Interview With Vitaliy Katsenelson by Philip Durell and Bill Mann

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In October, I had a great pleasure to be interviewed by two of my favorite Motley Fools: Philip Durell advisor to Motley Fool Inside Value newsletter and Bill Mann co-advisor to Motley Fool Hidden Gems newsletter. In this in depth interview I discuss everything: economy, stocks I like, international investing, practical application of QVG framework, absolute P/E model and of course my book.

By Philip Durell and Bill Mann

November 14, 2007

Bill Mann: Vitaliy Katsenelson is one of my absolute favorite investment thinkers. He and I have swapped ideas for several years now. His new book, Active Value Investing is brilliant.
Vitaliy Katsenelson: (Laughs.) Thank you.
BM: It seems to me that a very good alternate title would have been When and How to Sell.

VK: (Laughs.) Well the thing is, if you are in the range-bound markets, which I think we are, then the selling discipline become extremely important. Over the last 200 years and especially the last 100 years, every time we had a full-blown bull market, similar to the one we had from 1982 to 2000, it was followed by a range-bound market, defined as a market that is going up and down, but not really going anywhere. We seem to think about markets in binary terms, bull or bear, but, in reality, we’ve only had one bear market: The Great Depression. All the other markets were range-bound.

The reason range-bound markets happen is very simple. When you have a full-blown bull market, stock prices and stock price-to-earnings ratios get to extremely high levels. Range-bound markets are like the clean-up guys. They come in and, by deflating the P/E of stocks, they clean up the mess that was caused by bull markets. The P/Es are going down gradually and the earnings are growing and they kind of cancel out each other.

It has happened so consistently that there is a very high probability that we are in one of those markets, therefore, you should invest accordingly. So in the first part of the book, I make the case for range-bound markets and, [in] the second part of the book, I provide a strategy for investing in those markets.

Philip Durell: Can I interject here, Vitaliy? I can’t see exactly why your strategy wouldn’t work in a bull or a bear market. Why only range-bound markets? I can understand that selling might be more important in a range-bound market, but overall I think your strategy is good for any market.

VK: Philip, you are absolutely right, but let me put it this way: I know the strategy that doesn’t work is the one a lot of value investors use in bull markets. Bull markets basically teach us to be buy-and-hold investors. You buy with a discipline and selling is not as important because stock prices begin cheap and fairly cheap, go to fairly valued, overvalued, tremendously overvalued, and then Hubble telescope-kind of overvalued. So selling is not as important.

The strategy I am describing in my book is what would work in any market, there is no question about it, but it is specifically geared for the range-bound market for a few reasons. One is the selling element and the other one, which we shall get to in a second, is the value traps that you might step into. But you are right; this strategy should work in any market.

PD: In your presentations, you give a very nice, concise example of what actually happens to P/Es, earnings growth, and prices during bull, bear, and range-bound markets.

VK: Oh sure. We tend to think that stock market cycles are caused because of low economic growth or high inflation, etc.; that has not been the case. I looked at the past 100 years, and economic performance in range-bound markets or bull markets was extremely similar. In fact, in the book, I put up two tables and asked the reader to choose and tell me which ones were the bull markets and which ones were the range-bound markets. Truth is, you can’t really tell. So we know the market cycles were not caused by inflation, they were not caused by interest rates, and they were not caused by economic growth. In fact, real GDP growth has been one of the most consistent economic statistics throughout the past 100 years. It has been growing about 3.5%. So what have really caused those range-bound markets were the high starting valuations that gradually contracted.

So look at it this way: If you have a high valuation and good economic growth, you can have a range-bound market. If you have high valuations and bad economic growth, you have bear markets. If you have low valuations and just OK or average economic growth, you have got bull markets. So that is basically as simple as it gets.

BM: Well Vitaliy, let me challenge you to define your terms. One of the real reasons that many investors thought that homebuilders were still cheap at the beginning of last year is because they were trading at P/Es of six, seven, and eight. So from an earnings basis, it would be easy to look at them and say “these are not expensive stocks,” and yet they have now lost 60%, 70%, and 80% of their value and are trading at very high P/Es or trading at no P/E at all.

VK: Actually Bill, you are making another point; you are making a perfect comparison. When measuring price to earnings, you know the price, right? That’s straightforward. The problem is what the earnings are. Currently, corporate profit margins are at a 20-year high, so when you look at the P/E of the whole stock market, it looks very cheap. The only problem is the corporate margins are very high and, therefore, the earnings are overstated.

BM: So you mean that corporate gross margins are at their highest point in the past 20 years.

VK: That’s right. At some point, profit margins will revert to the mean, and usually mean reversion means they go below the mean, then the corporate profits either stop growing or they will decline. So you just described homebuilders, [so] probably the economic growth is going to be less dramatic than homebuilder’s earnings, but they [are] either stagnate or they decline.

