Issue 86 Published Second Quarter April 2008 Jump to: Quarterly Letter Conversations with Ron From the Front Office Inheriting Your Spouse’s IRA Mark Your Calendar

Quarterly Letter 
by Ron Muhlenkamp 

We may have passed the point of maximum pain in the debt and equity markets.

From an economic point of view, the questions concern recession:

 

• Are we in a recession?
• When will we know?
• What shape will it take?
• How long will it last?
• How deep will it be?
  
  

But, from an investment point of view, these questions may no longer matter because by the time we know for sure, it’s too late to do anything about it.

In the U.S., we’ve had ten recessions since WWII. In each case, the slowdown was triggered on purpose by the Fed, which acted according to its charter in containing inflation. But they also squeeze out the excesses of the prior expansion.

If we review our economic history, we note that prior to the 2001 recession, there were excesses in the technology and “dot-com” sectors. Looking back at the 1990 recession, the excesses were in the real estate and energy sectors, resulting in several banks and S&Ls going out of business. What we are learning this time is the excesses have been in the financing of real estate and other assets.

A soft landing was the Fed’s goal each time it slowed down the economy. In ten cases, the result was recession. In most cases, the Fed squeezed until something broke. (Translation: a major firm went bankrupt.)

This time, the Fed quit squeezing two years ago which is why we were expecting a soft landing. But participants in the credit markets (including mortgages) didn’t get the message. As short-term rates moved up, Adjustable Rate Mortgages (ARMs) became less attractive to the borrower and less profitable to the underwriter and lender. This should have resulted in fewer ARMs being written. Instead, the underwriters changed their terms. They allowed lower down payments, less documentation, or used greater leverage to try to improve their profits. In short, they pushed the limit until they broke themselves.

At the individual level, if you have a three-year ARM written in 2005, it’s up for renewal in 2008. A year ago, short-term interest rates were well above the rates in 2005 and many feared that borrowers wouldn’t be able to afford the rates being charged at renewal. Since then, the Fed has lowered rates to nearly the level of 2005, so the rate shock at the time of renewal wouldn’t be huge. But if the original mortgage exceeded 80% of the value of the home, or the current balance exceeds 80% of the current value (because the value of the house has declined), the borrower may need to make up the difference between the current mortgage and 80% of the current value of the house. It depends on the original terms of the mortgage.

Obviously this can make it tough on the borrower. But it also makes it tough on the lender, which results in declines in the market value of existing mortgages.

To understand how this impacts a business, let’s look at Carlyle Capital Corp. This was a fund which functioned as both a borrower and a lender. It lent money into the mortgage market by buying mortgage-backed securities, and borrowed money from other sources to fund their purchases. (This model only works if the returns from lending exceed the cost of borrowing by more than the expenses of running the business.) What happened was, as spreads narrowed, Carlyle should have backed away from the business. Instead, they increased their borrowing until it exceeded 30 times the equity in the business. The result was it went bankrupt — defaulting on $17 billion worth of debt and ceding the collateral to their lenders. The lenders, in turn, sold this collateral in the open market, resulting in the decline in the market value of existing mortgages.

Given this environment, other primary lenders have become less willing to lend to intermediate lenders like Carlyle. The result has been some forced selling, leading to a decline in the market value of existing mortgages.
The primary lenders, who plan on holding their mortgages and bonds to maturity, have seen the current market bids for such bonds fall far below what they believe is the long-term value of the securities. And their accountants have interpreted the accounting rules to say that at year-end 2007, they must value these assets on their books at current market bids.
(For this discussion, I’m defining primary lenders as those who lend but don’t borrow; e.g., pension funds and life insurance companies. I’m defining primary borrowers as those who borrow but don’t lend; e.g., the homeowner with a mortgage, but no bonds. I’m defining intermediate lenders/borrowers as those who do both, such as banks, Carlyle Capital, some hedge funds, and brokers including…Bear Stearns. Note that although the media has been discussing a federal “bailout” of Bear Stearns, what the Fed really did was provide a location for Bear Stearns clients and customers to continue doing business. The shareholders of Bear Stearns will receive less than 10 cents on the dollar.)
Another example of the current environment involves AIG (an insurance company we own). The company believes the value of their holdings has declined by $1 billion. Their auditors, however, have said that, reflecting current market bids, AIG must devalue their holdings by over $10 billion.
Over the past month, three things happened which we think are sufficient to break these trends:

1. For companies reporting on a calendar year, the end of February was the deadline to satisfy the auditors for the annual report. This means that these assets have been appraised at the current bids (which we believe may be well below economic values).
2. In response to the above, the SEC has clarified their rules on “Fair Value” reporting, implying that the “marked to market” many auditors required at year end may have been overdone. This should help to alleviate the markdowns.
3. In response to the insolvency of Bear Stearns, the Fed has made it clear that while they’ll allow a major firm to go out of business, they’ll support the assets (and the customers) of the major brokerage firms as well as the banks.

