m&c webinar, december 1, 2016 amended transcript · 2016. 12. 1. · m&c webinar, december...

M&C Webinar, December 1, 2016 Amended Transcript Ron Muhlenkamp, Portfolio Manager Jeff Muhlenkamp, Portfolio Manager Tony Muhlenkamp, President Tony: Good afternoon everyone and thank you for joining us for today’s presentation. My name is Tony Muhlenkamp and I’ll be hosting our webinar this afternoon. Our goal today is to share our thoughts and observations about the current economic and market conditions that we are seeing as we prepare for a number of things we see coming down the pike. Particularly the opportunities we think will be available to active value managers like ourselves as a result of the recent shifts to passive investing and changing stock valuations. As different stocks rotate in and out of value or in and out of favor, we expect that some things that were expensive will get cheap and some things that have gotten cheap may get more recognition and how are we preparing to take advantage of that?

Frankly, we are probably near the end or very near the end of a 35-year bull market in bonds. So these are things we’ve been preparing for. And frankly despite the market rallies you’ve seen since the presidential election, we think investors still face an investment mine field. So today our portfolio managers, Ron Muhlenkamp and Jeff Muhlenkamp, are going to talk about some of those mines, where they are located, and how we are working to navigate past them for our clients.

We will have time for questions and answers during the second half of our presentation. I will let you know how to submit questions at that time. So with all of that being said, Jeff, please go ahead and get us started.

December 1, 2016 Webinar –

Jeff: Thanks Tony. Good afternoon everybody.

This is the rough agenda we are going to follow. We’ll start with currencies and global rates because they will end up having a bearing on a lot of the topics that we will cover later on in the discussion. So it’s important to give you the context in which decision makers are making choices when they weigh what to do with their money.

For most of the charts, we will actively discuss just the last couple of years, but we will include on the chart a much longer time frame, so again, you have the context with which to view what has been going on lately.

Just a little side note, I’m going to use the pointer here, the mouse has a laser indicator—a little red dot—so, I’m going to use that to help focus your attention on the portions of the chart that we are talking about. With that said, we’ll go ahead and get started.


Above is a chart of the exchange rate of four different currencies against the dollar. Red you have the Chinese renminbi, blue the Japanese yen, in green the euro, and the British pound is in brown—all of them since 2005. The rates have been normalized with 2005 levels equal to 100. So when the plot goes down that means the dollar is strong against that foreign currency—one dollar will buy you more of that currency than had been the case.

I want to focus on two time periods…the first is early 2014 to mid-2015—during that period, the dollar strengthened against the renminbi, the euro, and the pound (the big one being the euro), but not the yen. The strong dollar reduced overseas sales by about 5-10% for the U.S. exporters and U.S. companies that had large overseas portions of their company. It was a significant topic of discussion for many of those companies during their earnings calls. I highlight that to you because, in fact, the dollar and the movement of the exchange rates does matter to companies that we pay attention to and, in some cases, own.

The second period is from the end of 2015 until today, where the dollar is strengthening against all four currencies. This has not yet hit corporate earnings, and it has not yet been the topic of conversation on earnings calls, but if the recent strength of the dollar continues, I expect that it will become a topic of conversation and will become a drag on earnings and revenues.

Two other things that I would highlight—both of them have to do with the Chinese renminbi. In August 2015, the Chinese renminbi dropped overnight against the dollar. That was coincident or perhaps triggered a 10% correction in the U.S. stock market. A very similar event happened in January 2016, the renminbi dropped against the dollar and once again the U.S. stock market corrected. In January, there were also some additional concerns that the U.S. was entering a recession because of other things going on. Since then, the renminbi has continued to fall to levels far below where it had been during either of those two drops, and


yet the markets have not seemed to care. I don’t know if that continues going forward or not. It’s something we are keeping our eye on.

Finally, I’d like you to remember that while a strong dollar reduces profits for U.S. exporters, it is a boon to U.S. consumers who buy goods produced overseas. So whether that’s a Japanese television, a Korean television, or French wine. You will get more for your money with a strong dollar than with a weak dollar. There are always two sides to a change—some folks benefit and some folks are hurt. A strong dollar will hurt our exporters and help our consumers.

This is an update of a chart we’ve shown a number of times before. The chart shows the nominal interest rates for government bonds with maturities from one to 30 years for a variety of European countries plus Japan and the United States. The green boxes are positive rates. Red boxes are negative rates. A negative nominal rate means that, at maturity, less money is returned to you than you originally lent, including any coupons that you may have received.

In Switzerland, for example, if you lend the government $100 for ten years at the end of those ten years, you would receive back $99.86. Lending $100 for ten years cost you fourteen cents! Negative real rates (which we’ll talk about on the next slide) are more common than you think, but negative nominal rates are, in my opinion, an historical aberration—we’ve never seen them before. We do think that negative nominal rates are causing massive dislocation in the allocation of savings by all those folks that normally save. So whether it’s you as an individual, or a pension fund, a bank, or an insurer—it causes them to completely rethink what they do with their money and some very strange things happen.


For instance, in Belgium, what you’ll notice is nominal negative rates out to five years. A lot of their mortgages are variable rate. So when rates went negative, banks started writing checks to the borrower, instead of the borrowers sending checks to the bank. Really weird things happening!

The above chart adjusts for inflation. So this is the very same chart you saw before except for now we’ve adjusted each of the rates for inflation in that local country. If it was green on the last slide but red on this slide, that means you’re going to receive your original loan back at maturity—at least in terms of the number of dollars that you received. However, inflation has eroded the purchasing power of the currency so you can actually buy less with it—inflation is eating up your returns faster than compounding interest is growing it.