BM: So what is it that you suggest that investors do here in late 2007?

VK: The second part of the book outlines how you can make money. So when I talk about analysis, I introduced this framework, which I call QVG — Quality, Valuation, and Growth. It’s basically a way to look at the stock that helps to clarify our analysis. When I look at quality, I’m talking about competitive advantage, strong balance sheets, recurring earnings, good management, significant free cash flow, and high return on equity. Obviously, I go into greater depth in my book, but quality is critical in range-bound markets.

When I consider growth, I’m looking for growth of earnings/cash flow. Not necessarily very high growth but consistent growth. When I talk about valuation, I am talking about how to value a company using different valuation tools. What I found is that 90% of the returns in the range-bound market came from dividends. If you compare this to bull markets, only 19% of total return came from dividends. So dividends become extremely important in range-bound markets for a couple of reasons. First of all, they create a floor under the stock price. When a company pays high dividends, the stock goes down, yield goes up. The stock, thus, attracts more investors, [and] it goes up. Also, a company that pays high dividends doesn’t really have to do much in earnings growth to provide you nice total returns. So that is another reason why dividends are important.

On valuation — and this is the dimension that requires the most amount of work in the range-bound markets — you have to make the most adjustments. First of all, don’t step into relative valuation trap. I will give you an example: Wal-Mart at the end of the last bull market. Wal-Mart traded at a P/E of 45. You guys will agree that that was too expensive. But it looked cheap if you just looked at the relative valuation analysis, it looked cheap when it was traded at 40, 35, 30, 25, 20 times earnings.

BM: When you say “relative,” you are comparing it to say Home Depot or you are comparing it to its own historical valuation?

VK: Oh no, just with past valuation.

BM: Oh, OK. You are framing this argument to assume that when a company that used to trade at X P/E and now it’s at X divided by two P/E, therefore, is cheap.

VK: Exactly, yeah.

BM: Which is a horrible argument.

PD: I picked up on your idea that in range-bound markets quality is very important. But it is also true that a lot of the quality companies go up in price as soon as people feel that there is a problem in the market. For example, everyone starts buying Berkshire Hathaway, which is probably a very good thing, but then obviously a lot of those quality companies themselves actually get more expensive because a lot of people think “Oh, I had better buy quality.”

VK: I hate to use growth and value analogies, but it is in the extremes that it makes sense. Suring the ’66 to ’82 range-bound market P/Es for growth stocks — high P/E stocks — contracted at a very fast rate, and P/Es of cheap stocks either stayed the same or increased.

Value investing beats growth investing during the range-bound markets hands down because the P/Es of high-growth stocks contract at a much faster rate, negating the benefits of high growth. The 2000 to 2002 Nasdaq market crash was proof of that.

PD: Now you were just saying that you don’t like growth in range-bound markets, perhaps you could explain to us what you mean by growth in your framework?

VK: First of all, I want to just define this. When I say “growth stock,” I assume it is also a high valuation stock. That is a very important clarification because I think growth in general, which is basically growing earnings and cash flows and dividends, are extremely important in any market, so I don’t want to dismiss.

As I invest, I want to find companies that grow in earnings, but I want to make sure that a good chunk of the growth is recurring in a sense that it comes from where they have a high recurrence of revenues. Because that makes the growth more stable, which goes back to quality as well.

Also absolute valuation tools like discounted cash flow analysis are a lot more important in range-bound markets than in bull markets because you are less likely to lose money using absolute valuations tools and discounted cash flow analyses. I also use other frameworks like absolute P/E analysis. I am not sure how much you wanted to go into that, so you tell me how much you want to hear about that.

PD: You could just perhaps describe what you mean by absolute P/E.

VK: In my book, I outlined a framework that helps figure out the correct P/E for a company. It is partly a quantitative framework, but it is actually a lot more qualitative because data inputs that I ask you to contribute are extremely qualitative like expected growth rate, business risk, financial risk, and earnings predictability. The latter is based on how far forward you feel comfortable projecting super-normal growth rates. My framework may be more useful to new investors.

In range bound markets, you should also increase your margin of safety in setting you buy price (margin of safety = percent below valuation of the stock). We talk about the analytics and the knowledge that requires as a strategy. This is why Bill thinks my book could also be titled How to Sell.

In range bound markets, the buy-and-hold approach to investing is not the best way to make money. I am not saying you should be a day trader, not at all, but you need to figure out at what valuation you want to part with the stock at the time that you buy it.

BM: I have a very simple way of describing that when people ask me because they believe that I am a buy-and-hold-only investor. I say, “No, no, no, you don’t understand. Every single one of my stocks is for sale every single day, just give me the right price.”

