Quarterly Letter, January 2020

By Ron Muhlenkamp, Founder and Jeff Muhlenkamp, Portfolio Manager

In round numbers, the S&P 500 Index had a total return of 31% in 2019, the Russell 3000 rose 30%, the Dow Jones Industrial Average rose 25%, and our accounts increased by about 14%. (Individual performance varies by account, see your annual statement.) Why the difference? While recognizing the limitations of all generalizations, we would argue that there are two categories of companies that the market continues to award a premium to: very safe, defensive companies (think utilities and Real Estate Investment Trusts) and disruptive or high-growth companies (examples include Amazon, Tesla, and Mastercard). We own little of either category, so the market is bidding up stocks we mostly don’t own. We remain interested primarily in profitability over the longer term and the price at which we can buy it while the market appears to be less concerned than we are about profitability and pretty price insensitive for popular companies. We expect eventually the market will come back to our way of thinking, but it sure didn’t in 2019. On an absolute basis we had a good year, on a relative basis we did not.

Looking back over 2019 only two things really mattered much to the economy of all the things that hit the headlines: tariffs and the Federal Reserve. The imposition of tariffs on imported goods forced a re-evaluation of a lot of supply chains and was a headwind for businesses. The Fed reversed the direction of policy in January: shifting from raising rates and reducing their balance sheet to lowering rates and expanding their balance sheet. This avoided a problem: when the Fed is raising rates and pulling money out of the economy by shrinking the balance sheet, sooner or later highly indebted companies have a problem rolling over their debt. This is the concern we voiced over two years ago when they began this “tightening.” Now that they’ve reversed themselves our longstanding concern is deferred to a later date to be replaced by worries that higher inflation is now more likely. There is no free lunch. On average, the economy continued to grow at a modest pace, but if you look at it by sector the results were mixed. Housing improved, but industrial production declined. Energy was weak due to low oil prices, retail was a mixed bag, etc. Inflation remained low. Unemployment continued its downtrend and median wages picked up. We spoke on a number of occasions during the year about the areas where we see warning signs and areas that look pretty good. It’s been a mixed bag all year and remains so at year end.

Looking forward, what do we expect? We think the point of maximum uncertainty in trade rules is behind us and businesses will stop postponing strategic decisions. If inflation remains low, the Fed will keep short-term interest rates low and market-based long-term interest would also stay low. Rising inflation would be a problem for stock and bond markets and force some hard decisions on the Fed—we have no strong opinion on the direction of inflation in 2020. We’ll be watching measures of industrial activity closely, a further or extended decline would be worrisome. We will also watch credit metrics closely—they look pretty good right now. Our baseline is for continued moderate economic growth in the U.S. and we’ll let you know if we are seeing signs of a further slowdown or acceleration.

The bull market in stocks has run for a decade now and there are portions of the market that look expensive to us. Safety, disruption, and high growth are all attributes of companies that have been bid up. Momentum seems to have legs in this market as well, perhaps because of the increased use of market-cap-weighted Exchange Traded Funds. As our holdings become fairly valued, we’ll pay more attention to the price trend, selling when it appears to be rolling over. We continue to hunt for the underappreciated and thus cheap stocks and will buy them when we find them.

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.