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Quarterly LetterBy Anthony Muhlenkamp

Issue 113 Published First Quarter January 2015

MuhlenkampMemorandum

Tony had some ideas and observations he wantedme to share, but I thought it made sense for himto tell you directly in this edition of our QuarterlyLetter. Ron

2014 was a year of mixed results and mixedemotions.

The headlines make no secret that the marketis setting new highs. However, the marketthey are referring to is the S&P 500, which is

dominated by the 20 largest market capitalizedcompanies in the United States. Outside thosetop 20 is a mixed bag of winners and losers.Small caps in the Russell 2000 are flat forthe year; energy stocks are down for the year;international stocks were down for the year;bio-tech was up for the year.

Additionally, the gains did not occuruniformly; instead prices were choppy andadvanced/declined with your particular choiceof stocks. If you were out of the market onparticularly good days, or particularly bad ones,then your performance differed radically fromthat of the market. If you were taking out somemoney, or adding some money, the timing of

that transaction could make a big difference inyour performance.

A friend of mine confided that his wifes 401(k)is allocated 30% international, 30% domestic,and 30% bonds and that her performance thisyear was just 1%. So how you did this yearhinged on what you owned (or didnt own)and when you bought or sold it. This was notthe homogeneous market we hear about onthe news.

For our clients, we continued the strongperformance we had in 2013 through the firsthalf of the year, to the extent that we startedharvesting the companies that had done

well for us and realized some capital gains.In the third quarter the market prices of ourcompanies were bid down and from there itwas a mixed bag.

A big factor in the last half of the year wasthe price of crude oil dropping from $110per barrel to $60 per barrel; a drop of 45%.Our energy holdings are primarily natural gas

related and should not have been impacted byoil prices being halved, or so we thought. Weknow the price of natural gas and the price ofoil have been on separate tracks since 2009;(see our booklet Natural Gas: An EnergyGame Changer). The separate tracks for theprices of oil and natural gas continued in 2014but the prices of the stocks of the companiesinvolved went down with the price of crude.This should be an opportunity, but owning

natural gas companies hurt our performance inthe last half of the year.

The big beneficiary of the decline in the price ofoil is the U.S. consumer, and to a lesser extent,the world consumer. There are 42 gallons ina barrel of oil, so a $50 drop in the price perbarrel is a drop of $1.20 in the price per gallon,and youve seen that at the gasoline pump (andto a lesser extent, so far, at the diesel pump).We talk more about the effect on consumersaround the world in the accompanying articleEffects of Currency Manipulation.

The people hardest hit by the decline in theprice of oil are the producers of oil, both

domestic U.S. producers and internationalproducers, including the drillers, the servicecompanies, the landowners; etc. Producers whoare particularly vulnerable include the nationsof Venezuela and Russia. Their problems arecompounded by the rapidity of the decline.The producers, their owners, and their lendershave not yet had time to react. We expect someof them to go bankrupt.

Our biotech companies helped us, as did ourairlines and our financials. But you never ownenough of the ones that go up, and you alwaysown too much of the ones that dont.

We are disappointed when we under-performthe market, but that disappointment istempered by the realization that we own verygood companies that are selling for less thanthey are worth. We have written in the pastabout our internal performance benchmarkbeing average annual returns of at least 5%over inflation for periods of time measured inyears, not in days, weeks, or quarters; and wecontinue to meet that standard.

Returns of 5% over inflation are not availablein cash or bonds, so we are looking for

companies that areprofitable enough,and priced low enough,that we can reasonablyexpect those returns over time. We are focusingon our companies and how profitable theyare; how well they are growing; how well theyare managed; and whether they are currentlyselling for more or less than they are worth.What is the business worth? Can I buy it for

less than that or sell it for more than that? Howmuch less, how much more? Simple questionsthat dont always have simple answers.

We are also paying attention to central banks,government policies and economies aroundthe world because they set the terms by whichour businesses have to operate. We have spokenand written extensively comparing investing tofarming and how it helps to know the climateand the season you are operating in, andthese macro factors determine the investingclimate and season. These macro factors helpus know what to plant and what is ripe andcan be harvested. They determine whether ourcompanies enjoy tail winds or face head winds

as they run their business and provide theproducts and services consumers desire. Thosesame macro factors can also influence whetherconsumers have the desire and the ability topurchase those goods and services. In a freeeconomy, the consumer is king and companiesdo well that benefit the consumer; so consumerincentives are important.

Today we observe that the market is a mixedbag; some companies are profitable andgrowing, some companies are not. Somecompanies are selling for much less than theyare worth, some are selling for much more. Wecall that a stock pickers market, and its wherewe like to live.

We observe that economies around the worldare growing, although some are not growingas fast as they could. Some consumers aroundthe world are OK; some are being squeezed.In general they are OKnot starving, but notnecessarily thriving eitherand we are onthe lookout for policies that will make theconsumers life easier, or harder.

