Quarterly Letter, January 2017

By Ron Muhlenkamp and Jeff Muhlenkamp, Portfolio Managers

2016 was a disappointing year for us as our accounts, on average, lost about 3.56% of their value over the course of the year (individual performance varies by account), while the S&P 500* gained 11.96%—both figures include reinvestment of income. The obvious question is “Why the underperformance relative to your benchmark?” The short answer is that we didn’t own enough of the best performing sectors in the market: energy, financials, and industrials and we owned too much of the worst performing sector in the market: health care.

Low crude oil prices in January and February gave us an opportunity to buy energy companies cheap, and we did. In retrospect we should’ve bought more as crude oil prices have nearly doubled off of the bottom and energy stocks have been the market’s best performers this year. In a similar manner our energy holdings have been our best performers this year.

Last year and early this year, we deliberately reduced our positions in companies that are sensitive to the business cycle which includes industrial and financial companies as prices fully reflected the value we saw in those companies and our expectations for business performance during the current economic expansion. The market turned a cold shoulder to those companies through March, but warmed up to them in the spring and summer and fully embraced them postelection. Industrials and Financials have been the best performing stocks in the last two months. They didn’t get cheap enough for us to buy into them earlier in the year and so we didn’t participate in their outperformance late in the year.

Health care stocks have been declining for over a year and we found some great companies at low prices throughout the year. Unfortunately, the market has yet to agree with us on our assessment of these companies and their stock prices have continued to lag the market. We don’t expect that to last forever and believe we are best served by waiting for the market to come around to our point of view. This year, however, that attitude has not been profitable.

Throughout the year our technology companies have done quite well both in terms of company performance and stock price appreciation.

So in summary, this year we zigged and the market zagged—as a result we look pretty dumb. That doesn’t mean we’ve changed our approach to investing: we haven’t. We continue to invest in companies that are selling for less than we think they are worth, and sell them when the market price fully reflects that value. We continue to believe that, on average, doing so will produce satisfactory investing results. This year it did not.

Continuing to look in the rear view mirror, we saw ongoing slow economic growth both in the U.S. and internationally and a continuation of unprecedented central bank** intervention in both the European Union and Japan. U.S. companies, in aggregate, reported declining revenues and earnings during the first two quarters of the year with growth in both measures returning in the third quarter. They haven’t reported the fourth quarter yet. Interest rates declined from January through July, with the benchmark 10-Year U.S. Treasury yield going from 2.2% in Jan to 1.4% in early July then rising to 2.6% or so by year end. As a reminder, bond prices move inversely to yields, so bonds had a good first half of the year and a poor second half. Politics were also responsible for some big market moves with the Brexit referendum in the United Kingdom driving the pound sterling to record lows and the election in the United States spurring an impressive rally in the U.S. equity markets.

Looking forward, we see no reason to expect a near-term resolution to many of the global risks we’ve been watching: European banking problems and existential threats to the European Union; massive debt and economic stagnation in Japan; and massive debt and slowing growth in China. Each of those regions could spark a global financial crisis of some sort and we’ll continue to keep an eye on them.

The U.S., however, has changed a little bit—you may have noticed. The U.S. voter opted for change and installed a Republican majority in the Senate and a fairly unique Republican in the White House. We think many (but not all) of the changes suggested by the newly elected politicians should result in stronger economic growth in the long run but implementation will matter and it will take some time to put the new rules, once they’re actually written, in place. So we are much more optimistic about the long-term direction of the economy than we were a few months ago, but we don’t expect an immediate impact to the economy from changing policies, regulations, and laws—there will be a lag. The market, however, shifted in less than thirty days from anticipating a Democratic agenda to anticipating a Republican agenda. In the process it may have gotten a little bit ahead of itself. As noted above, interest rates have been on the rise since July with the election in November and the Federal Reserve rate hike in December adding to the ongoing move. Historically, long-term interest rates have been about 3% above inflation, so we view a further movement higher in rates as simply a return to “normal” conditions. A return to normal will not necessarily be painless, however, and we’ll keep a close eye on default rates and credit spreads*** if rates continue to rise. Rising interest rates in the U.S. while the rest of the world keeps their interest rates abnormally low also creates the conditions conducive to a strong dollar, which we have been observing the last few months already. A strong dollar of course is beneficial for the U.S. consumer buying imported goods and a headwind to the U.S. producers selling overseas or owning overseas assets. It also encourages overseas investors to buy investable assets in the U.S. for as long as it continues since they’ll get the asset return plus a positive currency return. Full employment and rebounding commodity prices put inflation risks back on the table, so we’re keeping an eye out for higher inflation as well.

We believe the stock market in general is fairly priced and good companies at cheap prices are few and far between. When we find them, we’ll invest appropriately. Until we find them, we’ll continue to be patient with our cash. We remain uninterested in bonds as they are still priced above what we view as “fair” relative to current inflation and will decline even more if inflation picks up. Conversely they will likely do well if a financial crisis brews up and investors rotate from stocks to Treasury bonds in search of safety. We believe the long-term decline in interest rates has pretty well come to an end which implies the long running bond bull market has also ended. Few bond investors can remember a time when interest rates weren’t generally falling and they are susceptible to thinking bonds are “safe” when we would argue that is no longer true.

With our best wishes for the New Year,

The comments made 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.

Earnings growth is not representative of an investment’s future performance.

*S&P 500 Index is a widely recognized, unmanaged index of common stock prices The S&P 500 Index is weighted by market
value and its performance is thought to be representative of the stock market as a whole. One cannot invest directly in an index.

**Central Bank is the entity responsible for overseeing the monetary system for a nation (or group of nations). The central banking system in the U.S. is known as the Federal Reserve (commonly referred to “the Fed”), composed of twelve regional Federal Reserve Banks located in major cities throughout the country. The main tasks of the Fed are to supervise and regulate banks, implement monetary policy by buying and selling U.S. Treasury bonds, and steer interest rates.

***Credit spreads refer to the difference in the number of percentage points or basis points in yield. The level of risk correlates with the
potential for returns.

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