Quarterly Letter

Ron Muhlenkamp

2011 was another year of economic crosscurrents and mixed results. We began the year with some confidence that the U.S. was gradually on the mend and that Europe was beginning to deal with its problems. This actually worked out through mid year (June/July). In August it became apparent that not much was being accomplished by the leadership in Europe or the U.S., and both world and U.S. markets got hit hard. By yearend, the large cap U.S. indices (the DOW and S&P 500 Index) eked out gains for the year; the small cap indices (Russell 2000) did not. European and emerging markets (MSCI Indices) closed down 20%-25% for the year. Our focus was on large, U.S.-based companies, but we still were down for the calendar year; please click here for standardized performance. Going forward, we believe large, U.S.-based companies remain the place to be as illustrated by the Top Ten Holdings listed here.

The issues which we have been discussing with you continued with some progress in a few areas and a frustrating lack of progress in others. We presented a review of these issues at our November 7 investment seminar, (which was been revamped in an essay in booklet form), and in a number of market commentaries since mid year.

A brief review follows:

The U.S. economy continues to expand, but at a modest rate. Consumer spending is growing at 2%-4%, with savings now at 3%-5% of income, down a bit from the 5%-6% of income saved in 2009-10. We believe restrained growth in consumer spending will continue.

Businesses continue to run lean and to husband cash. They are reluctant to increase capital spending and employment, largely due to low utilization rates of  existing capacity, along with increased regulation and uncertainty about tax rates.

U.S. banks continue to rebuild their balance sheets and have begun to lend more to business; (commercial and industrial lending is now increasing). We think the credit crunch in U.S. banks is pretty much over. The major remaining risk to U.S. banks is a contagion from European banks.

The U.S. Federal Reserve continues to put downward pressure on short- to immediate-term interest rates in an attempt to stimulate consumer spending. We believe lower interest rates have retirees and near retirees to spend less, not more. Thus, the interest rate stimulus has been largely ineffective.

Congress and the Administration have extended the 2% FICA (payroll) tax cut to give employees greater after-tax income—but low consumer confidence and the temporary nature of the cut have encouraged saving, rather than spending. We believe that the U.S. populace is being offered the choice of continuing down the path to a European-style welfare state, or a return to a greater reliance on free markets and private enterprise. This choice deserves a year’s discussion, which we are now in. We don’t expect clarification on the choice until the November 2012 election.

Some states and municipalities are making strides at getting spending under control, many others are not. This will be a gradual process.

The growth of the Chinese economy continues to slow in response to the tightening credit conditions their leadership imposed several months ago. We anticipate that they will loosen credit at some point, but not yet. A number of other “emerging” countries, including Brazil and India, are on a similar path.

The primary source of recent headlines and markets fears has been Europe. A number of European countries have promised their citizens welfare state benefits beyond their capacity to pay for them. Until now, they’ve borrowed the difference, but have exhausted their credit. For well over a year now, European leaders have been in a series of discussions, trying to appease lenders on one hand, and the voting publics on the other. And the voting publics in different countries have responded in different ways. So far the leaders have bought a bit more time, and a bit more time, and a bit more time…but the issues have not been resolved.

In response to these pressures, we’ve held more-than-normal cash, and focused on companies with strong balance sheets, earnings, and free cash flow. We continue to look for turning points in China, Europe, and the U.S. We expect these turning points in 2012.
 

Required Minimum Distributions

by Susen Friday, Client Service Regional Manager

This is the time of year that we get many questions from IRA shareholders regarding required minimum distributions (RMDs).

If you are an account holder of an IRA and turned 70½ this past year, there is one more thing you will have to do. You will have to determine how you would like to take the required minimum distribution from your account. Once you have reached this milestone, you will be required to take this distribution from your IRA annually.

If you have already taken your first distribution by December 2011, fine. But, if this has somehow slipped your mind, you still have until 4/1/2012 to take the distribution. However, you will also have to take the 2012 distribution by December 2012. As a result, you will have to pay taxes on two distributions in 2012.

