Muhlenkamp Memorandum Muhlenkamp Memorandum

Issue 100Published Fourth QuarterOctober 2011

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Quarterly Letter

Ron Muhlenkamp

Stock prices were down in the third quarter. Lack of confidence in European government finance and in the U.S. government actions—combined with signs of slowing in China—drove down prices of stocks and, by the quarter end, of commodities, as well.  During the quarter, we consistently sold cyclical stocks and held increasing amounts of cash, but it wasn’t enough to protect us.

When sitting down to write this Quarterly Letter, I reread prior letters to see what has changed. I now fear I am sounding like a broken record.

In the U.S., the economy is expanding, but at a modest rate. Consumers continue to save more and to be cautious in their spending. This behavior is necessary and proper to rebuild their balance sheets. Businesses continue to run lean and to hoard cash. With modest sales growth—and facing increased taxes, regulations, and healthcare costs—businesses are reluctant to hire people, so unemployment remains high.

The following chart (Figure 1) of month-over-month employment shows that businesses were hiring until our government passed the Patient Protection and Affordable Care Act (Obamacare) on March 23, 2010, which knocked employment below the zero line. It stayed below zero until the prospect of a new Congress promised to extend current tax rates for two more years. 2011 Month-Over-Month Employment

Source: Bloomberg

The Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act was signed into law on December 17, 2010, at which point employment began to pick up. But when President Obama made it clear that increased tax rates are still on his agenda (May/June 2011), employment slowed.

Folks, it’s very unusual for anyone (outside professional sports) to earn $1 million in a year without hiring other people to help you do it. Our government promises to further tax people with higher incomes, and then castigates these same people for not increasing their hiring of others.

So, our economy remains weak and the Federal Reserve keeps trying to do “something.”  The latest move, a “Twist,” is to drive low interest rates further out in time.  At current rates, our retirees have already cut back on spending because they’re getting little or nothing on passbook savings. The Fed’s new program promises to drive rates lower on 3-5 year CDs, further reducing the interest received by anyone trying to live off their “income.”  The people near retirement are cutting back on spending because, at lower interest rates, the amount of assets they need to retire is increased.  The Fed is betting that extended low interest rates will encourage homeowners to refinance their mortgages and to spend the money.  We expect them to refinance the mortgage and save the money as they have done recently.

In Europe, it’s been 15 months since the debt problems of Greece, Ireland, and other countries hit the headlines. Most of these countries have promised to spend less in return for “bailout” money, but with widely diverse levels of follow-through.

To date, actions taken by Ireland and Spain are being met with credibility in the bond markets; (people are willing to lend them money at reasonable rates).  Actions (or promises of action) taken in Greece and Portugal are not.  Figure 2, a chart of bond prices in various European countries, is a good illustration.

Source: Bloomberg

Net, as a group of nations, Europe’s problems are not yet being resolved.

The one area with a clear direction from the government is China, and it is slowing down on purpose.  China is raising interest rates and slowing its economy to contain inflation, using methods largely similar to those used by the U.S. Federal Reserve a dozen times since WW II. The U.S. Fed managed to finesse a soft landing just once; in the other cases, we had recessions of various intensities. Frankly, we doubt that China can engineer a soft landing, and we expect the parts of the world economy heavily influenced by China (like commodities and heavy machinery) to experience a slowdown or recession. One fear is that a slowdown or recession in China will drag the slow-growth U.S. economy into recession as well.

Two items that were big at the time, but which are likely to make little impact on long-term world economics are the earthquake/tsunami in Japan, and the revolutions in the Mideast, including Libya.  I must say that, while I believe this statement to be true, I find it rather amazing.

One area where we are seeing significant progress is in the spending discipline of a number of U.S. states. As these states continue to get their spending more in line with revenues, this should result in a greater belief that spending disciplines can be successful—and should allow these states to serve as models for their neighbors. But this will take time.

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New Regulation: Cost Basis Election and Reporting

Michelle Orphall, Marketing Specialist at Muhlenkamp & Company

The Emergency Economic Stabilization Act of 2008 (the Act), mandates financial institutions to report to both the IRS and the shareholder the cost basis method on file, the gross proceeds, and whether the holding period for shares redeemed is considered short- or long-term. The reporting is in effect for mutual fund shares purchased in taxable accounts on or after January 1, 2012.

