Muhlenkamp & Company, Inc. is a Pennsylvania Corporation effective October 1, 1981 and is the successor to Muhlenkamp & Company, a sole proprietorship founded by Ronald H Muhlenkamp in 1978.
2. Which of the following best describe your investment approach: value; growth-at-a-reasonable price (GARP); high earnings growth. If you do not believe your investment approach fits with any of the above descriptions please explain why.
“Value” is a reasonable description of our investment approach. We don’t buy only cheap stocks because sometimes stocks are cheap because the company behind the stock is no good. The GARP description implies companies without earnings or revenue growth aren’t worth owning, and that isn’t always true. The high earnings growth description usually ignores price and implies being willing to pay premium (if not unlimited) prices for that high earnings growth; there is always a limit to what we are willing to pay for a company.
We believe you can turn a good company into a bad investment if you pay too much for it, and in that sense we are pure “value managers”. But we also believe that a good company should be profitable, with revenue and earnings growth, and companies that demonstrate those abilities may in fact have higher “values” and command higher prices. We think the value, GARP, and high earnings growth styles all have something worthwhile to offer, and we try to incorporate those elements in our management.
We do not define our universe by market cap range, we look at all market caps. We start our search with the broadest universe of publicly traded securities possible, and narrow the list of stocks followed based on our Return on Equity (ROE) and Price to Earnings (P/E) criteria. We are most interested in companies with ROE greater than 14% and a P/E below the ROE.
We have rarely exceeded 10% in foreign equities, but would be willing to own them to the extent we could not find domestic companies that meet our criteria. We need to see higher potential returns from foreign equities than we can find in domestic equities to offset the additional risks of currency exchange rates, different accounting rules, different political and economic climates, etc. Currently, we are finding enough domestic companies that should meet or exceed our required returns that we are not heavily invested in foreign equities.
We don’t use market capitalization as a criteria for stock selection. Our experience is that profitability, revenue and earnings growth, free cash flow, and valuations are better predictors of investment soundness; we don’t really find market cap useful and I don’t want to give the impression that we use it. We don’t track the market cap range of our portfolio very carefully, or very often.
Since we do not use market capitalization for stock selection, these allocations COULD change completely over time. It really depends on where we are finding values. For example, in 1998, 1999, and early 2000 we were finding good values primarily among small and mid sized companies. Many large cap companies that met our profitability and growth criteria were selling at prices that we weren’t willing to pay. However, from 2000 to 2002, and again since 2008, a lot of those large cap prices came down dramatically, and the stocks became better values. So we are finding more values among the large cap companies than we did previously.
We try to do three things for our clients: preserve their capital, earn them a decent return, and help them sleep at night with what we are doing. We think a decent return should be AT LEAST 5% after taxes and inflation. So we focus on trying to earn after tax, after inflation returns of at least 5% annualized over any three year period. That is our benchmark.
We find it most useful to ignore indices in order to meet those objectives. Frankly, beating an index over time only results from ignoring all the indices. Having said all that, the Wilshire 5000 or the S&P500 are the best indices for our portfolio. Since we do not restrict our universe by market cap or by style box we think the broadest possible index is most appropriate.
Our initial screen is based on ROE and P/E. This usually results in a workable number of less than 300 companies for us to research further.
We combine all the methods of research you describe, because they each have something to offer. Once we complete our initial screen we conduct fundamental research on the companies using their financial statements. Our primary sources of information are company financial reports, Value Line Investment Survey, Wall Street analysis, Ford Investors Database, Business Week and other financial publications. We use this information in trying to understand how the company achieved the numbers that attracted us in the first place and to determine if those numbers are sustainable. We then conduct interviews with management to the extent we need their input. Once we identify the companies we want to own we use quantitative analysis to help us identify the buying and selling pressures that are driving the stock price currently. This is the bottom up process.
We build bottom up, but we also edit top down. We think in terms of three time frames for investments; the long term climate, the intermediate term business cycle (which we call the seasons) and the short term day to day market (which we call the weather.) We believe that the investment climate changes due to changes in inflation and interest rates (which often result from government policies). In 1930 the federal government implemented some policies that gave this country (and the world) a depression, and that was certainly a climate change. In the 1970s the government printed money, running inflation and interest rates up, and that drove P/Es down, so the investments that worked in the 1960s didn’t work in the 1970s; that was a climate change.
