VALUE ADDED


Muhlenkamp Is Still a Great Fund

Steven Goldberg

When bad years happen to first-class funds, it's often time to buy. That's the case with Muhlenkamp fund.



Not everybody had a great 2006. Ron Muhlenkamp -- and shareholders in his Muhlenkamp fund (MUHLX) -- are nursing wounds. The fund returned a miserly 4% -- 12 percentage points less than Standard & Poor's 500-stock index. The performance was bad enough to put Muhlenkamp in the bottom 1% among all value funds.

My advice: Put some money in this loser. Like every first-rate manager, Muhlenkamp has a bad year once in a while. Just ask Bill Miller, whose streak of beating the S&P ended at 15 years in 2006 when his Legg Mason Value Trust returned just 6%.

When bad years happen to good managers, it's often time to add money to their funds. They may not bounce back immediately, but so long as their investment strategies remain sound and their funds haven't become bloated with assets, bounce back they will -- and you'll be glad you signed on for the ride.

Muhlenkamp is a terrific fund, one of the Kiplinger 25. It has returned an annualized 11% over the past five years and 13% over the past ten years -- five percentage points per year better than the S&P 500 for each period. Over the past 15 years, it has returned an annualized 14.5% -- four percentage points annually better than the S&P. Muhlenkamp ranks in the top 35% among all value funds for the past five years, in the top 11% over past ten years and in the top 12% over the past 15 years. With just $3.5 billion under management ($2.9 billion of that in the fund), Ron Muhlenkamp is hardly in danger of asset bloat.

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As far as I can tell, nothing has changed at Muhlenkamp's nondescript suburban Pittsburgh office. "We're having a terrible year this year," he said in late December. But he hardly sounded like he was ready to jump off a roof. He sounded like he always does: Confident, didactic and a bit windy. While Muhlenkamp often talks about his background growing up on an Ohio farm, my hunch is that he would have ended up a university professor had he not found his calling in managing other people's money.

Muhlenkamp doesn't suffer from an excess of self-doubt. The kind of confidence he displays verges on stubbornness -- but not to the point of being unwilling to re-examine his conclusions. It's a trait that I consider one of the hallmarks of successful fund managers. It's what keeps them from abandoning their approaches during the inevitable dry spells.

And why should Muhlenkamp be depressed? At 62, he has been managing money since 1968. He has bad years before -- and he has always snapped back. In 1998, 1999 and 2002, the fund lagged the S&P and its peers. Most notably, the fund trailed the S&P in 1998's bubble market by more than 25 percentage points. He wasn't undone by that year's market, so why should he be too upset by last year's?

What went wrong in 2006? Believing a recession wasn't around the corner, Muhlenkamp held onto his investments in stocks of economically cyclical companies -- namely energy and industrial materials firms, homebuilders and mortgage lenders. Many of these went down. Hence, a poor year.

Economic analysis

A Harvard MBA, Muhlenkamp does more macro-economic thinking than most managers. That's understandable in a manager who cut his teeth in the early 1970s -- a time of skyrocketing inflation and interest rates, and wretched stock performance. "I was bearish in the 1970s," he says. "Since 1982, I've been bullish on the big picture." Consequently, he hasn't made huge moves based on his forecasts for the economy's short-term ebbs and flows.

Muhlenkamp believes the Federal Reserve has engineered another soft landing -- that is, the Fed has slowed the economy enough to control inflation but not so much as to throw us into recession. The market isn't as sure as Muhlenkamp -- which is why it has knocked down some cyclicals.

Looking at stocks individually

But Muhlenkamp is more than a macro thinker. Where I think he adds the most value for shareholders is as a stock picker. He's a longtime believer in investing in companies with low price-earnings ratios and high returns on equity. ROE is a measure of a firm's profitability. To derive it, you divide a company's earnings by its book value -- assets minus liabilities. The higher the ROE, the more profitable the company. "Today, we want an ROE above 14% and a P/E below 14," he says. "We want above-average companies at a discount."

He and his four analysts don't just buy those stocks willy-nilly. They research companies in depth, looking at how they operate, how much earnings are growing, whether growth rates are sustainable and how well corporate managers reinvest cash flows.

Muhlenkamp goes where the values are. In 2002, the average market value of stocks (share price times number of shares outstanding) in his fund was a mere $3 billion. Today the market value is seven times larger -- $21 billion. Like most talented managers, he's currently finding bargains among larger companies.

One of Muhlenkamp's poorest investments last year was in homebuilding stocks. He owns six of them. "It did surprise me how quickly people stopped buying houses," he says. He doesn't expect the housing market to recover rapidly. "What usually happens with real estate is that it moves sideways until the economy catches up," which can take years. But the big homebuilders have become financially disciplined and continue to take market share from the mom-and-pop operators. He likes that long-term story.

Plus, they're cheap. NVR Inc. (NVR), for instance, sells at seven times the previous 12 months' earnings. Muhlenkamp expects earnings to continue falling and estimates NVR trades at ten times where 2007 earnings will wind up.

Not all Muhlenkamp's favorites are economically sensitive. He bought shares of Johnson & Johnson (JNJ), Pfizer (PFE) and UnitedHealth Group (UNH) because "they're good, well-run companies selling cheaply."

He also owns a slew of financials. They include Citigroup (C), Merrill Lynch (MER) and Morgan Stanley (MS). "Financials never get sexy so they seldom get overpriced."

Muhlenkamp is a savvy manager. Count on him to stage a comeback before too long. After all, the last time he lagged his peers two years in a row was 1994-95.

Steven T. Goldberg is an investment adviser and freelance writer.




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