Muhlenkamp Memorandum Muhlenkamp Memorandum

Issue 105Published First QuarterJanuary 2013

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Quarterly Letter

Ron Muhlenkamp

2012 was a year of mixed results on the economic front, but generally good investment returns as measured by the S&P 500 Index. Some progress was made in Europe and China, and some clarification in direction was made in the U.S. We presented our thoughts on these topics at our December 6 seminar; an archive will be available on our website.

A brief review follows:
 
The U.S. economy continued to expand, but at a modest rate. Consumer spending is growing moderately at a 2%-3% annual rate; consumer saving is at 3%-4% of income. Consumer confidence has improved since 2009, but is still at the subdued levels seen during the prior recession. Gasoline consumption has declined 5% since 2006, after climbing steadily prior to that. Housing has begun to recover and car sales are approaching “normal” levels.
 
Business investment and hiring remain subdued as businesses await clarification of the rules on taxes, regulation, and government policy. Business and commercial borrowing are picking up a little. Bank health continues to improve. 
 
The Federal Reserve continues to hold interest rates at artificially low levels, squeezing the returns to retirees and pension funds. The Fed’s balance sheet is no longer growing. The remaining big question in the U.S. is whether we contain government spending, which has been shown to lower economic growth. A major problem is that many think government spending enhances economic growth. 
 
Commodity prices have leveled off, but remain quite volatile. In the energy markets, there remains a huge spread between the price of crude oil and natural gas. In early 2012, the fuel cost of natural gas fell below that of coal, causing many power plants to shift consumption to natural gas. We expect these fuels to remain competitive for the foreseeable future. 
 
While the recent rise in tax rates (and FICA taxes) will serve as a drag on the U.S. economy, we expect the U.S. to avoid recession with modest growth.
 
In Europe, the crisis of policy seems to have peaked, but much of the continent is reentering recession. We think the probability of Europe’s problems threatening the viability of the U.S. based international banks has lessened. 
 
China appears to have achieved its goal of containing inflation by slowing the economy and is likely to resume Gross Domestic Product (GDP) growth, but at a slower than historic rate and with a focus on the consumer.
 
During early 2012, we held more than normal cash reserves and remained focused on large, U.S. based companies with strong balance sheets and cash flows. As some of the above-mentioned issues were clarified, we’ve invested most of the cash, some of it in smaller companies.
 
Our resulting performance, while trailing the S&P500 Index for the full year, has tracked a bit above it in recent months. We continue to seek good companies at modest prices.  
 
 
The comments made by Ron Muhlenkamp in this commentary are opinions and are not intended to be investment advice or a forecast of future events.
 
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Considerations for Dividend and Capital Gain Distributions

Ron Muhlenkamp

Step One – The Rules

You may be aware that if a corporation earns dividends or interest on its investments, it must pay a corporate income tax on its earnings. If it then pays the remainder out to its shareholders, they must pay an additional personal income tax on such a dividend. (Thus the phrase: “corporate dividends are doubly-taxed.”)
 
IRS regulations stipulate that a mutual fund can avoid this double taxation as long as it pays out, or declares, distributions to its shareholders of at least 98% of its net earnings from interest, dividends, and capital gains in any fiscal or calendar year. IRS regulations further stipulate that interest, dividends, and capital gains keep (or “pass through”) their character to the fund shareholders.
 
Step Two – The Wrinkles
Before the end of the year (2012), it was unclear if the Bush-era tax rates would be extended. The following changes to dividend and capital gain distributions were being proposed:
The tax on dividends will go from 15% to the individual’s (couple’s) rate on ordinary income.
The tax on capital gains will go from 15% to 20%, plus a 3.8% surcharge for high-income tax payers; ($200,000+ in Adjusted Gross Income for singles and $250,000+ for couples). 
 
Step Three – The Implications 
As the manager of the Muhlenkamp Fund, my goal is always to make my shareholders a good return after taxes and inflation. This means attempting to minimize the tax rate and to postpone capital gains to the extent that it’s profitable. With probable higher taxes on the horizon, I was inclined to harvest some profits before December 31, 2012.
 
As a result, there was a long-term capital gain distribution in the amount of $4.49 per share, along with a short-term capital gain distribution in the amount of $0.49 per share paid on December 27, 2012 to shareholders of record on December 26, 2012. There was also an income dividend paid in 2012 in the amount of $0.35, per share paid on the same date. IRS Form 1099-DIV will be issued by the middle of February 2013 to all taxable accounts that received a distribution in excess of $10.00. 
 
