Muhlenkamp & Company’s All-Cap Value SMA conference call transcript for the month of September 2016.
Muhlenkamp & Company’s All-Cap Value SMA (Separately Managed Account) is designed for investors’ accounts over $100,000. We employ full discretion, applying fundamental analysis.
We seek to maximize total after-tax return through capital appreciation, and income from dividends and interest, consistent with reasonable risk.
We invest in undervalued assets wherever they may be found. Typically, this results in holding a portfolio of companies we believe are materially undervalued by the market. Bonds may be included in the portfolio if they are a good investment.
We start with a bottom-up scan of domestic companies, typically looking at most U.S. companies at least four times per year. We add to that an understanding of the sector dynamics in which companies are operating, an assessment of the business cycle, and a review of macroeconomic conditions.
Our primary screening metric is return on shareholder equity (ROE). We are looking for companies with stable returns that can be purchased cheaply, or for companies with improving returns that have not yet been recognized by the market.
We don’t believe that a holding period of “forever” is appropriate in all cases, but are comfortable holding companies as long as they continue to meet expectations.
We define investment risk as the probability of losing purchasing power over long periods of time, which is quite different from Wall Street’s definition of price volatility in very short periods of time. Taxes, inflation, and spending will ALL impact the purchasing power of your assets.
Muhlenkamp & Company Conference Call Transcript
Tony Muhlenkamp: Good afternoon, everyone. We appreciate you joining us. Our goal for this conference call is to share our thoughts and observations about current market conditions and how that translates into the decisions we make regarding the portfolios we manage for clients and shareholders. While that’s usually a wide-ranging conversation, we may not address all your questions or topics. If so, please call us or email us after the call; we’d be delighted to talk with you. With that said, let me introduce the two speakers, portfolio manager Ron Muhlenkamp and comanager Jeff Muhlenkamp. Let’s begin the conversation with Jeff.
Jeff Muhlenkamp: Welcome everybody. I thought we’d start, as we often do, with the big picture and work our way down to narrower and narrower subjects.
When you look around the globe and start with the economy, economies around the globe are generally still pretty slow. Europe is at less than 1% real GDP1 growth. The United States, for the first half of the year, has averaged about 1% real GDP growth. China is slowing down from 7-8% growth, which it had done a couple of years ago, to now, 5-6% at best, depending on the numbers you want to look at. Japan is flat at about no growth.2 The emerging markets are somewhere between growing decently and, in Brazil’s case, in a deep recession.
Central banks3, in response, the big ones, the ones that most concern us, are goosing economies for all they are worth. They are doing that by keeping interest rates very low. In the case of Europe and Japan, interest rates remain negative—that is, they are pushing short-term interest rates down, so that it is a negative nominal value.
They [central banks] are also buying assets. The European Central Bank (ECB) continues to buy both government and corporate bonds. In fact, some European corporations are intentionally front-running the ECB, they are crafting bonds that specifically meet its requirements, so they have been bought up in that fashion. The United Kingdom, after the Brexit vote that happened in late June, had decided to push interest rates down and to start up its bondbuying program; so they, too, have joined the QE (Quantitative Easing)4 crowd. Japan’s central bank continues to keep nominal rates negative and to buy government bonds and Japanese ETFs (Exchange-Traded Funds).5 So, Bank of Japan is accumulating equities of Japanese companies, as well.
Ron Muhlenkamp: Just to give you an indication of how large this has become, there are $12 trillion in sovereign (government) bonds that now have a negative interest rate. Among Japan, Europe, and the United States, the central banks have bought $25 trillion of bonds and stocks. Just as a comparison, the total value of the S&P 500 Index6 in the U.S. is about $20 trillion, so these have been major sizes of assets bought up by the central banks.
Jeff Muhlenkamp: The effect on folks overseas…The goal of the central banks, their stated goal, has been to inspire growth. That’s not really happening. Certainly it’s driven down the interest rates that countries are paying, so it has helped the likes of Spain and Greece to afford their debt and roll over their debt as necessary. It’s also driving savers to buy things like safes. We have seen news articles from Japan, and now Germany, that safe sales are going up as individual savers are more interested in holding cash in their basement than they are in holding cash in the banks. The reason they want to do that is that the banks are getting squeezed. So, as the net interest margin (the difference between the rate at which a bank borrows and the rate at which it lends) shrinks, the banks are trying to pass their costs on to their customers. In many cases, those are retail consumers. To the extent that they can do that, the banks will continue to be profitable. To the extent that the retail customer pulls money out and keeps it in a safe, the bank will be unprofitable. So we are seeing a squeeze internationally on banks—and also on insurers, which are large buyers of bonds that, historically, match their liabilities quite nicely. Insurers are also getting squeezed by the negative rates.
