26 September 2011 ::

The U.S. Government has been keeping interest rates low to encourage the economy to get back on track. Is this policy working?

Read Ron’s opinions on the current and future direction of the U.S. economy in an interview at Forbes.com.  Click here to read the article.

24 June 2011 ::

In the midst of continuing economic uncertainty and market volatility, what’s the plan for the Fund to make a reliable, consistent return?

At our May 3 investment seminar, Ron addressed How We Plan to Make Money in the Current Investment Environment.  For an overview of our investment strategy, please read the following electronic booklet: May 3 Seminar booklet.  If you have any questions, or would like to discuss further, please give us a call.

18 May 2011 ::

Speaking of blue chip technology stocks, what is your current take on Cisco since you bought the stock? What about Microsoft, Google, and Apple? Are valuations appealing? What are your thoughts on pre-IPO stocks of Facebook, Twitter, and Zynga?

Certain technology companies that were market darlings in the mid-to late-nineties are now value stocks. Despite a decade of poor stock performance, many of these companies have continued to see significant sales and earnings growth.

Since fiscal year 1999, Cisco grew profitability 283%, Intel 57% and Microsoft 141%. Yet their returns including dividends from 12/31/99 to 3/31/11 were -68.0%, -41.8% and -45.2% respectively. The implication is clear: valuations matter.

We've said in the past that you can turn a good company into a bad investment if you pay too much for it. The performance of these technology shares over the past decade serves as an example. That alone doesn't make them cheap today.

We own two of the four you mentioned, (Cisco & Microsoft), along with Intel, because they have above average returns on equity (ROE) and low price to earnings (P/E)) multiples. They continue to have attractive growth opportunities.

With respect to pre-IPO technology names, this is likely the first time we've seen these sorts of outsized valuations prior to an IPO. Part of this is due to scarcity effects and the capability to trade (and speculate) the underlying shares in private markets. One other important distinction is the impaired capacity to short the shares so these private markets lack the counter-balances present in public markets.

12 May 2011 ::

Do you foresee the U.S. dollar being replaced as the World Reserve Currency and if so, will that action really send the U.S. into long-term financial and economic chaos?

Our short answer to your question is no, we do not see the U.S. dollar losing its reserve currency status anytime soon.

Lately, there has been a lot of discussion regarding the U.S. dollar losing it reserve currency status. Despite the rhetoric we see in the financial press, the global financial system still heavily relies upon the U.S. dollar for trade. At $14 trillion in size, the U.S. economy is still very large having a substantial financial infrastructure which is necessary to accommodate the global demand for U.S. Dollars. Today, most global financial contracts, commercial loans, and international reserves are still denominated in U.S. dollars. Should global market participants desire an alternative reserve currency they are likely to adopt it slowly over time.

20 April 2011 :: A few weeks ago we were asked what we thought the impact of the Japanese earthquake and tsunami would be on the global economy and the markets. We addressed four areas we thought likely to be impacted: supply chain disruption, energy use patterns, nuclear energy, and Japanese governmental financing. Here’s an update:

 
1. Supply chain disruption: Automotive and electronics supply chains worldwide have been impacted by component shortages. Unsurprisingly Toyota, Honda, and Nissan plants in Japan are all mostly shut down with most of the manufacturers trying to get limited production going again in April. Component shortages have affected other manufacturers – GM shut down a Belgian plant for a week due to component shortages. Supplies of microcontrollers and lithium batteries appear to have been hardest hit as small companies that manufactured them had a large concentration of capacity in the affected region. Interestingly it took several weeks for details of the specific problem areas to come to light. 
 
2. Energy use patterns: we haven’t seen too much change in Japanese energy production yet. Coal prices have moved up a bit, but Japan’s ability to import all of the energy producing commodities (coal, gas, oil) is impaired by damaged port facilities. To date Japan is mostly trying to optimize the energy they are still able to produce.
 
3. Nuclear energy: the problems at the Daiichi reactors continue to concern folks, most notably in Germany where they have shut down all their older nuclear power plants pending safety reviews and the Green Party scored a historic victory over Angela Merkel’s Christian Democratic Party in Baden-Wuerttemburg state elections on March 26th.
 