We are finding enough companies that meetour criteria, and we think macro conditionsare good enough, that we are fully invested incommon stocks.

Continued on page 2


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MuhlenkampMemorandum is a quarterly information service of Muhlenkamp & Company, Inc. 2015

Quarterly LetterContinued from cover

We continue to believe that emotionaldecisions are bad decisions. This is almostuniversally true, and clearly true for investing.We write these letters, hold our seminars,and publish booklets on various topics tohelp build an intellectual framework forinvesting and to counter the corrosive effectsof the emotions that are so prevalent amonginvestors. Please let us know how we are doingand if there is more we can do for you.

The comments made by Tony Muhlenkamp in thiscommentary are opinions and are not intended tobe investment advice or a forecast of future events.

S&P 500 Indexis a widely recognized,unmanaged index of common stock prices. TheS&P 500 Index is weighted by market value andits performance is thought to be representativeof the stock market as a whole.

Russell 2000refers to the Russell 2000 Index,a small-cap stock market index of the bottom2,000 stocks in the Russell 3000 Index. TheRussell 2000 is by far the most commonbenchmark for mutual funds that identifythemselves as small-cap.

One cannot invest directly in an index.

At our November 12, 2014 investment seminar,

I stated that the devaluation of the Japaneseyen may prompt other export-reliant countriesto devalue their currencies in turn as they try tokeep their exports competitive. A listener askedme later what the impact of such competitivedevaluation would be. In short, it would squeezeconsumers in the countries that successfullydevalue their currency. Let me explain how Iarrived at that conclusion.

First an important point: when you talkabout devaluing, you have to devalue againstsomething elseit is always relative. So youcan devalue the dollar against the yen, the Euroagainst the dollar, or the won against the yenbut you cant just devalue the dollar. Since the

U.S. dollar is the closest thing the world has toa global currency and most commodities arepriced in dollars, most countries try to devalueagainst it. So lets say Country X is interested ingrowing its economy and employing more ofits population by increasing its exports. In orderfor their export products to be more competitiveinternationally, they choose to lower the price.Reducing the selling price without reducing theproduction cost will put their companies outof business, so Country X must also reduce thecost of inputstypically mostly labor. Workersgenerally dont like wage cuts very much, soanother way to achieve a lower selling price is tomanipulate the exchange rate. If the exchangerate falls the international price of the countrys

exports will drop, but workers wages willremain unchanged (measured in the currencyof Country X). Everyone wins! To execute thisplan the central bank prints money and lowersinterest rates. (If their exchange rate is pegged,they lower the peg over time.) This combinationusually results in a lower exchange rate; i.e. moreof Country Xs currency equals the same amountof U.S. dollars. Country Xs products are cheaperinternationally, sales go up, more citizens areemployed, etc.

But did everybody really win?

No. Because the exchange rate declined,anything County X imports is more expensivethan it had been. Devaluing Country Xs

currency benefits the exporter (a business withemployees) and hurts the importer (anotherbusiness with employees), along with anyonein Country X who buys imported goods. Whatreally became cheaper from an internationalperspective is the cost of labor in Country X.Since Country Xs labor got cheaper, there ismore demand for it and employment goes up.Who benefitted? Consumers outside Country Xthat buy Country X products at a lower price andnewly hired employees inside Country X. Whopaid the price? Country Xs workers who receivedless compensation for their labor than they

otherwise would have, Country X consumers

who pay more for imported goods, and theworkers outside Country X who lost their job tocheaper labor in Country X. Everyone cant win,there are always those who benefit and thosewho are hurt. There is no free lunch.

Growth through exports aided by a cheapcurrency is called mercantilism. Mercantilismhas been tried by a lot of countries, oftenwith a fair degree of success in the short- tomedium-term. Japan did it coming out ofWorld War II. You could buy cheap Japanesecars in the U.S. in the 70s because Japaneseworkers and engineers worked cheaper thantheir American counterparts, and the exchangerate was a big part of that. China has done it for

the last 20 years: they pegged their currency atan artificially low level, so their products werecheap, and cheap Chinese labor attracted a lotof industry to their shores starting with the reallylabor-intensive stuff like making clothing andassembling electronics.

This method of growth requires at least the tacitcooperation of the foreign trading partners.Generally, after a time, mercantilism reaches itslimit and other means of growth are necessary.Notice that the Japanese yen in the 1970s tradedat 300yen/dollar; now, it is about 110yen/dollar.Depreciation against the dollar gave way toappreciation against the dollar. The Chineserenminbi is similar. You may recall duringthe 2008-09 recession there were loud calls

in America for China to quit manipulating itscurrency and allow it to appreciate. Americabecame more interested in the welfare of itsexporting workers than its importing consumersand tolerance for a cheap renminbi declined.