These actions may well be sufficient to bring some liquidity and stability to the credit markets. If so, we may have passed the point of maximum pain in the debt and equity markets.

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 at www.muhlenkamp.com.

As of March 31, 2008 Carlyle Capital Corp. and Bear Stearns were not holdings of the Muhlenkamp Fund.

As of March 31, 2008 the Muhlenkamp Fund held 4.11% of AIG.

As with all mutual funds, the Securities and Exchange Commission (“SEC”) does not approve or disapprove these securities, or pass upon the accuracy or adequacy of this article. Any representation to the contrary is a criminal offense.

Conversations with Ron Every week, the staff of Muhlenkamp & Company conducts a Friday morning meeting with Ron. Following are excerpts of our weekly conversations:

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Are we entering a recession and what is the potential impact on the markets?

Talk about recession ignores a couple of points. By the time we know for sure we are in or have had a recession, it is too late to do anything about it. Recessions are a normal part of business/economic cycles. We used to have one every 4-5 years but we have only had two recessions in the last 25 years; the last recession was in 2001.

Last year, we believed a soft landing in the economy would be mirrored by a soft landing in the markets. That was a mistake. We failed to recognize that the markets fear a recession whether you actually get one or not. Currently, we are encouraged by the fact that some people count the number of times the word ‘recession’ is used in the media; in the last three months, that count went straight up. We are encouraged by this because in the past fears of recession have given us pretty good opportunities to buy stocks.

A useful strategy for dealing with recession fears is to ask yourself: How did you do during the last recession? After all, we have all been through similar periods before.
For more on this topic, plan on participating at our May 8 investment seminar at which Ron will address “Recessions: What Do They Look Like?” Registration details for the live event and 2 p.m. ET webcast are included in this ‘Memorandum.

Why is there so much volatility and can we expect it to continue?

Margin calls, higher lending standards from banks, and deleveraging are continuing to cause forced selling in the credit and stock markets.

Investors in collateralized debt products are getting margin calls because the prices on those products have tanked and their lenders are pulling in their loans. They are selling whatever stocks they can to cover those margin calls. So, you have a bunch of people that have to sell, and nobody that has to buy. Those that are buying are making lowball bids – and when the bids get “marked to market,” it causes another round of selling based on equity requirements, creating a domino effect.

How and where did the precipitous drop in stocks get started?

The falling stock market has been driven by problems in the credit and fixed income markets. Here’s why:

Bank and insurance company assets are essentially loans and bonds. The regulations say that the higher those bonds are rated, the less equity you need to back those assets. If the credit ratings on those bonds fall, banks and insurance companies will have to raise equity or sell some of their holdings — even if they have to accept lowball bids. This serves to drive prices lower.

Further, money market and “stable value” type funds are coming under pressure. Money markets traditionally invest in securities with less than 30-day maturities, but some have recently been investing in longer maturities, then using derivatives to hedge the short-term volatilities. This works as long as there are bids for those derivatives, but as those bids dry up expect to see some money market funds drop below the characteristic $1 per share level. It may only be by 1-2%, but once the faith is broken the backlash can be sizable.

Add to this mix pension plans which have also invested in hybrid fixed income products called “auction rate” securities that have long-term maturities, but are priced on a short-term basis — supposedly reducing their risk. For these products to work there has to be a daily market for them. Major financial institutions made supporting bids on the products they had sold their pension plan clients. In the past few weeks, however, some have failed to make supporting bids, throwing this market into disarray.

We don’t know how low prices will go and how long all of this will continue, but it’s giving us a chance to buy what we believe are good companies at low prices. We are double and triple checking our companies to try and make sure they are not exposed to the credit market issues, and we are taking advantage of current prices to add to existing positions and to add new stocks to our portfolio.

Has our investment strategy changed in light of these events?