VK: Exactly. Bringing the QVG framework into this, when you have a quality company and growing earnings, you have got a good company. When you have got a valuation part to it, you have got a good stock. So if the valuation gets very expensive, you still have got a good company, it is just not a good stock anymore. That is when you sell it.
You want to make as few marginal decisions as possible. You don’t want to lose money in the range-bound markets because it is so difficult to make it back. The selling discipline is extremely important. You should be a willing seller. You are right. Every stock is for sale at the right price.

On example in my book is Jackson Hewitt, the tax preparation company. It only becomes valuable as a brand over time because it puts 6% of its revenues into advertising every single year. Actually, I have been very impressed with management. This is a company that declined from $35 or $37 to $27 because officers at one of its franchisees were doing some illegal stuff, falsifying W-2 forms, allegedly.

The good thing is that happened only at the franchisee level. Three days after this happened, management already hired an ex-IRS commissioner to do an internal investigation. They found nothing at the corporate level, which you kind of expect because management has absolutely no incentive for doing this stuff. Four or five months after that, they already settled with the SEC and basically they admitted no wrongdoing and they paid a $1.5 million fine just to make this issue go away.

Still, the stock remains down 30%. Every year, they consistently increase dividends or buy back stock. They built an incredible company because they are growing earnings 20%, 30% a year for the past three, four years. Very impressive. The balance sheet has some debt, but they basically could pay off their debt in less than two years from their free cash flows. It is a very stable business and it is counter-cyclical. You can sense when the time it goes down, more people are going to come to their offices to do their taxes because they want a refund sooner.

They have a high incremental return on capital, because most of the growth comes from franchisees, which actually pay them to be a franchisee, so their return on capital is incredible. It scores very high scores in quality.

They have five or six different engines of growth and what I like about this, even if one growth engine fails, the other ones will pick it up. They are opening about 10% of new stores a year. There is inflation in this industry, which is ranging between 5% and 8%. Last year, I think it was 7%. They are buying back 5% to 6% of their stock a year, so that is another engine of growth. A lot of their stores, more than half of their stores, are less than five years old. Therefore, there is a built-in same store sales growth as their stores mature. There is still room for margin expansion and there was a 2% dividend, so even if one of the engines fail or two, they can still deliver earnings between 15% to 25% a year, so there is a fairly wide range.

This is a company that is trading basically at 12, 13 times earnings; traded nine times free cash flows and I find my value of the stock is around $50 to $70, so it is a cheap stock. If you get a P/E expansion, you get another 50% upside right there.

BM: I think it is pretty easy to identify what kind of market we are in hindsight. I remember back to 2003 and shamefacedly, I will admit I was one of these people who felt like the world was going to end. Everyone was hording cash, and yet it’s four years later and everything has gone well. How do you know or how do project what kind of market we are in?
VK: You don’t. You want to price your stocks, not time them. You are trying to find high-quality companies that are growing earnings and you want to buy them cheap. You want to keep doing it over and over again. Because you really don’t know what market you are in. Timing the market I found to be a very fruitless exercise because it is only apparent, as you said, in hindsight.

BM: Really to me one of the more interesting things is the thought that international markets don’t necessarily correlate with one another. So even if you are in a market that is moving sideways here, there is a bull market somewhere.

VK: Bill, there is no question about it. And also, our perception is that when you invest internationally it is usually more risky. If you go to invest in Tajikistan or some little country in Africa, yes, you are increasing risk, but there are so many other countries that are developed and they have rule of law, so when you invest there, you are actually reducing risk. One of the stocks that I really like, and I know Philip likes it as well, is Lloyds TSB. When I was looking to buy banks in the U.S. and I could find just a handful that I liked, I bought Lloyds instead.

BM: It is from the Banana Republic of the United Kingdom. (Laughter.)

VK: From the perspective of my portfolio, what I just did is I added a high dividend stock that is growing earnings. Lloyd’s is actually one of only two AAA rated banks in the world that are not government backed and basically I didn’t increase the risk of my portfolio, I actually lowered it.

BM: It is a currency hedge if nothing else.

VK: Exactly and especially if the dollar is declining, the 6.5% dividend is becoming a 7.5% dividend. This is beautiful. There is definitely a case for international investing just because it raises incremental opportunity cost in your portfolio.

PD: I think that is a really good example because I can remember Lloyds as one of my earlier picks in Inside Value and I picked it at the time mostly because it was just coming around, the turnaround, with excellent management and it has pretty much gone that way. But the bonus, and we did mention it, is the fact that it was an international investment and I think I valued it originally and the exchange rate was 1.7, OK? So for one U.S. dollar, you got 1.7 pounds sterling. Of course now, the exchange rate is 2 or 2.01 actually. So that is a very good example of why you would invest some of your money overseas.

