Vitaliy’s Contrarian Edge

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Add comment August 13th, 2008

You Don’t Have to Be Sick To Own HMOs

You want to buy straw hats in the winter. This sums up an important kernel of successful value investing: making decisions (buying and selling) that are unpopular at the time. (Of course, one has to make sure that, due to global climate change, winter is not swiftly followed by an ice age. In the case of the stocks I am about to discuss, today is winter and the summer will come again.)  

In the following article that I wrote for Forbes.com I describe why we believe that HMO stocks like United Healthcare (UNH) and Well Point (WLP) (we own both) are incredible buys.   Stocks had a small run since I wrote it, but their valuations are still compelling. 

P.S.  If you would like to receive my articles by email (usually couple days before I post them to this website), drop me a line.  

Add comment August 5th, 2008

Kimberly Clark, an Opportunity?

If you believe at some point oil prices will follow the fate of the global economy and decline, Kimberly Clark (KMB) is one of the better ways to play it.

Yes, I know you can buy airlines (Delta (DAL), AMR Corp. (AMR), Continental (CAL), etc.) but an airline may still go belly up as economy cools down: People will travel less, capital markets get tighter and investors realize that there are only two type of airlines: Southwest (LUV) and the ones that go bankrupt every recession.

It seems that KMB had a horrible quarter, and may not have a good year - it’s possible, but it still made a lot of money and the lower outlook was entirely caused by an incredible jump in one commodity - oil.  KMB cut costs and raised prices, but it could not do it fast enough as oil prices are up almost 40% year to date.

However, just imagine what would happen if oil prices decline: Margins will go through the roof. Over last five years KMB cut hundreds of millions of dollars of costs. If we were to normalize KMB’s profit margins to about 11%: 1-2% below of what it achieved in its margin prime or about a 1% higher where it was in 2007 and assume it would have revenues of about $50 a share next year, you’d get EPS of $5.50.
In other words, KMB is trading at about 10x normalized earnings. This is pretty cheap for a company of this quality.

4 comments July 15th, 2008

Two Interviews: BetterInvesting and Vinny Catalano

I have not written anything for awhile.  It seems that I am researching ten stocks at once which often pushes me into indecision paralysis.  High conviction ideas are hard to come by, though we recently found a few which I’ll write about soon.

We are stress testing our portfolios for two additional risks which makes stock selection even more difficult: 1) extremely strong balance sheets – today’s recession, which is a consumer driven one, may last longer than the ones in the past.  Thus as I mentioned before access to capital markets may turn into a privilege not a birthright.  I want to own companies that don’t have a burden of debt and preferably suffer from a burden of cash. 2) normalizing profit margins, which in most cases today results in lower earnings and higher valuations (in my presentation I use Paccar (PCAR) as an example of an industrial “stuff” stock that may not be as cheap as it appears to be, see slide 35).

Here are two interviews I gave:

1. BetterInvesting Magazine interview where I discuss the Absolute P/E framework.  I developed that framework originally to answer a question so often asked by my students  - “what is the right P/E for a stock”.   Later I adapted that framework in our research process.  I discuss that framework in the book in great detail, but I’ll say the same thing say in the book:

“My goal in this discussion is to provide the qualitative framework and illustrate its possible use with quantitative examples. Using the so-called precision of math, I am trying to illustrate the process of analysis, not a secret formula that will answer investors’ prayers (sorry). The quality of any model is as good as the inputs that go into the model, and this one is no different.  

1. Second is audio interview with Vinny Catalano, (here is a link) where I discuss range-bound markets and profit margins.  I met Vinny when he moderated a CFA Society of Colorado forecast dinner in January.  I was very impressed with his interviewer/moderator skills.  

8 comments June 18th, 2008

American Express Analysis

Here is a link (opens PDF) to a 9 page analysis I did of American Express (AXP).  Warning: it is a bit dry.  I was going to present American Express at Value Investing Congress in Pasadena, but the stock ran up and exhausted a good portion of margin of safety.  

Amex is one of the best, most transparent (you can actually analyze it) financial companies I’d want to own in today’s environment.  We’ll probably get an opportunity to load up on it in the future, albeit at a lower price.

