Issue 83 Published Third Quarter July 2007 Jump to: Quarterly Letter Questions and Responses - Investment Seminar 4/26/07 Mark Your Calendar

Quarterly Letter 
by Ron Muhlenkamp 

The economy continues to grow, along the track of a soft landing. We missed our call on the weakest quarter. We had thought that the third quarter of ’06 would prove to be the low point, but it turned out to be the first quarter of 2007. Of course, if you waited for signs that the economy had bottomed, you missed some nice gains in stocks. In ’07, stocks are up nicely, even though bonds are down. We think this is likely to continue.

The weak spot in the economy is housing which has been exacerbated by the problems in sub-prime lending. A number of firms in sub-prime mortgage lending should go out of business and are doing so. There has been a limited amount of carry-over into the rest of the economy, at least so far.

Meanwhile, volatility in prices continues, particularly on a short-term (daily and weekly) basis. We expect this to continue as well.

Individual companies are doing well, with good profits and cash flows. We continue to search for, and look to own, the stocks of such companies.

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.

Muhlenkamp & Company Inc. Investment Seminar – April 26, 2007
Questions & Responses   Back

During our April 26 investment seminar in Pittsburgh, Ron provided an update to the topic Where to from Here? which was originally presented in November 2006. At both events, he examined the long-term picture of the last 80 years, the intermediate picture of the economic business cycle, and the current short-term fluctuations. (For your viewing convenience, each presentation is available on DVD. Please let us know if you are interested in receiving copies.)

Afterwards, Ron and his team of investment analysts entertained questions from the audience. Tony Muhlenkamp served as moderator.

TONY MUHLENKAMP
While questions are being collected, I’d like to ask:

When the markets are up, would you like us to be up? And when the markets are down, would you like us to be up? And would you like us to do that each and every calendar year?

While such expectations are a tad optimistic, recently, we’ve been addressing concerns like: “Everybody’s up; why aren’t you?”

Folks, the only way we can improve upon the market, is to differ from it.
Recently, I ran some numbers going back to 1998. When measuring our Company’s performance on a monthly basis, we out-performed the S&P 500 half of the time, which means we under-performed half of the time. When looking at quarterly performance, it’s roughly the same. When measured annually, however, we out-performed about two-thirds of the time. And when measured every three years, we out-performed about 80% of the time.

A big part of successful investing is a function of time horizon, which is why you should not hire us for money that you expect to need in a month. A month is not long enough. A year is not long enough. You need a minimum of three years. We say: “Markets are rational in the long term, and it often takes three years for the rational long term to override the often irrational short term.” The studies behind this statement are covered in our booklet, The Basics, and are included in Dad’s book.

And now, let’s move on to our first audience-asked question:

With the housing market continuing to go down for the foreseeable future, at what point do you expect homebuilders to turn around, and when will it be reflected in your performance?

KEN DUPRE
Here’s what we know: Housing is in a recession. The industry is down 25% from its peak of over two million housing “starts” in 2005. In contrast, we have a growing economy, low unemployment, and low interest rates – a wonderful environment for housing.

Right now, most of our [housing] companies have depressed earnings, so to evaluate using only price-to-earnings (P/E) ratios is not very fair; a better way to value homebuilders is price-to-book value. Since they are trading near book, we should start seeing some price support.

One of the reasons we’ve owned homebuilders is that they exhibit competitive advantage. They keep taking market share from the small guy, and they trade at very reasonable valuations.

What is your selling discipline on undervalued companies that continue to drop? Can you cite a homebuilder as an example?

RON MUHLENKAMP
As long as our companies are doing what we expect them to do, and the market marks them down, we’re fairly patient. If the companies start to disappoint, they get sold pretty quickly.

When homebuilders mark down the value of the real estate they own, they run it through their income statement. When other companies do something similar, it becomes a non-income statement item. In other words, it comes right off the book – but not for homebuilders.

NVR [Ryan Homes] owns no lots; they option 100%. In the last year, NVR bought back 20% of their own stock and the company’s stock has rebounded.

Meritage, an outfit that builds homes in Texas, Arizona and Nevada, options about 80%. Meritage reported earnings yesterday; their stock was up today.
We think the carnage in housing stocks is over. Understand, however, that home building will continue to level off while they work off some inventory. And until I start hearing that folks are inviting their kids back home to live with them, I don’t think the inventory will be a problem.

We held some homebuilders longer than we should have, so we realized only four times what we paid, instead of five or six [times]. We still own NVR, however, where our average cost is below $60 per share. Today, the stock trades at $800 [per
share].