No.  Here’s why:

Climate Favors Equities
As you can see from the Ibbotson chart, below, historically equities have provided the best absolute returns; i.e. 5% after taxes and inflation.  With stable inflation and reasonable interest rates, we think the climate continues to be well-suited for investing in equities. Given the declining value of the U.S. dollar, we favor U.S. producers with global customers.

Figure 1 — Historical Index Growth of $1.00.

SBBI stands for “Stocks, Bonds, Bills and Inflation.”
Stocks: S&P 500 Index.
Municipal bonds: 1926-1984, 20-year prime issues from Solomon Brother
Analytical record of yield and yield spread; since 1985, Mergent’s Bond Record.
Government bonds: 20-year U.S. Government Bond.Treasury bills: 30-day U.S. Treasury Bill

The S&P 500 is a widely recognized, unmanaged index of common stock prices. The figures for the S&P 500 reflect all dividends reinvested, but do not reflect any deductions for fees, expenses or taxes.  The 20-year prime issues from Solomon Brother Analytical record of yield and yield spread and the Mergent Bond Record provide complete and accurate coverage available on government, municipal, industrial development/environmental control revenue and international bonds.The 20-year U.S. Government Bond is issued by the U.S. government and regarded as the highest grade of securities issues. Treasury bills are represented by the 30-Day Treasury Bill, comprised of non-interest bearing obligations of 30 days or less that are fully guaranteed by the U.S. government.

Good Companies
We begin to define a good company by looking at ROE or Return on Shareholder Equity.  ROE can be thought of similar to the interest that is paid on a bond.  (For example, if you paid $1000 for a bond that has paid you $100 per year your interest rate or return has been 10%. If a company has $1000 in shareholder equity, assets minus liabilities, and net income of $100, the ROE is 10%.) ROE has been a stable statistic averaging around 13-14% since World War II.  If we can find a company providing an ROE above 14% it is our first clue that we are dealing with a good company.  As of 3/31/08, the average ROE of the companies in our portfolio exceeds 18%.

Today we also are paying close attention to sales growth.  We believe most industries have ample capacity.  Therefore if a company is going to do well, it will do well at the expense of its competitors; (e.g. if Wal-Mart is going to do well it will be at the expense of Kmart and Sears).  Our thinking is if sales are growing at 7-10% in an economy that is growing 2-3%, management is doing something right.  As of 3/31/08, the average sales growth of the companies in our portfolio has been 7.8%; further, the average long-term earnings has been 11.2%.

Good Prices
We always want to own good companies, but we believe you can turn a good company into a bad investment if you pay too much for it.  Therefore we pay close attention to what we are willing to pay for a company and look to own good companies when they go on sale.  We begin to define a good price by looking at company’s Price to Earnings (P/E) Ratio.  P/E is what you are paying for the earnings the company has made or what you would be paying for $1.00 of earnings.  P/E ratios allow you to compare what you are paying for $1.00 of earnings at one company versus another.  Today, the average P/E of companies is around 16.  We like to see a company trading below 16 or more specifically, below its current ROE.  As of 3/31/08, the average P/E of the companies in our portfolio is 11.6.

Once we have identified companies with an ROE greater than 14% and a P/E below the ROE we begin our fundamental analysis. We look at growth, profits, financial strength, labor relations and management teams.  We use this information in trying to understand how the company achieved the numbers that attracted us in the first place and to determine if those numbers are sustainable.  

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 at www.muhlenkamp.com.

Return on Equity (ROE) is a measure of a corporation’s profitability.  It represents the average return on equity on the securities in the portfolio, not the actual return on equity on the portfolio.

As of March 31, 2008 the Mulenkamp Fund held 0% of Wal-mart, Kmart and Sears.

From the Front Office by Tony Muhlenkamp

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Last quarter I wrote about our people and our process remaining unchanged. Since then, shareholders have been asking what they can expect from us and what they should do with their investments for the rest of 2008 and beyond. My crystal ball isn’t very clear for the immediate future, but there are some things I think you can expect in both the short and long term:

1. We anticipate our share price and performance will be volatile. Price swings of plus or minus 10% are normal and we have more people paying more attention to more misinformation than ever before, so the volatility will only increase.
2. 
   Prices could and may drop by more than 20% from peak to valley due to emotions in the markets. From our high in June 2007 to the recent low in March 2008 we dropped more than 20%. The last time we had a peak to valley drop of over 20% was between April and October of 2002. In 2007 it was due to a “crisis” in the credit markets; in 2002 there was a “tech bubble” that burst. You can expect some kind of crisis and/or bubble every few years, and a resulting performance drop of at least 20%.
3. 
   We expect that the stock market will be fragmented, and market leadership will rotate among industries, sectors, market caps, etc. As a result, we believe this means that our performance will not track the broader indices very closely.
4. 
   We anticipate performance in different asset classes (stocks/bonds; domestic/international; large cap/small cap;
   stocks/real estate; etc.) will be more highly correlated going forward, especially when things are hitting the fan. So we believe broad diversification across multiple asset classes won’t protect you as well during tough times, and will probably drag on your performance during good times.

