole truth and nothing but the truth.

Ironically, there is no oath or written law that can guarantee honesty. The investing public has been forced to face this fact since the well-known corporate fraud cases and the more recent mutual fund investigations became public. The scandals have raised the question of whether or not the investment industry has just been diagnosed with a terminal disease or if the incidents are mere symptoms of a rare illness. I would argue the latter. A small minority of people will always be willing to sacrifice their integrity in exchange for personal gain. The increased awareness of this fact does not signal a downfall of the entire industry.

Regarding the mutual fund scandals, Ron Muhlenkamp, Portfolio Manager of the Muhlenkamp Fund, is not willing to spread the illness. In the November version of the Muhlenkamp Minute1, Ron stated that late trading is not tolerated in the Fund and market timing is strongly discouraged.

In relation to the corporate scandals, as “purchasing agent” for shareholders of the Fund, the rare illness is one that Ron also tries not to catch.

“As the Enron saga demonstrates, some managers do lie to us (I figure about 3–5%), much like the general population. And we have no recourse against management lying — except to limit the amount we invest in any one company.” —Ron Muhlenkamp, Muhlenkamp Memorandum #62.

Ron suggests that he cannot guarantee immunity to any scandal, but instead attempts to diversify the risk away by owning a number of holdings.

A recent study conducted by the Federal Bureau of Investigation approximates the arrest rate of individuals involved in such misconduct, categorized by the agency as “white-collar” criminals, at 5,317 per 100,000 inhabitants. This translates to approximately 5 percent of the population — much like Ron’s estimate.

Of the dishonest few, the most destructive are by and large the least likely suspects. They are usually found among the most charismatic, entrusted, educated and seasoned professionals. A 2002 report issued by the Association of Certified Fraud Examiners (ACFE) concludes that one of the best indicators of the financial scale of a fraud scheme is the employment rank of the perpetrator. While managers and executives accounted for only 42 percent of the acts, the total financial damages they created were approximately 4 times greater than that of lower-ranking employees.

The ACFE study also reveals a direct correlation between the age of the perpetrator and median losses incurred: the older the perpetrator, the higher the price tag of the crime. Median losses by employees older than 60 years of age were 27 times higher than that of employees 26 years of age or younger. However, it is important to note that older professionals generally hold the highest–ranking positions. By virtue of their rank, they tend to have greater access and control over an organization’s assets.

The ACFE study indicates that college educated people and males also tend to commit more costly fraudulent crimes for the same reason. Ron states, “The last person I want to deal with is a smart crook.” He thinks that intelligent criminals are undeniably the most dangerous. On the other hand, in order to trust an individual’s opinion, Ron maintains that the individual must be knowledgeable and demonstrate good judgment, but it is absolutely essential that they possess integrity.

The financial scale of the crime is usually greatest in fraudulent cases where employees and managers act in unison. According to the ACFE study, in such cases the median costs are eight times greater than cases in which lower–ranked employees act alone. When managers collaborate with their employees, the system of control and oversight in a company breaks down, allowing fraud to thrive.

Surprisingly, these white–collar criminals are not only educated and the most mature, but they typically have no prior criminal convictions. Only seven percent of perpetrators were known to have a criminal history and three percent were charged for previous fraud–related offenses. By the time an offender is exposed, the crime has already taken place.

Whether a perpetrator has a criminal history or not, they all have one thing in common — a clear motive. Some thieves act in pursuit of easy profits while thinking they can get away with it. Others are tempted by some hidden incentive to commit the crime, or they simply find an opportunity to test their egos. In addition, white-collar criminals tend to feel little or no guilt for committing fraudulent crimes since they do not carry the same social stigma as violent crimes.

The fact is no fraud scheme can be committed without an opportunity. There will always be opportunities, or loopholes, that certain people will find and choose to test. As with the recent passing of the Sarbanes–Oxley Act, regulators continue to try and tighten the system. At the same time, fraudsters are also becoming more sophisticated; therefore, there will always be an element of fraudulent activity that can never be fully regulated away.

Further, there is no identified evidence that suggests that participants of any particular profession have a stronger inclination to commit fraud. The real flaw lies not within the nature of an industry, nor as a result of an oversight in the formation of any rulebook. The true imperfection lies within the core of the character of the perpetrator — it is revealed by their personal choice to be dishonest.

—Tori Soudan

Sources:
U.S. Department of Justice. The Measurement of White-Collar Crime Using Uniform Crime Reporting (UCR) Data. Retrieved December 3, 2003 from http://www.fbi.gov

Association of Certified Fraud Examiners. 2002 Report to the Nation: Occupational Fraud and Abuse. Retrieved November 6, 2003 from http://www.cfenet.com

Footnotes:
(1) A proprietary communication tool, the Muhlenkamp Minute provides opinions on current events and selected topics. To listen to the most recent recording, call (877) 935-5520 ext. 5, or visit our web site at www.muhlenkamp.com.