  I ended up presenting my very contrarian case on Joseph A. Bank, 93% of float is short. Here is a link to the full presentation, JOSB starts on slide 31.   

8 comments May 30th, 2008

Forbes Praises Active Value Investing

Rich Karlgaard, the publisher of Forbes magazine, mentioned my book in his article: 

The new Benjamin Graham is Vitaliy N. Katsenelson. I highly recommend Katsenelson’s book, Active Value Investing: Making Money in Range-Bound Markets (Wiley, 2007). I like to think the old Ben Graham would have recommended it, too.

4 comments May 24th, 2008

Kiplinger Interview on Jos. A. Banks

I was interviewed by Kiplinger about Jos. A. Bank (JOSB), my favorite retail stock I presented (download PDF of my presentation) at Value Investing Congress in Pasadena.  This is probably the most contrarian stock I ever owned – 93% of the float is short.  

Add comment May 24th, 2008

Income Pie Implications

By Vitaliy Katsenelson, CFA

The NY Times came up with a very interesting way to look at consumer spending. In the long run, consumer spending is a function of consumer income. Though since early 2000 it did not appear to be the case as consumers financed their spending by borrowing against their future income. If you believe that consumer spending is likely to stagnate but the cost of food, healthcare and energy is likely to increase (it did in 2007), then something has got to give.

In other words the income pie is not growing; some slices are expanding at the expense of “X.” And that is the question that this NY Times diagram may help to answer: at the expense of what?

Several categories come to mind right away: new car sales - yes we will be driving older cars (maybe we should look to used car or auto parts stores). We’ll be eating out less which will likely impact the full service restaurants by a large degree. Fast food may get hurt by this trend as well but at the same time, some may chose to downgrade to fast food from full service restaurants. In regards to travel, the vacation homes and hotels are likely to be another casualty.

1 comment May 13th, 2008

Plane Lessors Headed to the Desert

By Vitaliy Katsenelson, CFA

 This article in Forbes about aircraft leasing companies names some publicly traded stocks that appear cheap: Genesis Lease (GLS), AerCap (AER), and Aircastle (AYR). But that cheapness may be a bit deceiving.

Plane leasing looks like a great business. Despite U.S. and global economies facing a slowdown and oil prices making all time highs, demand for planes is still very strong.

However, the more I think about it, the more I realize that this business cannot escape the fate that mirrors its customers - the airlines. I could be wrong, but this business doesn’t really have a sustainable competitive advantage. It’s basically just an arbitrage business: a lessor needs to be able to borrow at a low rate than airlines and lease planes to an airlines at a rate greater or equal to what they could borrow. Airlines get to keep planes off the balance sheet, show high return on capital, but may try to renege on the lease when times get tough (many did that after 9/11).

I think this is where things get dicey. A global slowdown and a recession will do what it does every time: send airlines in a place so frequently visited by them - bankruptcy. They’ll renege on the leases and leasing companies will get their planes back. But unless they decided to start flying those planes themselves, demand will not be there. Planes will make their usual pilgrimage to the desert.

2 comments May 13th, 2008

Lloyds TSB, Still a Good bank but cautious…

By Vitaliy Katsenelson, CFA

My firm sold Lloyds TSB Group (LYG) a couple of weeks ago. I still think it’s one of the best run banks in the world, but its exposure to loans underwritten by other banks made us pause and rethink our thesis.

LYG has a securitization conduit called Cancara. It uses the conduit to securitize some of the loans it generates. There’s no problem there. LYG has proven to be very conservative in its underwriting and that’s why it sports a very rare AAA rating by S&P.

However, about two thirds of the $25 billion Cancara conduit are loans that have been generated by other banks. For a fee, LYG allowed other banks to fold their loans into Cancara and LYG basically insured those loans by its own balance sheet. Call me paranoid, but other banks have little incentive to care about the quality of the loans. Now, LYG is on the hook, not them.

This was my reasoning to sell the company I praised for a very long time. Again, there’s a good chance this may end up being nothing. We’ll monitor the performance of Cancara loans for awhile and may buy LYG back at some point in time.

