Quarterly Letter, January 2021

By Ron Muhlenkamp, Founder and Jeff Muhlenkamp, Portfolio Manager

In September 2020 we wrote that we thought COVID-19 was in the process of burning itself out in Europe and the United States. We couldn’t have been more wrong. As you already know the virus came roaring back on both continents prompting renewed restrictions by governments. The distribution of the first vaccines began in mid-December but hasn’t made a difference yet. As we look at charts of case counts and deaths today, it appears the numbers are starting to decline, but you’ll forgive us if we refrain from making any predictions about what we expect will happen in the next few months having failed so miserably three months ago.

As we reflect on 2020 it is quite clear that three things really mattered for the economy and the financial markets. The first was the spread of the COVID-19 virus. The second was government actions to slow the spread of the virus, mostly restrictions and lockdowns. The third was government actions to mitigate the economic damage done by the restrictions and lockdowns: relief spending by legislatures and various forms of bond buying by the central banks. We don’t know if the restrictions and lockdowns altered the course of the virus to any great degree, we do know that very few medical systems were overwhelmed by COVID-19 cases, which is probably the critical point. To date, government payments to businesses and individuals plus central bank purchases of various bonds have prevented economic catastrophe. The bond markets, which had a tense few weeks in March-April, are now functioning normally and interest rates have come back down for even the least creditworthy borrowers. The stock market is setting new highs. Home prices are rising. Businesses are failing, but not so many as to impair the banking system.

So far so good. This remains a work in progress. We’ve read some reports recently that indicate actual occupancy in New York office buildings is only 15% of what it was in 2019. How long does that remain the case? At what point do tenants start renegotiating leases with landlords? How many landlords get caught between the fixed cost of their mortgage and the need to cut rents to keep their buildings mostly rented? How far will real estate values in cities like New York fall? How bad will the damage be to the lenders who hold the mortgages? What’s the impact on all the small businesses that supported those urban workers (restaurants, for example)? No one knows yet. Our research to date indicates that commercial and residential rents have fallen on the order of 20% in New York City, San Francisco, etc. We don’t know how far rents and by extension real estate values will decline because we don’t know how many of the workers will come back to the office and when that will happen. The range of possible outcomes is very wide.

That’s the picture in commercial real estate, there is similar uncertainty in retail. Online shopping exploded during March and April out of necessity – many local stores were closed and many shoppers were unwilling to venture out. Restaurants have been devastated by restrictions on their business and the lack of customers. To what extent are those changes permanent? Many brick and mortar stores were struggling prior to the pandemic and the industry was already grappling with excess store capacity, the government restrictions significantly exacerbated the problems. The restaurant industry was fine pre-pandemic but has been devastated since March. Again, the range of possible outcomes is very wide.

It’s been said that recessions serve to correct the excesses of the preceding boom. As we look at the economy, it’s seems to us we are now dealing with excess capacity in oil and gas production, retail real estate, and probably commercial real estate. Because real estate is often collateral for loans, problems in commercial and retail real estate could create problems for the banks and other institutions that lent money against the value of the properties. We’ve written before that we are wary of the banks for these reasons, and we will remain wary until the scope of the problem becomes clearer.

We continue to watch for inflation. Unlike 2008-2009 the money created by the Federal Reserve has not just been distributed by the banking system but has also been directly distributed by the Federal Government. Yes, we’ve seen “helicopter money” this time around and Congress and the President have been flying the choppers. The new money hasn’t been bottled up in the banks like it was during the 2008-2009 recession – sitting in their vaults and not being loaned out. This time we have sent it to citizens and businesses, and it’s been spent or saved. Will that difference create inflation this time? We don’t know. If we see a significant uptick in inflation it will, of course, hurt bond holders and put the Federal Reserve on the horns of a dilemma. The current low interest rates do not compensate investors for the risk of inflation, and we remain uninterested in bonds as a way to grow wealth. No change there.

During the summer we reduced our holdings in Apple and Microsoft, which had become quite large, as the price of those stocks exceeded our value estimates and momentum seemed to come out of them as well. We found a number of companies in the industrial and energy sectors that were selling at prices we liked and took the opportunity to invest there. We’ve been pleased with those purchases so far.

We continue to hold roughly 5% of our assets in gold or gold-related companies. One of the ways historically used by governments to deal with heavy debt loads has been to devalue their currency and we are concerned that our government will seek such a solution (officials will, of course, not say that out loud). We view the profligate spending by our government and the massive expansion of the Federal Reserve’s balance sheet as consistent with actions that would result in a devaluation of the dollar. We view our gold holdings as a hedge against that possibility.

That’s what we’re seeing, and that’s what we’re doing. Please forgive us if we’ve written a little more about the risks we see than the opportunities we are seizing. Frankly, it seems as if “the market” has forgotten the risks, which makes it more important for us to remember them. (Conversely, in March it seemed the market could see only risks and it was more important for us to focus on the opportunities.) In general the companies we hold are doing very well and selling for fair, or less than fair prices. We continue to focus on individual companies even as we are mindful of the environment in which they operate.

As always, if you’ve got questions, give us a call. We’d love to hear from you.

The comments made in this letter 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.