Quarterly
Letter
The transition period we’ve been discussing for two years is lasting longer than we expected, and having greater negative effect on some of our companies than we expected. Nevertheless, the general pattern is familiar. After a period of economic and market expansion, the Fed raised interest rates to contain inflation and slow the economy. Subsequently, it has lowered rates to start a new cycle. We covered this pattern in some detail in Muhlenkamp Memorandum #84, three months ago. As often happens in boon times, some consumers and some companies lost sight of reality in pricing their products and have since suffered severely. In 1999-2000, it occurred among technology companies; in 2006-2007, it occurred in the credit markets. The credit markets include loans of all kinds. Much has been written about the problems in sub prime residential mortgages, but similar problems exist in commercial mortgages and some corporate loans, particularly for mergers and acquisitions. In the aggregate, these problem loans affect the balance sheets of financial companies, including banks and brokers. The problem to date is that no one knows how bad the problems will prove to be, or to what degree each company is affected. So the markets assume the worst. In one respect, it’s good to be at year’s end. In preparation for year-end reports, company management and their auditors are required to do a thorough assessment of the value of their assets and liabilities. So, some of these questions should soon be cleared up. (In the current instance, the risk might be that they over compensate and go too far.) The second part of a transition is often a change in market leadership, and our holdings are reflecting this change. We have decreased our holdings in home builders, financials, and consumer cyclicals and have increased our holdings in capital goods and technology. In doing so, our turnover has increased this year, resulting in sizable capital gains and the resulting taxes. In our recent essay on capital gains and taxes (available at www.muhlenkamp.com), we pointed out that the goal of investing is to achieve capital gains. Folks, in this cycle, we postponed it as long as we could, and somewhat longer than we should have. (For those of you who joined us less than three years ago, we’re quite aware that you haven’t yet seen the gains that justify the taxes.) If we’re right that the investment climate is good and the business cycle continues, we are now, once again, at the beginning of a business/investment cycle, giving us opportunities we haven’t seen in 6-7 years. The comments made by Ron Muhlenkamp in this letter are opinion and not intended to be investment advice, or a forecast of future events.
 The value of the U.S. dollar relative to other currencies has been a frequent news item recently, leading to a number of questions about international investing, the trade deficit and, by extension, the overall health of our nation’s economy. While we’re not in the business of predicting the direction and magnitude of currency movements, we are in the business of understanding how these changes are likely to impact the companies we own or intend to own. We’ve Been Here Before The 1978 trough occurred following a period of pessimism about the state of our domestic economy. Back then, the focus was on “stagflation,” a combination of inflation with slow economic growth. The 1995 trough followed a period of increasing trade – and trade deficits specifically – with Japan that began in earnest in 1984. Interestingly, from January 1985 to April of 1995, the U.S. dollar depreciated approximately 67% versus the Japanese yen. Despite this decline, the U.S. economy continued to grow during this period at a real rate of 2.8% on average, while inflation averaged 2.7%.