As money managers there are several things we are doing to take advantage of these conditions:

1. 
   We continue to harvest some of the stocks that have done well for us the last several years, and we are investing those profits in companies that represent better values. This harvesting process caused the distributions we made in 2007. We try to minimize the taxable distributions, but not at the cost of keeping stocks that should be sold.
2. 
   We exploit market volatility and fragmentation by buying good companies that are out of favor, and then being patient. We accept short-term volatility as the necessary price for potentially achieving longer-term performance.
3. 
   We invest for absolute returns, and we measure our performance against an objective measure of real (after inflation), after-tax returns of 5%. Since before the Depression common stocks have earned an average 5% after taxes and inflation and we endeavor to clear that hurdle over rolling three-to-five year periods. The only dollars you can spend are the ones you earn after taxes and inflation.
4. 
   We focus on finding profitable companies selling at bargain prices, and let that process diversify our holdings across market caps and industry sectors.
5. 
   We rely on long-term business and economic fundamentals instead of trying to predict and surf short-term trends and price momentum.

As investors, there are some things you can do as well:

1. 
   Review your investment goals and criteria and define what you are trying to do in terms of performance and timeframe. What returns do you require, and how often do you require those returns? Do you need those returns every year, or on average over three-to-five years? Are those reasonable expectations, given current market conditions and historical returns? Have you invested money with people that have similar criteria?
2. 
   Once you reaffirm what you are trying to do, and what you can live with while doing it, then take advantage of volatile prices and fragmented markets by using dollar cost averaging (DCA). If you are saving money and adding to your investments then invest a set amount at regular intervals. If you are withdrawing money to spend, then limit your withdrawals to 4% of your assets, and withdraw a set amount at regular intervals.
3. 
   Resist the temptation to move money around/between investments in the attempt to avoid 20% drops and minimize volatility. (There is a terrific critique of this idea by Richard Pzena in the February 29, 2008 issue of Outstanding Investor Digest; please call us if you are interested in receiving a copy.) Most people buy high and sell low instead of doing the opposite. To really avoid the drops, you have to pull your money out of whatever has gone up recently, and you have to invest it in whatever has gone down recently. And very, very few people have the discipline to invest in something that has been performing badly. Everybody says they want to buy low and sell high, but nobody actually does because buying low entails investing in whatever has done poorly recently. Review your own investing history. Have you been able to anticipate the turns and buy low and sell high; or do you chase performance only to catch it just as it turns? If your experience is losing money by chasing performance, then you need to find some funds you can buy and hold using a dollar cost averaging strategy.
   So I encourage investors to set realistic performance goals using a timeframe of at least three-to-five years; use money managers and mutual funds with a consistent discipline that they are comfortable with; dollar cost average their money into those funds using a consistent schedule; and to stick to that dollar cost averaging plan especially when prices drop by 20% or more.

Dollar Cost Averaging involves continuous investment in securities regardless of fluctuating price levels of such securities. The investor should consider his/her financial ability to continue purchases through periods of low price levels. Such a plan does not assure a profit and does not protect against loss in declining markets.
The S&P 500 Index is a broad based unmanaged index of 500 stocks, which is widely recognized as representative of the equity market in general. You cannot invest directly in an index.

The comments made by Tony Muhlenkamp in this article are his opinion and are not intended to be investment advice or a forecast of future events.

Inheriting Your Spouse’s IRA by Kathy Baum

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An inherited spousal Individual Retirement Account (IRA) is generally considered one of the largest assets to be passed on to a surviving spouse. Determining how to handle the IRA is often the most important financial decision facing many beneficiaries.

Several factors should be considered, including the current age and financial situation of the surviving spouse, as well as the age of the IRA account holder at death. To fully realize the financial benefits (and thereby limit the tax implications), it is essential for a surviving spouse to evaluate the options.

