Newsletter

August 11, 2007

Don't Overanalyze

The Muhlenkamp Screen: High ROEs at a Reasonable Price

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Don't Overanalyze

When your hard earned money is on the line, there's a strong urge to be extremely careful. Why? If you should make a mistake, you could end up taking a big loss, or worse yet, you could find yourself in a major drawdown situation.

It's a natural human tendency to be averse to risk, but if you're not careful, you may be afflicted with a severe form of analysis-paralysis. Although it is often the case that an analysis of all possible alternatives and all possible consequences of one's decisions is the hallmark of good decision-making, too much analysis can be and often is a distraction.

The question becomes; why are we consumed with making a mistake? Throughout our lives, we have been taught to make prudent decisions rather than acting on impulse. Great thinkers, such as Benjamin Franklin, advocated evaluating the pros and cons carefully before making a decision. Research studies have shown, for example, that cultivating a deliberative mindset helps people focus on and consider incoming information and decrease the influence of self-serving decision-making biases.

A study by psychologists Dr. David Armor and Dr. Shelly Taylor suggests that in some cases, it may be wise to just quickly choose an alternative and focus all your energy on achieving an objective. In a well-controlled experiment, participants were randomly assigned to one of two conditions. In the deliberative condition, participants were asked to decide between two equally effective strategies to obtain a reward, before using one of the strategies to reach an objective. In a second condition, participants were not given a choice, so they would immediately focus all their energy on using a single strategy to achieve the desired goal. There were clear advantages to focusing on a specific strategy, rather than deciding between two options. Participants who did not have to choose, and did not deliberate, showed greater determination, commitment, curiosity, and confidence than those who did. They also viewed the task as less difficult and performed better.

Many trading decisions must be made quickly before market conditions change. Through experience with the markets, you can analyze information quickly and reach a decision. While trading, it does not help to deliberate too much. It just doesn't pay off. You may not always be right, and you may have a few losing trades, but that's the nature of the game. Through a carefully devised trading plan and risk management, however, you can minimize the impact of a single losing trade, and make enough winning trades to come out ahead. So when you start to see yourself over-analyzing and becoming paralyzed, stop! Just put on the trade already. You'll trade more profitably in the long run.
The Muhlenkamp Screen: High ROEs at a Reasonable Price

Ronald Muhlenkamp started his career over 30 years ago as a portfolio analyst and soon was managing assets directly. In the early 1970s, Muhlenkamp undertook an extensive study of both fundamental and technical investment philosophies and practices and developed a proprietary method for evaluating both stocks and bonds-he still uses it today. Muhlenkamp founded Muhlenkamp & Company in 1977 to manage accounts for individuals and institutions and launched the Muhlenkamp Mutual Fund (MUHLX) in 1988. The Muhlenkamp fund has averaged a 10.4% annual rate of return over the last 10 years while the S&P 500 has returned 8.5%.

When people on Wall Street talk about risk, they really are talking about the variability of returns, not the probability of losing money. Wall Street maintains that stocks are riskier than bonds simply because there is a greater variation in the one-year return. We have found, however, that you don't need to predict interest rates to know when to own bonds. You only need to know whether current "real" returns are attractive. Muhlenkamp defines risk as the probability of losing purchasing power over time. When we look at bonds, we subtract the current inflation rate from the current yield level to get the expected "real" return. We then set a hurdle rate of a 3% "real" return before we are willing to lend money by buying bonds. Muhlenkamp believes the reason stocks perform better than bonds is not because they are "riskier" but because corporate management works for the stockholder and against the bondholder.

Muhlenkamp takes a total return approach to investing, seeking out investments that offer the best return prospects relative to their risk. While Muhlenkamp is normally invested in stocks, he can invest in bonds if they are attractive relative to domestic or foreign stocks. The complete public market makes up his investment universe. He uses a bottom-up approach to selecting stocks, but adjusts his benchmarks based upon the broad market and economic environment. He begins by looking for companies with a return on equity (ROE) above 14%. Muhlenkamp indicates that since World War II, the average ROE in the United States has been 14%, plus or minus 1%.

Return on equity indicates how much the stockholders earned for their investment in the company. Annual net income of $100 million created on a $300 million stockholder's equity base is very good. ($100 ÷ $300 = 0.30 or 30%) However, $100 million in annual net income relative to $3,000 million in shareholder's equity would be considered poor ($100 ÷ $3,000 = 0.03 or 3%). As a General statement; the higher the return on equity, the better. Muhlenkamp looks for an above-average return on equity, but the price he is willing to pay for that company depends upon the current and expected levels of inflation and interest rates.

While much of Muhlenkamp's approach is qualitative, here are some quantitative data points to construct a basic screen to seek companies with high return on equity ratios that are trading at reasonable prices.

The first filter looks for companies with a current return on equity (earnings per share over the latest 12 months divided by book value per share as of the latest quarter) greater than 14%. Muhlenkamp seeks good companies trading at a discount. The return on equity should be stable and sustainable. The next filter looks for companies whose average return on equity over the last five years is also above 14%. This helps highlight companies that have; performed on a more consistent basis.

REASONABLE PRICE

Muhlenkamp wants to acquire companies that are priced attractively relative to bond rates and inflation. Depending on current market conditions and economic environment a stock with a return on equity of 12% would be considered if it's trading with a price/earnings ratio below 17. The Muhlenkamp screen requires a current price-earnings ratio below 17.

SECONDARY FACTORS

Muhlenkamp feels that the smaller the company, the more you have to get to know management. But by and large, if there's good management, it comes through in the numbers. His analysis looks at companies in four ways: growth, profits, financial strength and labor relations.

CONCLUSION

Muhlenkamp attributes his long term success to sticking with something that works, while keeping an open mind. Muhlenkamp points out that there have been about three times in the 30 years he has been investing when the public changed its mind about something critical. He calls that a climate change, which changes the investment environment. For example, what worked in the 1960s didn't work in the 1970s, and what worked in the 1970s didn't work in the 1980s. In each of those periods the public changed its mind, and if you try to keep doing the things that worked prior to that, you get your head handed to you. Muhlenkamp provides a helpful framework to consider economic and market conditions when selecting stocks.

The Prudent Trader member watch list contains a Return on Equity screen, members are or should be aware that screens in and of themselves are not a buy or sell recommendation. Screens narrow your search, basis pre-defined criteria; you still must do your own independent research basis your individual criteria for investing/trading. Like all screens, this interpretation represents a starting point for further analysis.

Sources:
  • Muhlenkamp Funds
  • American Association of Individual Investors
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    Have A Great Week!

    Bill
    Prudent Trader.com

    Disclaimer: Trading in securities, of any type, may not be suitable for all individuals. The contents of this newsletter are not a solicitation to buy or sell securities. The opinions expressed are solely that of the author. You must do your own research, contact your own financial advisor for suitability of any investments. Data gathered is from sources believed to be reliable, but NO guarantee as to their accuracy is made.