The Act was enacted as a result of the IRS not being able to determine if the correct capital gains tax was paid when certain financial securities were sold. Indeed, the gross proceeds from the sale of shares for taxable accounts are reported to the IRS on Form 1099-B, but, prior to these new regulations, the cost basis was something that was never reported by financial institutions. The IRS would only see what was claimed as the cost basis by the taxpayer on forms such as Schedule D or if it conducted an income tax audit. Now “cost or other basis” is a box that is also included on Form 1099-B.

The Act requires that financial institutions provide the shareholder a process to elect the cost basis method that they wish to use in the sale of their shares. The cost basis method determines the order in which shares are redeemed and, ultimately, how much capital gains tax would be paid on the redemption of those shares. If the shareholder fails to make an election, the financial institution will report a “default method” of its choice, and will use that method to calculate and report any capital gain/loss to the IRS on Form 1099-B.

What are the different cost basis methods?

  • Average Cost (ACST) – the purchase price of all covered shares in the account are averaged to determine the basis.
  • First In, First Out (FIFO) – depletes shares in the order of the acquisition date; the oldest shares are redeemed first.
  • Last In, First Out (LIFO) – depletes shares in the order of the acquisition date; the newest shares are redeemed first.
  • High Cost (HIFO) – depletes shares in the order of highest cost per share; the most expensive shares are redeemed first.
  • Low Cost (LOFO) – depletes shares in the order of lowest cost per share; the least expensive shares are redeemed first.
  • Loss/Gain Utilization (LGUT) – depletes shares with losses prior to shares with gains, and short-term shares prior to long-term shares.
  • Specific Lot Identification – depletes shares according to the lots chosen by the shareholder.
  • Single Account Average Cost (SAAC)* – averages the cost of all shares in the account, even those shares purchased before January 1, 2012.For direct shareholders, this method is only available when there are pre-effective shares and the cost basis can be confirmed for these shares. (In contrast, ACST only averages those shares bought on or after the effective date.)

How will I make a cost basis election?

Direct shareholders of the Muhlenkamp Fund will receive a letter from our transfer agent, U.S. Bancorp Fund Services (USBFS), before the end of 2011 explaining the options for making a cost basis election for their shares. Muhlenkamp Fund shares held through omnibus accounts (brokerage firms) will receive information on this topic from the financial institution holding their shares.

Why is it important for me to make a cost basis election?

You may be able to reduce the amount of taxes owed depending on the cost basis method that you elect. Capital Gains tax is paid on the difference between the purchase price of shares and the sales price; (i.e. the sales price of shares, less the cost basis of shares, equals the taxable gain/loss).

If you bought all of your shares of a particular investment at the same time, or you are selling all of your holdings at the same time, the cost basis method doesn’t make a difference. However, if you bought your shares at various times and you are only selling a portion of your holdings, the cost basis that you choose can make a difference in the amount of tax you must pay for that year.

For example, if the price of a security that you own has been steadily increasing, and you have been purchasing shares at different times over the past few years, there would be a larger capital gain on the shares purchased earlier, compared to those purchased more recently. So, if you specified that you sold the older shares with the lower cost, you would pay more capital gains tax than if you sold the shares bought more recently at the higher price. Note: A potential tax savings can be disrupted, if you held some of the securities for a year or less. To encourage long-term investment, long-term capital gains (shares held greater than one year) are usually taxed at a significantly lower rate than short-term capital gains (shares held for one year or less). So watch how long you have held certain shares before you specify their sale.

You can manage your taxable accounts efficiently by considering how the different cost basis methods work best for you. Example: Specific Lot Identification Method allows you to have more control over the amount of taxes you pay by permitting you to “specify” the shares you are selling; (i.e. you can choose high-cost shares or low-cost shares). This can be beneficial when you know that your tax bracket will be changing, such as when you retire. Another instance where Specific Lot Identification Method can result in tax savings is if you gift shares to a non-profit organization. You could specify the shares sold as the ones with the lowest cost basis since you wouldn’t be the one paying the tax on them.

What if I don’t return the Cost Basis Election Form?

For direct shareholders, if USBFS does not receive an election form from you, your account will be coded as the “default method” which is Average Cost (ACST). The method is considered the industry standard default. Omnibus accounts should consult their brokerage firm for information.

Can I change my cost basis?