Add comment May 13th, 2008

Look to the margins when using the price/earnings ratio

May 3rd 2008 - Financial Times

By Vitaliy Katsenelson, CFA

I love the price/earnings ratio, but like all investment tools, it is flawed. This is because it is only as good as the numbers that go into it.  There is no debate about the “p” in the equation – price is quoted every second. But the “e”, though readily available, is only as good as the best estimates. 
Many people describe the stock market as cheap. After all, at 18 times earnings, p/es are half of what they were eight years ago (those bubbly valuations are not coming back anytime soon) and only three points above their long-term average of 15. However, the “e” is temporarily inflated by all-time high (pre-tax) profit margins, which are at 11.5 per cent, or about 35 per cent higher than their multi-decade average of 8.5 per cent. 

Historically, every time profit margins have become overextended, they have reverted towards the mean (that is, declined). This is because capitalism works. One company’s excess profits are another’s potential opportunity – increased competition puts pressure on profit margins. This time round is no different. If profit margins fell and stopped when they reached the average level – an aggressive assumption as historically they have overshot and gone lower – the market’s p/e would rise from 18 to 22. 

The same logic applies to individual stocks. Most excess profit today is generated from three sectors: “stuff” (energy, materials and industrials); financials; and the “new” economy (telecommunications and technology). “Stuff” stocks are responsible for about half of the overall excesses in profits. Historically their sales and profits have moved in tandem with the US economy. However, as fast-growing, “stuff hungry” nations such as India and China became a larger part of the global economy, these stocks started moving less with their domestic economies and more with the global economy. A slowdown in the US alone may not be enough to derail their high profit margins, though it may trigger a gradual process of global slowdown. The global economy has to slow down before the margins of “stuff” stocks will decline. 

These companies have a high proportion of fixed costs, meaning that their margins increase in good times (a concept known as operational leverage). But that leverage could now work in the opposite direction – lower sales and high fixed costs will push margins to the other extreme. Earnings will either decline or stop rising and cheap stocks won’t be cheap any longer. Timing the global economic cycle is impossible as it is driven by random variables. While it may appear that India and China operate by a different economic playbook, they do not. When growth, especially fast growth, takes place in countries where rule of law and free market practices are still developing, it breeds inefficiencies. Recession exposes underlying problems. The risk is China and India will slow down, fall into recession, and consume less “stuff”. 

[Since recession may bring a political unrest in China and India, their respective governments will likely fight it using every bullet in the monetary and fiscal arsenal, but recession can be postponed but cannot be escaped. ] The second group, financial companies, are responsible for about 20 per cent of excess profits. Cheap money and loose lending practises fuelled the excesses, but rising loan defaults mean that margins are now compressing. 

The last group, the “new” economy stocks are responsible for slightly less than 20 per cent of overall margin excesses. The technology and telecoms sectors have changed dramatically over the past two decades; higher-margin software and services now account for a much larger portion of sales. The “new” economy stocks should have higher margins than they had in the past, but by how much? I don’t know, but they likely will face a lower margin compression than “stuff” stocks and financials. We are in a “global cyclicality bubble” not unlike the bubble of the late 1990s or the housing bubble of the 2000s. Since cyclical companies have not seen the other, darker, side of the cycle for a while – many are granted historically high valuations on top of cyclically high earnings. 

Don’t abandon the p/e ratio, but adjust the earnings for high margins. Take a close look at the profit margins of the stocks in your portfolio and ask yourself if today’s margins are sustainable. If you adjusted margins to the historical average, would the stock still look cheap?  If you own a stock that belongs to the “stuff” or financial services groups, assume its high margins won’t last.  The writer is director of research at Investment Management Associates and author of Active Value Investing.

2 comments May 10th, 2008

Additional Thoughts On Starbucks

I’ll be attending Berkshire Hathaway’s annual meeting this weekend. I’ll do a book signing at the Omaha Dairy Queen from 8:30-10pm on Friday May 2nd (West Dodge Dairy Queen, 404 N. 114th St.). I am very excited about attending and speaking at the Value Investing Congress on Tuesday May 6-7 at Pasadena CA. If you happen to attend one of these events, stop by and say hi.

