Ron Muhlenkamp looks to his farming days to guide his strategy.
Farming and investing have a lot in common to Ron
Muhlenkamp, who has done his share of both. Born in 1944 on his
family's farm in Auglaize County, Ohio, the namesake and portfolio
manager of The Muhlenkamp Fund spent his youth learning life's lessons
from the soil and seasons. Even after earning degrees from MIT and
Harvard, and several decades of professional investment experience, he
often uses weather-related analogies when he talks about investing.
"If you get the climate and seasons right, it
doesn't matter what the market is doing today or the next day," he
observes. The "climate" he refers to is defined by broad economic
trends, such as inflation or deflation, that set the stage for stock
and bond market returns. These sweeping changes can last for a
prolonged period and have happened only three times in the last 30
years. Shorter-term cyclical business cycles are "seasons" that usually
extend for three to five years, although they can sometimes last
longer.
In line with that philosophy, Muhlenkamp combines
bottom-up, value-oriented stock selection with an investment strategy
that pegs expected stock market returns to prevailing interest rates
and inflation levels. "We always look for good companies at cheap
prices, but our definition of those terms [is] subject to modification
as the investment climate changes," he says.
If inflation heats up and interest rates increase,
stocks must deliver competitive returns or fall to pricing levels that
are reasonable enough to attract investors. That happened in the early
1980s, when inflation was 8% and long-term bonds yielded 12%. An equity
premium of 3% meant investors had little reason to accept stock market
returns lower than the 15% range. To achieve that, stocks fell to
prices of just six times earnings during the market bottom in 1982.
On the other hand, if inflation and interest rates
are staying the course, stocks can sell at higher valuations and
deliver more modest returns, yet still look attractive compared to
other investments. He believes that to be the case today.
Muhlenkamp maintains that the stock market is
positioned to deliver high-single digit returns even as investors face
a headwind of surging oil prices, rising interest rates and
inflationary pressure. He argues that inflation is well under control,
and expects it to remain at around 2% to 2.5%. "Oil prices are higher
than they were last year but prices on some things, such as clothing,
are lower. Inflation happens when most prices go up, and that has not
been the case."
He believes that nail biting about rising interest
rates is premature. "Historically, short-term interest rates are about
0.7% above inflation," he says. "So if inflation is running at around
2% or 2.5%, short-term rates should be in the 3% range and long-term
rates should be around 5%. That's about where they are now."
Money supply, a powerful inflation driver, has been
growing at a modest rate of 5%, which is "right in line with 3% real
GDP growth and 2% inflation. Inflation is a monetary phenomenon, and if
the government doesn't print too much money, it won't happen. We
haven't made the governmental policy mistakes that would give us a
depression or revived inflation. We are simply in the midst of a
seasonal expansion of the business cycle."
Stocks are fairly priced at current levels, although
"some are a bit cheap and some are a bit expensive. Historically,
stocks are priced to return about 3% more than bonds, which means that
our required equity return today is in the 8% to 9% range," he says.
But performance of individual stocks, even within
the same industry, is likely to vary widely. "When a shortage of
capacity exists, it is possible for an entire sector to perform well,"
he says. "But today, nearly every industry has ample capacity. We have
no shortage of retail stores or automobiles. If General Motors does
well, it will do well at the expense of another auto manufacturer. If
Wal-Mart does well, it will likely be at the expense of a J.C. Penney
or Kmart. So the game becomes what individual companies are doing, and
investing in stocks that are likely to outperform."
If the fund's returns are any indication, Muhlenkamp
has done a commendable job as both a stock picker and an economic
pulse-taker since the fund's inception in 1988. Over the last ten
years, its average annual return has exceeded that of the Standard
& Poor's 500 Index by nearly seven percentage points. Last year,
its 24.5% total return beat the index by 13.6%. Its worst year relative
to the market was 1998, when an aversion to pricey growth stocks led it
to underperform the index by more than 25% points.
Although Morningstar defines it as a mid-cap value
offering, the Muhlenkamp Fund's strategy defies any neat
categorization. The portfolio spans a broad range of market
capitalizations and industries, and has a sprinkling of foreign
securities. While the fund can also invest in bonds, its manager has
not done so since 1993 because he sees greater return potential in the
equity markets.
Muhlenkamp begins his stock selection process by
looking for companies with a competitive return on equity, which he
believes "is one of the best measures of how well management is using
shareholder dollars." This measurement of profitability and corporate
management compares corporate earnings to what stockholders have
invested in the firm. It is calculated by dividing annual earnings by
stockholder's equity (total firm assets, less debt and liabilities). If
a company generates annual earnings of $50 million on stockholder's
equity of $250 million, for example, its return on equity is 20%.
Historically, return on equity for the stock market
has averaged between 13% and 15%, so he demands numbers in that range
or better. The average company with a 14% return on equity should sell
at roughly 18 times earnings, he says.
By Muhlenkamp's standards, the most competitive
companies, whose stocks are likely to outperform the market, have an
attractive return on equity coupled with a cheap stock price. "The
stocks we want should have price-earnings ratios below the return on
equity for that company," he says. "If a company has an 18% return on
equity and sells at 14 times earnings, that tells me it is a
better-than-average company selling at a below-average price."
According to the fund's latest fact sheets, the portfolio had an
average return on equity of 23.5% and an average price-earnings ratio
of 11.5. He also examines other factors such as revenue growth,
management and balance sheet strength.
The goal of Muhlenkamp's evaluation process isn't to
buy the fastest-growing companies or the biggest industry leaders. He
just wants good companies at cheap prices.
"We try to buy Pontiacs and Buicks on sale," he
says. "We also like luxury cars, but those don't go on sale too often."
A low turnover rate of around 10% last year points to Muhlenkamp's
dedication to pedestrian picks such as Cemex, the fund's fifth largest
holding. The Mexican cement company, he believes, should benefit from
growth in the Mexican economy and the construction boom. The company
also commands a higher price per ton for cement because it sells its
product in bags, rather than in bulk.
Recently, he has been adding to the fund's existing
position in Johnson & Johnson and established a new position in
Pfizer. Increased health care spending by consumers sparked his
interest in those stocks during the 1990s, but he held back on any
purchases because he could not justify their lofty prices. Pullbacks
over the last year, however, finally got him to open his wallet. "Drug
stocks typically get beaten up in an election year, and that's what
happened here," he says. "These are good companies that have come under
a cloud. I don't expect their future to be as good as their past. But
with a return on equity in the 20% to 25% range and a price-earnings
ratio of 17, Johnson & Johnson is still a good company selling at a
reasonable price."
Muhlenkamp affixes a similar label to Altria Group,
the recently rechristened Philip Morris. "The risks in this company are
political, not economic," he says.
That philosophical view sums up his feelings about longer-term prospects for the economy and financial markets. "We now have a whole generation of people who have been through only one or maybe two recessions, and they still think of them as unusual. Well, to me they're no more unusual than wintertime in Pennsylvania. My father was a farmer who used a four-quarter cycle. I invest on something like a four-year cycle. The key is being able to adjust to the seasons."