For direct shareholders, the method that you elect (or not—the default method) will remain on file until USBFS receives a Cost Basis Election Form requesting a change. Note: If shareholders choose to elect a cost basis method, it must be done prior to selling any of the shares purchased on or after January 1, 2012. Omnibus accounts should consult their brokerage firm for information. Direct shareholders of the Muhlenkamp Fund will receive a letter from our transfer agent, U.S. Bancorp Fund Services (USBFS), before the end of 2011 explaining the options for making a cost basis election for their shares. Muhlenkamp Fund shares held through omnibus accounts (brokerage firms) will receive information on this topic from the financial institution holding their shares.

What about shares bought prior to 1/1/2012?

Shares purchased before January 1, 2012 (non-covered shares) will be redeemed first, regardless of the method you choose for shares purchased on—or after—January 1, 2012 (covered shares). Cost basis information on non-covered shares will not be reported on Form 1099-B. This will continue until all of the non-covered shares are redeemed.

Exceptions:  If you select the Single Account Average Cost (SAAC) method, you would see the average cost basis reported on Form 1099-B for the year you redeemed any shares, regardless of when they were purchased. Another exception is if you selected Specific Lot Identification Method, you would see the cost basis reported on Form 1099-B only if you sold covered shares.


For more information on calculating your cost basis, refer to the Cost Basis Reporting Overview and FAQ page on the IRS website at Further, talk with your tax adviser, or call us at (877)935-5520 x4, or U.S. Bancorp Fund Services at (800)860-3863, if you have any questions. We can’t recommend an election, but we can explain the differences so that you can make that choice.

The comments made by Michelle Orphall in this essay are opinions and are not intended to be investment advice or a forecast of future events.

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.

The Muhlenkamp Fund is distributed by Quasar Distributors, LLC which is affiliated with U.S. Bancorp Fund Services (USBFS).

The Energy Improvement and Extension Act of 2008 mentioned on the IRS website is incorporated into the Emergency Economic Stabilization Act of 2008 referred to in this article.

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Ron’s Conversation with Steve Forbes

On September 21, 2011, Ron Muhlenkamp and Steve Forbes had a conversation about the economy, the markets, and the investment environment. A video of their discussion is available at, which we hope you’ll take time to view. An adaptation follows.

Steve Forbes: Well, Ron, good to have you back—the last time you were here was about three years ago. They say the market is a great humbler, and certainly in recent years everyone has seen things they never thought they would see… First, describe what your approach is and then we’ll get into the environment today.

Ron Muhlenkamp: We think our task is to make money for our clientele within the stock and bond markets. And, most of the time, we prefer stocks to bonds because we’d rather own a piece of the company than lend it money. So we look at companies and, philosophically, we invest in companies. But we’re not the size of Warren Buffett, so as a practical matter, we buy and sell stocks. But what we try to do is identify good companies. We start with return on shareholder equity (ROE) because we believe it’s much more reliable than growth.

Forbes: Low debt?

Muhlenkamp: Low debt, yes. In particular, when times are tough you start with the balance sheet. You want to be sure that the companies you own can survive whatever the heck happens. Today, for instance, we’re saying we want balance sheets better than the federal government.

Forbes: That’s a pretty low bar now.

Muhlenkamp: Well, that’s exactly right. In expansionary times, once you get through a bottom, you look for growth. But when you expect rough times, you look for [rock-solid] balance sheets. So yes, we want good companies, sound balance sheets, nicely profitable [companies]. And then we want to be sure that they’re doing useful things with the money that they’re earning. So today, frankly, the big companies are selling cheaper than the small companies—but [we want] companies with good balance sheets, lots of cash, lots of free cash flow. As you know, if you don’t owe money they can’t put you out of business. But if you’re also generating cash, it’s at your discretion what to do with it. A lot of growth companies absorb cash. For example, if your growth is higher than your ROE, chances are you’re absorbing cash. Whereas if your ROE is up there with your growth or higher, you’re generating cash. In today’s market, we want [companies] that generate cash. But the bottom line is we want to identify good companies, and then buy them when they’re cheap, and then hold them as long as they fullfill our expectations.

Cash On Hand

Forbes: Now, in this kind of environment today, certainly since even 2008, you’ve seemed to have a lot of cash.

Muhlenkamp: We’ve got more than we had. We publish a quarterly newsletter, as you know. We said that if this were a normal recovery from recession, we’d be fully invested. We don’t think it is. We believe what happened in 2008 was all the good companies we identi ed got cheap, and then they got cheaper. We think there was a lot of forced selling going on because hedge funds got word from their bankers that they had to cut their leverage in half. And both hedge funds and mutual funds got redemptions.

