Value Investing

Muhlenkamp Memorandum For Q1 2015

Muhlenkamp Memorandum for the first quarter 2015.

Effects of Currency Manipulation by Jeff Muhlenkamp

At our November 12, 2014 investment seminar, I stated that the devaluation of the Japanese yen may prompt other export-reliant countries to devalue their currencies in turn as they try to keep their exports competitive. A listener asked me later what the impact of such competitive devaluation would be. In short, it would squeeze consumers in the countries that successfully devalue their currency. Let me explain how I arrived at that conclusion.

First an important point: when you talk about devaluing, you have to devalue against something else—it is always relative. So you can devalue the dollar against the yen, the Euro against the dollar, or the won against the yen… but you can’t just devalue the dollar. Since the U.S. dollar is the closest thing the world has to a global currency and most commodities are priced in dollars, most countries try to devalue against it. So let’s say Country X is interested in growing its economy and employing more of its population by increasing its exports. In order for their export products to be more competitive internationally, they choose to lower the price. Reducing the selling price without reducing the production cost will put their companies out of business, so Country X must also reduce the cost of inputs—typically mostly labor. Workers generally don’t like wage cuts very much, so another way to achieve a lower selling price is to manipulate the exchange rate. If the exchange rate falls the international price of the country’s exports will drop, but worker’s wages will remain unchanged (measured in the currency of Country X). Everyone wins! To execute this plan the central bank prints money and lowers interest rates. (If their exchange rate is pegged, they lower the peg over time.) This combination usually results in a lower exchange rate; i.e. more of Country X’s currency equals the same amount of U.S. dollars. Country X’s products are cheaper internationally, sales go up, more citizens are employed, etc.

But did everybody really win?

No. Because the exchange rate declined, anything County X imports is more expensive than it had been. Devaluing Country X’s currency benefits the exporter (a business with employees) and hurts the importer (another business with employees), along with anyone in Country X who buys imported goods. What really became cheaper from an international perspective is the cost of labor in Country X. Since Country X’s labor got cheaper, there is more demand for it and employment goes up. Who benefitted? Consumers outside Country X that buy Country X products at a lower price and newly hired employees inside Country X. Who paid the price? Country X’s workers who received less compensation for their labor than they otherwise would have, Country X consumers who pay more for imported goods, and the workers outside Country X who lost their job to cheaper labor in Country X. Everyone can’t win, there are always those who benefit and those who are hurt. There is no free lunch.

Growth through exports aided by a cheap currency is called mercantilism. Mercantilism has been tried by a lot of countries, often with a fair degree of success in the short- to medium-term. Japan did it coming out of World War II. You could buy cheap Japanese cars in the U.S. in the ‘70s because Japanese workers and engineers worked cheaper than their American counterparts, and the exchange rate was a big part of that. China has done it for the last 20 years: they pegged their currency at an artificially low level, so their products were cheap, and cheap Chinese labor attracted a lot of industry to their shores starting with the really labor-intensive stuff like making clothing and assembling electronics.

This method of growth requires at least the tacit cooperation of the foreign trading partners. Generally, after a time, mercantilism reaches its limit and other means of growth are necessary. Notice that the Japanese yen in the 1970s traded at 300yen/dollar; now, it is about 110yen/dollar. Depreciation against the dollar gave way to appreciation against the dollar. The Chinese renminbi is similar. You may recall during the 2008-09 recession there were loud calls in America for China to quit manipulating its currency and allow it to appreciate. America became more interested in the welfare of its exporting workers than its importing consumers and tolerance for a cheap renminbi declined.

Today, Japan is very interested in devaluing its currency against all other world currencies and is printing money at a fantastic rate to do that. Their goal is to spur economic growth through exports. Their problem is they import most of their raw materials and energy. Their exporting companies will benefit, but their consumers will see costs go up. There is both a benefit, and a cost—you never get one without the other.

There are several other countries whose governments are interested in economic growth via exports, including Korea, China, and Germany. Highly engineered German and Korean capital goods compete directly with Japanese capital goods. As Japanese products get cheaper, they should sell more of them—at the expense of their global competitors. Those competitors may decide to fight back, in part, by printing money and lowering their interest rates; i.e. devalue their currency! (against the dollar). Now you have multiple countries simultaneously trying to devalue their currencies in order to maintain market share in their export markets and thus keep their citizens employed.

