Issue 82 Published Second Quarter April 2007 Jump to: Quarterly Letter The Game of the Stock Market vs. The Business of Investing Mark Your Calendar

Quarterly Letter 
by Ron Muhlenkamp   
A shareholder recently asked, “In light of last year’s performance, do you intend to take any action to modify the current investments in the Fund?” My response was (is) “Do you really want me to change a philosophy and discipline that’s worked well for 40 years because we could have done better in a transition year like 2006?”

Folks, we’ve looked dumb before: the years 1994 (soft landing); 1998-99 (bubble); and 2002 (recession aftermath) are the most recent precursors to 2006. Each time we found that monitoring the economy and relying on the values of companies was the proper response. To that end:

The economy continues to expand.

The rate of expansion is a bit below 3% which is what the Fed was seeking, so the Fed remains on hold. We continue to believe that Q3/06 will prove to have been the slowest quarter of GDP growth in this business cycle, although the current pattern may be shallow (saucer shaped), rather than deep and quick (cup shaped).

The news is full of the repercussions of the Fed’s tightening; this time it is focused on the sub-prime mortgage area.

Folks, when the Fed tightens, it’s because an area of the economy got overdone and their actions are meant to cause pain in that area. A number of weaker firms go out of business and the stronger firms gain market share and go on to prosper. Because of the time lags in the system, the maximum pain for these firms is often 3-4 quarters after the time of maximum squeeze. For an investor, this becomes the ideal time to buy the good companies cheap.

At this point, we believe that we’re getting a chance to do it again. To the extent that the economy is cyclical, investors get a new chance every cycle (sort of like gardening or farming). Meanwhile, the markets remain quite volatile on a day-to-day basis; this will continue.

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 website at www.muhlenkamp.com.

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.

The Game of the Stock Market vs. The Business of Investing Back

“The Game of the Stock Market” distracts most people from making money in “The Business of Investing.”

A client has asked me to summarize my investment philosophy. With the recent crosscurrents in the bond and stock markets, it seems a particularly good time to do so.

– Ron Muhlenkamp


This essay was originally published in Muhlenkamp Memorandum Issue 33, January 1995.

Past performance is no guarantee of future returns.

Investment Philosophy
I entered this business in 1968. At that time, I had never owned a stock or bond, and I had never taken any courses in Wall Street finance. (I had taken courses in corporate finance.) So, I began my studies with a clean slate.

I soon learned that there are an unlimited number of people with ideas about how to invest your money, and all the ideas sound good at the time. Some of these people are paid to sell newspapers and magazines; some are paid to entertain on radio or television; some are paid commissions to sell financial products; and some are actually paid to manage other people’s money.

Only this last group publishes the results of their advice. The others tell me when they have been right, but I have to research what they wrote three to five years ago to get a complete picture. I also noticed that the gurus and the managers who were heroes in any one year seldom repeated; those who had good long-term records tended to stay on top, but they were seldom heroes in any one year.

Since my goals are good, reliable, long-term returns, I decided to study the philosophies of the people with good long-term records. I found that they all own corporate stocks, but their approach is to look at companies as businesses. And I learned that, over time, stock prices do reflect the values of the underlying businesses.

I also learned that these values and the resulting stock prices have increased by 9%–10% per year, indicating that if a person just buys good companies and holds them long enough, their returns would be 9%–10%.
By contrast, long-term returns on bonds have been 4%–5%, and CDs have been 2%–3%. So I have concluded that, as
a long-term investor, my “normal” position is to be 100% invested in corporate stocks.

The “Game” vs. the “Business”
All the problems with investing in stocks are in the short term, where changes in stock prices often seem unrelated to long-term values. Short-term prices are determined by whatever hopes and fears are currently driving the American public to buy and sell stocks. These hopes and fears are fanned by the media, the brokerage community, and various pundits with a short-term agenda.
But it is also true that much of the public insists on this short-term agenda and revels in the drama of it. I call it “The Game of the Stock Market” (as opposed to “The Business of Investing”), and it is very entertaining. The game focuses on the most dramatic and volatile aspects of price movements. Even the language is borrowed from gambling, focusing on “winners” and “losers.” The game can also be quite profitable, but requires an iron stomach and an against the crowd discipline which few people have.

A Reliable Business
Identifying a top or a bottom does no good unless you have the intestinal fortitude to act decisively on it. Professionals face the same problem. In mid-1987, Elaine Garzarelli became justly famous when she identified a short-term market top and avoided the decline in October of that year. But she then failed to buy in a timely fashion, even though her research told her to do so. Consequently, her advantage was dissipated as the market recovered to new highs in 1988 and 1989.

For most people “The Game of the Stock Market” is a distraction which prevents them from making money in “The Business of Investing.”

Periodic setbacks and a focus on the game result in their selling stocks when they should be buying, and vice versa. We focus on the long-term “Business of Investing” because we have found it to be more profitable and more reliable.