If you get redemptions, you’ve got to sell something. Or, if your banker tells you to cut your credit in half, you’ve got to sell something, so what you saw in 2008 was everything got sold because people needed cash. [As a result], I added a line to my checklist: “Who might have to sell and how much?” We think today the people that may have to sell are European banks and insurance companies—how much, we don’t know; it’s very hard to get data on it.

But I, along with a lot of other folks, particularly those who did well coming out of the dotcom era, never played in the dotcom game. By owning good companies at cheap prices, that made us look pretty good. Well, owning good companies at cheap prices in 2008 didn’t help. And if we have another round of forced selling, this time we would expect it to come out of the European banks, not the U.S. banks. That risk is still out there, so yes, we own more cash than we normally would.

Forbes: Timing, though, is very difficult to do.

Muhlenkamp: Yes, it is.

What’s The Buy Signal?

Forbes: You’ve said yourself—you buy a good company and you figure eventually you’re going to be rewarded for it. How do you know when to get in? What’s the buy signal for you? Aren’t you taking a big risk instead of just buying stock like Cisco, which seems to be a bank these days?

Muhlenkamp: Well, I bought Cisco, and then it got cheaper. But to answer your question, for most of the time I’ve been in this business—which is now something over 40 years—you could take your cues from the Fed. Most of the bear markets we’ve had have been affiliated with recessions. Most of the recessions we’ve had since 1950 have been triggered by the Fed, not necessarily caused by—but triggered by—the Fed raising interest rates to slow the economy down on purpose to lick inflation.

This time around, taking your cue from the Fed hasn’t worked. The Fed was squeezing in 2005, and I believe 2006. It was actually loosening up in 2007 and 2008, but it got overwhelmed by the problems with [shadow] banking stuff. So historically, I’ve made a whole lot of money owning companies when the Fed was putting money in and pulling back—certainly pulling back on cyclicals when the Fed pulled money out. This time around, that hasn’t worked.

So yes, I’ve said for years that I want to own good companies at a reasonable price when the time is right. And my best timing mechanism has always been the Fed. People say that the markets lead the economy by about six months. For most of the past 50 years, you could make a pretty good argument that both were responding to the Fed—it’s just that the markets responded quicker.

When the Fed prints money, it works through the banks and it works through the financial markets. When the Fed squeezes money, it squeezes through the banks and through the financial markets. The markets responded to the loosening and tightening quicker than the general economy does, so it looks like the markets lead the economy. And I repeat, this time it hasn’t worked.

Macro Concerns

Forbes: And so what do you have, 20% plus in cash?

Muhlenkamp: Something like that, yes. Right now, there are three big risks. We’ve talked a little bit about the one in Europe…In this country, the problems with the banks were with sub-prime lending; in Europe, of course, it’s with sovereign lending. And they’ve reached an agreement, but, of course, 17 countries have to approve it, and then there are two or three steps that have to happen. The EFSF (European Financial Stability Facility) has to be increased, and the German taxpayers have to approve it…All that’s going to take a long period of time.

In this country, we think there’s a huge dialog going on—which should be going on and is going on—but it probably won’t be resolved until November of 2012.

Forbes: Yes, 2012…

Muhlenkamp: But that’s 14 months down the road. And the third thing that’s going on is that China is doing much as our Fed did a dozen times since World War II. It’s raising interest rates to slow the economy down to get inflation under control. And it’s still squeezing, it’s still raising [rates].

So those three things—I’d have to see some improvement in one of those three. Now, in the last couple weeks, it looks like the repeated bad news coming out of Europe is having less impact. If you’re a European banker or insurance company and you haven’t cleaned up your balance sheet after the warning that you got from the U.S. in 2008 and the warning you’ve gotten out from Greece a year ago, you’d have to be brain dead. But some of them may be.

So what I’m saying is the big picture, the macro picture, overwhelmed the values of companies in 2008, and seeing that big picture continued to deteriorate—or at least being put off…Sometimes, even if you can’t predict the direction of a turn, if you can predict the timing, you say, “Well, whatever this problem—if it’s over in six months then that will remove some of the uncertainty from the marketplace.”