4. Japanese government financing: so far, so good. Japanese equity markets have held up fairly well, helped no doubt by an influx of money into Japanese ETFs as bargain hunters went shopping. Japanese bond markets remain fairly calm and the government retains its ability to borrow money.

29 March 2011 :: Do you think the current run up in crude oil price will continue and how much of it is due to fear and speculation, supply and demand factors, and how much is due to a falling dollar?

Here's what we know:

• Historically, (and currently), supply and demand for oil has been tight.  Many industry analysts believe the Saudi excess oil supply is overstated and can be estimated using past peak production when oil prices were $147 per barrel.
• World demand for oil is currently growing faster than supply.  The major issue with supply is that current total producing world oil wells are declining around a 4% rate.
• Nevertheless, world inventories of oil are at historic highs.
• Commodities priced in dollars will have a negative correlation to the dollar.  As the dollar rises and falls, commodity prices (including oil) will move in the opposite direction; this influence we can quantify.
• Demand for oil and energy ETFs increase the financial demand for oil. Commodity ETFs (including energy) have doubled in size over the past couple of years.
• Middle East tensions cause fear over the supply of oil; this influence we can't quantify. The obvious circular argument is: Much of this would suggest higher oil prices, but higher oil prices would suggest a slowdown in demand and a slowdown in world GDP as consumers and business are forced to allocate more capital to energy costs, which would result in declining oil prices. So the list of influences in your question is "on the money," but we don't know the relative mix. We do note that most of these influences were also present in 2008, prior to the price drop in 2009.

23 March 2011 :: The first time I read about your fund it characterized its investment strategy as "bottom-up." You often backed banks in financial downturns. You were able to wait for stocks with valuation in mind and wait for those "fat pitches." In the most recent downturn you had to cash in your chips. Are you finding similar opportunities now? I guess what I'm asking is: Are you still finding chips to hold? Brag about your portfolio a little bit more.

Coming out of this recession, we’d rather own companies that, by-and-large, manufacture goods and services that are sold to companies as opposed to those that are sold to the consumers. That’s not exclusive, but that’s the way we’re making a bet to some extent.

For a couple years we have found great values in a number of big technology companies which happened to be based in the U.S. but really sell throughout the world. IBM does the majority of its business overseas (65%). Cisco does nearly half of its business overseas (46%). Last year, 42% of Microsoft’s sales took place outside of the U.S.  So, from an investment perspective, one way of playing the strength in emerging economies while still having confidence in the accounting systems is to buy these major international firms.

By the way, Microsoft made us good money last year, Cisco didn’t. But Cisco has $40 billion in cash. Since the fall of 2008, we’ve commented that we want to own companies that have a balance sheet better than the U.S. government, except that’s not a very high standard anymore. In any case, we don’t have to worry about these kinds of companies getting a margin call, or having to refinance their debt, because the cash flows are superb.

Cisco remains in our portfolio. The arguments remain in place. The company is currently selling at 10 or 12 times earnings and sitting on $40 billion in cash. We suspect the stock price may have been affected by last year’s forced selling among European banks. (Our thinking is European banks own more companies like Cisco and Philip Morris than smaller companies.)

Our overall point is this: If you have companies that are servicing a global demand—and if their costs are in dollars and their sales are to the emerging markets—we think that’s a great place to be. Plus, a number of such companies have a Price-to-Earnings ratio of 11 or 12, which is hard to resist.

23 March 2011 ::

"Should price inflation outrun the ability of management to manage their business, it would be likely that we will move out of stocks and into cash."  Could you please elaborate on that?  

If inflation accelerates, cash would be the least defensive tactic. Is that because you would expect a significant correction in equities and would hope to buy when inflation rates become priced in?

Should the rate of commodity price inflation exceed the rate at which companies can pass along price increases to their customers, profit margins will compress and it is likely that stock prices will come down.  Positioning cash into short-term treasury bills will likely give us an opportunity to preserve the purchasing power of our money as interest rates move up. Once inflation slows and companies can adjust, we will likely move back into stocks.

