Pyrrhic Victory and Q&A with Kirk Report
A Pyrrhic victory is so called after the Greek king Pyrrhus, who, after suffering heavy losses in defeating the Romans in 279 B.C., said to those sent to congratulate him, “Another such victory over the Romans and we are undone.”
A quick thought on the debt-ceiling debacle. I believe that by August 2nd we’ll see the debt ceiling increased, as the cost of not doing so is simply unknown and most likely too high. However, it will be a Pyrrhic victory for whatever side claims it, as the victory will undoubtedly undermine the world’s trust in the US dollar and its debt ($37.5 billion leaving money-market funds that invest in Treasuries in one week proves the latter point already).
I analyzed Brown & Brown about a year ago (May 2010), and judging from the latest quarter this analysis it is still very relevant today (here is a link).
I was interviewed by Charles Kirk, the host of KirkReport.com.
(Watercolor “Mexican Shores” is by my father Naum Katsenelson)
Q&A With Vitaliy Katsenelson
A number of members have requested that I interview a value-focused investor with a longer-term time horizon. While there are many people I could choose, I thought it was about time I finally interviewed Vitaliy Katsenelson who fits that profile. Many of you know Vitaliy from his website, Contrarian Edge, as well as his books on investing.
While there are thousands of traders who read The Kirk Report daily, there are still just as many who utilize longer-term approaches and who are focused on finding value versus short-term momentum. No matter what your strategy or focus, we hope you find this interview helpful.
Kirk: Hi, Vitaliy! It’s great to have you here with us today. While I know many are familiar with you and your background, please start out by telling us a little bit about yourself and how you began to learn about the markets and investing.
Vitaliy: I was born in Murmansk, a city in northwest Russia, located above the Arctic Circle (think long winters with little daylight, intense cold and beautiful white nights in the summer). Murmansk, on the Barents Sea, is the home of the only Russian shipping port that doesn’t freeze in the wintertime.
Russia had (and still has) a draft army. Though in the United States most look at serving in the army as an honor, in Russia most parents dread the day their sons turn 17. Not because of fear of dying in a war – by the late ’80s the Soviet Afghan war was over – but because serving in the army is looked upon as a prison sentence, two or three years of lost youth. Draftees are usually sent away thousands miles away from their homes (the logic is that in case there is social unrest and the army brought in, soldiers more likely to use force against strangers than friends and relatives). Young soldiers are commonly abused by older ones, and the pay afforded soldiers barely leaves them enough to buy postage stamps to write home to ask for more money.
There were several ways to avoid the draft. You can fake sickness – a very sane friend of mine spent two months in a mental institution, faking mental illness (he succeeded). Or you can run away. However, despite the enormous size of the country, the authorities will find you. Or you could keep constantly having kids until you turn 27 – another friend of mine did just that. And finally – and this is the most common method – you can go to a college or university that has an exemption from the draft.
By the time I was approaching the dreaded draft age, all universities in Murmansk had lost their draft exemption except one, Murmansk Marine College. It was a somewhat unusual college: it accepted students after the 10th grade, and we were not usual students, we were cadets. The first three years we were required to live in an military-like dormitory. We wore navy uniforms, had commanding officers, walked to classes in ranks, and about twenty percent of our courses were military.
I hate following mindless orders till this day, and I hated every moment of being there. But, I was ten minutes away from my parents, and this was a much better alternative than going into the army. In other words, this was a milder version of hell. If I were to graduate I’d become a mechanical engineer on a fishing or transport ship. I was looking ahead with horror to my graduation, because I was about to get into a profession that I could not stand. To say I was not motivated to study is an understatement; I barely passed every class, with the exception for one: microeconomics. I felt almost like a hidden gene was suddenly activated; I had this intuitive understanding of the subject without opening a book. It was the only subject that I aced.
Luckily, I never had to face my worst fear of becoming a mechanical engineer because, in 1991, a few months before graduation, my entire family, blessed by the genetic lottery by being Jewish, was accepted for immigration to the United States (at the time, the Jackson-Vanik amendment forced Russia to allow Jews to immigrate to the US and Israel).