These two charts illustrate the problem many savers are having on a global basis; they can’t get a positive return in safe government bonds like they used to and they are seeking that return elsewhere, whether that’s in junk bonds, dividend paying stocks, nontraditional assets…wherever they can find it. Money is being chased out of the traditional home, if you will, for a lot of savers because they can’t get the returns that they need to meet their economic requirements.

I’ll also highlight to you that the negative rates, both nominal and real, have been deliberately engineered by the central banks of the world. Their stated reason for doing so is to spur borrowing. The collateral damage is to savers, banks, pension funds, insurance companies—the natural lenders. Frankly, we think the cure has caused more harm than the disease, and continues to do so.

We are going to shift now from the global picture to the United States.


Ron: Just to bring that home a little bit…if people have been taught anything by their parents and others, over the years, it’s been “spend the income, don’t touch the principal.” During most of that time, you could get a 4-5% nominal yield on passbook savings, on CDs, and on money market funds which gave you a 2-3% real return. Those of you who are retired know that during the last decade, as your CDs rolled over and you tried to reinvest them at 4 or 5%, you got maybe 1-2%. So, there’s a whole lot of what’s been taught over the years that simply couldn’t be done in the last few years. And, if you have a financial plan that is more than five years old, it’s based on spending probably 3-5% of your assets every year which showed up as income. That hasn’t been doable for the last few years—it’s all been thrown out. The savers and retirees of the world know this. It’s also hitting their pension plan, most people don’t know that. If you go into pension plans, most of them have actuarial assumptions of 7-8%. Which might have been reachable when treasuries were at 4 or 5% and stocks did somewhat better—it’s been very hard to do that.

The last greater part of a decade has been very unusual. As Jeff said, it makes no economic sense to have negative interest rates. It’s very hard on the retirees and the savers to have low or negative interest rates. Hopefully, we’ve now turned the corner on that, where our central bank is starting to talk about raising rates. The markets themselves are raising rates a bit, but we are nowhere near out of the woods—we still have European and Japanese central banks pushing very low and negative rates.

Jeff: We are going to shift now from the global perspective to a domestic perspective and look at U.S. interest rates over a period of time.

This is a chart of the yield on a 10-Year U.S. treasury bond since 2005. The blue line is the nominal or stated rate, the red line is adjusted for inflation. The first thing I’ll point out is that the blue line (the


nominal rate) has generally been in decline since about 2006. Back then it was at 5 ½ percent. Now the 10-year is around 2.4% the last couple of days.

In two periods, both 2008 and 2012, you actually had the inflation adjusted rate go negative. So inflation was eating away at your purchasing power faster than compounding was growing your assets. And that happened again for two relatively short periods of time 2008 to 2011-12.

During that time, of course, if you were a borrower, if you were on the other side of that equation, you were essentially being paid in purchasing power to borrow. That’s the reverse of what you think borrowing and lending ought to do for you. Nonetheless, when you get negative rates, that’s what you get.

Finally, notice that right out here in 2016 you’ve got very sharp upward movement of both the nominal and real rates. That’s a little bit pre-election and a lot post-election. So, you saw for the last year, real rates coming down. And now they are reversing back up. Prior to that, you had a rising trend out of 2011 and into 2015. Not surprising really, towards the end of 2015 you saw a slowing economy. Rates came back down and now they are jerking back up. If that continues, at some point that may slow the economy. We don’t think you are going to get there until rates get to something approaching normal and we consider normal real rates to be about 3% above inflation. That would be on the long government bond. On the 30-year bond, you would expect to see a real return of about three percent.

Shifting now from what the government pays to borrow money to what businesses and consumers pay to borrow money. The black line is inflation-adjusted BAA Corporate Bonds. So we’ll use BAA corporates, which is the lowest level of investment grade, to be a proxy for the borrowing rate for businesses. The red line is real 30-year mortgage rate. We’ll use the 30-year mortgage rate as the proxy for what it costs consumers to borrow in the long term. You see the very same pattern over time that you saw with the


treasuries in the last chart. So, they bottomed in about 2011 or early 2012. They have been rising since then to the middle of 2015, have come down for the last year and now a sharp spike up. So again, we think normal is probably in the range of four or five percent with these two metrics. Typically you’ve got a spread over long-term treasuries for both of them. Moving back towards that level, we think is a return to normal or a historical normal. If you get above that then you might start to pinch the economy a little bit.

Shifting now to measures of what’s going on in the economy in general. This is a graph of real U.S. gross domestic product since 1968. Real, of course, means that it’s adjusted for inflation. Vertical grey bars indicate periods when the U.S. was in recession. Which is officially defined as two or more quarter of declining GDP.

You can see that we recovered from the 2009 recession by about 2012 in GDP terms and since then, we have been growing at a fairly steady clip. When economist or politicians state that the economy is doing well, they’ll often look at a chart or show you a chart that looks a lot like this to validate their statement. But it’s not the only way to look at what’s been going on in the economy.


This is the very same information but we’ve adjusted for the population growth. So, this is real gross domestic product per capita since 1968. You see a very similar pattern but it doesn’t look quite so rosy. So you see the decline in GDP per capita during the recession bottoming in about 2009. But it took us until 2014 to regain the same level of economic activity per person that we had seen prior to the recession and it’s been growing more slowly since then. So, when people talk about a slow-growth economy, people talk about “gee, things haven’t really gotten a lot better for the individuals in the economy.” They are more likely to show you a graph that looks like this and look at it on a per person basis instead of an aggregate basis because the growth in the population hid or masked some of the declines in productivity that we’ve seen.

Ron: GDP the last five or six years has been less than two percent and population growth has been about a 1.4%. So you netted, whether you look at productivity or simply GDP per capital, less than ½ of one percent.