This distribution is definitely something that requires your attention. If you don’t take the minimum withdrawal, a 50% tax penalty will be charged on the amount you failed to withdraw in addition to the ordinary income tax owed.

If the IRA account holder dies, RMDs from the account must continue. Special rules apply with the determining factors being if the beneficiary is a spouse or not, and whether the death was before the 70½ birthday or not. If you are in this situation, any concerns you may have should be presented to you tax professional.

The following is an example of how the required minimum distribution is calculated for an IRA account holder who turns 70½ in 2011. If you will be turning 70½ in 2012, simply add one year to the dates in the example.
 
· The amount will be based on all of your IRA balances as of 12/31/2010.
· RMDs are calculated based on your birthday, the beneficiary’s birthday, and whether or not the beneficiary is your spouse or not.

Several decisions will need to be made on how you want to receive your RMD:

· You have the option of deciding if you want to take a portion of the total of all of your RMDs from each account, or only one account;
· You can go to the custodian of each IRA account you have and ask them to calculate the amount for the respective accounts;
· We can help you here; or
· You can go to any number of RMD calculators available on the Internet and calculate the total for all of your IRA accounts.

If you have only one IRA account and it is at Muhlenkamp, or if you decide to have that account pay its share of the RMD due from a number of accounts, our transfer agent, U.S. Bancorp, can calculate that amount and automatically send the distribution to you on an annual basis.

You simply have to complete our IRA/Qualified Plan Distribution Request Form which you can either request, or download from our website at www.muhlenkamp.com.

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.
 

Financial Fitness: Are You Prepared?

Michelle Orphall

• Financial goals defined – What are your goals?
• Financial plan in place – Are you taking the right steps to try to reach your financial goals?
• Current balance sheet – Do you know what your assets and liabilities are?
• Retirement Savings/401 K plan beneficiaries – When did you last update the beneficiaries? Are all beneficiaries still living? Are there any new children that you should add? Have any of the beneficiaries’ names changed due to marriage or divorce?
• Will – Do you have one? If so, has your family grown since you updated it last? Do you still wish to list the same executor? 
• Living Will (Advanced Healthcare Directive) – Have you documented your wishes regarding what type of medical treatment should or should not be used to prolong your life if you become permanently incapacitated and you are no longer able to make medical decisions? If so, have your choices changed since you created your existing document?
• Durable Healthcare Power of Attorney – Have you appointed someone to make medical decisions on your behalf if you ever become unable to make your wishes known due to incapacitation? If so, do you still wish to list the same person?
• Power of Attorney – Do you have one? Have your choices changed since you executed your present document?
• Guardian Assignment – If your children are minors, who do you have listed as their guardian in the event of the death or incapacitation of both parents? Have you had any babies or adopted any other children since you last assigned guardianship?

Regarding insurance matters, keep in mind Ron’s Maxims, published in Muhlenkamp Memorandum Issue 19:

- A good product can be a bad deal if the price is wrong. How do you know a good price? Shop around and be willing to walk away from any ‘deal’.  
- The purpose of insurance is to protect against financial disaster. Any loss that is nonfinancial cannot be remedied by insurance. Any loss that is not a disaster does not require insurance. 
- Financial products  are simply agreements written on paper. Although written in English, they are written by lawyers and designed so you won’t read them. Read them anyway, and read them again, and again, until you understand them.

• Homeowners Insurance – Is the amount of your policy enough to cover the replacement cost if your home is damaged or destroyed? (If you have done major improvements on your home and haven’t notified your insurance agency, you might want to have them appraise your home and increase the coverage amount.) 
• Renter’s Insurance – If you are a renter, it is still important to have personal property and liability protection.
• Personal Property Insurance (usually part of your homeowner’s policy or renter’s insurance):
  • Take pictures or videos of every worthwhile item in each room of your home, garage, and any out-buildings, as well as any rental storage boxes that you use.   
  • Enter each item, including description and current value into a spreadsheet. (Check with your insurance agency to see if they can provide a spreadsheet you can use to document your assets.)
  • Check with your homeowner or rental insurance agency to see if your current policy is enough to cover what you determine is the total value of your personal assets.
  • Store the copy (electronic or hardcopy) of your records in a safe place (for example, bank safety deposit box) outside of your residence in case of damage to your home.