Fund shareholders (except those with tax-deferred accounts such as an IRA, Roth IRA, Coverdell Education Savings Account, etc.) are required to pay taxes for the year the capital gain and income dividend distributions are received—whether the distributions are given as cash—or reinvested back into the account for the purchase of additional shares. 
 
For federal tax purposes, the Fund’s income dividend and short-term capital gain distributions are taxed as ordinary income or qualified dividend income; long-term capital gain distributions are taxed as long-term capital gains. For taxable accounts receiving a 1099 for 2012, the form will indicate the federal tax status of your dividend and capital gain distributions. 
 
Capital gain and income dividend distributions cause a mutual fund’s net asset value (NAV) or share price to decrease by the amount of the distribution. This is not due to performance, but reflects the fact that you will have more shares in your account—or have received a check—due to the distribution. If you reinvest capital gain and income dividend distributions, your account value will not change, you will simply have more shares at a lower price per share. The distribution looks like a paper shuffle, but one that allows the IRS to collect taxes; refer to the hypothetical example below. 
 
Reinvested distributions add to the cost basis of your account and are only taxed once. When you calculate and track the cost basis of your account, treat the reinvested distribution as another investment that you made out of pocket. This will increase your tax basis and lower your future tax bill. 
 
Reinvested distributions are treated as a purchase for “wash sale” purposes. Wash sale rules discourage people from selling securities just to take a tax loss. The rules disallow the loss from selling shares of a security if you buy shares of the same (or similar) security within 30 days of the sale. 
 
There are additional tax implications. The distribution in a taxable account is included in your Adjusted Gross Income (AGI) and may increase the tax you owe on the rest of your income. The distribution may subject you to the Alternative Minimum Tax (AMT), or may change what you should be paying in quarterly estimated taxes. This is especially relevant for people with large accounts worth tens or hundreds of thousands of dollars. So even though the capital gains will be taxed at 15%, the rest of your income could be taxed at a higher rate than you expect. I suggest that you consult a tax adviser to determine your particular tax situation and to make sure you understand the implications of the distribution for your individual taxes.  
 
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.
 
Hypothetical Example of a $2.00 per Share Distribution*    
  Before
Distribution
After
Distribution
Share Balance 100 125
Share Price (NAV) $10.00 $8.00
Account Value $1,000.00 $1,000.00
* Assumes the NAV or share price of the fund does not change due to market activity.    
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Required Minimum Distributions

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 owner of an IRA/qualified plan and turned 70½ during 2012, 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 accounts. Once you have reached this milestone, you will be required to take this distribution annually. 
 
If you have already taken your first distribution by December 2012, fine. But, if this has somehow slipped your mind, you still have until 4/1/2013 to take the distribution. However, you will also have to take the 2013 distribution by December 31, 2013. As a result, you may have to pay taxes on two distributions in 2013. 
 
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 may continue, 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 turned 70½ in 2012. If you will be turning 70½ in 2013, simply add one year to the dates in the example. 
  • The amount will be based on all of your IRA balances as of 12/31/2011.
  • RMDs are calculated based on your birthday, the beneficiary’s birthday, and whether or not the beneficiary is your spouse. 
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 RMD total from each of your IRA/qualified plan accounts, only one of those accounts, or any combination of these accounts; 
  • You can go to the custodian of each IRA account you have and ask them to calculate the amount for the respective accounts; 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 with the Muhlenkamp Fund, 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 Required Minimum Distribution 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.
 
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Financial Fitness: What Are Your Goals?

Michelle Orphall, Marketing Specialist

 As we begin another New Year, having financial goals in place may make you more disciplined in your spending. Rather than exhausting your tax refund on a weekend away, you may decide to add this money to your emergency fund. That way you are prepared to pay for any unexpected home repairs. You might be tempted to go on a shopping spree with a recent bonus, but your goal may be to pay off your outstanding debt first. Though you don’t want to deny yourself all the pleasures of today, saving extra funds for a future expenditure may give you peace-of-mind, knowing you are prepared for upcoming financial events or at least on your way. 

Are your financial goals written down—or are they something that you think about occasionally, but then push them out of your mind because they seem overwhelming? Some people establish their goals during discussions with their spouse, but then never put them in writing. That works for some individuals, but others may need to document them to become more committed to reaching their goals. 
 
So if you haven’t yet identified your financial goals or written them down, let’s get started. 
 