18 March 2011 ::

Any insight to Ron’s thoughts regarding the events in Japan? What will it take for a recovery and how will the markets be affected?

 
1. In the very short term, the headlines coming out of Japan will probably cause investors to reduce their risk exposure a bit, creating volatility and downward pressure in most markets.
 
2. Japan is the #3 economy in the world, and a major export producer of high-end goods from autos to electronics to aircraft parts. Companies with elements of their supply chain in Japan are right now figuring out how they are affected and beginning to adjust their operations. They are still in the discovery stage at this point. Depending on the company involved, there may be component shortages as inventory runs low and supply chains get put back together.
 
3. There will likely be shifts in global energy patterns as Japan is forced to find alternatives to its now inoperative nuclear reactors. In the very short term the answer is probably crude-based, in the intermediate term, the solution is probably natural gas-based. It isn’t clear if this will cause crude oil prices to rise in the near term.
 
4. We expect nuclear plants that were in the planning or building stages to be deferred until their designs can be reviewed in light of the lessons that will come out of Japan. Whether this event turns public sentiment against nuclear power, as Three Mile Island did in the US, remains an open question. Given the media hype, I feel the need to point out that comparisons to Chernobyl make no sense. The Chernobyl reactor had no containment vessel. Comparisons to Three Mile Island do make sense. The Three Mile reactor did have a meltdown, which ate 5/8 of an inch into a 5-inch steel containment vessel and put the reactor out of use. But no one died.
 
5. Insurance companies exposed to Japan will have to sell assets to meet their financial obligations to the insured. This may depress asset prices depending on how rapidly the insurance companies have to sell and how concentrated their holdings are. The Central Bank of Japan has bought billions of yen worth of bonds from Japanese banks to provide cash to its economy. It is also likely that the Japanese government will have to borrow more money than it otherwise would have to pay for the reconstruction, even as the population of Japan may be looking to spend its savings to rebuild or replace what was lost. The Japanese population is the major lender to its government; it will be very interesting to see how Japanese bond issuances go in the near to mid term.

10 March 2011 ::

Why didn’t I get a Form 1099-DIV from the Muhlenkamp Fund this year? 

Short Answer:
There were no taxable distributions from the Muhlenkamp Fund during calendar year 2010. (For written proof that no taxable distribution was paid in 2010, direct shareholders may refer to the Account Earnings Summary section on your year-end statement, where you will see Capital Gains and Income Distributions listed as $.00.)

There are other reasons to receive a Form 1099; (e.g. Form 1099-B for redemptions from a non-retirement account). For a detailed description of other tax forms click here.

Long Answer:
Typically we strive to minimize distributions; (i.e. income dividends and capital gains). A reason for this is because the Muhlenkamp Fund has a stated objective of maximizing total return to its shareholders with reasonable risk. Total return has two parts:

 
1. That which we make; and
 
2. That which shareholders get to keep, after paying taxes.

In order to affect total return, we strive to maximize what we make and to minimize taxes so that shareholders have more left over to keep.

One method of minimizing the impact of taxes is to offset realized gains (i.e. money made when securities are sold) with losses.

A second method for a mutual fund to minimize the impact of taxes is to defer them from one year into the next whenever possible. When taxes are deferred, capital gains can be earned on money that, otherwise, would have gone to the government.

A second reason we try to minimize distributions to shareholders is to give them greater control over their taxes. There are two events that can trigger a tax liability for shareholders of a mutual fund:

 
1. When the fund has a taxable distribution (i.e. income dividends or capital gains) ; or
 
2. When the shareholder sells shares of the fund thereby creating a capital gain or loss.

Under the first scenario, the shareholder has no control over the taxable event; it is forced upon them by the fund. Under the second scenario, the shareholder has much more control because it is their action to sell shares that is the trigger. Given these two scenarios, our preference is to allow shareholders the flexibility to pay taxes when they want and not to force it upon them.

10 March 2011 ::

Does the fact that you did not pay a taxable distribution this year mean you didn’t make any money for me? 

Not at all! While we try to suppress or defer paying distributions (as previously discussed), we also try to maximize returns. Those returns, in the absence of a distribution, would be realized by an increase in the Net Asset Value (NAV), i.e. the price, of our Fund.

