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    The Muhlenkamp Stock Screen: High ROEs at a Reasonable Price

    by John Bajkowski

    The Muhlenkamp Stock Screen: High ROEs At A Reasonable Price Splash image

    Ronald Muhlenkamp has devoted his entire business career to the professional management of investment portfolios. 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%.

    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, and small or large companies. The complete public market makes up his investment universe.

    Muhlenkamp uses a bottom-up approach to selecting stocks, but adjusts his benchmarks based upon the broad economic environment. Muhlenkamp 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 is a popular measure of profitability and corporate management excellence. The measure is determined by dividing the annual earnings of the firm by stockholder’s equity. It relates earnings generated by a company to the investment that stockholders have made and retained within the firm. Stockholder’s equity is equal to the total assets of the firm less all debt and liabilities. Also known as stockowner’s equity, owners’ equity, book value, or even simply equity, it represents investor’s ownership interest in the company. On the balance sheet it is the sum of preferred stock, common stock and retained earnings.

    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%) Generally, 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.

    Benchmark Returns

    Muhlenkamp uses prevailing inflation and interest rates to help establish his investment hurdles. 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.

    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%, then Muhlenkamp requires 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 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 but handles the calculation in relation to his required rate-of-return equation. To pay twice book value should not require paying for inflation twice, or the debt premium twice. However, it would require earning the equity premium twice, so that an 11% to 12% return on equity would be worth approximately two times the book value (2% + 3% + [2 × 3%], using the numbers in our example).

    Muhlenkamp takes his analysis one step further by noting that since return on equity is just earnings divided by book value, paying two times book value for a 12% return on equity equates to paying 16.7 times earnings when inflation, interest rates, and return on equity are as described in our example [(1 ÷ 0.12) × 2 ].

    Since the inflation and interest rates in the example are roughly in line with the current environment and the average return on equity is 12%, Muhlenkamp is willing to pay two times book value per share or 17 times earnings per share for companies with a 12% return on equity.

    Building Our Screen

    While much of Muhlenkamp’s approach is qualitative, we have some quantitative data to construct a basic screen to seek companies with high return on equity ratios that are trading at reasonable prices. AAII’s Stock Investor Pro screening and database program with data as of April 11, 2003, was used to construct the screen.

    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 the post-World War II average of 14%. Stock Investor Pro currently covers 8,259 companies and requiring a return on equity greater than 14% quickly reduced the number of passing companies to 2,157. The 30 stocks passing all of the Muhlenkamp filters have a median return on equity of 17.4%, which is significantly above the median 5.2% figure for all the stocks in the Stock Investor Pro universe.

    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 consistently. Adding this filter reduced the number of passing companies to 956 stocks. If you wish to use a more stringent screen, you can specify a high return on equity for each of the last five years. Averages can be skewed due to a few very strong or weak years.

    Reasonable Price

    Muhlenkamp wants to acquire companies that are priced attractively relative to bond rates and inflation. The earlier exercise revealed that in the current market 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. As an independent filter, 2,442 stocks have a price-earnings ratio below 17. Adding the filter to the return-on-equity filters further reduced the number of passing companies to 544. The median price-earnings ratio of the stocks passing all the filters is 11.5, slightly lower the 15.3 figure for all stocks. ICTS International’s price-earnings ratio of 0.6 is the lowest figure for the passing companies, while its 76.0% return on equity is the highest. The company offers aviation security services. With the government taking over security of airports, ICTS has been busy expanding its security services into additional industries, but the stock is trading at half of its 52-week high.

    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. Growth is an important consideration 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. An important consideration is 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.

    The first set of growth filters seeks companies with positive growth in earnings per share over the last five years that have experienced higher growth than the norm for their industry. These filters reduced the number of passing companies from 544 to 440.

    The table of passing companies (Table 1) lists both the historical earnings growth and the consensus average expected growth rate in earnings over the next three to five years. PEC Solutions has the highest historical earnings growth rate at 47.2%. PEC Solutions is a technology services firm that helps enable government organizations to use the Internet and other technologies to enhance productivity and improve services to the public.

    Sales growth, or top-line growth, drives the company’s bottom line. Revenue tells you whether the public is buying the product. The next filter requiring that the five-year growth in sales be greater than or equal to the five-year growth in earnings per share reduced the number of passing companies to 115. PEC Solutions again leads the pack with its 49.3% annual growth in sales over the last five years.

