In this article I showcase the total return strategy used by Ronald Muhlenkamp and give you a list of stocks currently passing the AAII Muhlenkamp screen. The Muhlenkamp approach seeks companies with high return on equity (ROE) ratios that are trading at reasonable prices. As of August 30, 2024, our Muhlenkamp screening model has an average annual gain of 26.4% over the past five years, versus the S&P 500 index’s 12.4% return over the same period.
Muhlenkamp has devoted his entire business career to the professional management of investment portfolios. Muhlenkamp started his career as a portfolio analyst and soon was directly managing assets. In the early 1970s, Muhlenkamp undertook an extensive study of both fundamental and technical investing philosophies and practices and developed a proprietary method for evaluating both stocks and bonds—he still uses it today. Muhlenkamp founded Muhlenkamp & Co. in 1977 to manage accounts for individuals and institutions and launched the Muhlenkamp und (MUHLX) in 1988. 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.
The Muhlenkamp Approach
Muhlenkamp uses a bottom-up approach to selecting stocks, but adjusts his benchmarks based on the broad economic environment. Muhlenkamp begins by looking for companies with a return on equity above the average return on equity since World War II, which was 14.0% at the time of his writing.
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 investors’ ownership interest in the company. On the balance sheet, it is the sum of preferred stock, common stock and retained earnings.
Muhlenkamp looks for an above-average return on equity, but the price he is willing to pay for that company depends on the current and expected levels of inflation and interest rates.
Muhlenkamp uses prevailing inflation and interest rates to help establish his investing 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 (P/E) ratios should be relatively low.
Building The Muhlenkamp Screen
While much of Muhlenkamp’s approach is qualitative, AAII has 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 was used to construct the screen. Criteria are based on historical data and are not adjusted for current inflation.
Sustainable Return On Equity
The first filter looks for companies with a current return on equity (earnings per share over the most current 12 months divided by book value per share as of the latest quarter) greater than 12.0%.
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 12.0%. This helps highlight companies that have performed consistently. 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 attractively priced relative to bond rates and inflation. The Muhlenkamp screen requires a current price-earnings ratio below 17.0. This number is based on historical data and has not been adjusted for current inflation.
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.
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.
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 requires that the five-year growth in sales be greater than or equal to the five-year growth in earnings per share.
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 an advantage over its competitors. The advantage may range from patent protection to a highly efficient operation running near capacity.
The Muhlenkamp screen requires that a firm’s net margin exceed the industry median.
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 that have a percentage of liabilities to assets that is lower than their industry median. The screen then requires that free cash flow—cash flow from operations less capital expenditures (capex) and dividend payments—be positive.
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 Stock Exchange (NYSE), the Nasdaq or the NYSE American. Finally, foreign-listed stocks trading as American depositary receipts (ADRs) were excluded.
Conclusion
Muhlenkamp attributes his long-term success to sticking with something that works while keeping an open mind.
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.
Companies Passing the Muhlenkamp Screen (Ranked by Return on Equity)
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The stocks meeting the criteria of the approach do not represent a “recommended” or “buy” list. It is important to perform due diligence.
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