I can’t tell you that any one of these three problems will be over in six months. China probably will, but I don’t know that yet. So I’d need to see some change in one of those three big problems to allow me to go buy these great companies selling cheaply. As you say, Cisco is half cash and sells at ten times earnings. And, over a period of four or five years, I believe I’ll make good money in Cisco. But I said that a year ago, and so far it’s moved down, not up.

And my clientele doesn’t allow me—if I’m two years early, I’m a year-and-a-half wrong. And they probably had more patience with me fi ve years ago than they do today. People are feeling beat upon. Money managers are feeling beat upon, but so are shareholders.

Putting Money In?

Forbes: This gets to a phenomenon: Money managers, even if they have a good long-term track record, every single one of them goes through a period like a baseball player in a slump, where for a couple of years they may lag the market. And it seems to be the phenomenon that the money comes in when they do well, which is precisely the time they shouldn’t be doing it. And the money flees when things get rough, when it’s precisely the time they should probably be putting money in. Are you in the “put-the-money-in” phase?

Muhlenkamp: When we resolve this—if November 2012 comes out the way I hope it will, and frankly think it will—I will probably put in my last nickel and borrow some money. We’re seeing great opportunity out there on any premise other than the U.S. is resigning itself to going downhill permanently. But our phrase on the way the public acts is “The public likes to plant corn in October because it’s grown so well since April.” They follow the markets, rather than lead.

My job is to figure out when it’s April—to know the difference between April and October, and the difference between April and February. And part of the problem was my discipline worked so well keeping me out of dotcom companies that, perhaps, I over relied on it the next time around when it didn’t work.

In 2000, if you owned home builders instead of Cisco…People were telling us in 2000 that we had to own Cisco. And I said, “Why?” [To which they responded] “It’s because it’s great stuff.” I said, “But it’s 60 times earnings.” So the same people who told me I had to own it at 60 times earnings can’t understand why I own it at ten times earnings.

And that worked so well in the 2000 to 2006 period that those of us who did that said, “Okay, the markets are making sense.” And then, in 2008, we think there was an override on that. I forget whose phrase it was, “Whom the gods would destroy, they first make successful,” or something to that effect. Well, the next time, we’ve got to get it right.

The Approach Hasn’t Changed.

Forbes: But your approach to stocks hasn’t changed?

Muhlenkamp: No. We look at companies the same way companies look at companies. What’s my cost of capital? In our case, it’s inflation—plus maybe 3% for bonds, plus another 3% for stocks. So, if inflation is at 2%, at an 8% return on equity, I’ll pay book, which is a 12 P/E (price-to-earnings ratio). And our average holding today has a 10 P/E, and it’s got a ROE of about 18 percent.

So these are very profitable cash-generating machines, but today, nobody cares about that. Now, one rationale is that to the extent that European banks and insurance companies own U.S. companies, they probably own the big international companies, not the smaller domestic ones.

And—if they are the forced sellers of the past year—that would at least provide the rationale to me as to why those companies are selling cheaper than the smaller ones. Today, P/E’s on the big, what I call the Cadillac companies are cheaper than the Chevys.

Historically, I haven’t owned Cadillacs because they always sold at a premium price. I made my money buying Pontiacs and Buicks on sale. Well, today I own Cadillacs, but nobody cares because they’re cheap. On a four- or five-year horizon I believe I’ll make good money on these companies; the next six months, I don’t know.

Forbes: But is there any way to persuade clients that, “Hey, this is the time to buy when everyone else is on the sidelines. And whether it’s six months or 18 months this stuff is going to pay off”? You’ve pointed out yourself, maybe you can touch on this, it hasn’t been since the 1950s where you have stocks yielding more than bonds.

Muhlenkamp: 1957, I think, was the crossover point. You had wild, crazy guys like T. Rowe Price, the man who said, “Growth should be worth something, not just the dividend.” A number of our companies…I can either own Treasuries and get 2%, or I can own an AT&T bond and get 5% or 6%, or I can own AT&T stock and get 6%—plus there’s another 40% of its free cash flow that’s not being paid out in dividends. To me, that’s a no-brainer. But, in our business, because stocks get priced every day, people extrapolate prices.

And if you’ve had a long winter, it’s very hard to convince people. We keep trying. We tell them why we’re doing what we’re doing; we make the argument. When they come in and ask, “How much cash should I have,” I ask, “Can you sleep at night?” And that’s an extrapolation of the past. I believe that’s part of this business. We’ve been publishing newsletters for 25 years now and people say they make sense, but they can’t live with it [the financial uncertainty]. So that’s part of this business. So we keep trying to educate, but it’s been a tough five years.

