Quarterly Letter, January 2015

By Anthony Muhlenkamp, featured in Muhlenkamp Memorandum Issue #113

Tony had some ideas and observations he wanted me to share, but I thought it made sense for him to tell you directly in this edition of our Quarterly Letter. -— Ron

2014 was a year of mixed results and mixed emotions.

The headlines make no secret that “the market” is setting new highs. However, the market they are referring to is the S&P 500, which is dominated by the 20 largest market capitalized companies in the United States. Outside those top 20 is a mixed bag of winners and losers. Small caps in the Russell 2000 are flat for the year; energy stocks are down for the year; international stocks were down for the year; bio-tech was up for the year.

Additionally, the gains did not occur uniformly; instead prices were choppy and advanced/declined with your particular choice of stocks. If you were out of the market on particularly good days, or particularly bad ones, then your performance differed radically from that of the market. If you were taking out some money, or adding some money, the timing of that transaction could make a big difference in your performance.

A friend of mine confided that his wife’s 401(k) is allocated 30% international, 30% domestic, and 30% bonds and that her performance this year was just 1%. So how you did this year hinged on what you owned (or didn’t own) and when you bought or sold it. This was not the homogeneous market we hear about on the news.

For our clients, we continued the strong performance we had in 2013 through the first half of the year, to the extent that we started harvesting the companies that had done well for us and realized some capital gains. In the third quarter the market prices of our companies were bid down and from there it was a mixed bag.

A big factor in the last half of the year was the price of crude oil dropping from $110 per barrel to $60 per barrel; a drop of 45%. Our energy holdings are primarily natural gas related and should not have been impacted by oil prices being halved, or so we thought. We know the price of natural gas and the price of oil have been on separate tracks since 2009; (see our booklet “Natural Gas: An Energy Game Changer”). The separate tracks for the prices of oil and natural gas continued in 2014 but the prices of the stocks of the companies involved went down with the price of crude. This should be an opportunity, but owning natural gas companies hurt our performance in the last half of the year.

The big beneficiary of the decline in the price of oil is the U.S. consumer, and to a lesser extent, the world consumer. There are 42 gallons in a barrel of oil, so a $50 drop in the price per barrel is a drop of $1.20 in the price per gallon, and you’ve seen that at the gasoline pump (and to a lesser extent, so far, at the diesel pump). We talk more about the effect on consumers around the world in the accompanying article “Effects of Currency Manipulation.”

The people hardest hit by the decline in the price of oil are the producers of oil, both domestic U.S. producers and international producers, including the drillers, the service companies, the landowners; etc. Producers who are particularly vulnerable include the nations of Venezuela and Russia. Their problems are compounded by the rapidity of the decline. The producers, their owners, and their lenders have not yet had time to react. We expect some of them to go bankrupt.

Our biotech companies helped us, as did our airlines and our financials. But you never own enough of the ones that go up, and you always own too much of the ones that don’t.

We are disappointed when we under-perform “the market,” but that disappointment is tempered by the realization that we own very good companies that are selling for less than they are worth. We have written in the past about our internal performance benchmark being average annual returns of at least 5% over inflation for periods of time measured in years, not in days, weeks, or quarters; and we continue to apply that standard.

Returns of 5% over inflation are not available in cash or bonds, so we are looking for companies that are profitable enough, and priced low enough, that we can reasonably expect those returns over time. We are focusing on our companies and how profitable they are; how well they are growing; how well they are managed; and whether they are currently selling for more or less than they are worth. What is the business worth? Can I buy it for less than that or sell it for more than that? How much less, how much more? Simple questions that don’t always have simple answers.

We are also paying attention to central banks, government policies and economies around the world because they set the terms by which our businesses have to operate. We have spoken and written extensively comparing investing to farming and how it helps to know the climate and the season you are operating in, and these macro factors determine the investing climate and season. These macro factors help us know what to plant and what is ripe and can be harvested. They determine whether our companies enjoy tail winds or face head winds as they run their business and provide the products and services consumers desire. Those same macro factors can also influence whether consumers have the desire and the ability to purchase those goods and services. In a free economy, the consumer is king and companies do well that benefit the consumer; so consumer incentives are important.

Today we observe that the market is a mixed bag; some companies are profitable and growing, some companies are not. Some companies are selling for much less than they are worth, some are selling for much more. We call that a stock picker’s market, and it’s where we like to live.

We observe that economies around the world are growing, although some are not growing as fast as they could. Some consumers around the world are OK; some are being squeezed. In general they are OK—not starving, but not necessarily thriving either—and we are on the lookout for policies that will make the consumers life easier, or harder.

We are finding enough companies that meet our criteria, and we think macro conditions are good enough, that we are fully invested in common stocks.

We continue to believe that emotional decisions are bad decisions. This is almost universally true, and clearly true for investing. We write these letters, hold our seminars, and publish booklets on various topics to help build an intellectual framework for investing and to counter the corrosive effects of the emotions that are so prevalent among investors. Please let us know how we are doing and if there is more we can do for you.

The comments made by Tony Muhlenkamp in this commentary are opinions and are not intended to be investment advice or a forecast of future events.

Refer to the SMA All-Cap Value Fact Sheet for the Top 20 Holdings and performance data as of the most recent quarter-end.

One cannot invest directly in an index.

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