Bottom line: There is no company that is so good that you should buy it regardless of price. Likewise, there are very few things that you should sell regardless of price. If the current bad news drives the prices low enough, we hope we have the stomach to take advantage of it.

Regarding international stocks, are there countries you avoid? What is the Fund’s exposure to international stocks?

TAMMY NEFF
We approach all investing looking for good companies at a good valuation. So, when we find a company with a return on equity (ROE) above 14, and a price-to-earnings ratio (P/E) below that, we dig a little deeper and look at revenue growth, quality of earnings, etc. It really doesn’t matter where the company is headquartered.

If the company happens to be outside the U.S., we take into consideration additional risk factors, such as currency risk, geopolitical risk, and accounting risk.

RON MUHLENKAMP
Regarding international stocks, right now we own CEMEX and BHP, roughly 8% of our holdings. We also own a number of companies which conduct business overseas; for example, Caterpillar and Conoco. Frankly, we would just as soon own American-based companies doing business in other countries, and have been doing so for a long time.

Connie and I just spent ten days in China. One of the things I learned is if you establish a new joint venture or manufacturing plant, you’ll be exempt from about twothirds of various taxes – at least for a period of time – and that you’ll receive a reduced rate on the others. I’m sure this is viewed as a good thing. But the way I look at it, there are still approximately forty different taxes on the books. At some point, the exemptions and reduced rates will go away. As investors, we would just as soon own companies with a history of conducting business there – and are doing so on good terms.

During our visit, sponsored by the “CEO Club,” we met with two or three mayors or vice-mayors every day. On one occasion, we witnessed signings of 120 agreements for various kinds of things and the opening of an exposition. They rolled out the red carpet and flower arrangements, and featured eight different dignitaries cutting ribbons, starting with the mayor. An hour later, once the mayor had gone, the cameras were gone, the carpet was gone, the flowers were gone – all hauled out for display at the next big event. Anything that you want to have done in China first requires the approval of the politicians. And even though they don’t run for office, the people in charge are absolutely politicians.

Last year, the China market was up 100%. To me, it looks an awful lot like a bubble, with the local Chinese as participants. And, as evidenced by their 9% one-day drop in response to an increase in interest rates (February 2007), it looks like the Chinese are worried about things growing too fast. I don’t think now is the time to enter China. In hindsight, investing a year ago would have been good. But, if we don’t have an edge, we get very leery.

Why is the dollar weakening, and how does it impact international investing?

KEN DUPRE
The dollar is a “floating currency,” meaning, every day, the free markets weigh the dollar against other currencies in the world. Additionally, every competing currency is affected by two factors: the health and vitality of its country’s economy, along with the size of its country’s trade deficit. With a strong economy, a currency is generally strengthened. A significant trade deficit tends to weaken a currency. In the U.S., we have offsetting factors. Our trade deficit suggests that our dollar should go down in value, and our healthy economy suggests that the dollar should
go up in value.

The good news is, because the dollar is a floating currency, we benefit from a naturally correcting mechanism. If the world gets too many dollars, it will cause our currency to drop. As a result, U.S. goods get cheaper and foreign goods get more expensive, bringing more business to the U.S.

RON MUHLENKAMP
The first driver of the dollar is relative inflation rates. If a country has inflation much above others, its currency would sink. Today, nearly all countries in the world have comparable inflation rates, on the order of 2%. The second order of magnitude is the relative growth rates of different economies. And then the third order of magnitude is supply and demand from people who are buying and selling.

TONY MUHLENKAMP
It seems we have a series of related questions:

What are the drivers of your year-to-date performance?

What strategy, in terms of sectors, will you use to capitalize on the soft landing?

Are there still as many good companies at reasonable prices as last year?

With the DOW at its all-time high, have the buying opportunities decreased?

RON MUHLENKAMP
Let’s review the last two weeks
[April 12-26]:

Caterpillar’s stock jumped when they reported earnings. A couple days ago, Whirlpool’s stock jumped 14% because earnings were a little better than expected. While they paid the price last year, Whirlpool is now benefiting from having bought Maytag two years ago.

For the past 18 months, we have been betting on a soft landing. If anything, we called it a bit early and the markets, which always lag, are now catching up. During the 4th quarter of 2006, our companies performed very well. In February, everything corrected. In the last three weeks, our companies sang.