Option A. The surviving spouse, as the sole beneficiary of a Traditional IRA and / or Roth IRA, may treat the inherited account as his or her own and avoid the post-death minimum distribution rules. (This privilege is not granted to any other beneficiaries of an IRA.)

There are three ways to go about this: 1) ownership, 2) rollover or 3) direct transfer. No matter which of these three ways is selected, once the change is made eligible contributions can be added to the account.

1. Ownership - Re-title the inherited IRA from the deceased spouse’s name and social security number to the surviving spouse’s name and social security number.
     The surviving spouse is now considered the owner of the account for all purposes. This option simplifies the process because the funds remain in the account and only ownership changes.
2. 
   Rollover - Roll over the inherited IRA to the surviving spouse’s new or existing retirement account.
     In this scenario, the surviving spouse receives a check for the proceeds from the deceased spouse’s IRA, and deposits the money into his or her IRA within 60 days of the distribution.
3. 
   Direct Transfer - Directly transfer the inherited IRA into the surviving spouse’s new or existing retirement account.
     The funds from the deceased spouse’s IRA go directly to the surviving spouse’s IRA. None of the monies are mailed to the new account owner. (The funds are transferred by the trustee of the deceased spouse’s account to the trustee of the surviving spouse’s IRA.)

If Option A is selected, the IRA will continue to grow tax-deferred and becomes subject to the minimum distribution rules (RMDs) only after the surviving spouse reaches age 70½. This benefit applies even if the deceased spouse was 70½ or older and already taking RMDs. (If the deceased spouse was scheduled for that year to take an RMD, but had not yet received it, the surviving spouse must do so — and pay tax — prior to treating the account as his or her own.)

NOTE: Roth IRAs are not subject to RMDs during the owner’s lifetime. If the surviving spouse requests a distribution from a Roth, it would be tax-free as long as the deceased held the account for the required five years. Remember, however, once ownership of the Roth IRA is changed, the surviving spouse must be 59½ to avoid taxes and penalties when making withdrawals.

Caveat: Option A is not available if the deceased previously inherited the IRA from a former spouse.

Option B. The surviving spouse may transfer the Traditional and / or Roth IRA assets to an Inherited IRA Beneficiary Distribution account and remain the beneficiary.

The deceased spouse’s IRA balance is transferred by the trustee of the account to the trustee of the surviving spouse’s IRA. Both the names of the deceased and the beneficiary remain on the account. Be aware that additional contributions cannot be made.

Option B can be advantageous if the surviving spouse is younger than 59½ and needs to access the funds from the IRA; one can do so without paying a 10% early withdrawal penalty. In the case of the Roth, the 10% penalty can be avoided as long as the account had been in existence for at least five years.

If the surviving spouse chooses to remain the beneficiary, they are not restricted from being able to rollover the account at a later date. This benefit would be valuable when the spouse is younger than the deceased IRA owner, and the owner died before reaching age 70½. The beneficiary spouse could rollover the IRA the year the deceased would have turned 70½ and delay the distributions even longer.

Option C. The surviving spouse may disclaim all or part of the inherited IRA.

If, after consulting with a tax attorney, the surviving spouse decides he or she will not need all or some of the inherited IRA, they may disclaim – or refuse to inherit — all or part of the assets. The disclaimed assets would then be passed on directly to the next eligible beneficiaries. Any required distributions would be based on the other beneficiary’s age, not the surviving spouse’s age. If the beneficiaries are younger than the beneficiary spouse, the situation may allow for the potential of additional tax-deferred growth with the inherited IRA.

Before taking possession of the account, the surviving spouse must disclaim the assets within nine months of the IRA owner’s death in order to take advantage of Option C.

Remember: a disclaimer is irrevocable, so this decision should be thoroughly discussed with a tax attorney.

Summing It Up

The surviving spouse does not have to pay taxes on the Traditional and / or Roth IRA at the moment it is inherited, but from that point on, tax consequences are determined by the treatment and type of the IRA.

Handling the account and having a thorough understanding of the tax ramifications can be very challenging. It is not a simple process and the decision should not be considered without a great deal of research.

The information in this article is to be used as a starting point, but additional resources need to be referenced. Additional tax information can be found in the IRS Publication 590. Each surviving spouse’s financial situation warrants, at minimum, a consultation with a tax attorney before making a final decision on the inherited IRA account options.

— Kathy Baum

Kathy Baum joined our Relationship Management Team in September 2007.
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.