Why is that so bad?

Remember that Country X’s worker was hurt as he received lower compensation than he otherwise would have. Country X’s consumer of imported goods was also hurt as import prices rose. Often, currency devaluations are accompanied by domestic inflation (which is a stated goal of Japan’s central bank). Inflation hurts the saver and benefits the borrower. Sum that all up and what do we get?

  • If Japan, Korea, Europe, and China simultaneously try to devalue their currencies it only has a hope of working if the U.S. doesn’t join in. (The U.S. must tacitly allow them to devalue against the dollar.) This implies a strong dollar and lower commodity prices (measured in dollars).
  • Who benefits? The only clear beneficiary is the U.S. consumer of imported goods. Japanese, Korean, European, and Chinese exporters don’t gain market share, they only succeed in holding what they had. If there is

The Healthcare Industry and the Consumer by Anthony Muhlenkamp

The headline topic for our November 12, 2014 investment seminar was “Game Changers in Biomedical Science” delivered by Tammy Neff, an analyst on our investment team. She has written about the topic in Muhlenkamp Memorandum #112, and in a booklet that we can mail you or that you can download from our website, but I would like to highlight an element from her talk that I found particularly interesting. What are the effects the consumer is having on the healthcare field; and what are the effects that the advances in biomedical science are having on the consumer?

Today, on a per-person basis, $.22 of every dollar spent in this country goes to healthcare. This average includes the money that you pay out-of-pocket, along with benefits paid on your behalf by your healthcare insurer. It encompasses doctor visits, hospital stays, lab testing, medications, outpatient physical therapy, etc.—and it’s the “biggest piece of the pie” of total consumer spending. Comparing apples-to-apples, 11% of all consumer spending went to healthcare in 1980. Stepping back even further, healthcare spending averaged 6% in 1960.1 So, starting in 1960, we nearly doubled what we spent on healthcare by 1980—and we doubled it again from 1980 to 2013.

Some argue this is a bad thing and conclude that healthcare costs are too high. We think it’s indicative of people being more prosperous than they were and not having to spend it all on food, clothing, and shelter. Despite best efforts, there appears to be a limit to what people can eat, and how much house and clothes people need. So spending on health care is a rational next priority.

Today, over $130 billion is invested annually in biomedical research2 and consumers are benefitting. If you were born in 1900, the average life expectancy was about 47 years; in 2012, it’s about 78 years.3

We think the significant increase in consumer spending on healthcare over the last 54 years results from a combination of:

  1. Continuous Innovation: For example, in the 1960s, open-heart surgery was perfected. In the 1970s, we gained MRI technology, enabling less invasive, more precise diagnoses. Today, there is genetic-based testing and precision treatment for cancerous cells.
  2. Aging Baby Boomers: As the U.S. population ages, consumers demand more services like hip and knee replacements.
  3. Expanded Insurance Coverage: 1966 brought us Medicare, providing healthcare coverage for Americans ages 65 and older. 2010 brought us the Patient Protection and Affordable Care Act, providing millions of Americans access to health insurance coverage. Additionally, in the ‘60s, health insurance predominantly covered hospital stays and surgical procedures. Insurance coverage now includes outpatient care, physical therapy, chiropractic care, medications, artificial limbs, etc.

We have often observed that in a free economy the consumer is king, and that any product or service that has direct and measurable benefits to the consumer is likely to have legs. The advances in the field of biomedical science is an area that may well fit that description. More and more people seem to be receptive to the idea of “living long enough to live forever,” and that can be a powerful trend.

With that in mind, we focus on those companies that we think will ultimately provide cost savings to the healthcare system, and the consumer, through the following game changers:

  • Transforming the model of healthcare from disease management to disease prevention through personalized medicine;
  • Rethinking the approach to the war on cancer; and
  • Curing diseases that were previously life-long conditions.

To learn more, please visit the seminar archive on our website, or call to request the DVD.

See full  Muhlenkamp memorandum below.

Muhlenkamp Memorandum For Q1 2015

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