Forbes: So in terms of where you have your 80% now, what companies are you buying? What do you like on your Cadillacs?

Muhlenkamp: We own Cisco; we own Intel; we own IBM; we own Microsoft—we paid less than $24 [per share]. I own AT&T, probably for the first time in my life. I own Exelon which is a yield—the yield plays today are dividends of good companies. These [companies] all have great balance sheets; they all have nice free cash flow. Most of them are international companies.

We do think that much of the growth will be overseas. I can either try to understand the accounting of China, or I can invest in companies that have been there awhile, whose accounting I trust and have dealt with these things for a period of time. The Cadillacs are on sale, but it does take a certain amount of stomach—and it takes a certain amount of patience.

Attractive Areas

Forbes: Now, any other areas that are attracting you right now? Healthcare or technology?

Muhlenkamp: We own more healthcare [companies] than we ever have. The last great time to buy healthcare was when Hillary Care was a threat. This time around, ‘Obama’ drove them down. We’re starting to get better returns out of them, but we own United Health, we own Covidien, we own Gilead Sciences.

We don’t think there’s any way that the world marches around without us spending more money on healthcare and, frankly, on technology. So, those two areas that I’ve always been light in, I’m now heavy because they’re cheap. You’ve got great companies selling cheap.

Forbes: You mention the sovereign debt crisis in Europe; you’ve mentioned obviously China slowing down by their standards. Here, in the U.S., what are the things that you’re looking for a change on? You’ve mentioned the election in 2012. What else are you looking at?

Muhlenkamp: Well, we host a couple seminars every year, as you know. And we did one a year ago—which we are updating—and one of the things that haven’t come back in this expansion from the recession is employment.

I’m an employer; you’re an employer. As an employer, I know that my regulations are increasing. Have you noticed how annual reports are getting thicker—the first half used to be glossy and the second half was numbers? Well, the glossy is gone, but they’re getting thicker because of all the Sarba-Oxley kinds of regulation.

I know President Obama proposes that my taxes go up. I know that the cost of health insurance is going up—I got my bill for next year a month ago and it’s up 20 percent. So, I understand why employment’s not going up.

We took a look at the recent numbers on employment. After the recession, employment was coming back very nicely until we passed Obamacare and it killed it. It was below zero—total employment was not growing until about last November, December, when Congress and the President said, “The Bush tax rates will continue for two years”—and employment started picking up for about five months. That continued until Mr. Obama suggested that tax rates are going up; it’s been killed since.

So what’s killing employment is we’re penalizing employers. I believe it was Abe Lincoln who said, “You cannot lift the wage earner by pulling down the wage payer.” Right now, the public’s doing what it should be doing—it’s saving more and spending less. Companies are doing what they have to do to survive. They’re holding tight, but the reason they’re not employing, not hiring more people is because they don’t know what the rules are.

We call it uncertainty. Well, I’m in the uncertainty business—uncertainty about what’s going to happen, who’s going to beat the other guy, who’s doing poorly…that’s part of the game. But, right now, we don’t know what the rules of the game are. We don’t know if you can build a plant in South Carolina and use it. We don’t know what the tax rates are going to be. We don’t know what the cost of healthcare is going to be.

Forbes: You had in one of your newsletters, I think, a table. You hired somebody at $40,000 a year, that individual will probably get $32,000 after all the deductions.

Muhlenkamp: And cost the employer close to $80,000.

Forbes: $60,000 to $80,000 depending on what you do.

Muhlenkamp: Yes, for my son or daughter to take home a dollar it costs me over two.

Forbes: So you have the social security tax portion, the Medicare tax portion, that you have to pay.

Muhlenkamp: And healthcare.

Forbes: You’ve got healthcare which can be anywhere from $6,000 to $13,000, depending on the state you’re in. If you’re generous with the pension, you’ve got to put money aside for that. So, in effect, what the employee gets in take-home pay is less than half of what it costs you to hire the person.

Muhlenkamp: Yes.

Forbes: And that’s not a rich person.

Muhlenkamp: No, but it marches all the way down the line. And if you increase that, it’s called a wedge; economists call it the wedge. But if you increase that…as I said, the bill that I got for health insurance for our company—we’ve got 20 employees—next year is up 20%; that’s $65,000. Now, who am I supposed to fire to pay that $65,000? Every dollar I pay in taxes I can’t pay in wages, period. So you can have it one of two ways, but you can’t have both.

