"Harvesting Profits on Wall Street:
Essays in Investing" by Ron Muhlenkamp

Ron’s new book, Harvesting Profits on Wall Street: Essays in Investing, is now available at major retail outlets. (You may continue to order copies directly through our website, or by calling us and requesting an order form.)

 

 

Questions and Responses Back

At our semi-annual seminar on April 27, 2006, Ron Muhlenkamp presented “How Much Money Are You Willing to Lose for a Theory?” to an audience in Pittsburgh and to others nationally via live webcast. Afterwards, Ron Muhlenkamp and his team of investment analysts entertained questions. Following is an abridged edition of the “Q&R” session. For additional commentary, please visit www.muhlenkamp.com.

About the Economy…

What will $100 per barrel crude do to the economy and the market? And since increasing oil costs should affect the cost of transportation for all imports, will inflation go up everywhere?

Ron Muhlenkamp: First of all, the cost of transport: Folks, truckers and railways have a pass-through of fuel surcharges, so they pass along those costs. At $100 per barrel, things would slow down big time. Whether we’ll get there or not, I have no idea – but my guess would be that if we did, it wouldn’t last very long.

What we found interesting in the last year is as gasoline went from $1.50 to $2.50 to… well, did anybody start carpooling? Have you noticed that your neighbors are driving less? When you get out on the interstate, have you noticed that traffic has been cut in half? None of that! It looks like at $3.00 [per gallon] it may be starting to bite. Folks, when prices change, until they change far enough that people start to change their behavior as a result, not much happens.

We don’t know what the price of oil will do. If I had to guess, I’d say it’s not going back down to $30 per barrel, and it’s not going to stay at $70 a barrel because it does look like it’s biting — and the volume used appears to be leveling off, so it’s not growing at quite the rate it was before. Again, we don’t know what the price of a barrel of oil is going to do, but we suspect that it stays below $70 and that it’s not going back to $30 or $35.

Ken Dupre: Also, one of the things that you never see advertised or reported in the media is that we are twice as efficient as we used to be with the oil. The effect of oil as it works its way through the economy is half of what it used to be, regardless of the price.

Ron Muhlenkamp: When we saw the price of oil run up in the 1970s, we ended up with a decade of inflation. The interesting thing about inflation is that the way we calculate it is to add up prices. But that’s not what causes it. What causes inflation is the government printing money faster than the economy is growing. The 1970s and ‘80s proved that.

Today, we’re not printing money faster than the economy is growing. The M’s, (various measures used by the Federal Reserve to compute the money supply), are growing at about 4%-4½%. The economy is growing at about 5%. You don’t see inflation running out of the box. Granted, I can only see out about a year ahead, but, basically the growth of the money supply doesn’t work beyond that.
Six months ago, with hurricanes Katrina and Rita shutting down about a third of our refineries and moving from operating at about 95% of capacity to about 65%, we warned we might have a shortage of gasoline. (Today, we’re operating at about 80%-85% of capacity.) Well, the oil companies managed to import tankers of gasoline, rather than crude oil, by using refineries in the rest of the world. More recently, we thought the effect might be that people would have to spend a lot more on heating oil this year. Well, we had a warmer winter. So we haven’t yet seen what the bite will be. We know that people will be spending more on gasoline than we had expected a year ago. What they spend less on, we don’t know. The surveys tell us that they’ll spend less on eating out and on movies and clothing. We’re rather skeptical of surveys. We want to see what happens. What will happen is that there will be a transfer to the extent that when you and I spend more money on gasoline, we’ll spend less on something else. We simply don’t know yet what that something else is. It probably includes SUVs, but we really don’t know that just yet. The fact that the price of oil goes up does not mean that inflation goes up. It means that the money you spend on oil doesn’t get spent some place else.

What are your views on trade deficits and China?

Ken Dupre: China fixes their currency to ours so that it is not floating. And the big loser with China having a fixed currency is the Chinese worker, who gets less for what he earns because the Chinese Yuan is so cheap. How that impacts the US is, yes, we do lose some jobs to other countries. But, as a result, US corporations have focused more on growth industries. We have a lot of high-tech and a lot of value-added industries where we’ve focused our capital and because of that, we have high value-added jobs. Workers here in the US get paid much more than they do in China — and since China does not float its currency, it hurts their workers. The flip side is it helps the American consumer. Since we let the markets decide and we let people decide where to spend their money, we get goods better, faster, and cheaper. So the US consumer wins — and as long as China wants to keep buying US bonds — our businesses and consumers get loans cheaper. In sum, for China to fix their currency to the US dollar, it ultimately hurts China and helps us more.