My revelation with the economics class helped me to understand that I wanted to be a business major when we arrived here and I went to university, but it took me a few more years to realize that I wanted to be an investor. In fact, I did not even consider investing as a career track at first. Being an investor was not an option in the Soviet Russian culture – there was no stock market! In fact, at first my understanding of investing was completely shaped by a Russian documentary I watched in late ’80s that showed videos of the NYSE, with people yelling and throwing papers around – I remember that a man complained of going deaf from all the noise. The impression I had was that the whole investing thing was like living in a really loud casino.
While going to college in the US, the only employable skill I had (except my winning smile) was my computer knowledge. To my great fortune, I landed a tech job at an investment firm. Now it sounds laughable, but the owner of the firm did not want spend the money on a fax machine that had a multipage feeder. Yet the firm needed to fax trade orders to multiple brokerage firms, so for the first few months I was the “auto feeder” for the fax machine. I spent several hours a day standing by the fax machine, feeding pages into it.
The owner, who is now a good friend of mine, decided that my talents were better put to use doing something more creative, and he asked me to write a relational database. I got lucky. At the time (this is the mid ’90s), Microsoft had unlimited technical support for its Microsoft Access product (that’s not the case anymore). I knew little about databases, but after spending three or four hours a day on the phone with Microsoft tech support (they were not in India at the time); I had learned Access inside and out. The database I wrote is still used to this day.
While working for this investment firm I had the chance to learn what investing was truly all about (it was not about yelling and screaming, and you didn’t need to lose your hearing). Portfolio managers were happy to share their knowledge, and I had unlimited access to a Bloomberg terminal. This is when I realized I wanted to become an investor. After that, nothing else mattered; I knew what I wanted to do. I changed my major for the sixth and final time to finance (that was the closest thing to an investment degree at the University of Colorado at Denver), and the rest is history.
Kirk: Looking back, was there any key experience or person who was most instrumental in your development?
Vitaliy: There was frustration in the early 2000s. I started out as a GARP (Growth at Reasonable Price) investor. As a GARP investor you basically look for companies that are growing earnings and trade at a fair value. This was the approach my firm, IMA, used in the late ’90s. It worked well, and we made a lot of money for our clients. However, in the early 2000s it stopped working.
At first I thought this strategy had simply fallen out of favor, and then I realized there was more to it. I was at a conference, and one of the speakers showed a chart of the Dow, going back 100-plus years. The speaker made the point that every time the Dow touched a 1 with a zero behind it the market stagnated. There was little explanation provided as to why it happened, but it sent me on a search to discover the answer for myself.
I did a lot of digging and realized that every prolonged (secular) bull market was followed by a sideways market that usually lasted 15 years or so. This happened because stocks got overvalued at the end of secular bull markets, when their P/Es went too high – they went to above-average levels, and it took time for the P/Es to contract to below average. I realized that the way we invested had to change, because buying companies at “fair” P/Es was not going to work in this environment. We needed to own companies at unfairly low P/Es, the ones that traded at a discount to their fair value. This realization turned me in an instant into a value investor.
I came up with the Active Value Investing approach, which spilled into my first book, Active Value Investing: Making Money in Range-Bound Markets – which basically spells out how my firm manages money today. Last year my publisher, Wiley, asked me to rewrite Active Value Investing for a wider audience, and this how The Little Book of Sideways Markets came to life.
On a personal note, as I get older I deepen my appreciation of the impact my parents had on me. Last year I watched Man of La Mancha, a musical with Sophia Loren and Peter O’Toole, based on Miguel de Cervantes’ Don Quixote. I had read the book when I was a kid, but I don’t think I understood its message until recently. Now I understand why this book is still read today, four hundred years later.
Don Quixote, despite being delusional, saw in people more than they ever possessed. He meets Aldonnza, a farm girl (a woman of the “oldest profession”) and, either blinded by love or insanity (probably both), he sees only a lady in her, and starts treating her like one, calling her by another name, Ducinea. She knows that she doesn’t deserve this treatment, but she starts believing him, and this belief transforms her into a different person – she aspires to be the person Don Quixote sees in her. My parents were like Don Quixote: they always saw a much greater person in me, though I rarely deserved it (they really had a rich imagination); and I tried to rise to become what they saw. Now that I’m a father of two wonderful kids, I try to do the same for them. The little things we say to our kids really do matter!
