The Muhlenkamp Approach: Screening for High ROEs at a Reasonable Price

    by Wayne A. Thorp

    The Muhlenkamp Approach: Screening For High ROEs At A Reasonable Price Splash image

    Ronald Muhlenkamp is the founder of Muhlenkamp & Company and has been lead manager of the Muhlenkamp Fund (MUHLX) since its launch in 1988.

    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, which he still uses today.

    His research has led to an average annual rate of return for the Muhlenkamp fund over the last 10 years of 17.3%. Over this same period, the S&P 500 has averaged a 10.7% annual total return (price change and dividends).

    The Muhlenkamp Methodology

    Muhlenkamp takes a total return approach to investing, seeking out investments that offer the best return prospects relative to their risk. He also uses a bottom-up approach to selecting stocks, but adjusts his benchmarks based upon the broad economic environment. The key criteria he uses are:

    • Above-average return on equity (ROE);
    • A reasonable price given the prevailing inflation and interest rates;
    • Positive, long-term earnings per share growth;
    • Long-term sales growth that matches or exceeds earnings per share growth;
    • Profit margins that exceed the industry norm;
    • Percentage of liabilities to assets that is below the industry norm; and
    • Positive free cash flow.

    Based on these filters, we developed AAII’s Muhlenkamp screen. The screening criteria for this strategy are presented at the bottom of this page. In addition, the Muhlenkamp screen is included in Stock Investor Pro, AAII’s fundamental stock screening and research database.


    Figure 1.
    Muhlenkamp Screen
    Figure 1 shows the performance of the hypothetical portfolio created with the Muhlenkamp screen. This approach was one of the top growth & value methodologies tracked by AAII for 2005. However, the approach has gotten off to a slow start in 2006, gaining only 0.1% for the first quarter.

    The Muhlenkamp approach has generated positive returns in seven of the last eight years—1998 was its only down year, when the approach lost 6.6%. The screen has also been able to outperform the small-, mid-, and large-cap indexes over the eight-plus year period, gaining a cumulative 347.3% between January 1998 and March 31, 2006, compared to a 33.4% increase for the S&P 500.

    Profile of Passing Companies

    The characteristics of the stocks passing the Muhlenkamp screen as of March 31, 2006, are presented in Table 1.

    Table 1. Muhlenkamp Portfolio Characteristics
    Portfolio Characteristics
    Muhlenkamp All Exchange-Listed Stocks
    Price-earnings ratio (X) 12.4 21.1
    Price-to-book-value ratio (X) 2.19 2.35
    Return on equity (%) 24.9 10.4
    PE to EPS estimated growth (X) 0.95 1.40
    EPS 5-yr. historical growth rate (%) 17.6 11.1
    EPS 3-5 yr. estimated growth rate (%) 13.1 14.5
    Sales 5-yr. historical growth rate (%) 32.9 8.0
    Market cap. ($ million) 659.6 478.3
    52-wk relative strength vs. S&P (%) –7 2
    Monthly Observations
    Average no. of passing stocks 21  
    Highest no. of passing stocks 44  
    Lowest no. of passing stocks 6  
    Monthly turnover (%) 25.7  

    For the last 52 weeks, the stocks that currently pass the Muhlenkamp screen have underperformed the S&P 500 by 7%, while the typical exchange-listed stock has outperformed the S&P by 2%. The Muhlenkamp approach does not depend upon selecting stocks with price momentum.

    Fourteen companies passed the screen as of this date and they are listed in Table 2 in descending order by current return on equity. The number of passing companies currently is down from the historical average of 21. The Muhlenkamp screen has below-average turnover compared to all of the strategies AAII tracks—on average, 25.7% of the portfolio is replaced each month.


    Return on Equity
    Return on equity (ROE) is a popular measure of profitability and corporate management excellence. It is calculated by dividing the annual earnings of the firm by stockholder’s equity and relates earnings generated by a company to the investment that stockholders have made and retained within the firm. It indicates how much the stockholders earned for their investment in the company. Generally, you would prefer a higher return on equity.

    In order to pass the AAII Muhlenkamp screen, a company must have a current return on equity greater than 14% (the post-World War II average). In addition, a company’s average ROE over the last five years must be at least 14%.

    For the companies that passed the Muhlenkamp screen as of March 31, 2006, their median current ROE of 24.9% is well above the hurdle; the median ROE for the typical exchange-listed stock is only 10.4%. One likely cause for this disparity is the positive long-term earnings growth requirement of the Muhlenkamp screen.