We always look for good companies at cheap prices, but we monitor whether in fact there has been enough of a change in the climate to modify our definitions of good companies and cheap prices. In roughly 1980, the climate changed again. Inflation started going down, interest rates started going down, P/Es started going up. So the investments that worked in the 1960’s didn’t work in the 1970’s and the investments that worked in the 1970’s didn’t work in the 1980’s. And we monitor that very carefully. So we build a portfolio from the bottom up but then we edit from the top down, trying to make sure that we don’t get blindsided by one of these climate changes.
The seasons correspond to the business cycle. Once we have identified the climate, we are fond of playing that cycle. Once we understand the climate and the season, the weather (day to day fluctuations in stock price) are largely irrelevant to our decision making, but can be useful to see if someone will pay premium prices for our companies, or sell us their companies cheap.
10. Please elaborate on the investment process, with detailed emphasis on the most important parts of the process. In particular, please describe the criteria and/or parameters that are used in selecting issues for purchase. Which of these criteria are the most important? Has there been any change in your investment approach over the past ten years? Please explain.
We start with the premise we are only interested in owning good companies, but we believe you can turn a good company into a bad investment if you pay too much for it. So our process is a business like evaluation of each company on its own merits and is designed to identify what a company is worth as a business today.
To find good companies, we start with return on shareholder equity (ROE). Since World War II the average return on corporate shareholder equity has been about 14%. And we like better than average companies, so basically we look for companies with ROE over 14%. In today’s market of 2 1/2% inflation and 4-5% interest rates we need to see a P/E equal to or below the ROE. By contrast, in 1980 when inflation was 9% and interest rates were 12%, we wanted a P/E of less than half the ROE. So we are always looking for good companies, but the price we are willing to pay for those companies changes as inflation and interest rates change.
Once we have identified companies with ROE greater than 14% and a P/E below the ROE we begin our fundamental analysis. We dig into their numbers to learn how they achieved that ROE, and whether it is sustainable. We look at growth, profits, financial strength, labor relations and management teams.
Growth is an important consideration, especially the relationship between growth and ROE. If ROE is higher than the growth rate, the company is probably generating free cash flow. Cash flow puts a company in control of its own destiny. Growth rates higher than the ROE are not sustainable in the long run without additional debt or equity financing. We prefer companies with ROE that can comfortably fund growth. We like to see growth that is driven by revenues growth and not just cost cutting or accounting sleights of hand. Revenue tells you if the public is buying the company’s product and should be near the level of earnings growth. Both earnings and revenues growth should exceed the industry medians.
Profits are another critical factor. The way to make profits is cost control, and we look for companies whose profit margins exceed the industry median.
Clean balance sheets are important, but can be more or less critical depending on the business and the stage of the economic cycle we are in at the time. Use of debt can help boost ROE when the company is performing strongly, but it can hurt the company when business slows down and the company still has to meet their interest payments. We look for companies with percentage of liabilities to assets lower than industry medians, and then look for free cash flow.
Labor relations and management teams are harder to quantify. In the final analysis, the quality of the management team is all you have got, but we don’t know a better way of measuring them than by how well they have done the job historically. The quality of the management teams usually becomes clear in the fundamental analysis that we perform.
Finally, our approach has been the same for at least 30 years.
Our competitive edge is that we look at companies the way companies look at companies, not the way Wall Street looks at companies. Wall Street focuses on price, we focus on value. We look at balance sheets, we look at income statements, and we try to make sure we have good companies. We can determine a fair price for that company, and we know why a fair price can change with economic conditions even if the company itself doesn’t change. We are disciplined enough to stick to our process even when it is out of favor because we understand why our process should (and does) work. We put our reasons down on paper so our clients can come to share in our convictions and so they can live with short term volatility because they understand the long term conditions. We don’t know that these are “unique elements”, but these are the source of any competitive advantage that we might have.
12. To what extent does research involve regular contact with company management, suppliers, competitors, etc? What are the objectives of these contacts? What percent of companies are visited before being included in your portfolio?
Whether or not we contact company management regularly depends on the company. Many big companies are so thoroughly followed by Wall Street that there is little we can add by talking to management. We focus on talking to management of those companies that may be overlooked by Wall Street. The smaller the company, the more we want to know the people and the more contact we will have with them, including site visits.