Kirk: That’s a very inspiring story, Vitaliy. Thank you for taking the time to share it with us.
How would you describe your current investment approach?
Vitaliy: I am an active value investor. To my mind, a value investor is one who looks at stocks as businesses, not pieces of paper, and wants to own them at a discount to their fair value. Active value investing is the value investing process that I created and modified for the sideways market we are in.
Kirk: You’ve been referred to as the next Ben Graham. Do you think that comparison is true?
Vitaliy: I almost fell off my chair when I read that praise from Forbes. It was not unlike our President receiving the Nobel Prize after being on the job for two weeks. Forbes’ comparison is very aspirational. No, I don’t deserve it.
Kirk: Tell us about your firm, Investment Management Associates. What do you do there – what’s your job at the firm?
Vitaliy: IMA was started in 1979 by my partner, Michael Conn. Michael ran one of the Founders mutual funds in the late ’70s, so he started IMA as an alternative to faceless mutual funds. He figured that even though mutual funds are appropriate for people who don’t have a lot of money to invest, the ones who had six figures would benefit from custom-tailored portfolios. I joined as an employee in 1997, later became a partner and CIO, and today the firm’s investment process is the process I described in the Active Value Investing book.
Kirk: To your firm’s credit, I really like the disclosed analytical process at the site, which concisely lays out the quality, valuation, and growth test. Who developed this model and what was it based on originally?
Vitaliy: I developed the QVG framework in the early 2000s. With this framework, the stock analytical process is broken up into three dimensions. The first two are Quality – a company with a competitive advantage, a high return on capital, good management, and a strong balance sheet – and Growth – a company that is growing earnings and paying a dividend. If you think about it, a company that scores well in the Q and G dimensions is a good company, maybe a company you want to work for; but only when it scores well in the third dimension, Valuation – trades at a discount to its fair value (has a margin of safety) – does it become a good stock.
What is important about this framework is that it stresses the importance of interrelations between and within each dimension. In a perfect world you’d love to own a company that aces each dimension, but the world is not perfect and it is very difficult to fill a portfolio with companies that meet all QVG criteria with flying colors. So you need to compromise. For instance, if a company that is growing earnings at a slow rate and pays only a small dividend, there needs to a higher margin of safety, because a larger portion of the return will come from the company’s valuation reverting towards the mean. A company that has a volatile business – a fashion retailer, for instance – needs to have a super-strong balance sheet, etc.
Kirk: How do you find companies that are able to pass this QVG test? Do you utilize any screening or filtering methods, or do other types of research?
Vitaliy: I try to use every tool possible. After all – why limit yourself? I screen for stocks. I have a watch list of several hundred companies that I’ve looked at and decided to pass on because of valuation. I set a target P/E and wait.
Over the years I’ve met a lot of value investors, and I was able to make a lot of friends. I talk to a few dozen of them on a semi-regular basis, and we share ideas (it goes both ways). I look at the portfolio holdings of investors I admire. I try to figure out why they bought or sold stocks. But I never buy a stock just because they bought it; I have to come to the “buy” conclusion through my own in-depth research.
I also read value investing letters, blogs, and mainstream media (though I find it less helpful in generating new ideas). The popularity of ETFs has created another good source of ideas. I track a few dozen sector ETFs – this way I can see what sectors are doing well or poorly. If I see a sector getting beat up, I start digging deeper in it looking for value.
Amazingly, I find Twitter a good source of news/articles on investing. I strictly use it for that purpose, and I share articles that I find interesting. You can follow me here.
Kirk: As a teaching example, please go through the process you went through for a previously closed-out, successful investment. Start by telling us how you found the investment, the decision-making process you went through to evaluate it, how long you held it, and finally what caused you to close out.
Vitaliy: Early this year we bought Electronic Arts. I’ve followed EA for a long time, but it suffered from the “too successful company” syndrome: it had a very large market share in the gaming industry and was very profitable. It lost focus, had too many titles, the quality of its games declined, costs ballooned, etc. The new CEO admitted to the problems – a very important first step – and then laid out an action plan: they killed a few titles, cut costs, improved quality etc.
