Quarterly Letter, January 2016

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

In the fourth quarter, the S&P 500 Index was up a bit over 7% and up 1.38% for the year. Our accounts, on average, were up 3.52% in the quarter and down 5.03% for the year. (Individual performance varies by account.) The gains for the broader Index in the quarter were mostly made by a small number of large capitalization tech stocks, Facebook, Amazon, Netflix, Google, and Microsoft among them. Since only one of those companies is found in our portfolios we did not participate in the “bounce” nearly to the extent that the S&P 500 Index did. While we are not pleased with our relative underperformance in the last 90 days, we feel no urge to chase those stocks that are running and, frankly, the limited number of stocks that has participated in the upward move gives us pause.

Last quarter we highlighted that aggregate second quarter earnings and revenues for U.S. companies were actually down year over year (y/y). That sad state of affairs continued when third quarter earnings were reported with revenues down 4% y/y in the aggregate and earnings down 3% y/y. Continued low energy and commodity prices, coupled with a strong dollar, hit the energy, materials, and industrial sectors particularly hard with a number of bankruptcies in the coal industry and among the small oil and gas producers.

Several years ago we warned about the risks of searching for yield in a low interest rate world. Two of those risks manifested themselves in the fourth quarter. First, two high-yield bond funds closed their doors and stopped allowing redemptions so they could realize the best value of their remaining illiquid assets. Second, Master Limited Partnerships (MLPs) have begun cutting dividends. MLPs became popular yield investments over the last few years attracting lots of money. Many of the MLPs relied on cheap equity capital to fund their growth plans even as they paid out most of their free cash flow; that game is over, as their share prices have fallen dramatically. Kinder Morgan (the largest pipeline operator in the U.S. and an MLP up until early 2015) finally recognized that model no longer worked and cut their dividend 75% in December.

The Federal Reserve finally raised the Federal Funds Rate one-quarter of 1% in December after declining to do so in June and September. As we’ve said many times before, artificially low rates are bad for the economy in the long run. The small increase in U.S. interest rates will likely help reinforce the strong dollar as both the European and Japanese central banks continue to keep their rates at zero (or negative) and execute their own quantitative easing (QE)programs.

In summary, here are the main things we are seeing:

• The ability of U.S. companies to grow earnings without growing revenues is waning.
• The strong dollar makes it incrementally more difficult to grow revenues. We see no reason for a weakening of the dollar in the near term.
• Low energy and other commodity prices are wreaking havoc in the U.S. energy sector and related industrial companies. This is having follow-on effects in the bond market, which are concerning. (The spread between junk bonds and government debt is widening. This implies that investors are increasingly worried about getting their money back from all but the most solid companies and are charging a higher interest rate to lend to lower quality companies than they had been.)
• Low energy prices benefit the consumer, but the windfall is not being spent on consumer goods; in fact, a number of retail companies reported very disappointing third quarter earnings and have been hit hard in the market as a result.

We continue to believe that stocks are fairly priced, on average. As previously discussed, we have sold those companies which had met our estimate of fair value, but have been patient putting the cash back to work. We are not yet finding the values we seek. We’ll let you know when we do.

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.

Free Cash Flow represents the cash a company is able to generate after paying out the money required to maintain or expand its business.