When we talk to management, we tend to ask a few initial questions. “What are your goals for your business? Where on that measure do bonuses start for employees (do people have incentives to achieve those goals)? Is there anyone on Wall Street who understands your business or your industry particularly well?” Knowing someone on Wall Street that does good work just saves us time, especially if we can find someone who loves the company and someone that hates it, that way we usually get most of the pertinent facts. We want to know what goals the company has for themselves because we think they are more likely to hit the targets they are aiming for. It is part of the job we do for our clients to decide if we think those are the right targets.
We don’t rely on economic forecasting, but we do monitor the difference between consensus forecasts and evolving data to aid our understanding of current investment conditions. Please refer to our essays titled “And the Climate Is” and “Why the Market Went Down”.
14. Please describe your sell discipline. To what extent do you allow your winners to run? Do you have an investment time horizon or expected holding period during which an investment should reach your targets?
Our sell discipline is a function of our purchase discipline. If a company disappoints, it gets sold. If the stock price gets to what we consider fair value, we sell it down to a 4-5% position in the portfolio. But if the company is doing what we expect it to do, and it’s simply that the stock price is down, we are fairly patient-particularly if we understand why the stock price is down. If we cannot figure out why the stock price is down, if relative strength is breaking down, then we suspect someone may know something we do not, and the company gets sold. The rule is: if in doubt, sell out. We don’t have an expected holding period, but we tend to own companies for 3 years or more.
We believe our clients hire us to make them money after taxes and inflation. So we manage the portfolio to minimize taxable distributions, thereby deferring income and capital gains taxes. We don’t let the tax tail wave the investment dog, but we have preferred capital gains to income and utilized tax loss swapping and low portfolio turnover to minimize distributions.
16. Do you have a policy for staying fully invested? If so, what is your definition of fully invested? What factors would lead you to hold more or less cash? Is there a maximum amount of cash you are likely to hold?
We do not have a policy for staying fully invested. We will hold cash or fixed income while we look for companies that meet our criteria and that we believe will generate the returns we require. We do run a diversified portfolio, so we think in terms of no more than 5% of our assets in any one company, or a minimum of 20 companies. If we could only find 10 companies that met our criteria, we would be half invested, and the other half would be in cash or fixed income while we redoubled our search. A climate change, such as we discussed in Question # 9, could lead us to hold more or less cash. If we thought that conditions were ripe to cause a Depression similar to what his country saw in the 1930’s, we would be fully invested in US Treasury Bonds, because in a Depression you want to own Government Bonds. If we believed that we were due to repeat the economic and investment conditions prevalent from 1968-1981 we would go to cash and then look for investment opportunities in real estate and possibly commodities. Currently, the climate is suited to equity investments where we think we can reasonably earn 8-9%.
Please refer to the Quarterly Asset Allocation for a report on our portfolio allocations to cash.
We typically take a 2-4% position when we first purchase a company.
A single company will not exceed 5% of the portfolio at purchase.
19. Is there a policy regarding industry or sector diversification? What are the maximum concentrations allowed in a single industry or sector? To what extent might you have large concentrations in specific industries?
We diversify across sector and industry, limiting our exposure in an industry to 20%. However, we do sometimes define sectors and industries differently than analysts do, which can lead to seemingly concentrated positions. For example, at one point in the mid 1990’s outside consultants concluded we were 40% in “Financials” but when we looked at specific holdings we concluded that Fannie Mae was in a very different business from Citigroup, which was different from Morgan Stanley, which was different from Fidelity National Financial. So where consultants saw financial stocks, we saw a mortgage company, a global bank, a global broker, and a title insurance company. We diversify by owning very different companies, in very different businesses, even when they can sometimes be grouped together.
Please refer to the Muhlenkamp & Company, Inc. All Cap Value SMA Fact Sheet for a description of our portfolio.
Please refer to the Quarterly Company Equity Turnover.
We diversify across market capitalization, industry and sector. We limit an individual position to less than 5% of the portfolio, and we emphasize fundamental valuation to focus on quality companies with strong balance sheets. Finally, we insist on buying these companies at a discount from their intrinsic value.
We limit our use of derivatives to options, specifically covered calls and straddles. We use options to supplement our fundamental research and to enhance our total returns. Having determined fair prices for our companies, we will use options when we don’t mind being called out and we collect a sizeable premium for the privilege. We limit our use of options to less than 5% of the portfolio, and we expect to use fewer options when the premiums are no longer attractive.