EA required a little bit of imagination. Statistically it did not look cheap, maybe it was fairly valued at best. But if you looked at its close competitor Activision (ATVI), whose sales were about the same as EA’s, you saw that its profits were much higher (due to better margins). You could have said, well, if EA closes the margin gap, partially due to what management is doing, then EA is cheap. We bought EA under 16, it reported good numbers, improved margins, and the stock went up to the low end of our valuation target, so we sold it at about $24 in the second quarter.
Kirk: Excellent. This shows the value not only in monitoring relative valuation, but also how important it is to compare companies with their direct competitors.
Please take us through one of your worst investments recently.
Vitaliy: Nokia was by far the worst investment. We first bought in 2004, when Nokia had missed the flip phone craze. We started buying it in the low teens, and then the company came out with good flip phones, earnings went up, and we sold it in late 2007 in the high $30s.
In 2008 Nokia stock declined to the low $20s. We figured its earnings power was about $2 or $3. Its telecom equipment business was losing money, and we thought that if they shut it down or simply got it to breakeven, earnings would improve. So we jumped back in.
The iPhone should have been a blessing for Nokia; it showed what phones of the future would look like. But Nokia was too successful and far removed from the US to understand how important the iPhone product was. We gave the company the benefit of the doubt at first – they were the largest cell-phone company in the world, and they had missed product cycles in the past – but the signs were there if you chose to see them: They grossly overpaid for Navteq. They came out with a music phone, which was basically a semi-dumb phone with a music service. Then they were desperately trying to take Symbian, an operating system that did a marvelous job running Nokia’s dumb phone, and make it into something it could not be, a smart-phone operating system.
We were already thinking of throwing in the towel on Nokia, but then it announced a partnership with Intel to develop a brand-new, Linux-based operating system, MeeGo. It made perfect sense; MeeGo would not be burdened by the code that had been written for dumb phones. We decided to wait and see.
The old CEO was fired, and Stephen Elop, a Microsoft executive, was brought in as CEO. It seemed that things were getting brighter. However, knowing what I know now, I truly believe that Mr. Elop was the worst thing that ever happened to Nokia and one of the best things that had happened to Microsoft for a long time. Elop announced that Nokia would abandon both Symbian and MeeGo and start making cell phones to run exclusively under the Microsoft Windows OS. With this move, Nokia went from being an Apple-like business that could differentiate itself from competitors because it controlled software and hardware and commanding low-teen profit margins (Apple’s margins are actually pushing the low 20s now), to a Dell-like company with net margins of 5% in a good year.
Though the Windows decision may have benefited Nokia in the short run, in the long run it reminded me what IBM did with Microsoft in the ’80s: it saw little value in the software and went after the hardware business. Cell-phone hardware will become ubiquitous in a few years and Nokia will be competing on price and manufacturing efficiency with its rivals. Microsoft on the other hand will get Windows installed on a huge number of phones, and it will benefit from Nokia’s enormous distribution system. And it only cost Microsoft a billion or two. When this announcement was made the market rightfully punished Nokia stock, and we got out at around $8.
Mr. Elop’s actions have the smell of being a double-agent for Microsoft. He said that neither Symbian nor MeeGo were ready for primetime; by the time they’d be ready the party would be over, and it would be too late for Nokia to have a relevant product. When I heard that I thought, well, he must be right; after all, he is the CEO; he gets to see Symbian and MeeGo firsthand. However, a few weeks ago Nokia came out with the N9, its newest MeeGo phone. What is shocking is that it is an incredible, iPhone-worthy phone. After seeing this phone, Elop’s decision to kill MeeGo-based phones makes no sense.
I try to learn as much as I can from my mistakes, so they don’t go to waste. In this case, I let our success with Nokia the first time around cloud my judgment.
Kirk: I think we’ve all been there at one time or the other. The key, as you say, is to learn from your mistakes.
What would you say is your average hold time for individual stock positions?
Vitaliy: We look for about a 50% upside when we buy a stock. If it takes a week for that to happen, then so be it, we’ll sell it (it never happened to me yet, and if it did it would be sheer luck). We hold stocks for months and years.