Today, [stock] prices are fair. As you know, we are always looking for good companies at cheap prices. Often, that means being out of favor with the markets. For example, credit card losses and mortgage losses are usually highest about 9 to 12 months after the slowest part of the economy. If the slowest part of the economy was the 3rd quarter of last year, all the recent news about sub-prime mortgages and credit losses makes sense. [More recent data suggests that the slowest part of the economy was actually the 1st quarter of 2007.] Bottom line: If we didn’t already own homebuilders and credit card companies, we would be buying them. Folks, when a company is out of favor, it’s the time to buy – if your stomach will let you do it. Frankly, I get paid more for my stomach than for my head. The head part of this game is reasonably easy. It’s the stomach part that catches up with you now and then.

Stocks are priced to return about 8%-9% annually. But stocks almost never return 8%-9% each year; they’ll do 0% one year and 15% the next; that’s because people get excited and unexcited. The short term is always dictated by human psychology – and it’s as variable as the daily weather.

As long as the investment climate is favorable [inflation and interest rates are back to “normal”]; stock prices are fair; and the markets are on a positive trend; we want to be fully invested in stocks. On a day-to-day basis, prices are going to fluctuate all over the place. If you’re a long-term investor, however, you know that the markets are rational and governed by business economics.

What are you seeing in healthcare?

TAMMY NEFF
We’re continuing to see value in part of the healthcare industry, and we’re most interested when we see this coupled with revenue and earnings growth. This has been a little more challenging for pharmaceutical companies, given the patent expirations and new product disappointments we’ve been hearing about. We still like UNH (United Healthcare), which focuses on cost containment by managing healthcare benefits. They are moving beyond the options back-dating issues that hurt the stock a few months back and are focused on executing their business strategy going forward. Their numbers still look good.

The numbers on Johnson and Johnson (JNJ) and Pfizer (PFE) looked good and we liked them when we bought them. Each company, however, had a few negative surprises that hurt their stocks. PFE had to pull a major late-phase drug from the development pipeline, and JNJ was hit with the controversy regarding Drug Eluding Stents. The stocks didn’t perform as well as we thought they would; i.e. when defensive stocks do well in the cycle. We still think these are good companies, but given where we are now in the cycle, we’re finding other names we like better.
What are your thoughts about REITs?

RON MUHLENKAMP
Let’s start with a definition: A REIT is a real estate investment trust; it’s a mutual fund that invests in real estate as opposed to investing in stocks.

We think the appreciation in REITs is over.

One fellow who made a fortune in real estate is named Sam Zell. Ten years ago they called him the “grave dancer,” because he was buying so many distressed properties. A couple of months ago, someone asked to buy Sam’s properties. He responded that he wanted $45 [per share]. By the time bidding was over, he got $54. Here’s a fellow who got 20% more than his asking price! If Sam is selling, you don’t want to be buying.

What about Oil Trusts in Canada?

RON MUHLENKAMP
In Canada, some trusts in the oil and gas business are currently taxed at the capital gains rates. The Canadian legislature, however, wants them to be taxed as ordinary income. As a result, trust’s prices have dropped by 30%. This is because the payouts, averaging 7%-8%, could be taxed at 30% or more (ordinary income), versus 15% (capital gains).

A year ago there was a pretty good argument for Canadian Oil and Gas Trusts. With the changing tax laws, that game is over. Folks, be careful when they change the rules, because it can change the game big time.

Are you investing in technology stocks?

JACK KUNKLE
Technology is an exciting area right now.

Recently, Comcast announced very good earnings. Their “triple play” (voice, video and data, bundled as one product) is booming. Cable companies are beginning to take significant market share away from telephone companies. We’ve been anticipating such traction for the past six to seven years.

The really interesting opportunity, right now, is assessing what happens with the data side of the triple play. Imagine using your television to access Internet resources for content and subsequent viewing. The company that eventually “owns” the consumer’s family room, by successfully organizing and delivering (Internet) video content, will emerge as the winner. Right now, the battle is being fought by cable, telephone and satellite companies, versus Internet-based content providers. The next great opportunity for investing in technology lies in this space.

Please comment on airline stocks.

BRIAN JACOBS
Surprisingly, airline stocks are pretty attractive right now. The industry went through significant turmoil with the events of September 11, 2001, and the ensuing bankruptcies that took place in 2003-05. Right now, planes are full and are running at record capacity utilization. Also, airlines have lowered their cost structures significantly, particularly by reducing wages.