Now if you let me pay it in wages, that employee, hopefully, will pay some taxes—but you can’t go both ways. What I tell the public is if you think unemployment’s too high, go hire someone. They respond “Who me? I can’t afford that.” Well, neither can business. Remember when we put the big tax on yachts?

Forbes: Yes, in the early ’90s.

Muhlenkamp: Now we’re talking about [taxing] people who fly private airplanes. When we put the big tax on yachts, we quit buying yachts. People don’t need another yacht. But the losers were the people who were building the yachts, the guys in the company who were building it. All of a sudden they were out of a job and Congress says, “Oh, that’s not what we meant.” No, but that’s what they did.

In Henry Hazlitt’s Economics in One Lesson, it’s made clear that if you look past the first transaction to the second or third, the dollar that goes to the people who build the yachts, in turn, hire the local restaurants and what have you…

Pension Fund Socialism

Forbes: Looking down the road, one of the things that seemed to concern you is what Peter Drucker called pension fund socialism.

Muhlenkamp: Yes. Pension & Investments Magazine every January has a table of top pension funds in the country. Twenty years ago, I started adding those up. If you add those up, it amounts to over 60% of the market value of the stocks in the country.

So what’s happening now—it’s no longer us versus them—it’s us versus us. I made this argument at a presentation in Cleveland a year ago. (It’s included in Muhlenkamp Memorandum #97). A young lady stood up and asked, “What do you mean by that?”

I asked, “What do you do for a living?” She says, “I’m a school teacher.” I responded, “Do you have a pension fund?” She said, “Yes.” I said, “How does your pension get funded?” I elaborated, “There are really only three places: some of it comes from you, your contributions; some of it comes from the school district, which is of course the tax base of the district you’re in; and some of it comes from the assets that are already there growing over a period of time.”

I added, “The last ten years the assets haven’t grown all that much on their own. And over the last five or six years, the value of the homes in your district probably hasn’t gone up very much, so it’s going to be tougher to get money out of the local school district.” I said, “So the third is the money you put in yourself. Now, I don’t know what happened in the last negotiation, but I’m willing to bet when your contract comes up, the school district’s going to ask you to contribute more to your pension fund. So it isn’t you versus the home owners and the tax payers anymore, it’s you versus you.” Our pension funds are the owners. When we nationalized Chrysler and General Motors and stiffed the bond holders, we weren’t stiffing Wall Street fat cats. We were stiffing pension funds. Many of those bonds are owned by pension funds, public and private across the board. And the numbers I gave you are just the funded part, of course. There’s a whole other unfunded part… (This data is included in Muhlenkamp Memorandum #2.)

So my phrase is we have worker socialism, we just didn’t get there the way Karl Marx thought we would. We got there through the pension funds, which in the aggregate own American business. And so it’s “us versus us.” We’ve always thought of ourselves as workers; with a little help from Ralph Nader, we came to see ourselves as consumers. But through our pension funds, the average guy is also the owner. And there’s a huge difference between thinking as an owner and thinking as a worker.

Richard Trumka [President of the AFL-CIO] probably does not think of himself as an owner of the business when he talks about what the owners are doing. And yet the pension funds are the owners of the business. CalPERS, California Public Employees Retirement System, realized this 20-25 years ago. It’s so big it concluded that they couldn’t just buy and sell stocks. It would write letters and got any number of chief execs fired because it didn’t think a company was well run. Well, it was thinking as owners. We’re all owners—we just haven’t realized it yet.

A Public 401(k)?

Forbes: So does that mean in the future we’re going to see more 401(k)s in the public sector equivalent?

Muhlenkamp: Most likely. There are people who argue that we’ve got too many defined contribution plans. As you know, defined contribution means a company puts in so much, whereas, historically, pension plans were defined benefit. General Motors guaranteed the benefits somewhere down the road.

Of course, today, companies like IBM have a defined contribution plan. If you ask IBM or if you ask any public sector to provide a defined benefit plan…for IBM to go to a defined benefit plan today, it would set itself up to be General Motors 20 years from now, i.e., bankrupt.