Jeff: Another way to look at what’s going on in the economy is to look at employment. This is a chart of full-time employment in thousands of workers since 1968. Prior to the recession it peaked in 2007. We reached that pre-recession peak again in 2015, eight years later. When economist talk about unemployment being strong or unemployment being low, they will again typically point to a chart like this. We’re back to and now exceeding the high in aggregate employment that we saw pre-recession. That’s not the only way to look at it.


So, this chart is the ratio of employed persons to the total employable population. Which the government defines as being between the ages of 16 and 65. I probably ought to call them and ask them how to get a sixteen-year old to work, because I’ve had no success with that with my sixteen year old. If you have ideas, let me know, I’d be interested. Nonetheless that’s the denominator in this case.

What you see is a pattern of increasing percentage of working age adults working throughout the ‘80s. You have more people joining the workforce and it falls off in recession, achieves a new high in the ‘90s, falls off on a recession, improves a little bit, but doesn’t quite get back to where it was in the late ‘90s. Falls off big time, and again this is a percentage now, and recovers much more slowly than previously. So, our peak of people working as a percentage of those at the right age to work was 64% of the population in 1999. It’s currently 60% of the population. On a population base of 320 million, that’s 13 million jobs that if we were still at that percentage, we would have that we currently do not have. From that perspective we are nowhere near the level of employment that we were in the late ‘90s and nowhere near the level of employment that we were in 2007. So again, depending on how you define your terms, you get a very different picture of the health of the overall economy.

Ron: And a very different perspective from the people who are working in it from the people who are measuring it. We have been doing a couple of seminars a year and all though this, the public has been telling me they think we are still in recession. If you look at these kind of numbers, you at least see what they are looking at which is a whole lot different from the top down perspective. That’s the point of the exercise.


Jeff: Another thing we keep an eyeball on is industrial production in the United States. This is a chart of industrial production since 2007. The numbers are indexed with 100 being arbitrarily set for the level of 2007, so you can see the changes both positive and negative against that.

Recessions are again, indicated by the vertical grey bars. You can clearly see that in every recession since 1968, it was coincident with the reduction in the industrial production—and that outside of recessions, industrial production rarely declines. The last year and a half being quite the exception. We achieved the pre-recession peak in industrial production in 2014. So the 2007 level, we got there again in 2014—seven years later but we never exceeded it. So we didn’t set a new high, we just kind of matched the old one.


We have been telling you for the last year that industrial production was in decline in the United States. This is the data that supports that statement or that assertion that we have made. You can look at it from an industrial capacity utilization perspective. That paints a very similar picture. This is a graph of capacity utilization in the U.S. since 1967. Again, recessions are marked by vertical grey bars. During every recession, capacity utilization declines and then recovers during the expansion. So you had a decline into the ’01 recession. You had an expansion into 2007, a larger decline in ’08, ’09. It expanded again and peaked in about 2014. The utilization has since come down. Declining utilization outside of recessions is fairly unusual and yet here we have had one. This has been a fairly unusual timeframe in our economy for the last year, year and half or so.

Ron: You’ll notice that capacity utilization never quite got back to the 80% level which has historically been the point at which companies add capacity.


Jeff: Another metric we keep an eyeball on is durable goods orders. Durable goods are products intended to last for more than a year whether they are ordered by the consumer or by business. The government collects that information on orders for durable goods and we plotted it here back to 1968. The red line includes transportation and tends be more volatile because of the large cost of aircraft and the big swings in aircraft orders, so we pay more attention to the black line which does not include transportation assets. Once again, recessions are shown as vertical grey bars. As you can see, durable goods orders decline during recessions and increase during recoveries—no surprise there, we have now said that for about three slides. For the last five years, they have been flat. And that’s again, fairly unusual although you see similar patterns in ’97-’98, and ’83-‘86. But this one is a little bit longer even than the ’83-’86 plateau there. What we are trying to do is to illustrate what’s been going on in the economy. People have not been ordering durable goods in a ramp-like fashion—which is more typical of a recovery out of a recession. It ramped up and then it leveled off. That’s been a little bit unusual and ends up getting reflected in industrial production capacity utilization.

Ron: …and never did get back to the levels of ’06, ’07.

Jeff: Correct.

Ron: When economist speak about economic indicators, they often speak about three time periods:

- leading indicator which tend to be stock and bond markets; - coincident indicators which are things like consumer spending and retail sales; and - lagging indicators, the primary lagging indicators are capital spending and employment.


What we find interesting about capital spending and employment are those are things that corporate execs make decisions on. They survey what they see going on and make an active decision as to whether to add plant or to add people. The weakness in the recent expansion since ’09 has been the weakness in capital spending and employment—which we have kind of demonstrated to you. What happens is, we started this webinar talking about interest rates. Interest rates affect all of that; they affect what consumers do; what businesses do; they don’t really affect too much what governments do. But they do affect consumers and businesses. Things like regulations, which we have been talking about for several years, affect businesses. Regulations tend to be on businesses not on consumers. We’re promised now that some of the regulation will come off. We may be at an inflection on that. But the two have differing effects on different groups of people and we need to monitor that going forward—which we will do.

Jeff: We are going to shift now from the broader economy and business to the consumer. We’ll start by looking at consumer’s income.

This is a chart of inflation adjusted median income in the United States since 1970. As you can see it peaked in 1999 and troughed since then. So you have kind of an echo peak, if you will, in 2006, 2007 and a big trough down there in 2011. Since then, it’s been recovering but we haven’t hit the pre-recession secondary peak yet and we certainly have not hit the 1999 all-time peak. So when people talk about “the worker has not benefited,” this kind of lends credence to that assertion. Over the last 20 year the median income has not gotten above where it was in 1999. That’s kind of what’s going on with median income in the U.S. and what the inflow looks like for folks like you and me on an inflation adjusted basis.