• Life Insurance – Look at your current situation. Do you have enough or too much? Do you have life insurance on the right individuals in your family? (Parents usually don’t need the same amount of life insurance coverage when their children are grown as they needed when their children were minors.)

• Automobile Insurance – Is it enough? Make sure you meet your state’s requirements.
• Long-term Care Insurance - Do you think that you need it? How much will it cost? What are your other options? 
• Disability Insurance - Do you think that you need it? How much will it cost? What are your other options?
• Health Care Insurance - Are you covered through your employer? Are you covered through Medicare?
• Identity Theft Protection – Do you subscribe to a service to monitor your credit reports and provide fraud alerts? If not, do you check your credit reports occasionally to make sure there hasn’t been any unauthorized activity? 
• Computer File Backup – If you store all of your financial information on your computer and it crashes, do you have a backup?  

One Family’s Perspective on the U.S. Federal Budget: 2011 Perspective

Ron Muhlenkamp

 In April 1988, I wrote an essay that attempted to make the U.S. federal budget easier to understand by looking at it on a per household basis; refer to Muhlenkamp Memorandum Issue 4. That worked out pretty well, so I updated the numbers in 1992, 2002, and 2006. Given the attention federal spending is currently receiving in the press and popular discourse, it’s probably time to visit the topic again. To eliminate the effects of inflation from the discussion, I have adjusted all the nominal dollar amounts in the data to 2010 equivalent dollars in the following figures.

Let’s start with the big picture and work our way smaller. Figure 1 shows U.S. Gross Domestic Product (GDP) per household, as well as U.S. Federal Government outlays, revenues, and deficit or surplus.
Figure 1
Household numbers from U.S. Census Bureau Historical Time Series table HH-1 Source of budget data: U.S. 2012 Budget Historical Tables, Tables 1.1 and 3.1, U.S. Office of Management and Budget

Looking at GDP per household (red line), you can see a pretty steady movement higher, interrupted by significant drops during the 2001 and 2007 recessions. After the 2001 recession it took until about 2003 for us to reach the prior high. Figure 1 doesn’t show GDP reaching the prior high after the 2007 recession—the data ends in 2010; we reached that GDP level in the summer of 2011. Looking at the total federal outlays (light green line), you can see it was fairly stable in the vicinity of $23,000 per household from 1991 through 2001; steadily increased until it stood at $25,000 per household in 2006, where it leveled off for about two years; then leaped to $30,000 per household in 2009. It’s come down a little bit since then, but not much.

Looking at federal revenues, you see them increasing a bit faster than GDP from 1991 to about 2000; declining from 2000 to 2003 likely due to the 2001 recession; increasing again from 2003 to 2007 as GDP grew once again; then moving down again in 2007 as the recession hit. I find it interesting that federal revenues per household were about the same in 2010 as in 1991, although GDP per household was about 20% higher in 2010 than in 1991. Finally, you can look at the plot of the federal deficit (light blue line), which was steadily declining from 1991 to 2000—actually turned into a surplus from 1997-2001—jumped up in 2003, and jumped again in 2009. Summarizing where we stand in 2010, the gross domestic output of the country was just over $120,000 per household. Government outlays were about $29,000 per household, or roughly one fourth of GDP. Of the $29,000 per household that the government spent in 2010, taxes and other revenue only covered $18,000—the remaining $11,000 per household was borrowed.

With that as a backdrop, let’s dig a little deeper into where the government is spending its money. In Figure 2 we’ve graphed Federal Government Outlays by category from 1991 to 2010 on a per household basis, and adjusted them to 2010 dollars. In order to keep the chart from being too crowded, we have not graphed any spending category that was less than 3½% of federal government outlays in 2010. (Veterans’ Benefits, at 3.1% of 2010 outlays, was the largest budget area that didn’t make the cut.)