You’re asking people to guarantee things they can’t guarantee. It’s one thing to ask you or me or the school district to put money aside to fund a pension. It’s another thing to ask us to guarantee it because there are no guarantees. Look at any, even a 20-year period, there are no guarantees.So what’s been fairly easy in the public sector was to promise these benefits down the road because, number one, you’re probably not going to be in office anymore. Number two, it’s a way to push it off. But [these issues] are coming home to roost. You and I saw it happen in the 1970s. Of course, pension plans just grew up after World War II, so it’s a fairly recent phenomenon.

In the 1960s, the economy was doing fine and the markets were doing fine, so a lot of peoples’ pension assets were growing along with the economy and the markets and not a whole lot had to happen. Then along came the 1970s, and we had a flat economy and flattened markets or down markets, and the pensions weren’t growing. By the end of the 1970s the people who were retired saying, “I’m getting $100 a month, but I can’t live on that, inflation has doubled my cost of living.” So they were saying, “I need more money,” which was absolutely true.

The trustees of the pension plan responded, “Oh, but we met our actuary requirements,” which was also true. But as a matter of equity they doubled peoples’ pensions, which meant that overnight their pension plan was under-funded by 50 percent. And these were defined benefit plans—no one had thought through or predicted what would happen when inflation ran up.

The creation of that problem drove companies like IBM to say, “We can’t guarantee a defined benefit anymore. We got to go to a defined contribution.” And in the ’80s and the ’90s this was starting to catch on. Well, we’re now back to where the economy has gone flat for a period of time, and the markets have gone flat for a period of time, and yet we’ve got promises out there to people that probably can’t be fulfilled as they’re currently made.

And what’s going to come out of that…I don’t know whether one step is to go to a 401(k) or a defined contribution…but it’s a huge problem. Of the list that Pension & Investments publishes, if you take the top 100 pension plans, half of them are public sector—they’re not corporate. And of those that are corporate, about a third of the pension plans exceed the market value of the company. General Motors’ pension plan at one time could have bought out General Motors, Ford, and Chrysler.

In Pittsburgh, when I came to town, U.S. Steel still occupied the U.S. Steel building. At the top of the building, the Plexiglas is 3/4 of an inch thick because some people like to picket U.S. Steel… But the Pennsylvania School Employee’s retirement plan could buy out U.S. Steel several times over, and nobody pickets the Pennsylvania School Employee’s retirement plan. If you’re interested in money or assets, the money’s in the pension plans, but they’re not really on anybody’s radar as being powerful…So how all this comes out, I don’t know.

Forbes: Shh, don’t tell the White House.

Muhlenkamp: Yes, I know.

Forbes: They might do what Argentina did, which was seize the pensions.

Muhlenkamp: I hope we’re not there.

Forbes: No, we will thank them.

Muhlenkamp: I don’t have an answer for that. I can identify the problem, but how we come out is as much political as it is economic.

Forbes: So hold the Cadillacs and eventually they’ll get Cadillac prices again?

Muhlenkamp: We think so, yes. But there is a very important date in November of 2012.

Forbes: Thank you, Ron.

Muhlenkamp: It’s been a pleasure.

Permission granted from Forbes Media. Copyright 2011, Forbes Media, LLC. All Rights Reserved. mo81765-12mo

Fund holdings and/or sector allocations are subject to change at any time and are not recommendations to buy or sell any security.

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Year-End Tax Planning

To our clients with separately managed accounts: It will be useful for us to know if you have a tax-loss carryforward from 2010. If you reported a tax-loss carryforward on your 2010 income tax return, please let us know the amount so that we can incorporate this fact into our tax planning for your account during 2011.

Should you decide that you wish to take capital gains in 2011 and pay taxes at the current rate, rather than defer to later years and possibly pay a higher rate, let us know. We don’t claim to know what future rates might be.

To our Fund shareholders: The Muhlenkamp Fund currently anticipates no capital gains dividend for the tax year 2011.  There may be a small income dividend (less than 1%).

There are a couple of other things to note about any distribution from a mutual fund:

The distribution will come to you in one of two ways:

  1. You will receive a check for the amount of the distribution.
  3. If you have elected the Automatic Reinvestment of Dividends, you will receive a notice of the purchase of additional shares for the amount of the declared dividend.

In any case, the share price, or net asset value (NAV) of the Fund will drop by the amount of the dividend. If you reinvest the dividend, you will have more shares at the lower NAV for the same dollar amount. And, for taxable accounts, the dividend will be reportable on your 2011 tax return.

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.

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