Our portfolio manager makes the buy and sell decisions and places trades directly through our dedicated, in-house trader.
The analyst staff is responsible for applying our selection criteria to the universe of publicly traded stocks and then doing the fundamental research on those companies that meet our criteria. The analyst staff meets with the portfolio manager formally once a week, and informally as required through out the week. At these meetings they bring new ideas, review old ideas, and offer new information on old ideas to the group for discussion. Analysts will make specific buy or sell recommendations, and will defend these recommendations to the group, which may result in portfolio changes.
We pay the portfolio manager and analyst team a salary and annual bonus. Bonuses are first based on the profitability of the company, which is a direct result of investment performance and assets under management. Investment performance leads to assets under management, which leads to increased revenues, which can be used to pay bonuses. The portfolio manager determines bonuses for the analyst team based on how the analyst’s ideas have contributed to investment performance.
26. What is the magnitude of the direct investment in the fund on the part of the portfolio management team (e.g., the percentage of the portfolio manager’s investable assets) and the management firm (e.g., via qualified plan assets)?
100% of the portfolio managers’ liquid assets are managed by the management firm.
Our portfolio managers, analysts, and other employees are permitted and do trade in their personal accounts, and their trading is closely supervised and audited by our compliance officer.
Please refer to the Quarterly Company Assets Under Management.
30. What criteria does your firm use to determine that there is sufficient liquidity for the firm’s total position in a stock? Is there a maximum number of days average trading volume and/or “days to sell” that the portfolio will hold in a particular stock?
won’t buy over 5% of a company’s stock. We like to keep our holdings below one month (20 days) trading volume. But sometimes the market changes, and “sufficient liquidity” becomes an oxymoron. For example, when the market crashed in October 1987, the only company we could get a decent bid on was Phillip Morris. Everything else was illiquid. Everything. In 2008, there was over a trillion dollars of forced selling which occurred in 3 months; and once again, everything was illiquid.
31. During the current management’s tenure, have there been any decisions (sector, themes, individual positions) that have had a significant impact on performance (either positive or negative)? What factors have been key in building the track record? What have been the biggest mistakes?
Our decision to stick with our valuation model and our discipline in buying good companies at cheap prices has been the key to building our track record. By remaining disciplined in our approach we tend to move counter to the conventional wisdom; enabling us to buy good companies that no one else wants and helping us to avoid paying too much for good companies when everybody else wants them. For example, coming out of the 1990 recession we were finding good values in financial stocks. It looked to us as though the consumer had enough cars, clothes, and house, but was spending money on financial products; so we bought title insurance companies, and insurance companies that sold annuities, and brokers, and global banks. Another example of sticking to our discipline came about in the fad markets of 1998-2001. By the end of 1999 our performance lagged most of the indices for 1998 and 1999, and we were criticized (by clients, consultants, analysts and the media) for not recognizing that it was a new world, a new economy, and for not realizing the old methods of valuing companies didn’t work anymore. We disagreed, and published our rationale in Muhlenkamp Memorandums #49-52. Basically, the stocks that were posting the best returns were selling at fantasy levels and we could not justify paying current prices for them. We owned companies that were running the businesses as well or better than the high fliers, but were selling for one third the multiples. So we held our course, and were willing to look dumb for two years, but that enabled us to post excellent returns in 2000 and 2001. Most recently, coming out of the 2008 recession we did not think the US was having a normal recovery from a normal recession even though the broad market behaved as though we were. So we focused on balance sheets and defensive positions in our portfolio. This led to good absolute returns, but relative underperformance. Fundamentally, our decision is to follow the numbers, stick to our discipline, and constantly check our valuations. If we do this, the numbers will take us to the companies we want to own, and the companies will provide the performance our clients need.
-outperform its benchmark/style peers
We should outperform in tough, volatile markets and under tough economic conditions such as recessions, high inflation, and in the early stages of recovery. Examples of when we outperformed are the 1970s, most of the 1980’s, and from 2000-2008. Essentially, we do the best, and are the most comfortable, when the conventional consensus is pessimistic.
-underperform its benchmark/style peers.
We may under perform when a “fad” mentality dominates the markets and the economy and everybody “knows” the future is glorious and all you have to do is own stocks, they will only go up. We matched the markets in the early 1990s, and lagged in the late 1990s because we did not get caught up in the fads. We tend to do relatively less well, and we get nervous, when the conventional consensus is optimistic.