Figure 2

Household numbers from U.S. Census Bureau Historical Time Series table HH-1 Source of budget data: U.S. 2012 Budget Historical Tables, Tables 1.1 and 3.1, U.S. Office of Management and Budget

We’ve included GDP per household (red line) again for reference. This chart is pretty busy, so let’s talk briefly about the bottom two lines, then drop them off and see what it looks like. You’ll notice that the dark blue line—interest on the federal debt—is the only one that has significantly declined in the last 20 years. This is mostly the result of declining interest rates: the budget surpluses from 1997-2001 brought the debt down a bit, but not a lot. We’re still paying about $1,600 per household on interest payments. The yellow line is the amount we spend on federal education programs, about $1,000 per household in 2010. Now let’s drop those two off and look at the top five outlay categories.

Figure 3

Household numbers from U.S. Census Bureau Historical Time Series table HH-1 Source of budget data: U.S. 2012 Budget Historical Tables, Tables 1.1 and 3.1, U.S. Office of Management and Budget In 1991, defense (pink line) was the largest single federal outlay at about $4,700 per household in 2010 dollars. It declined to about $3,600 per household during the drawdown after the Gulf War, and rapidly increased after September 11, 2001. Remember the decline in government outlays from 1991 to 2001 we discussed earlier? It looks like a decline in defense spending was a big piece of that. Social Security (light green line) has moved from the number two position to number one and now accounts for over $6,000 per household in federal spending. It was increasing at about the rate of GDP until 2008 and has increased rapidly in the last two years. The Income Security category, which includes general retirement and disability insurance, unemployment compensation, housing assistance, food and nutrition assistance, and federal employee retirement and disability outlays, (orange line) has gone from $3,000 per household in 1991 and 1999 to over $5,000 per household in 2010. You would expect a piece of this to be sensitive to economic cycles—unemployment and food stamps—and it appears to be—look at the bump up during the 2001 recession. The jump from 2007 to 2010 is huge—reflecting the extension of unemployment benefits, and some of the homeowners assistance programs and food stamps—and should come down a bit as employment improves. Medicare (black line) has been on a pretty steady march upwards, doubling from just under $2,000 per household in 1991 to just under $4,000 per household in 2010. Health (light blue line), which includes health care services, health research and training, and consumer and occupational health has more than doubled from 1991 to 2010, and cost each household about $3,100 in 2010. (Medicaid outlays in 2010 were 89% of the Health category, so “Health” is mostly Medicaid.) Overall this chart highlights to me that of the top five spending categories, two are at cyclical highs: Defense and Income Security. We can expect these categories to come down if employment increases and the wars end. But, the remaining three, Health (Medicaid), Medicare, and Social Security, have steadily increased over the last 20 years. If theses categories continue to increase at that rate, they will come to dominate federal outlays.

I find this approach to the Federal Budget makes the numbers real to me. The government in 2010 spent $29,000 on behalf of my family, of which $13,000 (44%) was spent on Social Security, Medicare, and Health (largely Medicaid). The federal government collected $18,000 in revenues, and borrowed the remaining $11,000. There have been times in my life where I borrowed 35% of what I spent, like the government is now, but I couldn’t do that forever, so I found ways to earn more and spend less and get my budget into better shape. Figures 2 and 3 show me what the big expenses are that dictate where we have to go looking for big savings, explaining why every politician who is serious about reducing the deficit talks about Social Security, Medicare, and Medicaid. Those two Figures also show me which parts of current outlays are cyclical and will come down—unless we fail to reduce unemployment or remain in a permanent state of war.

In the Appendix you will find a table that has the raw data used in creating these Figures, so you can look at the data yourself and see what it tells you, if you have a mind to do that. Sources are also listed so that you can double check the data or dive deeper if you care. The historical tables from the 2012 Federal Budget contain a wealth of information about where we have spent our federal dollars in the past, where we are spending them today, and projections for the next few years. The comments made by Ron Muhlenkamp in this essay are opinions and are not intended to be investment advice or a forecast of future events.