After I wrote a piece on Starbucks (SBUX) raising questions about its future success in international expansion and questioning the growth premium built into the stock, I got a lot of great emails that really made me think (the best kind!).

About the stock: I saw a lot of value managers that I respect loading up on it, even at $5 higher. As price keeps declining, the stock is definitely becoming more interesting, however, I have not done enough research to figure at what price it turns into a buy.

I still have many questions that need to be answered, but here is a little story that really tells you about the quality of SBUX’s brand: A couple of weeks ago I guest-co-hosted a radio show in Denver. I decided to bring a gift to my co-host. It was 9am on a sunny Saturday, and coffee seemed like the right choice (for a very modest gift), plus I had an excuse to get one for myself. I stopped by a Starbucks, one of three that I encountered on my two-mile journey to the radio station. The show went well and my co-host appreciated the gesture.

Here is the thing, though. According to consumer surveys, McDonald’s (MCD) has better coffee. But I would have looked silly if brought a McDonald’s coffee instead. Some may disagree about the taste, but Starbucks went into our dictionaries as quality coffee.

For example, it’s hard to go wrong giving a Starbucks gift card, but people may look at you funny if you give them a McDonald’s gift card.

I know the issues about Starbucks – the McDonald’s entrée, the copycats, recession sensitivity, too many locations, international expansion worries. I’d have to have a better grasp on them before I buy the stock, but one thing is definitely clear to me – SBUX has a unbelievably strong brand, at least in the U.S.

After looking over readers’ feedback, I came to the following conclusion about SBUX’s international expansion: so far SBUX has succeeded in places where coffee-drinking is not deeply ingrained into the culture. In fact, the less coffee is ingrained on country’s culture the, the higher the chances of SBUX’s success.

I was amazed how many SBUX stores I saw in London. The U.K. is not a traditional coffee drinking nation – tea is the national drink. Japan falls into the same category. However, SBUX will have to climb a steep mountain in a good part of Europe (including Austria, Italy, Turkey, etc.) where coffee drinking is deeply ingrained in the culture.

Ironically, it seems that SBUX’s international success will depend on converting non-drinkers into drinkers.

Continue Reading 4 comments April 29th, 2008

Is it a Bull, Bear or Cowardly Lion Market?

I wrote a guest column for John Maudlin’s weekly newsletter.  Here are links to PDF and John’s website.  John wrote the following introduction to the article: 

Are we in a bull, a bear, or a cowardly lion market? As we will see, the answer can make a huge difference in your investment portfolio. This week I am at my Strategic Investment conference in La Jolla. About four times a year I take a break from writing the letter and bring in a guest writer. This week Thoughts from the Frontline will have the very distinguished analyst and author Vitaliy Katsenelson. 

In his recent book, Active Value Investing: Making Money in Range-Bound Markets (Wiley, 2007), he exhorted investors to fasten their seat belts and lower expectations for the next decade or so. He also provided a strategy for improving returns in this environment, what he calls range-bound or cowardly lion markets. Long-time readers will recognize some themes consistent with my own research, but Vitaliy adds some very interesting twists that I believe will make you think. In today’s letter, Vitaliy runs through his analysis of what will happen and provides an overview of how investors can make money in what will otherwise be an ocean of stagnant returns. Warning: the letter will print long, but that is because there are a lot of great charts. 

Let me also highly recommend Vitaliy’s book, Active Value Investing. I think as you read today’s letter, you will get a sense of why I am so enthusiastic about his work. You can get you copy at Amazon.com.

6 comments April 20th, 2008

Active Trader Magazine Interview

I was interviewed by Active Trader Magazine (here is a link to PDF).  What do I know about trading?  Absolutely nothing!  This is exactly what I told David Bukey, the editor of the magazine, when he asked me for an interview.  He assured me that he read my book and thought my (investing) message was very important to his readers.  How can you say no to that?  David did a great job putting the interview together, though I’ll let you be the judge. 