VK: And also it paid a 6% dividend and earnings were growing 8% or 10%?

PD: Actually when I picked it, it was at 8% dividend yield.

VK: That is right. So you were looking at an incredible total return, just from earnings to dividends, it was just right there.

BM: Yeah, well I think it is an important thing to note and it gets back to what I was asking about trying to predict whether you are in a range-bound market or not. With Global Gains, I focus a lot on international investing. I don’t necessarily treat the dollar’s decline or rise as something that I consider to be predictable, but it is a hedge. If a hedge goes the wrong way and you are picking a good company and you are getting it at a good price, that is OK, but if it goes the right way, it is a lit match to your returns. And you can’t capture it if you are only focusing on U.S. based stocks.

VK: Absolutely. Another thing is, I am not a big believer in diversification in the traditional sense.

BM: I don’t think any of us are.

PD: No, I am not.

VK: Exactly, and you can argue that maybe the benefits of international diversification probably decreased over the years is because we are so much more interrelated, but so what. If you look overseas, you can find more attractive opportunities. I think that is more important than the benefits of diversification.

BM: I think, in the U.S., we’re probably more privileged than anyone else just by virtue of the size and the depth of our markets and the breadth of the companies we can invest in, it limits you from a whole lot of different opportunities.

VK: Actually Bill, there is another point I want to make there. In bull markets, cash is the enemy just because even if you just throw money at stocks, you will do fine, right? In the range-bound markets, stock selection matters a lot. Therefore, opportunity cost of bonds is a lot lower because the returns between stocks and bonds are not that much different. So what you want to make sure that, as I said before, you don’t make incremental kind of bad marginal decisions. You are buying it for the sake of being invested and one nice thing about international investing, it is going to lower you cash position, because you are probably going to find more opportunities if you look in the bigger pond.

PD: There is another point to international investing is that I think people sometimes lose sight of the value of some of the multi-nationals. I often say that is not really important where the headquarters is. If 60% of your production is in China and 70% of your sales are outside of the U.S., are you really a U.S. company or are you an international company?
BM: And I am looking at page 203 in the book where you had the subtitle, “Location of Corporate Headquarters Abroad May Not Constitute a Foreign Company.”
VK: That’s right. It is like saying that Nokia is a Finnish company. Yes, it is headquartered in Finland, but I think, I don’t know the number, but maybe 2% of its sales come from Finland. You can say it is a Chinese company for that matter, because that is where the growth is.

PD: So Vitaliy, I know that we have got a little while left and I know that you have probably got a couple of other companies that our subscribers would like to hear you talk about.
VK: Sure. One of the stocks is a REIT. The REITs had a huge run and then they declined, but this REIT did not really have a huge run. It is HRPT Properties. It has a yield of 8.6% and the best part is it trades at book value. I usually don’t pay attention to the book value, but in this case, this book value is assets, real assets. I would argue that the office buildings that it bought over the last ten years are worth a lot more than its accounting value, so there is a hidden asset right there.

It has an OK management. I am not crazy about the management. It hasn’t destroyed a lot of value because it hasn’t made stupid acquisitions. The problem is, they haven’t done a good job growing the company, but the way I look at it, I have a very nice yield and I have a very high-quality REIT because interest coverage is great, the dividend is well covered, and leases are about seven years long. So it is a very conservative REIT, very nice yield, 8.6%. I feel comfortable holding this.

Another one, and I know you guys both like is First Marblehead. This stock trades at what, eight, nine times earnings? It has a phenomenal growth rate ahead of it and I think the investors still put it into the subprime mortgage category, even thought the average FICO score of its portfolio is 714, which is very high; 83% of it loans co-signed.

The part that I love about it [is] this whole speculation about major customers JPMorgan and Bank of America going away [and] you can quantify that easily. You can figure out what impact it would have on the portfolio if both Bank of America and JPMorgan dropped First Marblehead and actually I figured it out and kind of my worst case, a year after JPMorgan dropped; if JPMorgan and Bank of America leave First Marblehead, its revenues would be up 20% or 30% over where they are today. So my downside is basically none.

You could argue that the margins may become compressed, but that the JPMorgan and Bank of America business is growing so fast that it should overcompensate that. I know you guys will agree.

BM: Obviously, we agree with you. (Laughter.)

PD: Just a little bit.

BM: The book is called Active Value Investing and Vitaliy, it is on the market now?

VK: Yes, sir.

BM: Thanks so much for spending the time with us!

Copyright The Motley Fool


Vitaliy N. Katsenelson, CFA, is Chief Investment Officer at Investment Management Associates in Denver, Colo. He is the author of Active Value Investing (Wiley) and The Little Book of Sideways Markets (Wiley). His books were translated into eight languages. Forbes Magazine called him "The new Benjamin Graham".

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