Ron: If you wonder why people voted for change in both ’08 and ’16, you might keep this chart in mind.


Jeff: This is a chart of consumer confidence since 1967. You can see that consumer confidence invariably declines in recessions and invariably recovers afterwards. We went to record low levels in ’09 and it took us four years just to get back to normal recessionary levels of confidence. Since then, we have continued to improve so now we are at a level that is consistent with where we have been at prior expansions but nowhere near where it was during the go-go years of the Dot-com bubble. That’s kind of how the consumer is feeling or how confident he is about his economic situation right now.


The consumer’s mediocre wages and positive, but not exuberate, attitude has translated into increased savings. This is a chart of the U.S. Personal Savings Rate as a percentage of disposable income since 1959. Savings rate generally declined from ’74 to 2006, bottoming at about 2% and has since rebounded to about 6%. So add those two things together and what you get is the consumer saving a little more. Not clear if he is going to save more yet or if it’s going to level out there. I have no prediction on it, but he (or she) is saving more than he was four of five years ago.


We keep an eyeball on credit metrics. One of the ones we keep an eyeball on is credit card delinquencies. This is a chart that shows credit card delinquencies going back to 1991. We saw a big spike in the last recession. We’ve seen delinquencies come down pretty dramatically and pretty steadily since then hitting all-time lows. They’ve been pretty stable at about 2% of outstanding credit for the last year or two. So at this time, we’re not seeing any stress in this specific metric that has us worried about the consumer as we look at things.

Ron: There is an interesting aspect going on in ’08, ’09, it was the first time that people paid their credit card but let their mortgages slide. In prior recessions, it had always been the obverse. They would pay their mortgage but let the credit card slide. Today their credit cards are pretty much paid up. What we’re seeing creep up a little bit are student loans and autos, particularly non-prime auto loans. So that’s a little bit of where growth of credit has been the last few years, so whether that becomes a trend or not, we don’t know. But the surprise in ’08 was big—that they would pay off the credit card and let the mortgage slide. And of course, that is what we refer to that as the housing bubble, when people had stretched to pay mortgages to buy houses. Right now it looks like they are stretching to buy cars. So whether that results in delinquencies among auto loans we’ve seen it begin to creep up—whether that continues or not, we don’t know.


Jeff: Continuing to look at what the consumer is doing, here is a chart of light vehicle sales in millions of cars seasonally adjusted since 1970. As usual, the grey bars indicate recessions. You can clearly see the drop-off in auto sales from ’07 – ’09. That big spike there in about 2010, that was cash for clunkers. Since the recession you have had a really nice steady increase in auto sales that peaked so far in late 2014 early 2015 and appears to have leveled off. So we think we are back in the range of normal for what auto sales ought to be. So, the consumer has clearly gone back and started buying cars. That’s not really true of housing. We are going to start by looking at how affordable housing is and then we will look at absolute number of houses that they buy.


This is a chart of the housing affordability index and the idea around the blue line here is that when the index measures one hundred, a family earning the median income has exactly the amount needed to purchase a median priced resale home using conventional financing. Conventional being, how much they put down, what percentage of their income they are paying, those sorts of things. An increase in the index means a family is more likely to be able to afford the median priced house and a drop means they are less likely to afford the median priced house.

So, what you can see is houses got a bit expensive in ’06. When housing prices started to decline they got considerably cheaper from an affordability perspective going into ’09 when rates really hit the bottom they got cheaper yet going into 2010. Since then, mostly house prices have come back up so the affordability has come down and again that’s all relative to median income. So median income plays in here as well. If housing prices continue to go up faster than income rises, or a combination of mortgage rates and housing prices go up faster than income rises, you will see this continue to come down. Right now housing is more affordable on a relative basis then it has been, frankly, for the entire duration of the chart. Nonetheless people aren’t really buying houses hand over fist.


This is a chart of new, privately owned housing units started since 1959. You can see a number of housing booms in the ‘70s, not quite so much in the ‘80s, a big one, of course, in the early 21st century. That collapsed in 2009 and has been recovering slowly since then, but is really at the low end of what we consider historical norm, particularly since the population has grown since 1959. So really, even though the affordability is there, consumers have not flocked back into buying houses like they did buying cars. Cars came back strongly, houses did not.


We are going to shift gears on you once again and talk a little about what the market has been doing lately specifically the S&P 500. The black line here is a chart of the S&P 500 Index since May of 2014. I already talked about the 10% drop in August of 2015. That was perceived to have been due to the depreciation of the Chinese renminbi. I talked a little about a 10% drop in January, February this year. Oil was coming down at the time. The renminbi again was devalued and I think there were concerns about a recession. We recovered out of that basically back to the 2015 high, maybe a little short of it by June or so. At that point we labeled it Brexit (when the United Kingdom voted itself out of the European Union). That hit the stock market for a period measured in days, maybe weeks after which the market hit new all-time highs. Then going into the U.S. election, it sold off a bit. Coming out of the U.S. election it has ripped a bit and has once again hit all-time highs for the S&P.


The picture hasn’t been quite as pretty for either earnings or revenues of the constituents of the S&P 500 index. So this chart shows in blue what revenues per share in aggregate for the S&P 500 have done over the last ten years since 2006 and in brown what earning per share have done over that same time frame. So you can see they both dropped into the recession, earnings much more than revenues and that’s typical as margins get compressed. Expanding nicely through about the middle of 2014. And then, both revenues and earning started to decline. Now part of that was the drop in crude oil. Crude oil started during this time frame, call it 2010 to about 2014 at roughly $100 a barrel, by February of this year it was at $26 a barrel. It took about a year and a half to get there, so a piece of the decline is what is going on in the energy industry as revenues decline, earnings tank—all due to the decline of crude oil prices. A piece of that, as I previously discussed, was strong dollar related as anybody that had large overseas businesses were translating those revenues and earnings back into dollars from that overseas’ currency. That was a part of it. Nonetheless, for a period of six quarters you had declining revenues and for a period five quarters, you had declining earnings. That ended in third quarter of 2016. So this quarter that just ended was the first time in over a year we actually got year-over-year growth in revenues and earnings out of the S&P in the aggregate.