Observation 1: Trends in currency values are measured in multiples of years, rather than months or annually. We are approaching year seven of a weak U.S. dollar relative to our trading partners. Observation 2: Declines in currency value do not necessarily lead to inflation or reduced GDP growth. Observation 3: Using broad trade-weighted foreign currency as a proxy, the decline of the U.S. dollar has added 3.3% per year to returns for U.S. based investors in foreign assets since January 2002. It’s a Matter of Supply and Demand… and Expectations. Today, concerns about U.S. economic vitality are fueled by our increasing trade deficit with China (among others), historically high oil and food prices, and domestic credit quality issues. Fortunately, things are seldom as bad (or as good) as they seem. Currencies exist at the intersection of economics and geopolitics. Politicians make the rules, which affect the economics. Specifically, rules regarding fiscal and monetary policies impact the value of a country’s currency relative to their trading partners. Undervalued currencies permit a country’s producers to gain a cost advantage over their foreign competitors, but at the expense of their consumers. Overvalued currencies permit a country’s consumers to pay less for goods and services, but at the expense of their producers. Both sides have a winner and a loser. However, we typically only hear from those that have lost, as the winners are reluctant to bring attention to their good fortune. Whether a currency is overvalued or undervalued is more subjective than you might think. Even organizations like the International Monetary Fund (IMF) and the World Bank struggle with how to compare various currencies. Fundamentally, it becomes a question of supply and demand. If you and I are eager to exchange our dollars for Euros at the current price, that’s a good sign our currency is overvalued relative to the Euro. If our European counter-parties are eager to accept dollars for Euros, one would come to the opposite conclusion. At the core of both these examples are expectations. If expectations are for a currency to appreciate/depreciate, market forces will move it in that direction until a catalyst appears to reverse the momentum. What these catalysts are, and when they will appear, can be difficult to identify in advance. (In the case of the U.S. dollar and the Japanese yen in 1995, the catalyst was the Japanese reducing their lending rates relative to the U.S. in order to stave off deflationary forces.) You Don’t Have to Predict the Future, but You Do Have to Understand the Present To understand what’s really going on, it’s useful to look beneath a general trend line and dig deeper into what is driving the change. In the case of examining the U.S. dollar, potential inflection points can be identified by studying International Transactions. There are two main categories of International Transactions: trade and investments. _____________________________________________________________________ Our trade account is known as the “Current Account” which includes both imports and exports of goods and services, along with income receipts and payments. The U.S. has run a deficit in this category since 1983, having had our last surplus in 1982. Our investment account is known as the “Financial Account” which keeps track of our investments overseas and foreign-owned investments in the U.S. We have run a surplus in this category since 1983. The Financial Account is an offset for the Current Account and vice versa. Why? International Transactions are balanced in the sense that if we run a deficit in trade, the “surplus” of dollars overseas comes back to us primarily in the form of investments. The relationship isn’t always one-to-one. There are other offset categories and, sometimes, our cash is simply held as cash outside the U.S. Also, the data collection techniques are estimates, but the relationship holds over time.
Source: Bureau of Economic Analysis The above figure shows the percentage of each account relative to GDP since 1973: This figure tells us that since 1991 the overall trend has been increasing deficits in our Current Account, but the trend began to reverse in 2007. This figure also indicates an off-setting increase in the Financial Account; in 2007, this trend also began to reverse. Periods where the trends change direction could signify an inflection point. During such times, it can be useful to identify and understand what’s driving the change.
Source: Bureau of Economic Analysis In the above table, we’ve highlighted some of the significant changes in International Transactions through 9/30/07 versus last year. Positive amounts reflect dollars coming into our economy, while negative amounts represent dollars leaving our economy. What does the table tell us? Within the Current Account you can see that exporters are doing quite well (+12% YTD), which shouldn’t be surprising since the dollar has declined for the past six years. Note that imports are still growing (+4.6%), but at a rate significantly below that of export growth. Bottom line: Imports still exceed exports, but the difference is beginning to narrow. Within the Financial Account, you’ll find that U.S. investors continue to send money into foreign investments, but Q3 2007 saw a significant slowing of that trend. Year-to-date, U.S. investors have invested $1.071 trillion dollars overseas versus $771.5 billion last year. Bottom line: It may be too early to tell, but U.S. investors may be growing a bit more reluctant about investing overseas which would reduce pressure on the U.S. dollar. Taking a look at Foreign Official Assets, you’ll note that growth in U.S. dollar reserves owned by foreign governments has slowed significantly. Foreign governments added $262 billion during the first three quarters of 2007 as compared to $355 billion during 2006. (The emergence of the Euro as a secondary “reserve” currency has not resulted in dollar reserve liquidation, but likely has slowed the rate of further dollar reserve accumulation.) In Other Foreign Assets, “Direct Investments” which represent the purchase of U.S. based assets to acquire or grow a U.S. based business saw relatively flat inflows through Q3 2007 versus last year. Of interest, inflows seen during Q3 were the largest we’ve seen since Q4 2000. Remember, as the dollar loses value, our assets become more attractive to foreign investors. Looking further, Q3 2007 witnessed a net redemption in “U.S. Securities other than Treasuries” which includes stocks and non-treasury bonds. We haven’t had an annual redemption in this category since 1965, and quarterly redemptions are rare as well. Since 1973, we have only had quarterly redemptions in Q4 1974, Q4 1987 and Q3 1990. Observation 1: Current conditions favor U.S. producers over U.S. consumers. Observation 2: Potential trend reversal in the Current Account may reduce the supply of U.S. dollars going forward. Observation 3: Growth in foreign direct investment in the U.S. may provide incremental demand for U.S. dollars. At Muhlenkamp & Company we believe one doesn’t need to predict changes in the investment climate, but we do believe it is important to monitor and adjust to changes as they occur. We don’t yet know whether the changes we see in our trade and investment accounts indicate an inflection point in the value of the U.S. dollar relative to other currencies, but we are monitoring and will respond to the data as appropriate. To that end, we continue to favor U.S. producers that sell to the rest of the world. Steve is a member of our Investment Team, whose opinions are not intended to be investment advice or a forecast of future events.