There is a small typo at the very end, the website I recommend (in addition to gurufocus.com) is Stockpickr.com NOT stockticker.com.

7 comments April 6th, 2008

Starbucks International Growth

I just came back from a week-long trip in Europe where I spent four days in Vienna and three days in Sofia (Bulgaria). I was surprised to find very few Starbucks (SBUX) shops in Vienna.

Despite traveling extensively around the city I counted only two. Both are primarily frequented by — you guessed it — tourists. I’ve been told SBUX has closed down a number of stores over the years. After visiting London in August and seeing a SBUX on every corner, I figured the firm had spread the decaying American capitalism evenly around the world. Remember, Britain is a nation that drinks tea - or so we’ve been told.

The only explanation I could find was that Austrians look at coffee as an experience. Since they pay a couple euros for a tiny little bitty cup of coffee, they figure they may as well enjoy it by spending an hour drinking it. In America we drink the same amount in a sip. Maybe Austrians want their coffee brought to them. Though I have to confess, service in Europe rivals service I receive in the local Post Office on the day before Christmas.

Continue Reading 15 comments March 28th, 2008

Jackson Hewitt - To Be or Not to Be?

DENVER (MarketWatch) — The certainty that we have to file a tax return every year, that the number of tax returns is rising, tax preparation is getting more complex and thus despite availability of tax preparation software more and more people outsource their tax preparation peaked my interest in Jackson Hewitt.

Well, of course, if flat-tax Ron Paul becomes president he’d pull a rug out from under the tax preparation industry. But let’s be real, a complex tax system is here to stay as it brings too many carrots and sticks which politicians will not part in a million years.

However, when Jackson Hewitt (JTX) reported its quarterly results in March the certainty was not certain anymore. Jackson Hewitt’s revenues were down 15%, street expectations were missed, and the stock took a dive. How could this happen?

Continue Reading 3 comments March 11th, 2008

Katsenelson Predicts

I find January to be one of the most difficult months for long-term investors. In the spirit of the fine American tradition of making New Year’s resolutions, we feel a need to make a resolution for the stock market (as if it will listen to us) in the form of a prediction.

I don’t dismiss the benefits of forecasting, but we should forecast what we can forecast – market timing is not it. We just listen to our gut (which for all I care could be influenced by the fat content of food consumed at the time of the prediction) and verbalize it in well structured sentences that give our fortune telling much needed sophistication.

Though some do a great job playing market timers on business TV, with the assistance of sound horns and theatrical Oscar-like performances, the advice granted is not worth the damage to your ears or eyes. Timing short-term markets is a loser’s game. Let’s be honest with ourselves - we really don’t know.

The problem with forecasting short-term market movements is that even if you get the economic event right and Lady Luck kisses you on the cheek and you nail its timing, the market may just spit in your direction and chose to ignore it till a later date. Last summer, for example, the housing bubble finally burst, bringing the toxic waste (sub-prime) loans onto the surface. Credit markets froze… and you’d think the stock market would decline? No, the Dow went on to make an all time high, hitting 14,000 and ignoring the problems for months.

Let’s leave the market timing to the media, take a drink of cold water and approach forecasting the right way. Even a long-term investor has to recognize that long-term consists of a series of short-terms. The tsunami of short-term events may change the direction of the long-term. We have to accept that we probably won’t get the timing right, adopt an “I’d rather be vaguely right than precisely wrong” attitude, focus on identifying shorter-term risks that may stand between us and the long-term, and stress test our portfolio for them accordingly.

It would be careless to dismiss the possibility of a recession (some argue that we already are in a recession). Past recessions were caused by excesses of inventory and overcapacity in the corporate sector. As corporations rationalized their inventories and factories, higher unemployment followed – we were in a recession. Excesses were worked out, corporations started to hire, and voila - we were out of the recession.

Continue Reading 6 comments March 5th, 2008

Patience and More Patience

This market requires patience and more patience. Identify high quality companies you want to own, determine at what price and wait. That is what I’ve been doing. Also, since profit margins are hitting all time high, the “E” in the P/E equation is very deceiving. Earnings in many cases have been tremendously overly stretched to the upside: They’ll need to be un-stretched (i.e. normalized).