The dash line here is the estimate of what it’s going to do going forward. Frankly we think the earnings and revenues estimate is a little bit high. We don’t have confidence that it’s going to meet the current projections. But that’s been a bit of an interesting story. So you’ve had an earnings and revenue decline outside of the recession which is again pretty unusual, it doesn’t happen too often.


If you have been with us a little while, you’ve seen this chart before. The black line is the S&P 500 Index going back to 1992. You can see it doing its wiggly thing up and down and up and down and up. Periods here of red are when, on a net basis, investors have borrowed on margin to invest in stocks. So this is when investors, in the aggregate, are net on margin. In green periods are when investors have a net cash balance. So you can see that peaks in margin borrowing tend to coincide with peaks in the market. Peaks in net cash tend to coincide with troughs [in the S&P 500].

Right now we are big time net on margin. I don’t know if it’s a peak yet. You really don’t know until you cross back over the zero line. The rise in net margin debt is coincident with the rise of the S&P since about 2013. We kind of view this as the potential for a decline should investors change their mind and decide to hold cash instead of borrow to own stocks.

Ron: Or should they get margin calls.

Jeff: Or get margin calls…Ron reminds me of a point I like to make. People talk about fear in the market and people selling because they are afraid. When you’re on margin, you don’t need to be afraid to sell, you don’t need to have an opinion at all. If the price goes down, and you get a call, it’s mechanical—your banker sells it for you so it’s just a machine and the crank gets turned simply because the prices are falling. It doesn’t matter what you think about what the future of the market is, if you’re on margin, you may be forced to sell.

So, this kind of illustrates what the potential for that kind of selling is without giving us any indication whatsoever as to when that kind of selling might occur. That is by no means forward looking. Those are really our comments on what the market has done and where the market is at.


These are some of our largest holdings as of the end of November. The price to earnings ratio (P/E) that’s listed there is the current price divided by the 2016 earnings. Obviously we’ve only had three quarters of 2016, so three quarters of that earnings number is fact and one quarter is an estimate. The ROE (Return on Equity) that’s listed there again has an element of forecast in it—it’s not all fact either. Because the market looks forward, I thought this was the most useful time frame to look at in terms of giving you a snapshot of our companies.

In general, we like to buy when a company that is more profitable than the market sells for less than we think it is worth. Typically, that’s for less than what the market is selling. A number of these names meet that criteria but several of them don’t, which really should indicate to you that they’re not ones we are interested in accumulating any more of. If you look at Microsoft, it has a nice high ROE, but frankly at 29 times this year’s earning we view it as fully priced.

Ron: You might point out that we got to $29 the right way. We doubled our money in Microsoft. People always learn what our largest holdings are which isn’t necessary what we are buying today.

Jeff: You should draw no conclusions from this list today about what we are thinking of buying or selling. And don’t ask us, because we won’t tell you. These are, in fact, our largest holdings and I thought we’d just give you a look at that.

You can look at the aggregate number for the S&P 500 Index at the bottom [of the chart]. The S&P is currently priced at 18 times this year’s earnings—there’s is a little bit of forecast in there. We think that the listed ROE is probably a little bit high. On a trailing four-quarter’s basis, the ROE is only about 12 ½ percent...the difference between 12 ½ and 15 is…four quarters ago was a really bad quarter, particularly for


energy and there’s probably a little bit of optimism built into the fourth quarter of this year. But that number is probably just a little bit high.

Ron: Our Mantra is better than average companies at below average prices. We are in there.

Jeff – Finally this will be the last slide before we get to the questions. We’ve used this checklist for a number of years now and we continue to update it. It gives us a useful framework to keep track of what we are seeing and what we ought to be paying attention to. I’ll just walk down it real briefly.

We try to keep an eyeball on what consumer spending looks like and what the consumer is doing. We described that to you in some detail over the last few minutes. We think it’s mixed—we’ve had good auto sales, poor housing sales. The consumer in general is spending fairly well but ramping up their savings a little bit too so it’s not going gang busters and we don’t see any reason for that to change as we look forward, so our expectation is for very little change in that.

Business investment, as we described, has been low for a number of years and we don’t see any solid indicators that tell us that’s going to change in the near future. You can get a little hopeful and we’ll talk about that when we get to taxes and regulation, but we haven’t seen concrete evidence of a change just yet.

We keep an eyeball on credit and bank health, those two tend to go together because a lot of people borrow from the bank. The banks are in pretty good shape right now in the U.S. We pay attention to credit default swaps which is the market’s way of telling you when a bank is under stress and those are pretty low.


As Ron discussed, we’re seeing pretty good things in credit with the exception of auto loans and student loans. We don’t expect to see a lot of problems in mortgages simply because they had so many problems six and eight year ago. It’s pretty unlikely that you have the same kind of shenanigans recurring in that lending category so soon after everybody just got burned—so that’s fairly unlikely to happen. But it does kind of look to us like standards have gotten pretty loose in auto lending and you’re starting to see anecdotal evidence that defaults and delinquencies in auto lending are ramping up, so we are paying some attention to that. If we see more definitive information on that, we might change our future outlook from good to not so good.