Types of Financial Goals: 
  1. Eliminate Current Outstanding Debt
  2. Create an Emergency Fund
  3. Save for a Significant Upcoming Expenditure 
  4. Invest for a Significant Future Expenditure
  5. Determine Non-Monetary Financial Goals
Eliminate Current Outstanding Debt – Interest on debt costs you money! Rather than paying money out every month in interest, strive to rid your personal balance sheet of debt, then you may be able to invest those extra assets and start making your money work for you. Since debts with the highest interest rates, such as high-interest credit cards, cost you the most, it’s usually best to pay these off first. It is not necessary to pay off all debts before you begin investing. Mortgage payments are usually at a more manageable interest rate than credit cards or other debt. Depending on the IRS (Internal Revenue Service) rules at the time, interest payments on your mortgage may be tax-deductable, lowering the overall cost of this debt. If rates are lower now than when you obtained your mortgage or last refinanced and, if you are eligible to refinance, you may be able to reduce the amount of your mortgage payments. 
 
Another way to reduce your expenses is to consolidate high-interest credit card balances to a credit card company offering a lower rate. Once you are able to pay off your entire credit card balance, try to only spend what you are able to pay for each month. If you ever overspend, make sure to pay what you can on-time so that you don’t waste any money on late fees.
 
Create an Emergency Fund – Have emergency money available so you don’t have to borrow for unplanned expenses. Not having enough money can cost you interest, late fees, and/or penalties. Since we don’t know what the future will bring, it’s best to be prepared financially. Whether it’s a natural disaster, layoff, or broken dryer, having enough money saved will make a bad situation a little easier to deal with. 
 
The next big storm may take power lines down. Without electricity, credit/debit cards are useless as well as bank ATM machines. So you may want to keep some of your “safety net” in cash in case of an emergency situation. With cash on hand, you may be more likely to purchase any needed supplies.
 
Hopefully, you will never need to use your emergency fund due to unemployment, but, if so, having one could help get you through rough periods without incurring debt, foreclosure, or bankruptcy. It’s suggested to save enough money to cover six to nine months worth of basic living expenses, if not more.
 
An emergency fund also comes in handy when paying for the unplanned expense incurred when things break down and need repaired or replaced. In addition, knowing that you have money set aside for unplanned expenses may make you decline an offer to buy additional protection plans when in the past you usually accepted. These product protection plans on appliances and electronics can get expensive in relation to the cost of the product. 
 
These ”insurances” are things that you have to look at on an individual basis to determine what is right for you and what is unnecessary. An emergency fund does not eliminate your need for certain insurances. Insurances such as Life, Homeowner’s, Renter’s, Automobile, Health Insurance, etc. are usually recommended for most individuals.
 
Save for a Significant Upcoming Expenditure (occurring in three years or less) – You may have some significant upcoming expenditure or event that exceeds your monthly budget. Are you able to cut out some current luxuries each month to set aside money to be able to pay for these? Some goals may be only a few years away and others may be further down the road. It’s usually advised not to put the money that you set aside for goals occurring in less than three years into investments that have high volatility. 
 
If you are able to accumulate enough assets to pay cash, it can sometimes save you money in two ways. Some retailers offer cash discounts because they don’t have to pay the credit card company’s fees on your credit purchases. The second way you can save is by not paying interest in addition to the cost of the item when you purchase an item on credit.
 
Invest for a Significant Future Expenditure (occurring in more than three years) – Start saving for planned significant future expenditures as early as you can. The more you are able to save, the less you or your loved ones will have to borrow to pay for an event such as a wedding or college education. If you are saving for a purchase that you expect to occur in more than three years, you may want to invest these assets. This way you can use the effect of compounding to help pay for the expense. 
 
Determine Non-Monetary Financial Goals – Sometimes financial goals aren’t about saving money, but about taking action. Maybe you still need to create a will, update beneficiaries on your IRA accounts or life insurance policies, organize your financial records, create a budget, or buy life insurance. You may just want to learn more about finance; economics and its impacts; how to invest; where to invest; or who to turn to for help in managing your investments. 
 
Achieving your financial goals
The documentation portion of goal creation might be the easiest part. Actually achieving your goal can be more difficult. It takes discipline and thought to determine how to best allocate limited funds, but with a goal in place, you know what you are aiming for.The following steps can help you get started in documenting your goal. 
 