Shifting now to the U.S. economy…The U.S. economy at the end of last year, last fall, the industrial portion of the economy took a step down. When we spoke with you at that time, we argued that the industrial portion of our economy was largely in a recession. Frankly, that remains true. The companies in that portion of the economy have not seen an improvement, nor a degradation, in the activity of their business.
Ron, please talk about how the consumer is doing vis-a-vis the industrials.
Ron Muhlenkamp: The consumer [economy] has growth, but low growth: we’re seeing 0-2%. We’ve gone about six years where the estimates coming in each year were 3%-plus growth and each year it has been less than 2 percent.
As Jeff mentioned earlier, for the first six months of this year, U.S. GDP has been growing about 1% real (net of inflation). Looking at the consumer economy, it still looks as if we’re growing at a modest rate: we are seeing 0-2 percent.
If you look at the industrial economy, frankly, it looks as if we’re in a recession. Businesses are still not hiring people in large measure, and they certainly are not expanding capacity because they are told that economic growth going forward is going to be 1-2%, the “new normal”—and for that you don’t need to build a new plant.
Jeff Muhlenkamp: In fact, capital goods spending by businesses is negative.
Ron Muhlenkamp: And productivity has gone to 0%, which is the output per capita.
Jeff Muhlenkamp: So that is what we’re seeing with the economy.
The market reaction to that…There were three things going on at the beginning of this year:
- You had the step-down in the industrial portion of the economy;
- You had a strong U.S. dollar and the Chinese renminbi devalue against it; and
- You had declining crude oil prices.
So, right out of the gate, you saw U.S. markets sell off into late February. The Federal Reserve (Fed) at that time was saying it was still interested in raising interest rates. Two things happened in late February that reversed the dynamics. The first is that the Fed indicated, ‘Gee, maybe we won’t raise rates after all.’ The second is that commodities, specifically crude oil, found a [price] bottom. So, from late February, what you saw was high-yield bonds’ spreads over Treasuries—which had gone very wide—so, high-yield bonds were selling off. Those started to come in and the markets started to correct. What you had was a 10% correction, where there was a bottom of crude oil prices at about $26 per barrel. By the middle of June, oil prices were back to around $45 or $50 [per barrel], and the stock market had recovered the losses it had experienced going into February. That is the story of what happened in the first half of the year.
What did really well the first half of the year—if you had bought into commodity-oriented stocks at the bottom in February—you did very nicely coming out of that. In fact, energy is one of the best sectors this year, to date.
In late June, the U.K. held a vote amongst their people (‘should we stay or should we go?’). Contrary to conventional wisdom, British citizens voted themselves out of the European Union. As a result, both the European markets and the U.S. stock markets went down pretty hard in early July, down about 6-7 percent. You also saw a rally in the bond markets—a big rally in the English bond market. And you saw a big rally in the U.S., such that, by the middle of July, our bond market was at an all-time high and Treasury yields were at an all-time low. The equity markets recovered very rapidly, gaining 5 or 6%, and they were at an all-time high. That’s pretty unusual that you have both the bond market and the stock market at record highs at the same time. Then, August was pretty flat.
What did well for you in that portion of the year were bond equivalents:7 telecoms did quite well in that portion of the year; utilities did quite well in that portion of the year. We think that in February the markets were about halfway priced in a recession and, then, changed their mind—but the economy hasn’t really changed underneath it.
As we’ve listened to companies’ conference calls this year, in both the first and second quarters, this is what has come through:
- Companies are not spending money;
- Revenues, in general, aren’t growing; in fact, year-over-year revenues have declined for five quarters now; and
- Overall, earnings aren’t growing; on a year-over-year basis, earrings have declined, now, for four quarters.
So you don’t see a great business environment, which was impacted to a fair extent by energy—also impacted to a fair extent by the strong dollar. Big, international companies that had significant sales overseas, when translated back into U.S. dollars, sales were lower; companies would quantify the impact to their revenues, usually around the 5-6% mark.