We listed the velocity of money. Velocity of money is a calculated number that relates the current money supply to the volume of goods produced and the price of those goods. Velocity of money can’t be directly measured but it does kind of help us keep a handle on what’s going on with inflation. Velocity of money has been declining ever since the recession. It has not found the bottom and we have no real idea if it will or not—it’s a lagging indicator and it’s probably about sixty days behind facts. It’s something that we keep an eyeball on.

We had U.S. politics on here. We think the big question on U.S. politics had been resolved for a little while so we replaced that with inflation. Inflation is back on our radar. A move either toward deflation or higher inflation would cause problems for the economy although in very different ways and we’re not sure which we are going to see. Ron, do you want to talk about that a little bit?

Ron: It looks to me like the chief risk of deflation has probably passed, so our concern is shifting towards extended inflation. It’s something that, as you know, the central banks of the world have been trying to inflate for six to eight years, and because the economies have been slow it hasn’t taken root. They put money into bank reserves but the banks haven’t lent it, partly because nobody wanted to borrow it. So, if the economy picks up a bit, and there’s some signs that’s happening a little bit and right now there’s little bit of hope that that may happen. The risk would shift from deflation to inflation. We think we have passed the maximum risk of deflation. About as far as my crystal ball can see.

Jeff: When Ron talks about that when you had China open up to the world twenty years ago, suddenly you have a huge supply of low-cost labor and that put a massive deflationary influence on labor costs globally. When you had, in the last seven or eight years ago, as Chinese demand for raw materials ramped up and you had everybody from copper producers, to steel producers, to oil producers spend a ton of money on capital expenditures to bring more supply on the market. Well, that all came on the market about the same time that Chinese growth slowed. So now you have a glut in most commodities. So you had deflationary pressure because you got a glut, now about four years later you started to work through that.

Ron: Well the headline is in oil. November of ’14 the Saudis said we would no longer support the price of oil. Yesterday, they said we might support it a little bit. In the meantime, oil went from $110 a barrel to $30 to $45 two days ago to $50 today. Many commodities did a similar thing. They weren’t as dark as oil. They weren’t as widely written about as oil. But all of this capacity that came on (in oil it was in the United States), but in various other commodities it’s in different places. That capacity is still there. If you will, the huge deflationary bubble was from November of ‘14 to November of ’16. Now the pressure is on the other side. We have several questions as to where we think the price of oil goes. And, a week ago, we were saying $50 plus or minus five or ten. Today it’s at $50 and we’re still saying $50 plus or minus five or ten. One of the things that’s interesting—we also get questions about what we think of the price of natural gas—is three years ago we had a seminar and wrote a booklet. At the time natural gas was $6 a Mcf. We look forward and said we think it will center around $4. We have since lowered that to $3—today on the Henry Hub, it’s


in fact $3.00 per Mcf. At the wellhead, in Pennsylvania (where we live) it’s $1.50 because there’s a glut of natural gas in Pennsylvania and there’s a shortage of pipelines to ship it out. Kind of our benchmark today our oil is at $50 plus or minus $5…our gas is $3 plus or minus probably fifty cents…but there’s a glut at the well-head in Pennsylvania both southwest and northeast at the present time.

Jeff: And those are the arguments for a little bit more inflation. I would say the arguments for a little bit more deflation are if you get dramatic declines in the renminbi versus the dollar. So if you started having currency wars and putting downward pressure on prices in that regard, or if you started to have loans start to go bad. When you borrow more money collectively in the economy, when you increase credit that tends to be inflationary (it grows the money supply). The flip side is, when loans go bad and get written off that’s deflationary (it destroys the money supply). So those are the kind of risks on the deflation side. That’s in part why we say “we’re not sure.” That’s how we think about inflation. That one is back on our radar and we’ll see where that goes.

The Federal Reserve and Treasury. The low rates, as I think we have made clear, we think have been counter-productive and harmful to the economy because they penalize the saver. It’s hard to grow your assets when your saver is getting destroyed. And we still have negative real rates. So we think that if rates rise—if the fed allows them to rise that would be beneficial…but they’ve told us three times now for a year and a half running that they are going to raise rates tomorrow and it never quite seems to happen. So they have another decision to make in two weeks, and I hesitate to predict what they are going to do. So we are still unsure on that one.

Taxes and regulation. We had talked in the past that we thought that high taxes and regulations were impeding growth here domestically and we list them now as less harmful because, frankly, for the first time in eight years we have reason to believe that taxes may get rationalized and regulations may get streamlined and some of the road blocks to growth may be lifted. We are not clear on what the new administration exactly is going to do. But three weeks ago, four weeks ago, we had no hope whatsoever that regulation was going to be decreased and now at least we have that hope and as Ron put it, we may be at a inflection point.

Europe, Japan, and China. Those have been potentially disruptive for quite a while. I think they are disrupting markets on a global basis as banks and insurers and pension funds reallocate funds, on an ongoing basis (from where they like to have them…government bonds and those sort of things) into places they are less comfortable with, but they’ve got no choice because they’ve got to hit their targets for returns. If one of those countries or regions does something really stupid or, if you have a political event…Italy, for instance is having a referendum on their constitution this weekend. There is some potential for that to cast doubt depending on how they vote on whether or not they are going to stay in the European Union. So you have potential still out of those three areas for something really disruptive to wash across all of the markets around the globe. We don’t think that potential has declined. We don’t think it’s increased. We think it’s hanging out there—kind of like the sword of Damocles, if you will. So that’s what we’re seeing and what we think about going forward. With that, Tony, I’ll pass it back to you for questions.

Tony: Thank you Jeff. Ladies and gentlemen, you should be able to submit a question by clicking on an orange arrow which will open a control panel where you can use your question feature.