Airline stocks should continue to be attractive over the next few years because domestic carriers do not have access to new planes. The order books for Boeing and Airbus are full with international orders. At the same time, the fleets of the large domestic carriers are getting very old and will need to be replaced. Any new planes will serve as replacements and not expand the industry’s capacity. As demand continues to grow and the supply continues to be constant, we anticipate continued upward pressure on airfares, thus, improving industry profitability.

What about the Congress and their unwillingness to extend tax rates on dividends and capital gains?

RON MUHLENKAMP
Folks, 15% tax rates for dividends and capital gains are as good as it gets. Uncle Sam says, if you make money, he wants his cut, which can run from 15% on capital gains to 45% on estate taxes. With elections on the horizon in 2008, it’s not too soon to start calling your Congressman today.

If we think rates will go up, we might purposely takes gains. So far, we’ve been able to postpone and/or minimize, but I will never apologize for taking long-term capital gains, and paying the taxes.

What do you think will be the Federal Reserve’s next move?

RON MUHLENKAMP
If inflation ticks down over the course of this next year, the Fed will lower rates. Hopefully, this would allow the economy to continue growing at a decent rate.
The Fed does not adjust interest rates according to GDP changes; the Fed is focused on inflation. When I was in school 40 years ago, we were taught that growth causes inflation. In fact, growth offsets inflation. Printing money causes inflation. Reagan and Volcker proved this over 20 years ago, although not all academics have realized it yet.

Central bankers know that if inflation ticks down, rapid growth in the economy will not bother it a bit. Over the short term, the two tend to run together. Over the longer term, the lags are different. When the Fed prints money, it first shows up in GDP growth and then shows up in inflation statistics. And when the Fed squeezes money, it first shows as a slowdown in the economy before taking a bite out of inflation. One has about a six-month lag; the other has about an eighteen-month lag. Over a longer term, the two actually offset each other.

Why do so many financial planners talk about allocation and diversification?

RON MUHLENKAMP
Folks, the people who tell you to diversify are telling you that they don’t know the difference between a good investment and a bad one. And I agree! If you can’t tell the difference, then you might as well own some of everything.

When you were teenagers you probably experimented with various styles of colors and clothing. I suspect that as you became a little bit more knowledgeable, there are some things that don’t end up in your closet. If you don’t know any better, you might as well own some of everything. These folks are telling you, up front, that they don’t know the difference between a good investment and a bad one. If that’s the case, why would you pay them a fee?

Have you changed your view on “small caps” in terms of valuations?

RON MUHLENKAMP
We think that [company] size is irrelevant. Seven or eight years ago, the only values we saw were in small- and mid-sized companies, so we owned them. Today, we are seeing values in a fairly consistent mix across the board, so we own some small companies and some large ones. We don’t care about the size of a company, never have. We care about profitability and about the price we pay.

BRIAN JACOBS
I’d like to add that we’re seeing good reports coming out of the big multi-nationals. Earlier, we were asked about international investing and currencies. You can really take advantage of companies like Caterpillar, or even Microsoft, GE, or Cisco that have exposure to international currencies as the dollar weakens.

What effects do you expect from the war in Iraq and the impact on the price of oil, here?

RON MUHLENKAMP
There are about 40 million people in Iraq and Afghanistan who have had the chance to vote for the first time in their lives. I think we’ve given them the chance to take over control of their own countries. We are about to find out if they can do that or not. That has had some impact on the price of oil.

We’re not running out of energy, folks, we’re just running out of cheap energy. What we found in this country is that until the price of gasoline reached $3 per gallon, people really didn’t use any less. At $3 [per gallon], they cut back a little bit. We’re now getting fairly close to that again.

We’re running out of cheap energy – cheap being relative. When I was growing up we cut wood for heat. I think gas, at current prices, natural gas or gasoline, is pretty cheap. When you see your sons and daughters going to cut wood for heat, you’ll know that energy has gotten expensive. Right now, I think it’s pretty cheap.

Past performance is no guarantee of future results.

Opinions expressed are those of the individuals named and are subject to change, are not guaranteed, and should not be considered investment advice.

Return on Equity (ROE) is a company’s net income (earnings), divided by the owner’s equity in the business (book value).

Price-to-earnings ratio (P/E) is the current stock price divided by the earnings per
share.

Book Value (BV) or “Book” is the owner’s equity in the business, often quoted as Book Value/Share; Book Value = Total Assets – Total Liabilities

Click here to see the top 10 holdings in the Muhlenkamp Fund. Fund holdings are subject to change and should not be considered a
recommendation to buy or sell any security.