Kirk: Looking back over the first half of 2011, what have been your best performers to date?
Vitaliy: Electronic Arts and United Health.
Kirk: Without disclosing your entire book, can you take us through a few companies that match what you look for and that you think offer excellent upside potential?
Vitaliy: Computer Sciences and Xerox look very interesting. Both are not high growers (especially Xerox), but this is the case when an insanely low valuation (free cash-flow yield is greater than 13%), a stable and slightly growing top line, combined with management willing to buy a lot of stock, creates enormous shareholder value. Both companies generate huge free cash flows. Xerox announced they’ll start buying stock back in September, and Computer Sciences as soon as they file financials with the SEC (they were delayed in filing due to a $50 million accounting irregularity in one of their subsidiaries, but this is a company that has $16 billion in revenues).
Kirk: On a sector basis where is the most value to be found in this market?
Vitaliy: High-quality, noncyclical, or slightly cyclical large companies are the most attractive asset class. Think J&J, Medtronic, Microsoft, Cisco etc. Interestingly, these companies are labeled as value traps. I believe they should be called “growth traps” instead. The distinction is very important. Their stocks have gone nowhere in a decade or so, so they were a trap, but not because their earnings have stagnated or declined.
Earnings in most cases tripled for each company, but their valuations (i.e., P/Es) declined from unreasonably high levels in the late ’90s to current insanely low levels. Their earnings growth going forward will be lower than it was over the last decade – they are much larger companies today – but they’ll still have growth. Current valuation is factoring in declines, but that is an unlikely scenario.
Kirk: Where do you think there are real value traps to avoid in this market?
Vitaliy: Most value traps I see today are in the highly cyclical companies whose revenues are driven by rises in demand for industrial commodities. I’ve written a lot about it, but to sum up in a few sentences, I believe China is in the midst of an over-investment bubble of enormous proportions that will make our real estate bubble look like child’s play. Once it bursts, demand for industrial commodities and heavy equipment will drop off substantially. Companies that benefited tremendously from the bubble will become its casualties.
Take Caterpillar, for instance. It is trading at 15 times earnings, but if you look at projections of CAT’s earnings for 2014-2015, it trades at more like at 8x times. Cheap, right? The problem is that CAT’s revenue is expected to double from the height of the 2007 bubble, and its margins that are hitting all-time highs today are expected to rise further. China is responsible for all incremental demand for industrial commodities; and as the Chinese economy stops growing and likely starts contracting, CAT will experience what the new normal means for the global economy. Its revenues will decline and profit margins will come back to earth. Suddenly investors will discover that CAT earnings power is $2 or $3 a share, not $6 or $12, and at over $100 CAT will be a value trap.
The spillover effect of the Chinese bubble is huge. Think of countries that are heavily dependent on commodity exports, like Australia, Brazil, Canada, and many others that are currently primary beneficiaries of what is transpiring in China. They will suffer as well. For instance, 25% of Australian exports go to China today, up from 5% a decade ago. CAT is just one illustrative example, but if you think about the primary and secondary beneficiaries of unsustainable Chinese demand for commodities, the large list of stocks that were rocking and rolling over the last few years suddenly doesn’t look very appealing.
I’ve written a lot on China for those interested in learning more.
Kirk: That’s very interesting. I’m curious – do you currently see the U.S. market as undervalued, fairly valued, or overvalued, and why?
Vitaliy: Well, statistically, if you look at forward earnings the market is cheap, but only statistically. Corporate profit margins are hitting all-time highs. Historically, profit margins have been mean-reverting creatures: they have never stayed at above-average levels for long. The reason is simple: when a company starts making excess profits, competition waltzes in and starts offering a product at a lower price, driving profit margins down. To assess true cheapness of the stock market, one should look at price divided by ten-year trailing earnings. This ratio normalizes data for cyclicality (volatility) of profit margins and tells a much different story: stocks are not cheap at all, and in fact trade at over 40% above average valuations. This article explains this point in greater detail.
Kirk: How does the performance of the overall market impact your analysis or decision-making process?