For instance, if you look at Moody’s (MCO), the stock, it may appear cheap, about 15 times 2007 earnings. Not bad for a legal duopoly. But MCO’s earnings are up tremendously since 2004. I’d argue that earnings since 2004 were bubbled by the housing-derivatives-easy-credit bubble. Thus when valuing MCO I’d put little faith in 2007-2008 numbers and go back to more normal times with 2004 EPS of 1.50 (as opposed to $2.50 MCO earned in 2007).

I’d gladly pay 14-15 times earnings for this still incredible business, thus Moody’s will go on my “Stocks I’d Love to Own” list at $21-22. Yes, stock has to decline 40% for me to become interested. Am I too conservative? Will I miss buying a great company? Possibly, but there are plenty of other great companies where this one came from.

2 comments March 3rd, 2008

Interview with Advisor Perspectives

After I wrote the profit margin article for Barron’s couple of weeks ago, I received many inquiries asking me to identify which sectors were the least and the most impacted by rise of corporate profit margins.  In the interview I gave to Advisor Perspectives (link to download PDF and link to website) I did just that. 

Add comment February 20th, 2008

Interviewed by Jim Puplava at Financial Sense

I was interviewed by Jim Puplava at FinancialSense.com.  This is the most detailed audio interview (you can stream audio or download MP3) about the book I’ve given so far (about forty minutes long). 

4 comments February 9th, 2008

Down to the Last Drop of Profit Growth

The following article was published in February 4th, 2008 issue of Barron’s.  It is revised, updated partial excerpt from my book Active Value Investing: Making Money in Range-Bound Markets.

By Vitaliy Katsenelson

STOCKS ARE ALLEGEDLY CHEAP NOW, at 17 times 2007 earnings. And they are cheap by historical standards. Only seven years ago, they were at price/earnings ratios double today’s; they are even cheaper if you compare their forward earnings yield of 6.7% to Treasuries’ yield of 4.25%. They are cheap, cheap, cheap! Or so we’ve been told.

Unfortunately, the cheapness argument falls on its face once we realize that pretax profit margins are hovering at an all-time high of 11.9%, almost 40% above their average of 8.5% since 1980. Once profit margins revert to their historical mean, the “E” in the P/E equation will decline. If the market made no price change in response, its P/E would rise from 17 to 23.8 times trailing earnings.

Many disagree that the profit-margin reversion will take place. Here are the most common arguments against it, and some food for thought on why “common” doesn’t necessarily translate as “wise.”

Who said that margins have to revert to a mean; why can’t they just remain high?

Profit margins revert to the mean not because they pay tribute to mean-reversion gods, but because the free market works. As the economy expands, companies start earning above-average profits. The competition reacts to fat margins like bees sensing sugar water. They want some, too, so they fly in and start cutting into these above-average margins. This always has happened in the past, and it will happen again and again in the future.

What about the billions of dollars U.S. companies poured into technology — weren’t they supposed to make these operations more efficient and bring higher profit margins?

The billions of dollars did not go to waste; companies are more productive now than ever before. Efficiency gains stemming from productivity were a source of competitive advantage and higher margins when access to proprietary technology was a competitive advantage.

For example, Wal-Mart’s rise in the retail industry was achieved through a very efficient inventory-management and distribution system that passed cost savings to consumers and drove less-efficient competitors out of business. Today, however, that same — or even better — technology is available off-the-shelf to retailers like Dollar Tree or Family Dollar, whose outlets are about the same size as a couple of Wal-Mart bathrooms put together. Oracle or SAP will gladly sell state-of-the-art distribution/inventory software systems to any outfit able to spell its name correctly on a check. Increased productivity didn’t and won’t bring permanently higher margins to corporate America — the consumer is the primary beneficiary of lower prices. If profit margins didn’t respond as they do, Wal-Mart’s net margins would be 25% today, not 3.5%.