What is our long-term investment management plan? We are shifting the mix as we see the opportunities change. Two years ago we were at 15% in housing (stocks); today, we are at 1%. A year ago, we were at 20% in financials; today, we are at 5%. A year ago, we were at 0% or 1% in technology; today we are at 10%, owning companies like Cisco and Oracle. We also own companies like Caterpillar (capital goods) because they produce machines domestically and sell throughout the world. These changes have occurred because we are seeing better values than we had seen earlier. A year ago, some people were saying the shift would be to growth stocks. I’ll admit to that, provided you define “growth stocks” as companies that are now growing as opposed to the ones that used to grow. If you think about it, every decade gets a new round of leadership stocks, so we’ve been looking hard at revenue growth. In my November 8, 2007 presentation, you didn’t hear me talk about what Cisco’s earnings did; you heard me say their revenues grew by 17%. If you are in a 5% growing economy and your revenues are growing at 17%, you are doing something right. Unless a stock is overpriced to start with – which some are – “growth” is an area worth exploring and where we appear to be finding some values. You maintain that inflation has been contained, so why does it seem that energy and food prices have skyrocketed? The prices for energy and food have gone up. But house prices are going down, clothing is going down, and computers are certainly going down. Two percent inflation says, on average, that it is 2%. If you spend more for gasoline, unless you get a raise, you are going to spend less on something else. For example, if you look at your own spending and you spend more on gasoline, you can probably spend less at restaurants. It will come out someplace, and we each make our own decisions about that. But have you noticed that while people complain about the price of gasoline, nobody complains about the price of beer or water? Bottled water is a lot more expensive than gasoline. My friends will go to a ball game and complain about the price of the gasoline, but not about the tickets, or the hot dog, or the beer. The things we want are the things we’ll pay up for – and that’s where the margins are! Take a look at who makes better margins and better returns: Coca-Cola or Exxon? Coca-Cola is twice as profitable as Exxon, but nobody complains about the price of Coca-Cola. If banks are pooling and selling mortgages, what are they writing down as losses? For example, Citigroup just wrote down several billion in losses. [On November 4, 2007, Citi announced at least $8 billion of fourth-quarter write-downs on mortgage investments.] In the case of Citigroup, it was twofold: First, they got stuck with a loan inventory that they had hoped to sell profitably, but the market conditions changed and the fair market value of those loans fell. Second, Citi had direct exposure through collateralized debt obligations (CDOs) and residential mortgage-backed securities. Here’s a brief history: Residential mortgage-backed securities were introduced thirty years ago. Along with this, Wall Street introduced tranches, (French for “slice”), into which the pools of mortgages are sliced with various projected maturities: one year, five years, ten years, etc. Wall Street marketers found ways to repackage lower-level (sub-prime) credits and have some of it rated AAA. It worked. Some hedge funds would combine this with borrowing the Japanese yen on the cheap to buy U.S. dollars to invest in sub-prime debt. Nearly every type of financial entity participated: banks (both domestic and foreign), pension funds, hedge funds, insurance companies, even money market funds. In response, mortgage companies kept writing sub-prime mortgages at terms that eventually became non-economic. It took some time, but the Federal Reserve tightened enough to wipe out nonsensical behaviors like sub-prime credit packaged at low interest rates. As the Fed raised rates, the assumptions used to price those mortgages and structured investments (default rates, home price appreciation, and market appetite) failed. As a result, today, potential buyers are on the sidelines trying to figure out how to price them – but the lack of pricing and the existence of lowball bids have created fear about the asset quality of institutions like banks and insurance companies. One of the first to fall prey (June 2007) was a Bear Stearns Hedge Fund with about $4 billion worth of sub-prime mortgage-backed securities. And the fall-out has continued. Remember: These debt instruments are structured / customized / synthetic products that do not trade on a daily basis. As a result, many of the bids are lowball bids. An example of this is if I were to put my home up for sale. I think I know the value of my home and, some days, I receive bids that approach