Vitaliy: So far, believe it or not, the market is performing by the “sideways/range-bound” market playbook. A secular sideways market is full of cyclical (short-term) bull and bear markets – the last, 1966-1982 sideways market had a half a dozen of each. Since 2000, that is when the current sideways market commenced, we had a cyclical bear, a bull, a bear, and a bull again; but we are still not far from where we started, and valuations are still high.
However, the Great Recession may have increased the duration of this sideways market. Let me explain. Sideways markets are really a drama of two opposing forces: growing earnings and declining P/Es. It is really the earnings growth that gets us out of sideways markets. Stock prices in general, though volatile, remain the same but earnings growth compresses P/Es from above- to below-average.
GDP growth for the first two-thirds of past decade was supersized by increased consumer leverage: people spent money they did not have to buy things. Now it’s payback time.
It is not unreasonable to expect that consumer deleveraging will slow down economic growth. At some point in the not-so-distant future, our government will have to join the deleveraging party, which will further slowdown economic growth. In addition, high government indebtness should lead to higher taxation and/or higher interest rates – both are detrimental to economic growth.
So if you assume economic growth going forward will be a few points below that of the past, then this sideways market will likely last longer. In the long run, GDP growth equals earnings growth. I know we’d like to think that the economy’s earnings can grow at a faster rate than the economy (this would require always-rising profit margins), but historically that has not been the case.
From our decision-making process, we are presently very defensive in our stock selection.
Kirk: I can understand why, given those keen observations.
In my experience, many value-focused investors have an exceptionally tough time knowing when they are wrong in a position or have been caught in a so-called value trap. How do you manage risk when you’re wrong?
Vitaliy: You bring up an excellent point. A value trap is the value investor’s version of hell. A value trap is when you buy something that is seemingly (usually statistically) cheap, but earnings/cash flow collapses, and suddenly it is not cheap anymore.
There is only one way to avoid a value trap through analysis. There is no magic to it. Borders looked cheap until the last day of its existence. Also, you need to be willing to walk away from a stock and say, “I don’t know, I don’t understand.” But let’s be realistic: an occasional visit to that hell is unavoidable; you just want to minimize the damage it inflicts on your portfolio.
Kirk: What is the best way to spot a value trap?
Vitaliy: I’ve been thinking about value traps a lot since our VALUEx Vail conference. The easiest one is where you see a tectonic shift – for example, the Internet’s impact on book and music stores and the newspaper industry. It is extremely difficult for a company to adapt to this type of transformation, as it requires undercutting its current, very profitable business for a future though yet unprofitable one. We know the obvious examples of value traps, but there have also been a few successes: Amazon did a terrific job with Kindle and Netflix with its video streaming.
Best Buy stock now has the smell of a value trap. Consumers today are equipped with smart phones that allow them to scan the barcode of a large-screen TV and get comparative prices from on- and offline retailers in a second. Online retailers offer better selection and often better prices. So to some degree Best Buy is becoming a free showroom for Amazon and the likes. Unless Best Buy’s management is thinking how they’ll drastically transform their business, it may turn into a value trap.
Kirk: Would you say that value-focused investing is more challenging to learn than other approaches? Why or why not?
Vitaliy: In theory value investing is easy – you buy stocks when they are cheap and sell when they are loved. It is not difficult to learn how to value stocks. However, the difficult part is the psychology. You are usually buying stocks that everyone hates, so you need to have the confidence to stick with your convictions when the crowd disagrees with you, and have the humility to change your mind when you are wrong. My mistake with Nokia was a psychological one, not a valuation one.
Kirk: Is it realistic to suggest that individual investors have what it takes to do the type of homework you and other professionals do, without a CFA?
Vitaliy: In short – the answer is YES.
I am a Chartered Financial Analyst, and I learned a lot from going through the CFA program (as well as from getting two finance degrees); but the problem with the CFA program is that half your time is wasted on useless concepts, and since there is an exam, the program also requires you to be a good test taker (I was never good at that).
It is probably still the most relevant program if you want to be an investor; but in all honesty, you can take the CFA curriculum, pick relevant subjects, e.g. economics, accounting, valuation (excluding Modern Portfolio Theory), statistics, behavioral finance, and derivatives, and study them on your own and just not worry about taking the exam. You’ll learn a lot, won’t waste your time on irrelevant academic and politically correct topics like ethics (all you need to know is to always put clients’ interests first, and err on the side of the perception of wrong doing vs. legality. When people trust you with their life savings, you never want them to question your true motives).