Ron Muhlenkamp: Remember in the 1970s when we worried about the trade deficit with Japan? What happened? For a while, the Japanese bought our Treasury bonds because they trusted the US Treasury market more than they trusted Japanese banks. The same applies today: the Chinese trust the US Treasury market more than they trust Chinese banks. Back in the ‘70s, the Japanese got very prosperous and bought things like Rockefeller Center and Pebble Beach. I saw the prospectus on Rockefeller Center — and the Japanese paid three times what it was worth! The media complained about that, but the Rockefeller’s didn’t complain. And I suspect that one of these days, the Chinese will start buying overpriced stuff in the United States.

What really happened in Japan was once the next generation came along, they were not as willing to work quite as hard as their parents had, and things leveled off. My best guess for what is going to happen with China is a repeat of what happened in the 1970s with Japan. Incidentally, in the ‘70s, the Dean of Engineering of MIT came to Pittsburgh and said, “We’ve got a problem. The US, in terms of technical papers, publishes more than any other country in the world; Japan is second.” He continued to say, “The Japanese translate all of our papers into their language, but we don’t bother to translate theirs into our language.” And, if you remember the ‘70s, that’s what was going on. Well, China is doing amazing things as an economy, but nobody’s taking for granted that we have nothing to learn from the Chinese, as we did about the Japanese thirty years ago. To me, the overall argument is a repeat of the past. And it’s worked out rather well.

About our Investment Strategy…

Can you tell us if you’re investing internationally and why

Tammy Neff: We look for good companies at value prices, and wherever the company is headquartered doesn’t really matter; location is not a constraint for us. That said, when investing internationally, you have to consider some additional risk factors like currency risk, accounting differences, and geopolitical concerns.

Right now, we think a lot of attention is being paid to international [equities] because they have done so well. It’s a momentum play. And you can certainly make money with momentum, if you are good at predicting the future. We think we do a better job at identifying values.

Ron Muhlenkamp: We have no objection to investing in foreign companies — we just want to get paid for it. We don’t currently see the values there; we’re not finding enough to be heavily invested.

Please discuss your perspective on technology companies.

Jack Kunkle: About five years ago I’d go to parties and “high-five” people because I’m a tech nerd. Now, I’m lonely at parties. I believe there is a sea change taking place in the technology industry, something we have not seen for over 20 years. In fact, Bill Gates seems to see the same thing in the sense that a few months ago he spoke to his engineers and said there is a major change going on in technology and that we must seize the change today. It is not something in the near future. It is today — and Microsoft’s survival is dependent on how we make this transition.

I believe firmly that “technology” should no longer be considered personal computers and chips and software. It’s about services on the Internet and in the family room and how we, as consumers, deal with these types of services. So I am watching, and I have to make sure that the companies that I choose grow their earnings, as Ron suggested.

Please address the pros and cons of investing in large-cap versus small-cap companies.

Brian Jacobs: What we have seen for the past five years has been dramatic out-performance by small-cap companies in terms of price appreciation. We believe the reasons behind that are a lot of investors adhere to a “momentum” style, or they are “indexers.” Momentum players chase performance; they see the out-performance of the small-cap stocks over the past five years, and they choose to continue throwing money at them. Indexers manage to an index: that is, when a certain stock in an index starts to move up, they buy more of it to keep up with the index to minimize their “tracking error.” And it creates a cycle. How long it continues is anybody’s guess.

What we do know is that we’re finding values in larger companies. Five years ago, if you had asked us would it be probable to have GE, Cisco, Pfizer and Merck, or Microsoft all looking attractive to us, we would have told you, “probably not.” Even though the stocks have done very well, their multiples have compressed. As a result, their price-to-earnings (P/E) ratios have come down. So, presently, we are finding more attractive names in the larger space than in the smaller space.

Are the investments of 15 years ago good investments today? For example, GM, Xerox, IBM, Steel, Reynolds, soap companies, etc.

Ron Muhlenkamp: Number one, you can’t lump them. You have to look at them individually.

Folks, GM is owned by its employees past and present. What happens at GM and Ford is up to the UAW (United Auto Workers), not up to the board of directors of GM and Ford. So if you want to bet your pick on the intelligence of the UAW… Roughly 15 years ago I was at a luncheon, sitting next to the president of the United Steel Workers and he was very proud of the fact that they had just signed a contract with National Steel, basically saying that National Steel couldn’t lay off anybody. In response, I asked “Who did National Steel get to guarantee to buy their steel?” He looked at me kind of funny and I said, “If nobody buys their steel, your contract is worthless.” That hadn’t occurred to him. That is what is going on at Ford and GM and with the UAW today.

We look at the “blue chips” if the return on equity (ROE) is over 14% and if the price-to-earnings ratio (PE) is below the ROE, and if the earnings are growing. IBM? Yes. Xerox? No, I don’t find it interesting. It’s item by item, company by company.