that value. On other days, I might receive a lowball bid at half of my home’s value. That doesn’t mean my house is actually valued at half, it only means I received a lowball bid! Today and especially at yearend, companies and their auditors are having to value these securities at a time when the trading in these securities has dried up and many bids (we believe) are lowball bids. How does this relate to the short-term volatility of stocks? Most hedge funds are highly leveraged. As holders of the mortgage securities that suddenly couldn’t be priced, they were forced to sell securities that could be priced, i.e. stocks, to meet the margin requirements on that leverage. For example, let’s say you are a hedge fund and you are borrowed 5:1 (on your equity capital), and the bank or the brokerage firm that has been lending you money says: “We are not really comfortable with that, why don’t you bring that down to 4:1?” You now have to sell 20% of what you own to bring your leverage down, right? You’d like to sell the securities you don’t want – but if you can’t get a bid, you sell what you can.
While Ron uses the ‘Memorandum to explain what he is doing in the “back office” of portfolio management, I want to share what we hear from some of our clients. Given the performance of the last two years, some clients are asking if they should continue to invest with us. The answer really depends on the client and their reasons for hiring us in the first place. If they hired us because we had a couple of years of great performance, and they expect us to beat the markets each and every year, we are going to frustrate them. On the other hand, we have a number of clients that hired us because of our long-term track record and a common sense approach to investing. Those people just need reassurance that who we are and how we invest money has not changed. We have not changed. We still believe you can turn a good company into a bad investment if you pay too much for it. We still look for the best companies we can find, and use our economic perspective to determine a fair price. We are still willing to walk away from making an investment if we cannot get our price. These are the same principles Ron has been using to invest money since 1968. Our process remains the same; it just hasn’t worked very well the last couple of years. We have used the Muhlenkamp Memorandum, seminars, and conference calls to explain why our work hasn’t produced results lately, and why we haven’t changed our process. Frankly, two years isn’t long enough to know whether we NEED to change our process. We believe it can take three to five years for our work to potentially yield results, so it’s too soon to know that our process is flawed. (We have made some changes to our holdings, but our process for MAKING those changes remains the same.) Ron continues to be the portfolio manager and he still works 60+ hours a week on finding ideas and investing money for our clients and shareholders. That hasn’t changed in all the time I have known him. We share the disappointment in our performance these last two years,
but our confidence remains high. Our confidence is based on having
a process that we believe makes sense, and having a manager with
lots of experience implementing that process. Please call Past performance does not guarantee future results.
On December 27, 2007 the Fund made a distribution of $13.82 per share. Ron has described his rationale for making the distribution from the Fund, and some of the tax implications of the distribution; visit www.muhlenkamp.com to review. In this article, we want to address the more detail-oriented questions we have received from shareholders on three other items that relate to mutual fund distributions: the change in NAV, the change in Cost Basis, and how the distribution affects the timing of redemptions in terms of the wash sale rule. 1. The Net Asset Value (NAV) or share price of the Fund is reduced by the amount of the distribution. If you reinvest the distribution, this means you will own more shares at a lower price, but the market value of your account remains unchanged due to the distribution. a. Example: On 12/26/2007 our NAV was $80.55, and so 100 shares of the Fund were worth $8,055. On 12/27/2007 we calculated a new NAV of $79.24, so those 100 shares were then worth $7,924 due to market action of the stocks we own in the Fund. We then distributed $13.82 per share in dividends and long term capital gains, so every 100 shares received $1,382. The distribution amount is subtracted from the NAV for the day, giving a new NAV of $65.42. Reinvesting the distribution means receiving 21.125 new shares (a $1,382 distribution divided by a $65.42 share price), so now you have 121.125 shares. At the new NAV of $65.42 per share, those 121.125 shares are worth $7,924, which is the same market value of the original 100 shares prior to the distribution.