Today, Japan is very interested in devaluing itscurrency against all other world currencies andis printing money at a fantastic rate to do that.Their goal is to spur economic growth throughexports. Their problem is they import most oftheir raw materials and energy. Their exportingcompanies will benefit, but their consumers willsee costs go up. There is both a benefit, and acostyou never get one without the other.

There are several other countries whosegovernments are interested in economicgrowth via exports, including Korea, China,and Germany. Highly engineered German andKorean capital goods compete directly withJapanese capital goods. As Japanese productsget cheaper, they should sell more of thematthe expense of their global competitors. Thosecompetitors may decide to fight back, in part,by printing money and lowering their interestrates; i.e. devalue their currency! (against thedollar). Now you have multiple countriessimultaneously trying to devalue their currenciesin order to maintain market share in their export

Effects of Currency Manipulationby Jeff Muhlenkamp

markets and thus

keep their citizensemployed.

Why is that so bad?

Remember that Country Xs worker washurt as he received lower compensation than heotherwise would have. Country Xs consumerof imported goods was also hurt as importprices rose. Often, currency devaluations areaccompanied by domestic inflation (which isa stated goal of Japans central bank). Inflationhurts the saver and benefits the borrower. Sumthat all up and what do we get?

If Japan, Korea, Europe, and Chinasimultaneously try to devalue their currencies

it only has a hope of working if the U.S.doesnt join in. (The U.S. must tacitly allowthem to devalue against the dollar.) Thisimplies a strong dollar and lower commodityprices (measured in dollars).

Who benefits? The only clear beneficiaryis the U.S. consumer of imported goods.Japanese, Korean, European, and Chineseexporters dont gain market share, they onlysucceed in holding what they had. If there is


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The Healthcare Industry and the Consumerby Anthony Muhlenkamp


MuhlenkampMemorandum is a quarterly information service of Muhlenkamp & Company, Inc. 2015

www.muhlenkamp.com (877) 935-5520

The headline topic for our November 12, 2014

investment seminar was Game Changersin Biomedical Science delivered by TammyNeff, an analyst on our investment team. Shehas written about the topic inMuhlenkamp

Memorandum #112, and in a booklet that wecan mail you or that you can download fromour website, but I would like to highlight anelement from her talk that I found particularlyinteresting. What are the effects the consumer ishaving on the healthcare field; and what are theeffects that the advances in biomedical scienceare having on the consumer?

Today, on a per-person basis, $.22 of everydollar spent in this country goes to healthcare.This average includes the money that youpay out-of-pocket, along with benefits paidon your behalf by your healthcare insurer.It encompasses doctor visits, hospital stays,lab testing, medications, outpatient physicaltherapy, etc.and its the biggest piece of thepie of total consumer spending. Comparingapples-to-apples, 11% of all consumer spendingwent to healthcare in 1980. Stepping back evenfurther, healthcare spending averaged 6% in1960.1So, starting in 1960, we nearly doubledwhat we spent on healthcare by 1980and wedoubled it again from 1980 to 2013.

Some argue this is a bad thing and concludethat healthcare costs are too high. We think its

indicative of people being more prosperousthan they were and not having to spend it all onfood, clothing, and shelter. Despite best efforts,there appears to be a limit to what people caneat, and how much house and clothes peopleneed. So spending on health care is a rationalnext priority.

Today, over $130 billion is invested annuallyin biomedical research2and consumers arebenefitting. If you were born in 1900, theaverage life expectancy was about 47 years; in2012, its about 78 years.3

We think the significant increase in consumerspending on healthcare over the last 54 yearsresults from a combination of:

1. Continuous Innovation: For example, in the

1960s, open-heart surgery was perfected.In the 1970s, we gained MRI technology,enabling less invasive, more precisediagnoses. Today, there is genetic-basedtesting and precision treatment for cancerouscells.

2. Aging Baby Boomers: As the U.S. populationages, consumers demand more services likehip and knee replacements.

3. Expanded Insurance Coverage: 1966brought us Medicare, providing healthcarecoverage for Americans ages 65 and older.2010 brought us the Patient Protection andAffordable Care Act, providing millions

of Americans access to health insurancecoverage. Additionally, in the 60s, healthinsurance predominantly covered hospitalstays and surgical procedures. Insurancecoverage now includes outpatient care,physical therapy, chiropractic care,medications, artificial limbs, etc.

We have often observed that in a free economythe consumer is king, and that any product orservice that has direct and measurable benefitsto the consumer is likely to have legs. Theadvances in the field of biomedical science is anarea that may well fit that description. More andmore people seem to be receptive to the ideaof living long enough to live forever, and that

can be a powerful trend.