Those were the things that were impeding revenue and earnings growth for the first half of the year. We’re not sure they will improve all that much going forward. The strong dollar has abated a bit. Whether it will stay where it’s at, we don’t know. Frankly, it probably has a lot to do with what the Fed does, in terms of raising interest rates later on this year. It certainly has a lot to do with what other central banks do as well.
What has done really well this year have been the telecoms, utilities, energy, and materials: two of those did well because they were bond substitutes: two of those did well because commodities hit a bottom in February and bounced quite nicely. What hasn’t done very well in the markets this year, the laggards, if you will, from a sector perspective are the banks and healthcare. The banks, we think, are doing poorly, for two reasons:
- Earnings are getting squeezed by low interest rates; this has been ongoing now for four or five years. It’s exacerbated by additional regulations; banks are not allowed to make as much money as they were before. Banks are forced to hold more equity; they are not as profitable on a return-on-equity basis, as they were before.
- To a degree, the credit side was rolling over…So, again, as oil prices were running down late last year, you had a lot of defaults from energy-related companies, or the threat of defaults from energy-related companies. The market response to that was that it wasn’t interested in paying up for banks and, frankly, still isn’t.
In my opinion, banks continue to be uninteresting because of their exposure to international banks. As international banks are squeezed by their own central banks and their own negative rates, there is the risk that there is a linkage between, for instance Deutsche Bank or Commerzbank in Germany and Morgan Stanley or JP Morgan here in the United States. Whether that is “counterparty risk” I’m not quite sure, but I think it’s there and I’m hesitant to go fishing just now into financials.
Healthcare has not done well either. Healthcare had run up quite nicely starting about 2½ years ago, primarily the biotech sector. It ran down and has been running down for about a year. Most recently, it has been hit by a whole lot of headlines as politicians find it productive for their own purposes to go and bash companies and talk about pricing and how they would fix pricing, etc. Surely, you’ve had some bad actors and Valeant is one of them in the healthcare sector. The problems at Valeant affected not only that company, but anything that looked or smelled like that company. We took advantage of that earlier in the spring and that worked out pretty well for us, but the concerns about drug pricing are also affecting anybody else that sells the drugs. So, if you are getting a good return on your drug, the risk is that you won’t get that going forward, and we think that’s hit the healthcare sector so far this year.
Ron, what would you like to add?
Ron Muhlenkamp: Thanks, Jeff.
We continue to find very good companies, but, as Jeff mentioned, sales have been flat-to-down for the last year. Earnings have been down a bit, so you are getting a squeeze on return on shareholder equity (ROE).8 Those of you who have listened to us for a long time know that ROE has averaged about 13% since World War II; it’s now getting squeezed down to 12 percent. Banks, incidentally, are at 10% ROE. Banks have become utilities, where the amount they can earn is being regulated, much as it was in the past.
With the push toward yield,9 utilities have steady dividends and people count on that. Utilities, which have about a 10% ROE, are now selling at 20 times earnings. Microsoft is yielding as much as most utilities. The difference is the dividend for an average utility company is about 80% of earnings. Microsoft has a similar dividend yield, but it’s about 50% of earnings. I commented on Closing Bell on CNBC last night that we view Microsoft as a bond substitute.
Jeff said we own no financials. We also own no bonds because our Federal Reserve has pretty much said that they are not going to negative interest rates—they are talking about raising them. When you raise interest rates, bond prices go down. We think bonds are overpriced from an economic point of view—they have been pushed to these levels by central banks buying in bonds. It looks like our central bank (Federal Reserve) is beginning to back away from that.
Japan and Europe … Japan has been trying to goose its economy for 20 years by government spending, and now by its central bank (Bank of Japan) buying bonds. It hasn’t worked—but they are still trying to do it. Europe is trying to do it… We’ve flirted with it. And, regarding negative interest rates, Stanley Fischer, Vice Chairman of the Federal Reserve, recently commented “We’re in a world where they seem to work,” noting that while negative rates are “difficult to deal with” for savers, they typically “go along with quite decent equity prices.”10 Well, as Jeff pointed out, negative interest rates have not helped the European economy or the Japanese economy—it has helped our markets because it’s driving money from their bonds and, in some cases, their stocks, to our markets. So we (U.S.) have benefitted from them doing it, but our Fed has pretty much said that they won’t [move to negative interest rates], so we own no bonds and we own no financials.