2. The cost basis of your account is increased by the amount of the distribution because reinvested distributions are treated as a new purchase. a. Example: If you bought the original 100 shares at a NAV of $50 per share, your account has a cost basis of $5,000. The reinvested distribution of $1,382 is added to the original cost basis, and the cost basis of the current 121.125 shares is $6,382. If you sell all your shares on 12/27/2007 when the account is worth $7,924 you would realize a gain of $1,542 ($7,924-$6,382), not $2,924 ($7,924-$5,000). The distribution is taxed once when you receive it, and adds to the cost basis of your account. 3. Reinvested distributions are treated as a purchase for wash sale
purposes. Wash sale rules discourage people from selling securities
just to take a tax loss. The rules disallow the loss from selling
shares of a security if you buy shares of the same (or similar) security
within 30 days of the sale. a. Example: Imagine you bought the original 100 shares at a NAV of $90 per share, and had a cost basis of $9,000. If you want to sell those shares to realize losses for tax purposes, you have to sell those shares more than 30 days prior or more than 30 days after the distribution. If you sell the shares within that 61 day window (30 days before the distribution, the day of the distribution, or 30 days after the distribution) the loss will be disallowed (partially or wholly) under the wash-sale rules. We are sorry if we caused any concern or confusion by not providing this explanation earlier. Please call us if you have questions about how the distributions work or the possible implications. We can describe the rules and help you understand how they apply to the Fund, but if you have specific questions about your own situation we suggest you call your tax adviser. We cannot provide tax advice.
During our November 8, 2007 investment seminar in Pittsburgh, Ron Muhlenkamp delivered Where to from Here…Continued, an update to what was originally presented at seminars in November 2006 and April 2007. Following are highlights of that presentation: • The long-term picture for the markets and the economy, what Ron
calls the “climate,” remains positive. Inflation remains stable at
2%-3%, and long-term interest rates are stable at 5%; the financial
markets are priced for bonds to earn 5% and stocks to earn 8%-9%.
This remains consistent with what we have been seeing and saying
for a few years. The comments made by Ron Muhlenkamp in the November 8, 2007 presentation are opinion and not intended to be investment advice, or a forecast of future events. For your viewing convenience, the November 8, 2007 presentation is available both on our website at www.muhlenkamp.com, as well as on a DVD which can be viewed in the convenience of your family room or PC desktop. Click Here to request a free DVD.
2007 Distributions Reminder: Please refer to the most recent Prospectus for additional information. 2007/2008 IRA Contributions When making a contribution between January 1 and the due date for filing your tax return, we suggest that you specify the year for which you are making the contribution. Too many people realize too late that they made a current year contribution (the year in which the contribution is actually received), and not a prior year contribution (the year for which they are filing their return). If you have any questions, please call us toll-free at (877)935-5520, extension 4. Traditional and Roth IRA contribution limits are the lesser of $4,000 or 100% of your earned income for tax year 2007 and the lesser of $5,000 or 100% of your earned income for tax year 2008. “Catch-up” contributions for persons age 50 and above are $1,000 for tax year 2007 and tax year 2008. Please refer to IRS Publication 590 for more information. CESA annual contribution limits are $2,000 for each beneficiary. Please refer to IRS Publication 970 for more information. You can download copies of the above mentioned IRS publications here. Remember: It’s not too early to begin funding your 2008 IRA. Equity returns compounded over long periods can be amazing. Any tax or legal information provided is merely a summary of our understanding and interpretation of some of the current income tax regulations and is not exhaustive. Investors must consult their tax adviser or legal counsel for advice and information concerning their particular situation. Neither the Fund nor any of its representatives may give legal or tax advice. Best Wishes
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Our performance the last two calendar years has resulted in our
clients being roughly where they were three years ago. At the same
time, the broader markets have shown decent gains for the same period.
To call this disappointing is a vast understatement.
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