    While Muhlenkamp looks for an above-average return on equity, the price he is willing to pay for that company depends upon the current and expected levels of inflation and interest rates. Higher inflation leads to higher required interest rates and stocks must therefore be priced more affordably to attract investors. The end result is that in a high inflation and high interest rate environment, price-earnings ratios should be relatively low.

    Required Equity Returns and Reasonable Prices
    Muhlenkamp derives a required equity return by taking the inflation rate and adding a long-term debt premium and a stock return premium to it. This required return is then used to arrive at a required return on equity and, ultimately, the maximum he is willing to pay for earnings.

    Short-term Treasury bills are very liquid and the normal risk-free investment benchmark. The Treasury-bill rate provides an indication of the ability to offset inflation on a current basis and benchmark against other investments. If inflation is 2%, which was the case in 2003 when this screen was created, Muhlenkamp would require at least a 2% return from Treasury bills.

    Long-term AAA-rated corporate bonds are riskier than Treasury bills and have a less certain payout. These qualities lead to a higher expected return before an investor will invest money in a long-term corporate bond. In general, Muhlenkamp requires a 3% premium over Treasury bills before he will consider investing in long-term AAA corporate bonds. If inflation and Treasury bills are both 2%, Muhlenkamp would require at least a 5% return on a 30-year AAA bond.

    Stocks are perceived to be riskier than bonds for a given company primarily because of the greater volatility of stock prices compared to bond prices. While Muhlenkamp reminds us that this volatility is less important as investors lengthen their time horizon, stock investors still demand a premium return over bonds as compensation for the increased volatility and risk inherent in stocks. Muhlenkamp notes that this stock return premium is normally 3% above the long-term AAA bond rate.

    For our example, with AAA bonds at 5%, investors would, on average, require an 8% return to even consider committing money to stocks. The equity return is based upon a 2% inflation rate, a 3% long-term debt premium and a 3% stock premium.

    Muhlenkamp does not like to pay more than twice book value for a stock, but handles the calculation in relation to his required rate-of-return equation. To pay twice book value in terms of the required return translates into a doubling of only the equity premium; it does not require paying for inflation twice or the debt premium twice. Thus, paying two times the book value using the numbers in the example above [2% inflation rate plus a 3% debt premium plus two times 3% equity premium] would result in an 11% to 12% return on equity.

    Price-Earnings Ratios
    Muhlenkamp takes his analysis one step further to derive a price-earnings ratio by noting that, since return on equity is just earnings divided by book value (E/B) and a price-earnings ratio (P/E) is price to book value divided by return on equity (P/E = P/B ÷ E/B), paying two times book value for a 12% return on equity equates to paying 16.7 times earnings (P/E) when inflation, interest rates, and return on equity are as described in our example:

    P/E = (P/B) ÷ (E/B)
      = 2 ÷ 0.12
      = 16.7X

    Rounding up to 17, this is the maximum price-earnings ratio allowed for our Muhlenkamp screen.

    While the AAII screen uses a maximum price-earnings ratio of 17 that is based on inflation and interest rates prevailing in 2003, it is interesting to note the inverse relationship between Muhlenkamp’s required rate of return (and resulting required return on equity) and the maximum price-earnings ratio. As his required rate of return increases, Muhlenkamp is not willing to pay as much for earnings, and vice versa.

    For example, using inflation and interest rates prevailing in 2005 (average inflation at 3.4%), Muhlenkamp’s required minimum rate on a T-bill would also be 3.4% (lower than current 90-day T-bills, which are yielding around 4.5%). Adding an additional three percentage points each for the long-term debt and stock premiums gives us a required equity return of 9.4%. However, since Muhlenkamp is willing to pay up to twice the book value of a stock, which means paying twice the equity premium on a given return on equity, a 12% to 13% return on equity would be implied (3.4% + 3% + [2 × 3%]). Thus, the maximum price-earnings ratio Muhlenkamp would accept for paying two times book value for a 13% return on equity would be 15.4 (2 ÷ 0.13), compared to the 16.7 maximum price-earnings ratio he would pay for a 12% return on equity. [We do not view this as a significant difference and, therefore, have not changed the original P/E requirement.]

    This relationship is also mirrored in the characteristics of the current set of companies passing the Muhlenkamp screen compared to all exchange-listed stocks. For the Muhlenkamp firms, the median price-earnings ratio is 12.4 (and a median 24.9% return on equity), compared to a 21.1 median price-earnings ratio for exchange-listed stocks (and a 10.4% return on equity).

