Charlie Munger, in his usual brilliantly succinct manner, spit out a few terrific zingers at the Berkshire meeting: “If an investment comes with a high commission, don’t even read the prospectus [run away]” and “Prostitution is a step up for compensation consultants” and “If short-term performance is something that turns you on, you should not be in this room.”  Watch this interview with Munger.  He is too old (88) and too rich to try to be politically correct – he is very refreshing.

Seek out people who disagree with you
While answering a question on his political views and their impact on Berkshire (see question 13), Buffett said something that really resonated with me, though for a different reason: “If you are going to choose your friends and your investments if they agree with you, you are going to have a very peculiar life.”

I have a dentist friend. He was born in Russia, moved to Israel when he was 7, spent 20 years in Germany, and then moved to Denver about 10 years ago.  He is extremely smart, very well-read, and a thoughtful person. His multi-continent background gives him a unique perspective on things.   However, I have yet to meet a person with whom I disagree more about US and global politics.  In the past I used to get angry at him.  After one of our regular debates, I’d sometimes go into avoidance mode for a few months.  His disagreements were passionate but also well-thought-out and backed up with facts and his own theories.

Last winter he invited to me to go skiing with him.  Overall he is a pleasant person, but I was a bit hesitant – it is a two-hour drive each direction from Denver to the mountains.  Four hours of disagreements in one day?  But I went along, and instead of disagreeing with him I started to listen.  I tried to identify the specifics of our disagreement, what assumptions both of us were making.  And then tried to focus the discussion on these more precise points of disagreement.  In the end we each learned from the other.  Our views have not changed much (political views are like religion beliefs, nearly impossible to change), but this summer we are going to go off bicycling together, and I am looking forward to it.

This applies to investing as well.  When you are long a stock you are naturally trying to seek out investors who have the same opinion, and naturally stay away from those who have contrary views.  Instead, we should try to do the opposite, seeking out smart people who, after doing their research (a very important point), came to a different conclusion from ours.  This point is a bit more nuanced.  If I talk to a momentum growth investor about Xerox, I know exactly why he’ll be avoiding it; there is no momentum in the stock price.  His view will bring me very little insight.  However, the perspective of a smart fundamental investor who’s done thorough research but arrived at a different conclusion might be very valuable.  When we find someone who disagrees, we need to identify exactly where the differences in opinion lie (assumptions, new/missing important data points, etc.) and then methodically and objectively try to refute those points.  If you cannot, maybe you are not as right as you thought you were.

I’ve seen Jim Chanos do this.  When he presents an idea he’ll say, “Bulls make the following assumptions…” and he’ll impartially spell them out; and then he’ll go, “But here is why we think they’re are wrong” (or the results are not achievable etc.).  Speaking of Jim, he was interviewed in the Graham and Doddsville newsletter.  I really liked this interview, because it went deep into Jim’s unique investment process. He also recently participated on an investment panel on China at the  Milken Institute.  It is worth watching.
The budget deficit is a stimulus
In answer to a question, Buffett said something along the lines of “When government runs a 10% deficit, it is a stimulus, though nobody calls it that.”  But the bond market will not let us run 10% deficits forever.  Unless an unlikely miracle happens and, due to super economic growth, we fill in that hole, taxes will have to go up, government spending will have to be cut, and/or money will have to be printed.  It is hard for me to see how the current (artificially set by the Fed, insanely low) long-term interest rates will stay there.  As Buffett mentioned, elimination of the deficit will be destimulating, so the future may hold a weird combination of low real growth and still-high interest rates.

China = post-bubble Japan?
On a different topic, The (UK) Telegraph has a fairly bleak article on the sorry state of the Chinese economy, which is coming to resemble the Japanese post-bubble economy at an increasing rate.  Here are some scary excerpts, with my comments:

• “China’s electricity output – watched religiously by bears – slumped in April. It is up just 0.7pc over the last year.” – This number is the hardest to cook.  The rate of growth has been declining for a few months.
• “State investment in railways has fallen 44pc, with an accelerating downward lurch over recent months. Highway construction has dropped 2.7pc.”
• “The Yangtze shipyards tell the tale. Caixin magazine said eight of the 10 largest builders in the country have not received a single new order this year.”
• “Housing sales slumped 25pc in the first quarter, testimony to the zeal of regulators. This has since fed into a drastic fall in new building.… floor place under construction fell 28.3pc in April.” – The housing market is extremely important for Chinese federal and local governments – see next data point.
• “Land sales provide 70pc of tax revenue to local authorities and 30pc to the central government.”
• “The People’s Bank said new loans fell from $160bn in March to $108bn in April. Non-conventional lending seized up altogether. Trust lending fell by 96pc, bankers’ acceptance bills by 90pc.”
• “Yes, consumer price inflation is 3.4pc – though falling – but consumption is a third of GDP. Fixed investment is 46pc, and here prices have dropped 3.5pc in six months. Export prices have dropped 6.6pc.”  This is not a dynamic and healthy economy; its growth was completely predicated on large-scale fixed-income investment.  Though it looks like the Chinese government has succeeded at fighting inflation, the system is so addicted to stimulus/construction that if they don’t restart building more empty cities and bridges to nowhere, the economy will stall.  It is a no-win situation.  (Is it already stalling?)

Etc…
I had the pleasure to participate (third year in a row) on the Value Investing Panel at Creighton University.  Bruce Greenwald – charismatic, brilliantly smart Columbia University professor – was on the panel as well.  Bruce and I had a lively debate about the usefulness of discounted cash-flow analysis.  I realize that for civilians (non-finance geeks) this disagreement is like two paleontologists arguing about dinosaurs’ procreation habits. You can watch it in its entirety (scroll to the bottom of the page – the video is horrible but the audio is fine).

While in Omaha I was interviewed by Yahoo! Breakout’s Matt Nesto.  We talked about Facebook, Microsoft, and Electronic Arts.  We were outside of Borsheim’s, a large jewelry store owned by Berkshire Hathaway.  There were probably a few thousand people who could not wait to buy jewelry and get their hands on free booze and food.

A year ago I did a 90-minute lecture at Johns Hopkins University in DC on China and Japan.  It has finally made its way to YouTube.

I was going send out an article in this email, but this is already too long – I’ll save it for next time.

And this is a good time to start a new a new tradition: at the bottom of each email I’ll include a link to my favorite music clip (I’m a classical music fan, so don’t get too excited).

My parents always loved classical music; in fact I don’t remember them listening to any other music.  When Mom put me to sleep she’d employ her favorite record, Rachmaninov’s Piano Concerto Number 2.  I think Rachmaninov is dear to me because it brings out memories of childhood and my mother.

When I came to United States I discovered a young Russian pianist (he is now a few years older), Evgeniy Kissin.  He was a child prodigy.  I’ve heard many pianists play Rachmaninov, but his interpretations touch me the most.  Here is the Rachmaninov Piano Concerto No. 2 with Evgeniy Kissin (part 1-1, part 1-2, part 2-1, part 2-2, part 3-1, part 3-2).

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.

P.S. Watercolor “European City. Evening.” is by my father Naum Katsenelson

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.

On January 18, 2011 I had a great pleasure to give a lecture on China and its impact on global economy at Johns Hopkings University Applied Physics Lab.  You can watch it now on youtube, click on this link

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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.

Deadline to register for VALUEx Vail is May 1^st. 

I am very excited about one of our “dessert speakers,” Jon Markman, who’ll speak about Jessie Livermore, one of the most successful (until he failed) and interesting traders ever, who lived in the first half of the last century.  No one knows more about Jessie Livermore than Jon, as he annotated one of my favorite books, Reminiscences of a Stock Operator.  Here is what I wrote about it a few years ago: “Jon’s skillful annotation takes you behind the scenes of Livermore story and provides important insights into characters and the backdrop of that very interesting time period.  Jon’s annotations are almost like a book within a book.”

Omaha!

It is Omaha time again!  This year Value Investor Congress, which I’ll be attending, has been moved to Omaha.  Congress is Sunday (May 6^th) through Monday.
May 4^th – Friday

May 5^th – Saturday
 

May 6^th – Sunday
 

China bubble today vs. Japan bubble in 80s

I am back from San Francisco, where I had the great pleasure of attending and speaking at FAME Symposium, diligently put together by students at San Francisco University.  One of the other speakers was a famous international investor, Charles De Vaulx.  During a break Charles and I were discussing the Chinese bubble today vs. the Japanese bubble of the  late ’80s.  This conversation got me thinking.  In Japan the bubble was the most prominent in commercial real estate and to a lesser degree in residential real estate.  The house-price-to-income ratio (just take the average house price and divide by average income) in Tokyo at the height of the bubble was 9, while in China in 2010, in the big cities this number was much greater (Beijing 15, Shanghai 13), and in fact the ratio for the whole of China was over 8.  The commercial real estate bubble might have been greater in Japan; it is hard to tell.  I remember reading that at the peak of the Japanese bubble the Imperial Palace was worth more than a state of California.  But from different reports I’ve seen, China has plenty of empty skyscrapers.