Folks, the media love to think in broad concepts. Usually, after the fact, they can identify a broad concept that encompasses what has worked. We don’t think that’s useful going forward. We think it’s useful to buy good companies at cheap prices. And if a number of them end up being in a “concept” later, well that’s about the time we are ready to sell them. Bottom line: we look at individual companies.

You have reviewed criteria and analytics for stock picking, but what about evaluating the company’s management? Does this go into your evaluation?

Ron Muhlenkamp: We ask these questions: Do we trust these people with our money? Do we trust their intelligence? Do we trust their judgment? Do we trust their integrity? If you don’t trust their integrity, then intelligence is a negative. I know I’m not capable of beating a smart crook; I’m capable of beating a dumb crook. So if you don’t trust their integrity, you walk because there are more companies out there. In the final analysis, we evaluate management teams using the same criteria you use for evaluating us.

The reason we never owned Enron is that we could never get the numbers to stack up. We saw what they were reporting and we couldn’t understand why the numbers were what they were. So we didn’t own Enron. When Tyco was at $60 [per share], it looked to us as if it was worth $30. And then we found out that Kozlowski was spending $800 million a year on all kinds of nonsense stuff. When it looked like he was going out the door, the stock fell to $20 and we felt that it was worth $30 — so we started buying it. It dropped to $10 based on the momentum, before returning to $30. We made good money in Tyco.

Tyco bought good companies and the top management didn’t mess around and screw up the companies they bought. We liked the underlying companies and we trusted the products and the markets they were in, and we felt that they could make money. So once rid of the problem, [Kozlowski], you could buy Tyco quite cheap. Our average cost was something like $17. We wish we had waited and bought it at $10.

Folks, people who look for value tend to be early. We have a discipline that allows us to put a reasonable value on a company. When it is selling 30%-40% below that, we get excited. But, sometimes, the current reputation can drive it much below that. So value folks tend to be early, both on the buying and on the selling. Momentum people tend to be late. By the time a trend is identified and it’s in all the newspapers, the momentum is well on its way. Folks, I learned in high school that I’m not good at fashions or trends.

You, as investors, get to take your pick: value or momentum. In either case, you have to have enough confidence, and the investment manager has to have enough confidence. You have to believe in something other than public opinion, or that you can be a half-step ahead of public opinion. What’s popular in the media is the trend-following stuff. They want to plan corn in October because it’s grown so well. If you were good at fads in high school or if you can identify people who are good at that, you can make an awful lot of money. If you are not good at that, you can lose an awful lot of money.

If a company misses an earnings estimate, up or down, it has a big effect. This seems unfortunate. What, if anything, can be done about it?

Ron Muhlenkamp: If the company is doing what we expect it to do and what is reasonable for it to do, then it is a chance for us to buy it cheap. If it’s a surprise to us, and we think that there are things going on that we don’t quite trust, then it gets sold. If the company is generally doing what we expect it to do, we’re pretty patient investors. If the company disappoints, then the stock gets sold pretty quickly.

What’s always interesting, of course, is when the company does well and the stock does poorly. Then you review all your information and try to be sure that you still believe the numbers. If the numbers hold up, then the only problem is the ‘stomach problem.’ Folks, I can teach you the brain part of this stuff. It’s just that every now and then the market tests your stomach. We get paid more for our stomach than we get paid for our head.

How do you decide to sell a stock?

Ron Muhlenkamp: If it becomes overpriced, or the company isn’t doing what we think it should do, it gets sold. If it gets to be fairly priced and we think it’s running on momentum, then we’ll sell it down to a normal position.

What’s interesting is when the company is doing well and the stock isn’t. The trouble with writing the rules is that you feel free, sometimes, to break them. With the stocks that aren’t doing well, the rule is that it should be sold. On occasion, I break that rule. Breaking the rule works about 60% of the time; the other 40% gets pretty painful.

About the Fund…

It seems lately that the Net Asset Value (NAV) has fluctuated more widely than the overall market. What brings this about? Also, what action will the Fund take if NAV reaches or exceeds $100 per share?

Ron Muhlenkamp: Allow me to answer the second question first. If it gets to the point where you send in an extra penny that gets lost in a rounding error for the number of shares purchased, we might have to do a stock split on the NAV. For example, if you send in $100 versus $100.01, the latter gets priced out to the fourth decimal place in shares and then rounded back down to the third. So, if it gets to the point when a penny does not buy an extra fraction of a share, we’ll deal with it.

With regard to the volatility of the NAV, there is so much quick money out there among individual investors and hedge fund managers alike that, on a day-to-day basis, prices are very volatile. And we happen to hold things like energy, which is ultra volatile. We hold housing which has been back and forth. Yesterday, good numbers were reported for housing and the stocks jumped. Today, a couple of housing companies reported their sales for the quarter were down. Overall, it looks like February was down and things came back a little bit in March. I call this a digestive process. Some people may think of it as indigestion, but, think about it: digestion is a pretty messy process.