Break the goal down:
  1. List your goals. 
  2. Estimate the start date of the expenditures or your target goal date. 
  3. Estimate the cost per year or occasion. 
  4. Multiply the cost by the estimated number of years or occasions. 
  5. Subtract the amount of money that you have saved already for this goal. 
  6. How many years is it until the estimated start date? 
  7. Calculate the average savings needed each year to reach your goal.
 If you have questions regarding setting or reaching your financial goals, let us know if we can provide assistance. Ron Muhlenkamp has been in the investment industry for over 40 years and has written about all of these areas. Some examples of Ron’s financial maxims include: 
  • “Work to move your assets toward the areas where returns are high and pay off debts where the costs are high.”
  • “The price of borrowing money is interest—and worry. Keep all borrowing below the worry point and don’t borrow to buy things that depreciate; you will lose on both ends.” 
  • “People think of inflation as prices going up. It’s not. It’s the value of money going down.” 
Visit the “Investment Principles” section of our website to find a collection of Ron’s essays. 
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The “FRIDAY FOCUS” on Retirement

Susen Friday, Client Service Regional Manager

Long-time participant in the DCIO(Defined Contribution Investment Only) market, former secretary and active member of the Women in Pensions Network(WIPN), member of the American Society of Pension Professionals and Actuaries(ASPPA) and former plan administrator, Susen also holds an Accredited Investment Fiduciary (AIF) designation.

Throughout 2013, Susen’s expertise and experience in the retirement field will be showcased in the Muhlenkamp Memorandum, referred to as The FRIDAY FOCUS” on Retirement.
 
Ahh…retirement. On a personal level, we save for it, plan for it, and dream about it. But did you ever wonder how the whole notion of retirement and funding it came about? How it has changed over time? 
 
Believe it or not, it all started with the Ancient Romans back in 13BC. Augustus decided that he would like to reward his legionnaires for their years of service and to offer a carrot to other young men to join the army. For 20 years of service, legionnaires received between two-thirds and three-fourths of their yearly income. Initially, Augustus funded the pension out of general taxation; later, it was covered by a 5% tax on inheritance. When Rome fell, the military pension system collapsed as well.
 
During the Dark Ages, many members of the nobility maintained standing armies. Some of them devised crude pensions for their military, often granting land to older soldiers.
 
As European history progressed into the late 1600s and the 1700s there are indications that some sort of pension payouts had been made to non-military persons. Such payouts were not wide spread, nor sanctioned by the government.
 
Up until this point, no one had given a thought about social insurance—a system of wide-spread coverage sponsored by the government. In 1889, however, Otto von Bismarck established the first such system in Germany. It consisted not only of a pension, but also accident and health insurance. The system has adapted well over time. In fact, my grandmother collected from this system until her death in 1966.
 
Much of industrialized Europe followed in Germany’s footsteps and created programs of their own. There were two main types: insurance systems that were related to the earnings of the recipients, and minimum systems which were essentially welfare systems for the elderly.
 
Retirement in the United States was conceived as a three-legged stool: one leg was the Social Security System, the second was private pensions, and the third was personal savings. 
 
In the United States, the Social Security System was created in 1935 by the Social Security Act. The System initially provided income to retired workers based on their earned income. Since then, it has been amended and expanded. Most notably, the changes are to cover those with disabilities and to provide medical coverage for those on public assistance.
 
The first private pensions established in the United States were by American Express (1875) and the B&O Railroad (1880). Many other companies followed suit, primarily in the banking, railroad, and public utility industries. 
 
The “retirement industry” was born in the early 1900s when insurance companies began offering group annuity contracts to companies. Insurance companies have continued to play a major role in retirement plans ever since.
 
Over time, private companies were encouraged to provide pensions to their employees. During both World War II and the Korean Conflict, the U.S. government imposed price and wage stabilization programs. Since companies could not reward their employees with higher wages, they turned to providing benefits as an alternative.
 
The growth of pensions in the coal, automobile, and steel industries was a direct result of collective bargaining by their respective unions. The availability of retirement plans spilled over into non-union companies and has been used as a means of being more competitive for skilled labor.
 
What’s important to remember is that retirement plans are dynamic creations that change over time! 
 
Plan design, or customization of individual plans, provides the framework within which a plan must operate. If the plan sponsor wishes to include a new feature in the plan, he legally amends the plan. Sometimes the government wants to change the rules under which qualified plans operate across the board. This is usually done by passing new legislation that is then implemented by either the Department of Labor (DOL) or the Internal Revenue Service(IRS). An example of this is the recent Regulation 408(b)(2), which requires greater transparency of plan expenses.
 
Where are we today? 
  • Social Security, funded as a “pay as you go” system, is in effect. 
  • A wide variety of privately sponsored retirement plans, including qualified plans created by the Employee Retirement Income Security Act (ERISA) in 1974, are in effect. These plans are governed by the Department of Labor and the IRS. (There are also non-qualified plans that address special situations.) 
  • In addition to the above, there is the option of contributing to either a traditional Individual Retirement Account (IRA) or a Roth IRA. 
 
Each of the above elements is treated differently at tax time.  
 
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