While no distribution was paid last year, our NAV appreciated from $50.69 to $53.80 for a return of 6.14 percent. For standardized performance please click here.

03 March 2011 ::

Many economists are predicting serious inflation ahead due to QE1, QE2, (Quantitative Easing) and continuing government bailouts. What is your opinion that we will enter an inflationary trend and, if valid, what do you think the timing will be? Are we already in it?

We have concerns about the QE2 program which is nothing more than printing money. Generally, the consequence of printing money is price inflation in the real economy over time. If price inflation outruns the ability of management to manage their business profitably, then we get concerned. We are actively monitoring the velocity of money, among other indicators, in an effort to determine if pricing pressures are accelerating inside the real economy. In terms of timing, it may be beginning right about now.

03 March 2011 ::

I hear a lot of talk about inflation risk and even you have said recently that it is time to "harvest" bonds from your portfolio.

Unfortunately, I believe this is too simplistic of a view. Rising interest rates will certainly negatively affect prices of investment grade bonds and, if you own bonds through a fund, yes, you will suffer losses. However, if you own the bonds outright and are happy with the return (interest) you are earning and plan on holding to maturity, do you still say ‘harvest’?

Is inflation risk the same for someone in their 50s vs. 30s? Other than healthcare, a person’s exposure to inflation (in their 50s) is quite different than a younger person.

I am 50 yrs old and have learned that I am more scared of being poor than not being rich, so I am reluctant to change from the 50/50 split I currently maintain.

It appears that you have defined inflation as prices rising over time. Generally, if you hold onto your investment in bonds until maturity, during a period characterized by an accelerating rate of price inflation, you may not lose the principal of your investment, but you will lose the purchasing power of your money. Price inflation hurts people at any age and, over time, can make anybody poor if they do not preserve the purchasing power of their money.

The last time we had accelerating inflation was the 1970s. During the 1970s, your money lost half its value (“purchasing power”) in only ten years. People who were happy with a 5% interest rate in the late 1960s were quite unhappy when interest rates went to 13% in the late 1970s (and the price of their bonds fell below 70 cents per dollar.

03 March 2011 :: If the US economy goes into a higher inflationary environment, what asset classes will the fund invest in?

If inflation moves to 3%-5%, we expect to own companies that can manage at these levels.

Should price inflation outrun the ability of management to manage their business, it would be likely that we will move out of stocks and into cash. 

22 February 2011 ::

What is your view on the prospects for small- / mid-cap technology companies that are benefiting from share gains using disruptive technologies like the Internet to deliver information and services?

We see investment opportunities among small- and mid-cap ‘tech’ companies that are oriented towards alleviating mission-critical bottlenecks.

With these sorts of companies, there are considerations that differ from their larger-cap brethren. Generally, smaller companies have a product offering that is part of a bigger solution. Oftentimes, that “part” may represent the totality of the business. With this comes the opportunity for greater rewards and greater failure, depending on which way market acceptance goes. It’s a bit like the Gretzky quote that you have to “skate where the puck is going to be, not where it has been.” However, by their very nature, investing in smaller companies requires more time to enter or exit a trade.

One of the potential benefits of owning smaller companies is—if we get the “technology call” correct—they oftentimes offer outsized returns versus owning a larger company. (Newer, disruptive technology doesn’t move the needle as much at larger companies.) A couple of the technology trends that drive some of our current investments include both the growing use of wireless devices and the growing volume of data being transported over the Internet, specifically digital video content.

14 February 2011 :: You’ve made the observation that investors appear to be putting funds into commodities, in particular, Commodity ETFs. Can you comment further?

When the Fed printed money in the 1970s, it went into consumer inflation. This time around, it looks like the money is flowing into commodities like gold and silver—even grains. Recently, we noted there is $320 billion in ETF commodity funds, up from $50 billion a year or two ago.

Over the last 18 months, there’s been a strong interest in commodities, primarily based on developments in the financial markets. A lot of the focus has been: How do you preserve wealth—how do you grow wealth in an environment where you’re not sure about the monetary base? And ETFs have made it very easy to own gold and precious metals.