With that in mind, we focus on thosecompanies that we think will ultimately providecost savings to the healthcare system, andthe consumer, through the following gamechangers:

Transforming the model of healthcare fromdisease management to disease preventionthrough personalized medicine;

Rethinking the approach to the war oncancer; and

Curing diseases that were previously life-longconditions.

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

1 U.S. Bureau of Economic Analysis; all data is adjusted for inflation.2 Research America; Truth and Consequences: Health R&D Spending in the U.S. (FY11-12)3 1900-1960, Andrew Noymer, University of California Berkeley; 1961-2014 World Bank

inflation in Japan, Korea, Europe, and China,it will benefit entities that borrowed in thosecurrencies.

Who loses? Japanese, Korean, European, andKorean consumers of imported goods. All ofthose countries are big energy importers, so

all of their consumers pretty much lose. (Forexample, the price of crude oil has recentlydropped by 45%, from $110 per barrel to $60per barrel. Since oil is still priced in dollarsit has benefited the U.S. consumer, but theJapanese consumer has seen no benefitbecause the yen has been devalued relative tothat same dollar.) Their export workers lose.To the extent they have domestic inflation, allof their savers lose.

Any foreign entity that borrowed in dollars,but whose income is in a foreign currency,will find it increasingly difficult to maketheir interest payments; expect defaults. And,of course, one mans debt is another mansbond, so the holders of those bonds lose.

The drop in commodity prices due to thestrong dollar makes it more difficult for theBank of Japan and the European CentralBank to achieve their stated goals of 2%inflation.

What happens if the United States tries toprevent other currencies from devaluing againstthe dollar and lowers interest rates and printsmoney like everybody else? Then, the onlybeneficiaries are the debtors, as their debtswill be denominated in increasingly worthlesspaper. All savers lose, all consumers lose, andmost workers lose. Since the biggest debtors aregovernments, they winat the expense of theircitizens.

Where are we today? Until October 2014 theU.S. was actively printing money. While theFederal Reserve didnt say it wanted a weakerdollar, thats what happened for the last fewyears (on a longer time scale, a weaker dollarhas been happening for decades). The U.S. hasended Quantitative Easing (QE), and may raiseinterest rates in the next six months. The dollarhas been stronger against most currencies overthe last 6 months; commodity prices are falling(measured in dollars), in some cases quitedramatically, creating additional trouble forRussia, Indonesia, and Brazil. Japan is activelydevaluing its currency, so far successfully. Ifthe other nations of the world allow Japan to

continue to do so the pain will be limited toKorean, U.S., German, and Chinese exporters,and the Japanese consumer. If other countriesbegin to devalue, the pain spreads as describedabove.

We pay attention to these types ofmacroeconomic issues because doing so helpsto avoid risk and identify opportunities forinvestment. As we learn things that are ofinterest and not well covered or understoodby mainstream media we will continue to passthem along.


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Inside this issue:

Quarterly Letter Effects of Currency Manipulation The Healthcare Industry and the Consumer

Muhlenkamp & Company, Inc.Intelligent Investment Management


GLOSSARY:

Currency Pegis when a country or governments

exchange-rate policy pegs its central banks rate ofexchange to another countrys currency. (Currency hassometimes also been pegged to the price of gold.) Alsoknown as a fixed exchange rate or pegged exchangerate, currency pegs allow importers and exporters toknow exactly what kind of exchange rate they can expectfor their transactions, simplifying trade. In turn, this helpsto curb inflation and temper interest rates, allowing forincreased trade.

Central Bankis the entity responsible for overseeing themonetary system for a nation (or group of nations).Thecentral banking system in the U.S. is known as the FederalReserve (commonly referred to the Fed), comprisingtwelve regional Federal Reserve Banks located in majorcities throughout the country. The main task of the Fedis to conduct monetary policy that promotes maximumemployment and stable prices.

Quantitative Easingis a government monetary policyused to increase the money supply by buying governmentsecurities or other securities from the market. Quantitativeeasing increases the money supply by flooding financialinstitutions with capital in an effort to promote increasedlending and liquidity. Central banks tend to usequantitative easing when interest rates have already beenlowered to near 0% levels and have failed to produce thedesired effect. The major risk of quantitative easing is thatalthough more money is floating around, there is still afixed amount of goods for sale. This may eventually leadto higher prices or inflation.

At our investment seminar

on November 12, 2014,Tammy Neff, InvestmentAnalyst, addressed GameChangers in BiomedicalScience. Additionally, RonMuhlenkamp, PortfolioManager, provided amarket update, and JeffMuhlenkamp, InvestmentAnalyst and Co-Manager,provided an update onwhats taking place in

Europe and Japan.

A video archive of thepresentations is available inthe Library section of ourwebsite. If you prefer, call usat (877)935-5520 and wewill mail you a DVD.

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