Quarterly Letter, October 2015

By Ron Muhlenkamp, Portfolio Manager and Jeff Muhlenkamp, Investment Analyst and Co-Manager

The domestic quiet we wrote about in June did not last very long. Between August 17 and August 25 the S&P 500 Index dropped 11%. The S&P 500 Index bounced back about 4% and, as of September 30, it is down 6.4% for the quarter. For the year, the S&P 500 Index is down 5.3%. Our accounts are down approximately 9% for the quarter-to-date and 7% year-to-date.

During the conference call we held on August 27 we were asked what caused the market to drop in August. The short answer is we don’t know for sure. The market drop followed a Chinese currency devaluation by a couple of days—was that the cause? Perhaps, but our opinion remains that 10% corrections can occur at any time and for any reason—or no reason. We can’t predict them and haven’t found anyone who reliably can. Nor do we find much value in trying to determine attribution after the fact. We think the more pertinent question is was the August correction the start of something bigger? That’s the question we are spending our time on.

We won’t spend as much time going around the world as we have in the past—you’ve heard much of this before and none of the problems have been solved. Europe is digesting the fallout from the VW scandal, which has driven Greek elections and Central Bank quantitative easing out of the headlines. Japan is quiet. As we expected, the Chinese were unable to prevent the continued selloff of their stocks, though they appear to have slowed the decline. The Chinese economy is growing more slowly than expected, which is not new.

The pain in many commodities has now become acute. Looking at the globe broadly, we are now in the “bust” phase of a boom—bust commodity cycle. The specific reasons differ a little bit by commodity, but everything from energy to metals to grains are oversupplied which has driven prices down dramatically. Brazil is feeling the pain of the bust as their currency falls against the dollar, their debt is downgraded, and they remain stuck in a recession. Several U.S. coal companies have gone bankrupt as have a small number of small U.S. oil and gas producers. Steel prices have plummeted, affecting steel producers and processors. Offshore drilling rigs that come off contract are unable to find new work, and sales of Deere and Caterpillar machinery are down as farmers and construction companies reduce their capital expenditures. Profitability in the commodity businesses will not improve until supply falls or growth in demand catches up with supply. It could be a while.

The impact to the U.S. is not confined to companies in the commodity business or their immediate suppliers. With the drop in commodity prices has come a stronger dollar which hits the revenues and earnings of most companies that sell overseas. We expect to hear more detail about that during the upcoming earnings reporting period. Last quarter, aggregate revenues declined by 3% and earnings increased less than 1%. We believe companies’ ability to engineer earnings growth in the absence of revenue growth via cost cutting and other methods is about done. Consensus estimates for 2016 earnings growth are 15%—far too high for the growth we expect to see in the U.S. We think those estimates will come down and are concerned about the ability of the market to remain at its current level in the absence of earnings growth. This is why we are selectively harvesting investments and holding a healthy amount of cash.

The Federal Reserve Bank at their September meeting decided not to raise short-term rates again. Ron likes to put it this way: “They keep doing more of the same because it hasn’t worked.” Sounds pretty close to the definition of insanity. As a result, real (inflation adjusted) Treasury Note rates out to about three years are still negative; holders of those notes are losing purchasing power over time. Or, to put it more plainly, savers are still getting killed. Which is why we still don’t like bonds.

We remain confident that buying good companies at a discount and selling them at a premium is a great way to grow wealth over time. We are comfortable holding cash when those opportunities are not immediately present, knowing that if we are patient and continue to look diligently bargains will come our way.

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.

The S&P 500 Index is a widely recognized 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.

Earnings growth is not a measure of future performance.

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