While a lot of investors seem to be looking for earnings growth at any price, Muhlenkamp Fund manager Ron Muhlenkamp is looking for something different: profitability at a fair price.
The fund manager, based in suburban Pittsburgh, Pa., uses a two-step process to choose stocks: screening for companies whose ROE, or return on equity, is higher than the market average, and then screening for stocks with a ROE percentage figure higher than their own price-to-earnings ratio. Because the market's average ROE is currently about 14%, he tends to buy stocks with relatively low P/Es. The average S&P 500 P/E is now over 24.
Muhlenkamp defines return on equity as annual per-share profit divided by per-share equity. A company that earns $7 a share and whose assets total $40 per share carries a ROE of 17.5%.
He looks at ROE instead of sales or earnings growth because "it relates the income statement back to the balance sheet. A company with an ROE of 18 is more than twice as well-run as one with a 7 ROE. We're not interested in companies that are growing fast but not profitable, or who can't sustain that profitability."
He believes too many investors stress year-over-year earnings growth--often using projections rather than hard numbers. "I have a lot more conviction in today's numbers. It's a little more reality, a little less hope."
Muhlenkamp, whose portfolio is loaded with transportation stocks, likes to ride to work on a Harley and uses car metaphors to describe his investment strategy.
"We like to buy Pontiacs and Buicks when they're on sale. I don't want a Yugo at any price. I like Cadillacs myself, but it's not too often they go on sale."
The fund is up just 3.4% year-to-date, but its longer-term record is stronger, with annualized returns of 22.3% over the last three years and 18.2% over the last five years, according to Chicago-based researcher Morningstar Inc. By comparison, the average mid-cap value fund has returned 0.1% year-to-date, and 16.2% and 14.4% annualized over the last three and five years, respectively.
"As of July, we still look smart. As of now, we still look dumb," Muhlenkamp says. "We're in the soup with all the value players."
He says the market "has been concept- and momentum-driven lately--like with the Internet stocks," but believes that in the long haul his value slant will pay off. "Over time, quality is rewarded."
The Times asked Muhlenkamp for his latest stock picks based on his mathematical model and fundamental analysis. His portfolio, which had been heavy in financial stocks in years past, now tilts toward cyclical companies beaten down by recession fears. In some cases, the P/E now exceeds the ROE. His choices:
* AMR, parent of American Airlines: "It's primarily a domestic airline--and we're not interested in those that fly to the Far East [because of economic woes there]. The overseas business is mostly to South America, which is in reasonable shape. The last several quarters, it's beaten Wall Street estimates, and when people get over their fear of recession they'll respond to how well it's doing. We don't expect '99 earnings to grow, but that doesn't mean it's not worth anything. Neither does a Treasury bond grow, but it sells for 20 times earnings--not 10."
* BE Aerospace: "It has 50% of the market of providing seats in airlines, and if you've been in an airplane lately, you know a whole lot of them need to refurbish their seats. A lot of airlines are making money again, so BE has a backlog."
* Conseco: "They sell annuities and supplemental insurance, primarily to baby boomers. Here we do expect sizable earnings growth--$3.25 this year and $4 in '99. It's cheap because of the acquisition of Green Tree Financial, the mobile home financing company. Historically, there haven't been a lot of mobile home refinancings, and some analysts misunderstand what's happened, only looking at half the picture. Green Tree is keeping all these refinancings on its books and getting spreads as good or better than they did on the original loans, but not getting credit for it from the analysts. And they lump them in with companies making loans on low-quality used cars, a couple of which went out of business, but that's a mistake."
* Ford Motor: "Frankly, we expect '99 earnings to be flat, but cash flows are good, and at a 10 or 11 [P/E] multiple it's a good place to put some money. With $20 a share in cash, it's not going out of business real soon. We're expecting a slowdown, but not a recession."
* National RV Holdings: "They make top-of-the-line motor homes. At a big show in Pomona [a few] weeks ago, National and its competition signed record amounts of business. People fear slowdown or recession, but their clientele at the moment is still buying."