Over the past 70 years, growth in corporate earnings and gross domestic product haven’t differed significantly. On the other hand, there has been a permanent benefit from increased operating efficiency: It lets companies hold less inventory and adjust more quickly and precisely to changes in demand. This has led to less volatile GDP.

Shouldn’t average profit margins be higher now, as the U.S. economy has transitioned from an industrial (low-margin) economy to a service (higher-margin) economy?

It is not as much of a change as we might think. In 1980, services represented about 48% of GDP. After 27 years and a lot of changes like outsourcing, services have increased to 58% of GDP. If we assume that the service sector has double the margins of the industrial sector (a fairly conservative assumption), increases in the service sector should have boosted overall corporate margins by about 40 to 70 basis points above their 27-year average — between 8.9% and 9.2%, but still far below today’s 11.9% margin. Thus, if we adjust corporate margins to reflect the transformation toward a service economy, corporate profit margins are still 30% above their long-term mean.

Shouldn’t globalization allow U.S. companies to increase margins?

A larger portion of U.S. companies’ profits is coming from overseas than ever before. However, globalization is a double-edged sword — U.S. companies are expanding and will continue to expand overseas and capitalize on new opportunities. But as the world flattens, they also face new competition at home and abroad. For example, Motorola-a company that used to represent American might in the telecommunications arena — has been marginalized in the U.S. and around the world by companies whose names we didn’t recognize 15 years ago — Finland’s Nokia and South Korea’s Samsung.

Although Wal-Mart is rapidly expanding overseas, it will soon face a new breed of competition. U.K. retail giant Tesco recently entered the American market. U.S. companies may get a larger portion of their earnings from overseas (the weak dollar will only help), but they’ll have to fight to defend home turf.

International expansion doesn’t guarantee fatter margins, quite the opposite: We are about to face competition from countries that may be more concerned with increasing market share, even at the expense of short-term profitability.

High oil prices are here to stay, so maybe multiyear high margins in the energy sector are here to stay as well.

This would be the case if energy companies sold their products to customers in another galaxy where somebody else bore all the costs of high-energy prices. Petroleum products are consumed by corporations and individuals. The profit margins benefiting the energy sector are achieved at the expense of lower margins for companies that consume their products-which really is the rest of the corporate world, in various degrees.

Today’s stock valuation is a lot higher than it appears if you normalize earnings to lower profit margins. And while it’s hard to tell when earnings will embark on a fateful journey to seek their historic mean, it should happen sooner than later. Earnings will either decline or grow at a slower pace than GDP.

Depending on the industry structure, companies that don’t have a sustainable competitive advantage will not be able to keep competition at bay, and will face margin compression, along with lower earnings growth or declining earnings. Look at your portfolio: Can the companies whose margins are hitting all-time highs sustain them?

VITALIY N. KATSENELSON is a portfolio manager at Investment Management Associates in Denver, and the author of Active Value Investing: Making Money in Range-Bound Markets (Wiley, 2007)

P.S. The following two charts really tell a great story about profit margin compression overtime.   Due to readers request I created one based on GDP and one based on GNP.  As you can see there is little difference between them as GDP (domestic product) and GNP (national product) are very similar.   An additional point: margins don’t have to revert and stop at the mean, historically they went below the mean (that is how mean is created).  

12 comments February 4th, 2008

What does Hank know?

Hank Greenberg, the ex-chairman of AIG (AIG), the guy who made AIG what it is today, hired an investment banker to help him figure out what the company is worth.

He is thinking about unloading the stock. If Hank doesn’t want to own this financial conglomerate - and he knows a lot more about its businesses than you and I ever will - should an average investor own it??

I looked at AIG awhile back, it looks incredibly cheap on price to reported earnings, but its balance sheet has $40 billion “other” lines. Is it “other” good stuff or bad stuff? I don’t know. In today’s environment it’s likely to be the latter.

3 comments January 22nd, 2008

BusinessWeek Video Interview

I talked to Jim Ellis at BusinessWeek about my book Active Value Investing (here is a link to the video).  As you will see, if you tie my hand I’d go mute.

