Quarterly Letter, October 2021

By Ron Muhlenkamp, Founder and Jeff Muhlenkamp, Portfolio Manager

In July we described at length the uncertainty that COVID-19 had introduced into the global economy. We called it “noise.” A summer wave of COVID hit a number of countries across the globe from Israel to Vietnam, including the United States, with the peak case count generally appearing in early September. The resurgent COVID slowed economic recovery and exacerbated the problems in global supply chains which had not fully recovered from the winter round of the illness and associated containment measures. While some shortages have been alleviated (lumber comes to mind) other shortages remain problematic (semiconductors for the auto industry, for example). Global transportation systems are still overwhelmed resulting in longer shipping times internationally and higher costs. Interestingly, late in the third quarter we began to see reports of energy shortages in a variety of countries: natural gas prices in Germany have more than tripled, there was a shortage of gasoline in England, power was curtailed to businesses in Northern China, etc. There is no single cause for the energy problems but it is interesting that they all cropped up simultaneously.

So the economic noise hasn’t abated. We didn’t really expect it would.

Shifting to inflation and interest rates: the August 31st U.S. CPI number was 5.25% higher than a year ago, indicating inflation of about 5%; well above the Federal Reserve’s target of 2%. The interest on the 10-year Treasury bond began the quarter at 1.48%, hit a low on August 3rd of 1.17%, and ended the quarter at 1.51%. While interest rates are little changed from the beginning of the quarter to the end, the upward movement in the 2nd half of the quarter coupled with higher than targeted inflation has market participants wondering if higher interest rates are coming. We don’t know, but it is worth mentioning that the Federal Reserve has shifted its stance on monetary policy and is now saying it will start reducing its bond purchases and may begin to consider raising short-term rates.

We have two thoughts on interest rates: First, we are not predicting higher rates, but we observe that the current interest rates are well below the rate of inflation, a situation we last saw in the 1970s. In that decade you could become wealthier via a bigger mortgage on a bigger house because mortgage rates were below the rate of inflation—you were being paid to borrow. Ron revisits that topic in a separate article in this quarter’s newsletter. Second, IF long term interest rates continue to rise, you should expect to see a decline in the value of existing bonds and downward pressure on the stock prices of high growth and high price to earnings (P/E) companies.

We also observe that corporate interest rates are very low, both on an absolute basis and relative to Treasuries, even for less creditworthy borrowers. There is currently no shortage of willing lenders.

Looking forward we expect the noise to remain with us for at least another quarter. COVID-19 is not done with us yet, though we think its economic impact will fade with time as vaccines and treatment options become more widespread. There are still a lot of exceptional measures in place both domestically and globally and while unwinding them may cause some disruption we continue to expect modest economic growth.

During the 3rd quarter, the portfolios we manage declined by generally two to three percent. We sold our holdings in Biogen as it became increasingly apparent to us that their new Alzheimer’s drug was unlikely to be a blockbuster. Our holdings in Biogen achieved a roughly 30% gain over the five years we held the stock, which was somewhat disappointing. Also during the quarter we initiated a small position in a Real Estate Investment Trust (REIT) that is selling for the cash on the balance sheet. The REIT management team has a very good track record of finding value and we expect to see a good return on our investment. Otherwise our holdings remain largely unchanged.

With our best wishes for your continued success and good health.

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.