    Profit is another critical factor. Muhlenkamp points out that the way to make profit is cost control, so he always looks at this factor. The net profit margin—net income divided by sales—reflects how efficient a firm is in operations, administration, financing and tax management per sales dollar. The greater and more stable the net profit margin, the better. A gain in profit margin translates into a gain in earnings for a given level of sales. Industry comparisons are critical for all of the profitability ratios.

    Margins vary from industry to industry. A high margin relative to an industry norm may point to a company with a competitive advantage over its competitors. The advantage may range from patent protection to a highly efficient operation operating near capacity.

    The Muhlenkamp screen requires that a firm’s net margin exceed the industry median. This filter cut out another 15 firms—leaving 100 stocks. Table 1 presents the company net profit margin and the respective industry norm. PEC Solutions has a 12.2% net profit margin, while the median margin of its industry (computer services) is a negative 15.0%. The majority of companies in the computer services industry had losses over the last year.

    Muhlenkamp then looks at the strength of the balance sheet. What do the finances look like? Is the company going to need more capital one of these days?

    While the use of debt can help boost the return on equity when the company is performing strongly, it can also saddle the company with interest payments that must be made throughout the business cycle, thereby slowing return on equity when business slows down and increasing the risk that the company may not be able to meet its interest payments.

    Basic leverage screens look at factors such as debt to equity or liabilities to assets. Companies in more stable industries can safely assume greater levels of debt. The Muhlenkamp screen first looks for companies with the percentage of liabilities to assets lower than their industry median, reducing the number of passing companies to 58. The screen then requires that free cash flow (cash flow from operations less capital expenditures and dividend payments) be positive. This filter further cut out another 21 stocks, leaving 37 passing companies.

    The fourth factor that Muhlenkamp studies is labor relations. This is very much a qualitative screen that must be considered when examining candidates passing all of the filters.

    Additional filters were added requiring minimum liquidity by specifying that a stock be listed on the New York, Nasdaq, or American Stock Exchanges. Finally, foreign-listed stocks trading as ADRs were excluded, leaving the 30 stocks listed in Table 1 and ranked by return on equity.

    Timing Buys and Sells

    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.

    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. Like all screens, our interpretation of the Muhlenkamp approach represents a starting point for further analysis.

    Members interested in the approach should examine the Muhlenkamp Financial Web site (www.muhlenkamp.com), which presents a complete archive of newsletters that explain Muhlenkamp’s approach and market viewpoints in quite a bit of detail.

       The Ronald Muhlenkamp Approach in Brief
    Philosophy and style
    Diversified total return approach that seeks good companies selling at reasonable prices.

    Universe of stocks
    Considers complete universe of securities—stocks and bonds, domestic & foreign, small & large companies, and growth & value companies.

    Criteria for initial consideration

    • Seek companies with above-average return on equity. Return on equity has been, on average, near 14% since World War II.
    • Seek companies with stable return on equity over time.
    • Seek companies with sustainable growth.
    • Price one should pay for above-average return on equity is dependent upon prevailing interest and inflation rates. Higher inflation and interest rates result in higher required rates of return from stocks, which translates into lower price-earnings ratios.
    Secondary factors
    • The smaller the company, the more you have to get to know the management. Quality of management is revealed in performance.
    • Monitor revenue—look for strong revenue growth near the level of earnings growth.
    • Examine cost controls—costs directly impact profitability. Look for consistent and improving profit margins.
    • Study the financial strength—seek companies with strong balance sheets. Determine if company is generating enough internal cash flow for growth or if there will be a need for additional capital to thrive.
    • Look for good labor relations.
    • Look at factors industry uses to judge performance and strength of individual companies. These vary across industries.
    • Look at parameters used to reward bonuses to employees. These should agree with your investment philosophy and approach.
    Stock monitoring and when to sell
    • Monitor for negative changes in trends of sales, margins, and return on equity. If a company disappoints, it should be sold.
    • If a stock price goes up to what is considered fair value, consider reducing its position to 4% or 5%.
    • If the price goes down and the decline can not be explained, then consider selling. Someone probably knows something you don’t.


    John Bajkowski is AAII’s financial analysis vice president and editor of Computerized Investing.


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