We saw “digestion” play out last year. At the end of September ’05, the Fund was up 7%; at the end of October, it was up 0%; and in December, it was up 7.9%. All the things that had run up nicely, and in our case that was energy and home building, gave it back in October. It has a lot to do with the momentum players who, when things turn negative, sell in a flash. We think it’s crazy, but it’s going on. There is so much money chasing “momentum” that we expect the volatility to continue. And that can either be a good thing or a bad thing.

Anybody here go to auctions? Why do you go to an auction? To get a bargain? Do you think that all prices at an auction are a bargain? If you’re the only bidder, you might get a bargain. If there are two or three bidders, can auction prices go crazy? Folks, the New York Stock Exchange (NYSE) is an auction market. The key to getting a bargain at an auction is knowing exactly what you want and what you are willing to pay for it. When we buy stocks, we want return on equity (ROE) above average with a price-to-earnings ratio (PE) below that, and we want growth above average. And if we don’t get a bargain price, we won’t chase it.

Another reason some people go to an auction is for the entertainment. Do you think the stock market is entertaining? They certainly think so on CNBC — and they are in the entertainment business! Folks, the real reason to go to an auction is for the volatility. If you know what you want and what you are willing to pay for it, then volatility is a great thing. It gives you the chance to buy it cheap, but it only works when nobody else wants it. You and I cannot buy a Buick at a Chevy price if everybody loves Buicks. Similarly, the only way you are going to get a good company cheap, is if people don’t like it. That’s the business that we’re in. We try to find values and determine what we’re willing to pay. We go to the auction. If we can get our product at our price, then we buy it. And if we can’t, we won’t.

Thirty years ago Connie was an Avon Lady. Remember when word got out that a couple of Avon gals had a stash of bottles up in the attic and they sold them for, I don’t know, $25,000 as collectors items? Connie had two gals on her route who bought one of everything. How many Avon ladies are in the country? If each one had just one customer who buys one of everything, what’s going to be rare? The only way you get ‘rare’ is when it’s junk. When a lot of people collect one of everything, it’s not rare anymore. When it becomes popular, it’s over — and that’s also true in the business we’re in. We refer to it by saying “Everyone wants to plant corn in October because it’s grown so well since April.” People want to extrapolate the gain as if nothing has changed. We think the time to plant corn is April, after it hasn’t grown for six months.

The comments made by Ron Muhlenkamp and his Investment Team are opinion and are not intended to be investment advice or a forecast of future events.

Dow Jones Industrial Average (DJIA) is a price-weighted average of 30 significant stocks traded on the New York Stock Exchange and NASDAQ. The DJIA was invented by Charles Dow back in 1896.

NASDAQ is a market-capitalization weighted index of more than 3,000 common equities.

Muhlenkamp Minute Back


Recent Trends in the International, Commodities, Bond and Stock Markets
Recorded June 1, 2006 – Ron Muhlenkamp, Portfolio Manager

Several trends have been in evidence over the last six to nine months, some of these trends
going back several years. Most of these trends have several things in common. They started from a “value” base, their prices rose to value levels but they kept climbing based on momentum. In our view, the public has insisted on playing each of these trends until it lost money.

In particular:

After 20 years of declining interest rates, long-term bonds were viewed as safe – until interest rates rose earlier this year resulting in losses on bonds.

Secondly, after three years of “out-performance,” emerging markets attracted a lot of money, then Bolivia nationalized oil and gas reserves and Ecuador seized the assets of Occidental Petroleum. Many emerging market securities have tanked in the last month with some markets down 30% - 40%.

Thirdly, commodities, especially metals, have been quite high. We’ve been hearing that financial buyers (think speculators and hedge funds) have bought more metals contracts in the last few months than have the users of these metals (think auto companies and Caterpillar). Metal prices, including gold prices, have cracked in the last few weeks.

Fourthly, small-cap stocks, which were great values several years ago, became fully priced in our view. The fact that many dedicated small and mid-cap funds have been closed to new money indicates their managers had the same view. The prices of some of these stocks have cracked in the last month, to the extent that the NASDAQ is down year-to-date, although the DJIA is up.

In our case, we didn’t trust the prices of bonds, commodities and emerging markets. We’ve been moving money toward some stocks that are larger in capitalization. Until now, that move has been early. We’re about to find out whether it’s been right!

In the meantime, we’ve been hurt by holdings in housing stocks. We continue to hold on to these stocks because we see great value there.

But the stocks have gone from 7-8 times earnings to 5-6 times earnings and this has hurt our performance. We think each
of the above trends is now turning.

This is Ron Muhlenkamp with the Muhlenkamp “two” Minutes.