Ten, fifteen years ago, if you wanted to own gold or other precious metals, you’d have to actually buy them. But ETFs allow you to take a position in gold without actually owning the physical property. As a result, the question that has recently surfaced is: If you buy an ETF that represents a precious metal, do you actually own that metal or not? Folks, Wall Street has created ETF synthetic instruments, that represent commodities (and a whole host of other asset classes), but not the actual physical properties.

In any case, one of the reasons we’re seeing more money going into commodities is that ETFs make these types of investments easier— with lower transaction costs—and that’s what’s driving more money into the asset class. But, buyer beware: As long as people are putting more money into these types of funds, they remain liquid. When that levels off or declines, the game can be over quickly, as it was in 2007.

14 February 2011 :: Any thoughts on the “Flash Crash”-why did it happen and can it take place again?

I still haven’t seen a good report that satisfies me in terms of why the May 6 “Flash Crash” took place—nor has anyone figured out how to prevent another one. The May, 6, 2010 "Flash Crash came out of nowhere, and had a huge effect on people’s psyche.

ETFs, as a group, got hit more than stocks did in the Flash Crash.

03 February 2011 :: What’s happening in Europe and how is the U.S. affected?

Europe has had the euro as a common currency since 1999. For countries to join the Eurozone, they had to get inflation below 3% and agree to keep government deficits and budgets below prescribed levels. Many countries failed to keep these agreements, particularly Portugal, Ireland, Italy, Greece, and Spain (hence PIIGS).

The upshot was that all these countries’ cost of borrowing money went down as they joined the Eurozone. Investors assumed they were more creditworthy than they had been—and, perhaps, had the implicit backing of Germany, Europe’s economic powerhouse. As examples, cheap credit fueled social spending in Greece and a construction boom in Spain. Additionally, European banks participated in much of the same madness that U.S. banks were participating in—buying packages of subprime mortgages and treating them as if they were high-grade bonds.

In the Spring of 2010, Greece was forced to borrow from other European countries, (paying much higher interest rates than the prior ten years), to continue paying its bills. Ireland recently joined Greece in borrowing from countries in the Eurozone, after its pledge to bail out its own banks proved too much to bear. (Note that while in the U.S. we talk about banks being “too big to fail,” for Ireland, the banks were too big for the national government to save. Ireland had to turn to entities with deeper pockets for help.) Today, serious questions remain about the solvency of other countries—along with their banks—including Portugal, Spain, and Italy.

Most sovereign bonds (bonds issued by a national government) are held by European banks across the continent. For example, the largest banks in France have 37% of their assets in these types of bonds—and we think the PIIGS bond crisis has generated some forced selling among them. (Some of the bonds are held in trading accounts and marked on a recurring basis to their market values.) Remember, with forced selling, you need to sell regardless of price. As a result of the forced selling by European banks, we think some of the U.S. “Cadillac” companies (IBM, Microsoft, Cisco) have gotten much cheaper.

So, my headline remains: The panic we had in the world markets and in the U.S. markets in the fall of 2008 has been relieved—but with what’s taking place in Europe, it doesn’t mean we can’t have another round. And gauging the size of the next round of potential forced selling is a problem.

Because of such circumstances, we’ve added two new questions to our checklist:

 
1. Will some investors be forced to sell?
 
2. If so, how much?

03 February 2011 :: Ron has stated, “If you own bonds, now is the time to harvest that crop.” Why?

What we’ve been hearing for the last 10 years is that bonds are safe, because in the prior 20 years interest rates came down—which means the price of the bond stayed at par or above. The economy grew, which means there was limited credit risk. So for 20 years, bonds have been safe because interest rates were coming down and the economy was growing.

Folks, an investment that is safe under one set of circumstances can be dangerous in another. The easy thing for people to trust is what’s worked well lately. As human beings, we all want to extrapolate what has worked in the recent past into the present, rather than taking into account today’s investment values. As a result, a lot of money poured into bonds during the last year. If there’s a bubble out there today, it’s probably in the Treasury market. We think this is similar to “Planting corn in October, because it grew so well since April!” If interest rates go sideways or go up, bonds are not safe. In the 1970s, we talked about bonds as “certificates of guaranteed confiscation!”