But China also has a couple more bubbles, in industrial overcapacity and overinvestment in infrastructure.  Japan did not have an infrastructure bubble, for several reasons: first, it was a more developed country than China.  Second, the government played a much smaller role in the economy – Japan did not have a command-control economy, and it did not try to build for social/political stability reasons.  Japan had your garden variety real estate bubble: easy credit, inadequate banking laws, etc…

Also, and this point is hard to quantify, but the quality of Japanese construction is better than in China.  There are many reasons for that: less corruption, no five-year plans (i.e., output-per-capita targets), and the Japanese put a higher value on human life.  I remember reading an interview, just a few years ago (before the high-speed-train crash in China) with a Japanese high-speed-train executive.  At the time the Chinese were showcasing their high-speed-train system and rubbing in Japanese faces the fact that their trains traveled at higher speeds.  The Japanese executive said something along these lines: “Our systems are very similar, since the Chinese stole our high-speed railroad designs.  We could run our trains at faster speeds, but we just don’t think it’s safe.”  Japan has a population of 130 million people, which is shrinking.  China has over a billion people and its population is growing.

The quality of Chinese construction is horrible; you read stories of glass and masonry falling off of buildings, and the latest story was of a girl swallowed by capsized pavement.   So they’ll have to do a lot more rebuilding in the future, and thus their return on capital, which was already very low, will actually be even lower.

Japanese economy, despite Government debt to GDP doubling, has been stuck in a rut for over two decades.   Just saying…

Dot-Social and dot-cloud bubbles

At the FAME Symposium I was asked if we are in the midst of another bubble – the social and cloud bubble.  I said that if one really wants to make some money quick he should start a company and call it “SocialCloud”.  I read a lot of articles defending Facebook paying one billion dollars for a company with less than a dozen employees, with an app that has terrific photo filters and 30 million users, but with no revenue and no network.  Once you take a picture, Instagram gives you the ability to post it to a half a dozen places, including Facebook and Twitter.  But Facebook will be paying for this acquisition with funny money – it has a $100 billion market cap on three or four billion of revenues.

The Instagram acquisition by Facebook has likely injected a lot of fertilizer into the angel investing bubble. I am sure there are a lot of startups out there that will be raising money from angel investors dreaming of selling themselves to the Facebooks and Googles of the world for billions of dollars.

I looked at recent IPOs, and their valuations appear bubbly.   Yelp – a terrific company (more on it in a bit) – has a market capitalization of $1.3 billion, and analysts expect its revenues in 2012 to hit $180 million.  Angie’s list – a website I recently used, since we were remodeling the house – has a valuation that is as silly as Yelp’s, except that its website is a slight improvement over Craig’s List.

I know the enormous appeal Facebook has to advertisers. Never before could advertisers target their customers with such precision.  Facebook knows your address, your age, where you went to school, the music you like, whether you are married or recently engaged, where you travel, etc… All this information we volunteer when we fill out our user profile. I get it, it is incredible.  I’ve yet to meet a person who doesn’t think Facebook will do well on its IPO.  But what if Facebook struggles to monetize its enormous user base?  There are only so many ads it can put up on a page before they start impacting the user experience.  The counterargument here is that since these ads are so finely targeted, they are more expensive and thus Facebook will not need as many.

What if people will simply get tired of the social thing?  Social networking may turn out to be a fad, or at least the amount of time we spend it on it may decline a lot.  I know large employers are blocking access to Facebook left and right; it is a huge productivity drain.