At about the same time I talked to TheStreet.com (here is a link to the video) about Apple (AAPL) and Jackson Hewitt (JTX).   It was taped right next Wall Street in October 2007.

Add comment January 22nd, 2008

Bank of America - The Contrarian

I welcome the Bank of America (BAC) acquisition of Countrywide (CFC), as for the first time as I can remember BAC acts as a contrarian investor. I really don’t know what CFC is worth but I know it is worth more in BAC’s hands than as a stand alone company. BAC will be able to provide CFC with liquidity and staying power to survive through the current crisis. In other words it brings continuity to the table (customers and partners that were having second thoughts about dealing with CFC are likely to stick around now).

I am applauding this deal because typically these are done at the top of the market, but BAC found a restraint to wait till things went to hell. Yes, it was early with its first purchase, but picking bottoms is not easy, even for almighty BAC. 

2 comments January 12th, 2008

Creator of Incentives

I originally wrote this short story to be a part of the article about Jackson Hewitt and IRS’ (possible) allegations that refund anticipation loans create an incentive for tax preparers to commit fraud.  

When I was in the third grade, growing up in Murmansk, a city above the Polar Circle in (then) communist Russia, my buddy and I decided to start a business. We pooled our modest funds (mostly lunch money), bought photo paper and chemicals, and borrowed my older brother’s photo camera and photo development machine. This was in the early 1980s, a time before scanners, laser printers and copying machines. We took pictures of music record covers from the likes of Iron Maiden, Jethro Tull and Kiss, developed those pictures and sold them in school during breaks.

The business was going well, we were onto something, there was nothing like this available. We recouped our costs, and had a small profit, until one dark day (it was always dark during long sunless winters in Murmansk). My buddy and I were taken into the principal’s office. We were told a student stole money from another student, and when he was caught he said he stole money to buy our pictures. Suddenly, with this twisted logic we were at fault. Never mind that we were breaking copyright laws. There was no way in early 1980s to obtain copyright, even if we wanted to. We created the incentive to steal.

My father unapologetically told the principal that we were as much at fault as the movie industry and toy retailers — the creators of incentives. Of course, none of that mattered. To appease the school authorities I donated my profit to the World Peace Fund (still not sure where that money went, maybe ended the Cold War? Nah, I doubt it). My buddy and I received an “F” for the behavior, which was not a big downgrade for me since I rarely got a grade much above “C” for behavior.

1 comment January 9th, 2008

Dragged Down by IRS and IRS is Your Friend

The avoidance of taxes is the only pursuit that still carries any reward.

John Maynard Keynes

Jackson Hewitt (JTX) declined significantly yesterday on news the IRS proposed regulation to ban refund anticipation loans, or RALs. Fear of the impact the new rules could have on JTX’s business drove it and H&R Block (HRB) down, although HRB faired better as it had already been beaten down by company specific issues stemming from its subprime mortgage business.

RALs are originated to customers who don’t want to wait a couple of weeks to get their tax refund from the IRS, and thus are willing to pay a 2-2.5% (capped at $95) fee to get their money right away. Though RALs are as controversial as payday loans that charge annualized triple digit interest rates, this is not the reason why the IRS is zeroing in them. After all, the IRS mandate is to collect taxes, not to legislate morality.

Continue Reading 5 comments January 4th, 2008

Will Gold Shine Again?

This article was originally called Will Gold Shine Again?.  It was excerpted from my book Active Value Investing and appeared in the Rocky Mountain News.  I have no intention of making an argument of where the gold prices will be over next month or five years from now - I simply don’t know.  My intention is to dispel this notion that gold was a great investment - it simply not the case, and offer a caution that gold may not be a great investment going forward.  

1 comment December 22nd, 2007

Denver Post Article: One step up, one step back

Denver Post wrote an article about my book Active Value Investing.  The question that comes to mind - what am I doing reading my own book (see picture in the article)?   I don’t really have a good answer to that question.  I’ve read it so many times while writing it that I really cannot read it anymore.   Denver Post’s photographer thought it was a good idea.  Now that I look at the picture, not sure I agree.  It is a good article though, read it. 

Add comment December 20th, 2007