This leads to my point: We think interest rates are below where they should be, and below where they will be, even though the Fed is going to purchase another $600 billion of Treasuries in an effort to keep interest rates down.

27 January 2011 ::

The Federal Reserve remains preoccupied with the high jobless rate and with employers’ apprehensions about hiring. As a result, it has embarked on a second round of quantitative easing (QE2). What are your thoughts about the Fed’s actions?

QE2 is the equivalent of starting up the Fed’s printing presses to create money for buying financial assets in the market—in this case, long-term U.S. Treasury bonds. Buying bonds pushes down their yields, along with interest rates across the debt markets that are closely tied to U.S. Treasury rates. Why is the Fed taking this measure? Primarily, to ensure that interest rates remain low, so that borrowing remains attractive.

Coming out of a recession, there have been times when lowering interest rates has boosted the economy. This time, however, there are many political and economic crosscurrents taking place. As a result, we think the Fed is applying the wrong prescription to the problem. Our problems are not with our monetary policy—our problems lie with our fiscal policies and new regulations.

For example, as an employer myself, I don’t know what taxes will be a couple years from now, but I’m quite confident they’ll be higher than they are today. I don’t know what regulations will be a couple years from now, but I’m quite confident they’ll be more restrictive than they are today. And we now have a health insurance bill—I don’t know what that will cost me, but I’m quite confident it will cost more than I was paying a couple of years ago. Such uncertainties make it difficult to hire, so I think employment is going to be slow to come back. Unemployment remains steady near 10 percent. With the exception of hiring census workers, we really haven’t seen a pickup in employment—and I doubt we will.

27 January 2011 ::

What happens if the U.S. economy goes the way of “Japan” (i.e. continued stimulus packages that don’t stimulate)? Where, then, will you invest?

If we have to move money overseas, we will.  In fact, we recently bought Telefónica, the telephone company of Spain, largely because 40% of its business comes from Brazil and Argentina. In essence, I could buy a Brazilian / Argentinean phone company—whose name happens to be Spanish—so it benefited from the fears in Spain, and pay 10 or 12 times earnings instead of a higher multiple.

Bottom line: If we have to move our money offshore to help preserve our investors' capital, we’ll do that.

03 December 2010 ::

Why do you favor U.S. equities, when bonds and emerging markets are doing well?

When I see 10% free cash flow in a time when yields on Treasuries are at 3%-3½%—and if I have any faith in management that they won’t take that free cash flow and pour it down a rat hole—10% looks a whole lot better to me than 3½%, especially if such companies are doing business in areas that are growing. IBM does two-thirds of its business outside the United States! So I have the choice of either investing directly in China, (where I have limited expertise), or hiring companies like IBM or Caterpillar that have been there for 20-30 years, and at least have a working knowledge of what’s going on. So far, that’s what we’ve chosen to do.

If there is good value, good cash flows, and a rock-solid balance sheet, there’s always someone willing to buy, and we’re seeing companies step up to do it.

23 November 2010 ::

What are the drivers of this year’s performance – and why is the Fund underperforming?

During 2010, we have underperformed the S&P 500 Index, partly because we have been cautious. We became quicker to sell after the 2008 collapse, and slower to buy—particularly after witnessing the forced selling by the public and by banks.

I am now going in with more conviction:

Today, we like companies with exceptionally strong balance sheets. (Normally, coming out of a recession, you can reach out a little bit on balance sheets. This is not a time to do that, especially with the financial markets where they are.) We are not willing to relax balance sheet criteria in the current market environment.

Also, coming out of this recession, we prefer owning companies that manufacture goods and services that get sold to companies, as opposed to sold to consumers. (Consumers continue to save, rather than spend—which is what they should be doing.)