But that would be just a start. Then you’d want to read a lot on value investing (books, blogs, newsletters/interviews, presentations, etc.) and finally, take as much money as you could afford to lose and start investing.
Paraphrasing Charlie Munger, learning about investing only from books is like learning about sex from romantic novels.
Kirk: The same can be said about trading. LOL!
So, if the average individual investor with some experience desired to learn how to quickly ascertain the “fair value” of any stock, what method would you recommend they learn first?
Vitaliy: To value a stock you first really need to understand the business; you need to understand what makes the business tick. The valuation is the easy part. Any model is as good as the inputs that go into it, so if you don’t understand the business you may come up with a precise value that is precisely wrong. I try to come up with a range of values, using different tools.
Some valuations tools are more appropriate to one industry vs. another. For instance, book value is an appropriate and useful tool when you value insurance stocks, but it’s worthless when you value software companies. My favorite tool is discounted cash-flow analysis.
It’s a very crude, extremely imprecise tool, which will spit out a precise number. But I like to use it, the process of building a discounted cash-flow model helps me to understand the company better; it directs me to what variables have the largest impact on the company’s value, etc. It is usually very helpful at the extremes, when a company is extremely undervalued or ridiculously overvalued. It would have kept you away from CSCO in the late ’90s, and probably give you the confidence to own CSCO today.
Kirk: How do you go about ascertaining a company’s earnings quality? Do you have a quick trick to share in this regard?
Vitaliy: The best way to assess a company’s earnings quality is to look at its cash flows. For every company in our portfolio, we come up with a cash earnings power, which is really normalized free cash flows (cash flows will always be more volatile than earnings, since earnings use a lot of accounting accruals that tend to smooth them). Cash flows are lumpier but tell a more accurate story of a company’s true earnings power. You want to adjust cash flows for benefits from issuing stock options; they actually increase operating cash flows. Also, a lot of companies now have underfunded pension liabilities; you want to nick their cash flow for that liability.
Also, a company that has a high recurrence of revenues will usually be less volatile and have more stable earnings/cash flows.
Kirk: Do you have books, websites, etc. to recommend to those who wish to learn value-focused investing?
Vitaliy: Here is my recommended book list.
Gurufocus.com is probably one of the better websites on value investing. It has a lot of articles on value investing and also shows you the holdings of “gurus.” Value Investing Letter is also another good source of articles on value investing. I also like Whale Wisdom to look at positions of other value investors I respect who may not be followed by Gurufocus.
Kirk: In The Little Book of Sideways Markets you offer the view that we are trapped in a sideways market. First off, what would change your view in this regard?
Vitaliy: After I wrote Active Value Investing I realized that I had inadvertently created a market cycle framework in which you could plug in your own assumptions and draw your own conclusions about the future long-term direction of the US stock market. Both secular sideways and secular bear markets took place after secular bull markets. However, the wild card that determined if it was a bear or a sideways market was the economy. Nominal earnings grew during sideways markets and declined during bear markets. If nominal earnings/economic growth over the next decade are negative, then our current sideways markets will spill into a bear market. The chances of a secular bull market arising out of our current very high (if your normalize margins) valuations are extremely low.
Kirk: Thanks so much, Vitaliy! Your perspectives offer a lot to consider and we appreciate your willingness to share them. Good luck with the rest of 2011!
Vitaliy N. Katsenelson, CFA, is Chief Investment Officer at Investment Management Associates in Denver, Colo. He is the author of The Little Book of Sideways Markets (Wiley, December 2010). To receive Vitaliy’s future articles by email, click here or read his articles here.
Investment Management Associates Inc. is a value investing firm based in Denver, Colorado. Its main focus is on growing and preserving wealth for private investors and institutions while adhering to a disciplined value investment process, as detailed in Vitaliy Katsenelson’s Active Value Investing (Wiley, 2007) book.
Copyright Vitaliy N. Katsenelson 2011. This article may be republished only in its entirety and without modifications.
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