Size Doesn't Matter

Ron Muhlenkamp manages a highly tax-efficient fund

Ron Muhlenkamp is a no-nonsense kind of guy. He likes good companies at cheap prices, and regardless of company size, he lets the numbers guide him to the most attractive investment opportunities. "We don't think size matters," he says. "We think profitability matters, we think growth matters, and we think a good balance sheet matters."

And Muhlenkamp lets his own numbers speak for themselves, too. With a five-year annualized return of 17.35% as of August 31, 2001, and a year-to-date return of 0.61% as of September 11, the Muhlenkamp Fund seems to be doing all the right things in this tough market environment. The fund also maintains a 10-year tax-efficiency ratio of 97.46% as of August 31, putting it in the upper echelon of mid-cap value funds. A diversified offering, the fund is the only fund that Muhlenkamp and Co. offers. Muhlenkamp sees this as a benefit to the average shareholder. He says, "We had a man call one day and said, 'Ron, you only have one fund, I can't switch,' and I said, 'If you know when to switch, you don't need me.'"

Muhlenkamp, who has been managing the fund since its inception in November 1988, holds a BS in Engineering from M.I.T. and an MBA from Harvard. His investment philosophies were primarily developed in the early 1970s when markets were down and he had the time to do research to see what did and did not work. As a result of that early experience, Muhlenkamp developed his own techniques that he still maintains 30 years later. Muhlenkamp states flatly, "We tell people we're looking for Pontiacs and Buicks when they go on sale. We don't want a Yugo at any price. We don't want a lousy company. We'd like to buy Cadillacs, but they don't go on sale very often. I'd rather get a Buick at a discount than pay sticker price for a Cadillac."

We recently spoke to Ron Muhlenkamp about his thoughts on tax efficiency, diversification, and the latest Federal tax cuts.

How do you maintain such a high tax efficiency ratio in your fund? We work at it. There are a couple of reasons we do this. First is that after-tax money is the only money you can spend. We've always run money for our clients with an eye toward taxes. My own money is in the fund, as is my family's. In many respects, what makes sense for investing also makes sense for taxes. If we buy 10 stocks, odds are we are going to be wrong with two or three of them, and we like to realize our mistakes early. Whereas when you're right about a company, you let it run a while. One thing we do is to make sure losses are short-term and gains are long-term. Another thing we try to do is always look for longer-term trends if we can identify them. We run money to maximize returns on an after-tax basis. What's been interesting is among the people who rank mutual funds, up until next year when you have to report after-tax numbers, as we did last year, the manager hasn't gotten any credit for being tax-efficient. The only things reported were pretax numbers. We think after-tax returns are the only numbers that make any sense.

What kinds of changes will we see because of the new reporting law? Presumably there will be more focus on it. It got play in the media a year ago and made me wonder what would happen when the media discovered the wheel. The only reason to invest money is on an after-tax basis and a year ago they acted like it was a new idea. People floated funds with that goal. What I can't understand is why they didn't look at who's been doing it that way and who hasn't. I would think the focus would be on after-tax returns going forward.

Is this the only fund that Muhlenkamp offers? Yes. We only have one fund on purpose because most people tend to switch [funds] at the wrong times. We think our record at switching from one area to another is probably better than the average shareholder's. We help them by not giving them the option of switching. The only reason I can see to have a second fund would be to have one that's designed for tax-free holdings so the things we do to get long-term gains would not be a restriction.

So the fund must be extremely diversified to meet all investors needs? Well, it's funny--when we talk to investors, they only have three needs. They all tell me they don't want to lose money, they all want to make a decent return, and they want to do it in a fashion that allows them to sleep at night. That covers all our investors. We don't know anyone who needs income. We know a lot of people who need spending money. We think our job is to grow their assets, and their job is to spend what they need to spend. A lot of people have been snookered by their advisors. They were taught to spend income, and not to touch principal.

Do you agree with Morningstar classifying you as mid-cap value? We think we're all-cap. We don't think that size is a useful criterion. In our fund we own some big, we own some middle, we own some small, and we own some very small companies. The only thing I can figure is that someone had a master's thesis due in six weeks and didn't have time to do useful work, so they figured out what the computer can measure. The computer can measure size pretty easily. So you've got these studies now of how big-cap works versus small-cap. We think the whole thing is nonsense. We look for good companies at reasonable prices. What we find is if the numbers take us to a lot of big stocks then that, in fact, is a good place to be. When it takes us to a lot of small stocks, then that's a good place to be.

So you are looking at the numbers to guide you along? Exactly. We don't think size of a company is a useful domestic criterion. I believe it was Warren Buffett who said "Growth is part of value." We agree with that. Morningstar, for instance, calls us a value fund. I asked them why and they said our P/E ratio is below average. It turns out our return on equity and our growth are above average. So in fact, if all our stocks doubled, I guess they'd call us a growth manager. We don't think this is useful either. So once you get rid of all those things, there is no reason to have more than one fund.

How have you been able to achieve such good return numbers with the way the market has been lately? Since the autumn of 1998, we've been in a split market. When the market got hit 20% in September '98, it was a little while before we knew that it was Long-Term Capital [the big hedge fund that failed spectacularly], that it was a financial accident, not an economic problem. The fear coming out of that period was a recession. That fear lasted all the way up until April 1999. The professionals were afraid. In the meantime, the general public ignored all that. At that time we were writing that the fear of recession had to die because in the spring of '99, when we talked to companies, they were doing well. We were half right. The fear of recession died, but the professionals replaced their fear of recession with the fear of inflation. From April of 1999 until January 2000, the big fear remained inflation.

