SMA FAQs

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.

“Value” is a reasonable description of our investment approach. 

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.”  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 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.

Our portfolio defies categorization by market capitalization. We don’t find market cap useful and  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. We allocate capital according to where we find value, it really depends on where we are finding values.  

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. Since we do not restrict our universe by market cap or by investment style we think the broadest possible index is most appropriate.

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.

This usually results in a workable number of less than three hundred companies for us to research further.

Each has 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, Morningstar Research, 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).

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

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.

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. We use a business-like evaluation of each company 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 we look for companies with ROE over 14%. In a climate of 2 1/2% inflation and 4-5% interest rates we need to see a P/E less than or equal to the ROE. By contrast, in a climate of 9% inflation  and 12% interest rates  we were screening for a P/E  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 meeting our ROE and P/E criteria 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 without additional debt or equity financing. We prefer companies with ROE that can comfortably fund growth. We like to see revenue driven growth, 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, 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 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.

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 excellent 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 for which they are aiming. 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”.

Our sell discipline is a function of our purchase discipline. If a company disappoints, we sell it. 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 the stock price is simply 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 we sell the company. 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 wag the investment dog, but we have preferred capital gains to income and utilized tax loss swapping and low portfolio turnover to minimize distributions.

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 twenty companies. If we could only find ten companies that met our criteria, we would be 50% invested in equities, 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 fully invest 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