    Long-Term Earnings and Sales Growth
    Muhlenkamp believes that it is important to consider growth in a number of ways. The relationship between growth and return on equity is key. If the return on equity is higher than the growth rate, the company is probably generating free cash flow. It’s important to find out how the company uses this excess cash. Muhlenkamp feels that most companies have a core business that they are very good at, but they get in trouble when they “do dumb stuff with it.” Nevertheless, cash flow puts a company in control of its own destiny, which is one of the reasons why Muhlenkamp likes return on equity as a starting place rather than growth rates.

    Growth rates higher than the return on equity are not sustainable in the long run without additional equity or debt financing. Taking on debt has absolute limits and must be done carefully by companies in volatile industries. Issuing additional equity dilutes the ownership of existing shareholders, making their stock worth less on a per share basis. Muhlenkamp prefers companies with a return on equity that can comfortably fund growth.

    Given the requirements of positive long-term growth in sales and earnings, it is probably not surprising to find that the companies currently passing the Muhlenkamp screen surpass exchange-traded stocks in both regards. The median, five-year annualized growth rate in earnings per share for the current group of companies passing the Muhlenkamp screen is 17.6%, while the median for exchange-listed stocks is 11.1%.

    The difference is more pronounced when looking at the median five-year sales growth for both groups of companies—32.9% for those companies currently passing the Muhlenkamp screen versus 8.0% for exchange-listed stocks.

    Interestingly, and without explanation, the median estimated growth rate in earnings per share for exchange-listed stocks (14.5%) is greater than that of the companies passing the Muhlenkamp screen (13.1%).

    Market Capitalizations
    Companies with high(er) returns on equity tend to be small(er) companies. As a result, we see that the median market capitalization for those companies currently passing the Muhlenkamp screen is almost $660 million.

    This does, however, exceed the $478.3 million median market cap for exchange-listed stocks.

    Timing Sells: Relative Strength
    Muhlenkamp does not attempt to time the market when building positions in stocks. He feels that if he buys good values, sooner or later the market will figure it out. His 30 years of investing experience have not revealed any market indicators that are reliable in timing the market. If the price is right, the time is right. Muhlenkamp feels that he can determine a fair price much more easily than he can determine the appropriate time to buy a stock.

    Interestingly, he does look to the market to reveal if it is time to sell a position. Muhlenkamp sells a company if the fundamentals are disappointing or if the stock is acting poorly and he can’t figure out why.

    In a sense, his rule is to sell when relative strength breaks down. Muhlenkamp notes that you can call up corporate management, and they will tell you the good news for the next five years, but they usually won’t tell you the bad news until after it’s happened and it’s too late.


    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.

    As always, it is important to realize that stock screening is only the first step in the stock selection process. The stocks passing the Muhlenkamp screen do not represent a “recommended” or “buy” list of stocks. It is important to perform due diligence to verify the financial strength of the passing companies and to identify those stocks that match your investing tolerances and constraints before committing your investment dollars.

       What It Takes: Muhlenkamp Screen Criteria
    • Return on equity for the last 12 months (trailing four quarters) is greater than 14%

    • The average return on equity over the last five fiscal years is greater than 14%

    • The current price-earnings ratio is less than 17

    • The compounded, annualized growth rate in fully diluted earnings per share from continuing operations over the last five years is positive (greater than zero)

    • The compounded, annualized growth rate in fully diluted earnings per share from continuing operations over the last five years is greater than or equal to the median compounded, annualized growth rate in fully diluted earnings per share from continuing operations over the last five years for the industry

    • The compounded, annualized growth rate in sales over the last five years is greater than or equal to the compounded, annualized growth rate in fully diluted earnings per share from continuing operations over the last five years

    • Net margin for the last 12 months (trailing four quarters) is greater than the median net margin for the last 12 months (trailing four quarters) for the industry

    • Operating margin for the last 12 months (trailing four quarters) is greater than the median operating margin for the last 12 months (trailing four quarters) for the industry

    • The ratio of total liabilities to total assets for the last fiscal quarter is less than the median ratio of total liabilities to total assets for the last fiscal quarter for the industry

    • Free cash flow per share for the last 12 months (trailing four quarters) is greater than or equal to zero

    • The company is based in the United States (not an ADR or ADS stock)

    • The company is traded on either the New York, American, or NASDAQ exchanges (not traded over the counter)

    Cara Scatizzi is associate financial analyst at AAII.

→ Wayne A. Thorp