We have a few questions that were submitted during registration. People have asked about the ranges of the prices of crude and natural gas and of crude oil for 2017 and the following next twelve months. Are there things that the energy department can do to help the oil industry right here and should they, for that matter?


Ron: We gave our thoughts on the price of crude. The energy department, in my opinion, the three things that are right up front and center for them is pipelines and pipeline approval. Right now the bottleneck is pipelines. There’s regulations on fracking and the whole idea of coal versus natural gas. Trump has said he’ll bring back coal, frankly, I hope not, but I hope he re-trains some coalminers to produce natural gas. Both are treated as fossil fuels but there’s a huge difference in their side effects.

There’s a big thing out there on ethanol. We’ve finally concluded that ethanol both economically makes no sense and environmentally makes no sense. That is, it takes more energy to create ethanol than what is in the ethanol. We send a third of our number one food crop, being corn, to the ethanol plant these days. That’s something the EPA could do in terms of changing the rules, changing the regs, on a fairly short basis. Whether they will or not we are about to find out.

Tony: The next question is why hasn’t technology participated in this post-election rally? Any thoughts on that?

Ron: Well, it never really got penalized by the rhetoric coming into the election. What did get penalized were things like financials with negative interest rates and that seems to be changing. So financials have rallied big time. One of the things that got penalized was healthcare. We had U.S. senators belaboring the pricing of drugs among other things and, of course, Medicare and health care, it’s been a huge political football for the last several years. So, the things that have bounced the most are the things where the markets perceived the pressure was coming off. There was never really a lot of pressure on technology, so it hadn’t had the bounce results.

Tony: Jeff, you had talked about the deflation risk. Rick H. wants to know why you think it may be lower now. Wouldn’t the default by major debtor sovereign states cause the dollar to increase with the removal of the currency? Is that, in fact, deflationary in itself?

Jeff: I don’t know that, if for instance, the Eurozone broke up, that that is necessarily deflationary in the United States. I think it would be strong for the dollar because you would have a bunch of people running to safety. When I say that deflationary pressures would come off, when you look at it on the ten or twenty year basis there have been a lot of very economic things that happed globally that drove down the price of all kinds of things from labor to basic materials. Those soft but strong winds, if you will, are gone. You already integrated China and its one billion workers into the global workforce, that’s not going to happen again. They’re seeing wage increases there. In fact, you are starting to see China lose business to Vietnam because the Vietnamese work a little cheaper that the Chinese do. Nonetheless, you can no longer do labor arbitrage by going overseas and hiring somebody cheaper because you’ve already reached the cheapest worker on the planet. And so at this point, everybody’s wages are coming up kind of on a global basis. That big steady slow pressure is done. The commodities we’ve overbuilt the heck of, that’s done. So what you’re left with is more credit cycle kind of stuff and I think that’s still there. It’s also kind of unpredictable. If you get big credit defaults, you can get deflation. If you get big currency devaluations, and right now the poster child for wanting to do that is first Japan, second Europe, and China, which has been doing that stealthily and whether Mr. Trump calls them on that or not, I don’t know. Those are your ongoing risks.

Ron: We had a couple of questions...our record had been pretty poor the last ten years and the question is why? If you had been with us through this period of time, you know that in the spring of ’09 we said that we thought we had reached the bottom in the market place and we put our money to work. We called that right. Since then, we have been pretty right on the economy. Every year, the estimates were that it would grow by three or four percent. The U.S. economy has grown by less than two. That’s been a reoccurring


theme. What we did after ’09, we said that a lot of balance sheets are in tough shape, so normally, if you have been with me a while, you know that I speak of the economic cycle the way my father talked about the farming cycle. When it’s springtime, you want to plant crops. What we did coming out of ’09, we said we’re going to be more cautious than normal because we don’t trust some of the balance sheets. So, we bought at the right time, but we bought cautious and we remained cautious through there. Much of the time since ’09 the markets have been set by what the central banks were doing. The economy was slow and it’s just now back to where it started. The market came back, big time. PE’s went up to 18 to 19 and 2% growth is not worth a 19 PE. If I thought we would continue at 2% growth, frankly, what we were doing the last six months or so was raising cash and selling some things. We now believe that growth will pick up. Right now we are pricing in accelerated growth, if it takes six or nine months to get there, there’s room for a run up and a pull back before the underlying economy picks up. If the economy begins to be set more by economic factors—what the consumer is doing (the consumer is in decent shape), what business is doing—balance sheets are in decent sheet (they just haven’t seen the growth in sales and earnings as Jeff pointed out a little bit ago).

In a fairly short period, we could get a change in the tax rate…Apple has ten percent of their market cap stuffed in cash in overseas markets. If we got a change in the corporate tax rate, they could bring that home and we could start dealing in $40 or $50 billion from one company. We’re seeing signs that the shift is occurring from central bank influenced markets, back towards economically influenced markets. That would make me more positive. The long and short of it is, we’ve been fairly right on the economy, it hasn’t helped our performance—we’ve doubled since the bottom, but the markets have done better than that.

Tony: Thanks. We are going to take time for one more question. Steve H. wants to know about gold being part of our top holdings. Is that a very unusual position for us to take?

Ron: It’s the first time we’ve owned it. We are down a little bit. Part of the thing that happened is since the election, gold has dropped as people have pulled money out of that to put it in other places. Jeff and I currently have a little bit of a debate going on, but we probably won’t buy more gold…whether we find something we like better than what we own.

Tony: What was the rational for buying it in the first place?

Jeff: I’ll take that one. The idea simply was that you had Europe and Japan, you had two central banks that if you look at what they were doing, they appeared to be actively trying to destroy their currency and so our purchase of a little bit of gold was really a bet that they would in fact succeed…so far they have not—that’s kind of where that came from.