Based on these criteria, the values we are finding are among the ‘Cadillac’ companies; (e.g. IBM, Cisco, Oracle). Such companies have done poorly this year. We think this could be attributed to some of the forced selling coming out of the banks of Europe. (We suspect that European banks owned more of the Cadillac companies than they did smaller companies.) We also think there has been continued momentum selling by the public and by pension funds in this country. Everybody knows that the numbers keep showing money coming out of equities and into debt (bonds).  Nevertheless, today, we own these "Cadillac companies" at Chevy prices. Our average holding has an ROE (return on equity) over 15%, and P/Es (price-to-earnings ratio) of about 11 or 12.

But I stand with what I know:  The best time to buy stocks is when the public is fearful.

20 August 2010 ::

Your treatise, Bailouts, Your Dollars & the Whole Credit Mess, presents a cogently reasoned argument against companies having to “mark-to-market” their assets. What, though, is the other side of the argument? i.e. What does the government claim is the benefit of assets being marked-to-market?

 

Mark-to-market (“fair value”) accounting was issued by the Financial Accounting Standards Board (FASB), a non-profit organization responsible for establishing financial accounting standards. Those standards are recognized as “authoritative” by the Securities and Exchange Commission (SEC). So, technically, it’s not a government standard, it’s the acceptance by a government agency of an independent board standard.

In November 2007, after twenty years of stable and rising prices, guidelines for how businesses should determine fair value estimations were implemented. The goal of Financial Accounting Standard (FAS) No. 157 was to eliminate the inconsistencies between historical costs and current values. Additionally, this measure was aimed at providing greater transparency, enabling investors to price their portfolios daily.
“Fair value” was defined as the current market price of the asset or liability (or for similar assets and liabilities). This pricing rationale is built upon the “efficient market theory,” which asserts that market prices incorporate and reflect all relevant information; therefore, they are always accurate and always fair. During the dot-com boom of 1999-2000 and the financial meltdown of 2008-09, we believe this theory was soundly disproven.

When some people are forced to sell-either to meet margin calls or to sleep at night- market-based measurement does not accurately reflect the underlying assets’ true value.  Attempts to make the evaluation of assets transparent and relevant ended up exaggerating market swings. Further, when banks and insurance companies were required to mark down their assets to the latest lowball bid, it forced big losses. The subsequent reduction in capital reserves contributed greatly to the seize-up in the financial markets.

FASB guidelines were relieved in the first quarter of 2009, reminiscent of FDR, who back in 1938, resolved he would not bankrupt the banking industry to fit an accounting standard and suspended mark-to-market accounting.

29 July 2010 ::

Where are you finding opportunities to invest?

On average, what we’re now seeing is that stocks are fairly priced based on this newer, somewhat slower growing future than we’ve had in the past. It’s now become a “pick-and-choose” market.

We always look for good companies at cheap prices, and we’re seeing that amongst technology companies to a greater degree than before. I have more confidence in companies being able to go out and buy computer equipment than I do in households being able to go out and buy ever bigger houses and ever newer cars. Companies’ balance sheets today are in better shape than consumers’ balance sheets. So we’ve been willing to own those companies. In fact, we own more technology companies than ever.

We also see more value in health care. I think that’s partly because of the fear of what was happening in health care. (What started out as a “health care bill” became the “health insurance bill,” which is a quite different animal.) So we’re seeing good values in health care and we own some of those companies.

Overall, we’re finding more values in big companies, the AAA companies or AA in today’s world. And amongst the “Cadillac’s,” we’re finding greater values at cheaper prices than we do in small companies. That’s different from ten years ago when other factors were being played out. Bottom line: We think it’s a stock picker’s market — and we’re picking and choosing among companies.

26 July 2010 ::

Has your selling discipline changed, given the volatility of the markets?

We think it’s going to be a little more of a trader’s market than it had been for the last decade, so we’ve tightened our sell discipline. Today, we are less willing to hold companies with soft earnings, even if they are compelling values. We are also quicker to harvest gains and reduce positions that exceed 5% of the portfolio in order to minimize the damage from negative surprises.

The panic we had in the world markets and in the U.S. markets in the fall of 2008 has been relieved — but it doesn’t mean we can’t have another round. And gauging the size of the next round of potential forced selling is extremely difficult. Because of such circumstances, we’ve added two new questions to our checklist:

 
1. Will some investors be forced to sell?
 
2. If so, how much?