We do own some technology companies, and we do own some drug stocks because they [the companies we own] are curing things. Ten years ago, AIDS was a death sentence; now it’s a managed disease. Five years ago, Hepatitis C was a managed disease; now we have a cure. Are these medicines expensive? Yes—and it has become popular to beat up on the drug companies because of this. But, because of what they are doing, we own a fair amount of healthcare-related companies.
We don’t own cyclicals. As Jeff said earlier, the cyclical part of our economy is in a recession. The cyclical part of the Chinese economy, which we said for four or five years was driving the cyclical part of the world economy, is slowing down big time.
To sum things up, early in the year, we lightened up on some things, and we bought a few companies. Now, we’re finding good companies, but not good prices. So, we continue to sit on a fair amount of cash.
Jeff Muhlenkamp: One comment, Ron, you were talking about bonds…I found a comment online pretty interesting. I forget where I was trolling around, but there was a twitter discussion or something and the commentary was, ‘Buy bonds for the capital gains because the rates just keep going down.’ So it used to be that you would buy stocks for the capital gains and you would buy bonds for the income. Now, you are seeing…it’s a whole lot more prevalent out there, people talking about buying bonds for the capital gains and stocks for the yield—for the income—which is the inverse of what it had been. Frankly, that makes me wonder if the game in bonds isn’t over.
Tony Muhlenkamp: And hasn’t that been Gary Shilling’s11 case (i.e., buying bonds for the capital gains and stocks for the yield)?
He’s continuing to say that there is room left in that, right?
Jeff Muhlenkamp: He does and there may well be—but the more people who jump on that bandwagon, the less money there is to be made. So it makes me wonder if that game isn’t approaching the end. We have been saying to stay away from bonds for a couple of years and, for a couple of years, we’ve been wrong. But that game doesn’t go on forever. Tony: Ron, you talked about the consumer portion of the economy…A whole lot of consumers are, in fact, retirees. Bring us up to date on what low interest rates are doing to retirees and pension plans and so on.
Ron Muhlenkamp: Low interest rates, zero interest rates, kill retirees. If you had a financial/retirement plan made more than two or three years ago, you were probably told that you could spend 4-5% of your assets because that’s what bonds threw off. That’s a little more than stocks threw off in dividends, and you expected some capital gains along with that. Today, that’s no longer true.
You’re seeing 65-year olds continue to work. You’re seeing 55-year-olds planning to continue to work because what they thought they could earn—the income on their assets in their retirement—has been taken away from them. It’s killing retirees and having the same effect on pension plans. I said earlier that there’s about $20 trillion in the S&P 500 Index. Pension plans in this country exceed $9 trillion and most of them assume that they can earn 7% or 8% on their investments. With bonds, today, they can maybe do 2% or 3% on corporate bonds—and they are not going to make up the difference on stocks. So, it’s killing any saver: It starts with retirees and it includes pension plans, and it also includes insurance companies, which is why we don’t own bonds and we don’t financials.
Jeff Muhlenkamp: The way I think of it is, a company’s cost of capital is the investor’s return on capital. So when a company like Apple can borrow at 1% for 30 years, somebody else is getting 1% for 30 years—some saver out there somewhere.
I’ll take Ron’s comments about pension plans and insurers one step forward: If the pension plan can’t make money on their assets, how do they make their money? The same for the life insurer: If they can’t make money on their assets, what do they do? They pass that cost to their customer base. In the case of an insurer, they pass it on to the insured. So, you might expect that your insurance rates are going to go up, because they can’t make up the difference any more with the returns on their investments. In the case of a pension, they pass it on to the supporting company, so, if you are Lockheed-Martin, if you are Boeing, if you are Delta Airlines, if you are Goodyear Tire, and you are still sponsoring pension plans, your contributions continue to go up. If the pension happens to be public, like public servants, like police and fire, then, as a tax payer, you are on the hook for making up that difference. You might expect the taxes that you pay would go up to support the promises that were made. The pain comes out someplace—you just have to walk the chain far enough until you find out where it is. In those cases, that’s who I think is going to pay the price that is being imposed by low interest rates.
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