Ron: One of the arguments against gold has always been that it doesn’t produce anything. Whereas if you have money in a CD or bank savings account, at least you get two or three percent.

Tony: Our outlook for Biotech? On one hand it’s tech, on the other hand it’s pharma care. We own a fair bit.

Ron: The two things that the American economy has done in superb fashion the last decade is to help to lower the price of energy and helped to increase the cure for diseases. We now have a cure for Hepatitis C. In the last ten years, HIV has become a manageable disease as opposed to a death sentence. Those are two big things that we want to keep a foot in. The amount that we are in will vary as prices move up and down.

Tony: And not to mention regulations. It’s political as much as anything.


Jeff: Particularly for generics…mostly for generics. What we saw over the last year, you had Valeant, you had Mylan, you had a number of companies that either were engaged in scandalous behavior or just unpopular behavior and were dragged in front of Congress, but for a variety of reasons generic companies were the punching bag publically for a lot of folks. And oh, by the way, particularly in Valeant’s case, for instance, a whole lot of hedge funds held them. So when things changed, and they started to sell off, you had a huge selloff in Valeant itself and anything that looked, or felt, or smelled like it might be close to a Valeant. When we saw that reach where we thought was crescendo and some of the momentum was about to wash out and we saw some prices that we really liked with some interesting companies, we put a little money to work there.

It’s a little bit different whether you’re talking about the Celgenes, the Gileads (the new drug producers), frankly, they’re going to be volatile because the nature of their business hasn’t changed. They put a lot of money to work looking for new drugs, most of the time it doesn’t pan out, when it does, man they hit a gusher, they hit a gold mine and it takes off. So it’s a little bit unpredictable and those are going to be volatile stocks and that’s just the way they are. Gilead, for instance, though was selling ridiculously cheap. They got like a 15% cash flow—just nuts cheap. Nobody thinks anything good is ever going to come out of Gilead again as near as I can tell. That’s very interesting to us. The generics sold off a little bit, they’ve got less pricing power than they had a year or two ago. But a lot [of generics], they’ve been the whipping boy for folks politically and there have been some bad actors and the whole sector has sold off with them, so we picked out some folks that we thought were not bad actors, had good businesses, and were selling cheaper than they ought to be. We took advantage of that. We haven’t yet seen whether we are right or not. We think we still are but we haven’t see the outcome yet.

Tony: I have one last question from Paul B. How do you see the ongoing effect of robots on employment and impact on artificial intelligence? Will there be any impact with that on decision making? Have you thought about that at all?

Ron: Sure. Your automatic washer looks to me like a robot. Your Roomba certainly looks like a robot. Many of the things that we use to consider drudge work, have been replaced by robots. Some people claim that as you go to robots, the jobs for people will disappear. I’ve never yet met the person that has everything that they want. And as long as people want something and if they are willing to pay for it, they are willing to hire people to provide that. So robots will change so that tomorrow’s jobs will look different than yesterday’s jobs—but that has always been the case.

I have lost many a job to a machine and some to robots—I don’t miss a blessed one of them. Will that be helpful? Yes. Will you have to train for something different? If you can fix the plumbing, it’s going to be hard to get a robot to fix the plumbing. It’s going to be hard to get a robot to fix the electricity, to do various maintenance things, to provide service. Robots are servants, not our replacement, as they have always been.

Tony: And on that note, ladies and gentleman, I do want to thank you for joining us. If we didn’t get to your question, or if we raised more questions for you than we answered, please give us a call. Send us an email. Log onto our website and send us a request through there. Hopefully by now you have a number of ways to get a hold of us. We would love to hear from you. We look forward to talking with you and working with you further. If we can help with anything, please give us a call. We will do our very best.

Ron and Jeff, thank you for this hour. We appreciate all of your thoughts. Ladies and gentlemen thank you and please enjoy the rest of your evening.


GLOSSARY

Central Banks are nationalized institutions, given privileged control over the production and distribution of money and credit. A central bank is generally responsible for the formulation of monetary policy and the regulation of member banks. Central banks conduct monetary policy by manipulating the money supply and interest rates. They regulate member banks through capital requirements, reserve requirements, and deposit guarantees. The central bank of the United States is the Federal Reserve System, or “the Fed,” which Congress established with the 1913 Federal Reserve Act.

Gross Domestic Product (GDP) is the total market value of all goods and services produced within a country in a given period of time.

Henry Hub is part of the natural gas pipeline system, it serves as a distribution center and is a pricing point for natural gas futures.

Nominal Rate refers to the rate of stated interest before adjustment for inflation.

Price-to-Earnings (P/E) is the current price of a stock divided by the (trailing) 12 months earnings per share.

Purchasing Power is the value of assets after adjusting for inflation; in other words, the money you have available to spend, if you choose. In order to increase the purchasing power of an investment, the value of the investment must grow at a rate greater than inflation. One way of doing this is to minimize the tax bite by providing long-term capital gains, which are currently taxed at a lower rate than ordinary income.

Real Rate of Return (or real interest rate) is the nominal rate minus the rate of inflation.

Return on Equity (ROE) is a company’s net income (earnings) divided by the owner’s equity in the business (Book Value); ROE = Earnings/Book Value. This percentage indicates company profitability or how efficiently a company is using its equity capital.

S&P 500 Index is a widely recognized, unmanaged index of common stock prices. The S&P 500 Index is weighted by market value and its performance is considered to be representative of the U.S. stock market as a whole. You cannot invest directly in an index.

Velocity of Money is the rate of turnover of money in the economy.

The opinions expressed are those of Muhlenkamp & Co. and are not intended to be a forecast of future events, a guarantee of future results, nor investment advice.

m&c webinar, december 1, 2016 amended transcript · 2016. 12. 1. · m&c webinar, december...

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