Meanwhile, the public had bought a computer, discovered the Internet, and the fascinating game of playing the stock market with the E*Trade's of the world. While these fads gained, the rest of the marketplace suffered because the Fed feared inflation and was raising interest rates. All through 1999 we were saying that as long as interest rates are moving up, it's going to be hard for most stocks to do well. It was a split market; in 1999, there were more stocks down than up. Even though earnings were strong, interest rates were going up. Long-term interest rates then rolled over in January 2000, at which point we thought it was the bottom of the market. What we've been doing is playing this market on the premise that in 1999 the Fed was raising interest rates to slow it down. When interest rates begin to peak and slow down, you want to own cyclicals. We have been ignoring the tech stocks as if they do not exist. This is what has made use look pretty good in 2000 and 2001. Tech stocks then rolled over in March 2000. If you believe in momentum going up, you have to believe in momentum going down. Once we realized this fad was going on, we realized it was too late to play it, so we didn't. Behind that, the rest of the market has been acting the way it normally does when the Fed creates a slowdown or a recession. When interest rates start coming down, you bet on a rebound in the economy. We start with financials and move into cyclicals, which is what we have done this year and it has made us look a little smarter.

Do you see more interest rate cuts in the near future? We think right now we are at the bottom of this slowdown. I can't prove it yet. Usually there comes a time when all the negatives are visible and people are starting to give up. Now we're hearing people say the Fed's been lowering rates and it's not having an effect. Last year people were saying the Fed was raising rates and it wasn't having an effect. Just about the time the media says, "Gee, we've been looking now for eight or nine months and we haven't seen any changes yet"--that's about how long it takes. It normally takes eight or nine months. It's only due about now because the Fed first lowered rates in January. If we're right, you want to own cyclicals, and if we're wrong, interest rates will go lower, so you'll want to own financials. We have one egg in each camp. We like being right there.

What do you think Morningstar means when they say your fund plays on theme-based bets, which adds volatility to the fund? I'd be guessing, but what we do believe is that you should be diversified. However, you should only be diversified among good stuff. A lot of people view diversification as owning some of everything. We would argue that the less you know, the more diversified you should be. The fact that we're willing to say we'll own things that look good, and won't own things that don't, will mean that we might have 20% or 30% in what other people might call a sector. We are not reluctant to place a few more bets than somebody else might be when we identify a theme that looks mighty good to us. We don't go all the way out on the end of the limb and swing, but we will go halfway out.

Do you consider yourself a tax-managed fund? Sure. We can't imagine why you'd do anything else. We don't tout it though. I don't understand why every fund isn't a tax-managed fund. What happens, and it makes sense in a marketing sense, is that people often think of their assets in a compartmentalized manner with a separate account for savings and one for college or retirement. In a human way, that makes a certain amount of sense. But in an investment way it doesn't. Dollars all look the same. We've managed to make good money after taxes.

Can you tell me a little about your background? I'm an old farmer. The first thing I learned in farming is that crops don't grow every month. The second thing I learned is that if you don't plant them, they don't grow at all. Then I went and studied engineering. What I learned in engineering is that if you learn the basics, everything else falls into place.

I also went to business school. I came out having never owned a stock or bond. I had no Wall Street finance courses, although I did have corporate finance courses. I got out of school in 1968, just about the time that all the things people believed quit working. Nineteen sixty-eight was a year quite like 1999. I had the great advantage of not being educated in all that stuff, so in the early 1970s when markets were going straight down I had time to develop my own philosophies. I was working for an insurance company and I had a lot of time to check all the theories and see which ones worked and which ones didn't. I evolved my own disciplines in the early 1970s and have stuck to them ever since. What it all boils down to is wanting to own good companies. The second thing you want to do is own them cheap.

In the last 10 years, 1994 was the only year your fund had a negative return (-7.19%). What happened? In 1994 interest rates went up, therefore P/Es went down. We didn't think it was going to be a recession, and in fact it wasn't. There ended up being a soft landing. If you put 1994 together with 1995 (32.96% return), we owned the same stuff. Our turnover was low. Put those two years together and we look pretty smart. I grew up in Ohio where the crops only grow six months per year. The only difference between what my father did and what I'm doing now with the business I'm in is that it takes three to five years to get a normal seasonal cycle. If you look at our numbers on a three- to five-year basis you've got to expect we'll have one down year out of four or five, or two down years in 10. This allows for a normal seasonal cycle. People used to think there was a four-year cycle in the stock market. I think there is almost a four-year cycle, or something like that, in the human psyche. Wall Street loves the short term, of course, and they love turnover. When people are feeling good they'll try to drum them up until they exhaust it and then they'll try to scare them on the other side. It looks a lot like spring, summer, fall, and winter.

Do you think the recent tax refund checks are going to help bounce the economy back? Short-term I think they have a small impact. Long-term I think the tax cuts have a sizable impact. When you start getting close to a 50% tax bracket, investors start to do dumb things. In the 1970s we had tax shelters. If you look at what people do to avoid estate taxes, they do dumb things. I think the tax cut was important to keep people working. What our politicians don't realize is that it takes two people to create a job: It requires someone willing to work, and someone willing to hire them. Even if the worker isn't in the 50% tax bracket, maybe their boss is and at some point you say 'Screw it, it ain't worth working.' The reason we had high unemployment in the 1970s was because it wasn't worth hiring people. Even if they made a buck, 70% went to taxes. People said screw it and took Wednesday or Friday off. I think the tax cuts are a net plus this time around, but not big.

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