Five Questions for Ron Muhlenkamp

Since 1988, Ron Muhlenkamp has generated impressive returns for his mutual fund, which holds nearly $3 billion in assets. Over the past ten years through October 31, Muhlenkamp fund returned and annualized 13.5%, an average of nearly five percentage points per year better than the record of Standard & Poor's 500-stock index. Its long-term performance has earned it a place in the Kiplinger 25, a list of the best stock and bond funds you can buy without paying sales fees.

Muhlenkamp looks for companies with high returns on equity and low price-to-earnings ratios. He's also a thematic investor and will position his portfolio according to his outlook for the economy. His fund has big stakes in homebuilding and energy stocks, which have been a drag on returns lately. In the first ten months of 2006, the fund lost about 1% while the SP 500 returned 12%. But over breakfast recently in New York, Muhlenkamp insisted that his fund is well positioned for an economy that is about to rebound.

KIPLINGER'S: Since you incorporate your outlook for the economy into your stock-picking strategy, why don't we start with that.

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MUHLENKAMP: For the past year we have been talking about a transition period, which is our way of saying that, in the big picture, we're back to the 1960s. Inflation has been between 2% and 3% for nine years now. Last time we had that was in the '60s. Long-term interest rates historically have been 2.5% to 3% over inflation. They've been in that range four years now and five out of the last six. Short-term rates had gotten unusually low. When they went from 1% to 4% they were just getting back to normal. All through the '70s, as inflation rates went up, people said they would come back down. All through the '80s and '90s, as they went down people said they'd go back up. Well they haven't for four years now. We think that inflation and interest rates are back to normal, but it's a normal we haven't seen since the 60s.

If this is a transition, what are we transitioning to? The reason we're calling it a transition is that for a year or so the soft landing [an economic slowdown that doesn't become a recession] had a greater-than-50% probability. We're seeing confirming evidence that it has happened. Long rates rolled over in April. The 30-year Treasury has gone from a 5.4% to 4.75% and is now about 4.85% (the bond finished trading on November 10 at a yield of 4.69%). That's a huge move. Commodity prices have rolled over, beginning with energy, but also steel, copper, lumber. The Fed has now kept rates unchanged three times. Mortgage rates have ticked down. So we think the odds are growing that this is a soft landing like '94-'95.

In April the fear was that we were going too fast and were going to get inflation. And the markets were led by things like commodities, foreign stocks and very aggressive stuff. Then everything corrected in May and June. Since June the leadership has been defensive stocks: food, utilities, pharmaceuticals. All of that makes sense if we're going into a recession. What people tend to forget was that in '94-'95, though we had a soft landing, the market was acting as if we were coming into a recession. The market prepares for a recession, whether you get it or not. That's kind of what has happened since April. We've seen signs that that's ending.

What do you buy coming off of a soft landing? When you go through a business cycle, you start with bonds and financial stocks, move to consumer cyclical stocks, then to deeper cyclical stocks and then to things like commodities. That is why in 2000 we were buying housing stocks. I've looked dumb in the past year, but I still own them. If I didn't own them I'd have to be buying them today. Because we're not having a recession, you don't get the length or the depth of the drop that people allowed for. If we are right on the soft landing, I own what I want to own. It's the same stuff I owned coming out of 2000.

But didn't housing stocks get too expensive? They rose all the way up to ten times earnings. When we bought them in 2000 they were selling at five times earnings and we fully expected that earnings would get cut in half in the 2001 recession, so we said okay, we're buying them at ten times earnings. The big surprise is that earnings didn't get cut in half. Between today and next year earnings probably do get cut in half. But in the meantime, most of the builders are buying in their own stock. We own some NVR. It has bought in 15% of its own stock in the past year and has another 5% to go. Even if earnings drop 20% on a per-share basis, we own 20% more of the company. This is a company that has been buying in its own stock for 15 years. The company bought in about 70% of it. The stock has gone from $15 to $500, which ain't all bad.

You also have been buying large-company stocks. We have more than we used to. At a price-to-earnings ratio of 15, I'll buy a Johnson & Johnson or a Pfizer. Ten years ago the average return on equity was 30 and P/Es were 30. Today the ROEs are 20-plus and the P/Es are 15. We tell the public we want to buy Pontiacs and Buicks when they go on sale. We also like to buy Cadillacs, but they don't go on sale very often. Today, some of the Cadillacs are on sale. Johnson & Johnson is a Cadillac. The average ROE in our portfolio is 18. The average company's is 14. So we own Buicks. Our average P/E today is 10. The average P/E out there is 16. So we got Buicks at below Chevy prices.