Zynga is another stock that looks bubbly (though less bubbly then when I looked at it a few weeks ago, the stock is down 40% or so).  Social games could be another passing fad.  At the conference I described a company that we recently purchased that may benefit tremendously from social games, but for them it is an added bonus (an option), while for Zynga social games are everything.  I don’t know if I am right on these stocks or not – maybe their businesses will go at a much faster rate than I expect.  But I can definitely sense that the second we mention the words social or cloud our objectivity in judging businesses dissipates.  This doesn’t just apply to dot-clouds or dot-socials, it applies to boring, real companies feeling the pressure to be in the space, who are paying insane valuations for dot-social and dot-cloud businesses (Centurylink buying Savvis at 10x EBITDA comes to mind).  Since we own plenty of real companies, my concern is that they’ll overpay for their dot-stuff.

Yelp

The last time I was in San Francisco, a portable GPS was a very expensive novelty.  That was early 2006.  My best friend and I were on a road trip, driving from Denver to San Francisco and back.  We had a GPS attachment connected through a USB port to a laptop and used Microsoft mapping software.  All phones were dumb (even Blackberry, the smartest phone at the time, was dumber than a brick compared to today’s iPhone).

This time around armed with iPhone, I was surprised how good the Yelp app was.  Though they are trying to expand beyond it, Yelp is a social app where users review and rate restaurants.  It is crowd sourcing at its best.  All I had to do was type “sushi,” select the distance from my current location that I was willing to travel, and Yelp showed me all sushi restaurants around me and their ratings.  In the absence of any other data points, you start heavily relying on Yelp’s ratings, especially since many restaurants have several hundred reviews.  The feature in the app that I found astonishingly innovative was the “monocle.”  You click on the “monocle” button, point your iPhone in any direction, as if you were taking a picture, and it shows you the restaurants and their ratings in that direction.

Apps like Yelp’s will have a significant impact on restaurants.  They facilitate the word-of-mouth restaurant recommendations between friends and extend them to strangers. They’ll also likely expedite the failure rate of restaurants.  Restaurants with high reviews will get more customers, and the ones with poor reviews will die a quicker death. 

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.

]]> http://ContrarianEdge.com/2012/04/25/omaha-bubbles/feed/ 0 http://ContrarianEdge.com/2012/04/10/not-buying-best-buy/ http://ContrarianEdge.com/2012/04/10/not-buying-best-buy/#comments Tue, 10 Apr 2012 21:13:39 +0000 Vitaliy Katsenelson http://ContrarianEdge.com/?p=3099  Best Buy’s CEO Brian Dunn did a courageous and proper thing for shareholders by resigning.  He was not the right person to lead Best Buy into battle against online-only competitors that use Best Buy’s spacious and beautiful stores as the showroom for their products.  To make things even worse, smart cell phones make comparison shopping so much easier nowadays, and structurally, Best Buy cannot have lower prices than its online competitors.  Its stores also lack the breadth of selection of Amazon and they are at a permanent, competitive cost disadvantage.  The new strategy Dunn announced a few weeks ago of closing big stores and opening a lot of smaller stores for mobile sales makes little sense.  It is basically morphing Best Buy into a Radio Shack.  It would be great if this strategy had worked for Radio Shack, but it didn’t.  Radio Shack’s margins are collapsing, and that is why its stock is scratching as-far-as-my-chart-goes-back lows.

I don’t know what the solution is for Best Buy.  It must involve a much tighter collaboration of physical stores and its internet presence – the stores need to be turned from a liability into an asset.  Or maybe a logistical miracle that would allow Best Buy to deliver a much, much greater range of products (like, hundreds of thousands) to its customers on the day they order them.  One thing is for certain: the new strategy will require thinking that cannot be delivered by somebody who spent 28 years in the Best Buy box.  It requires a Netflix or Amazon-like strategy, where management was willing to bring forward (and flawlessly execute) a disruptive strategy that undermines its current cash cowing business.  Amazon did this by bringing electronic readers to the masses, which undermined its core book business.  Netflix did it with streaming.  I am sure I’ll get plenty of dissenting emails about Netflix: “We don’t know if its model will be successful down the road,” etc.  I’ll admit, I don’t know what Netflix’s streaming business is worth.  But one thing is for certain, if it did not bring out streaming it would have been dead in three to five years.  Now it has a fighting chance to survive and maybe even create value for shareholders.

I am a value investor, and so when I see a stock dangling at six times earnings I’d be lying if I told you that I did not have an inkling to seriously consider it for our portfolios.  But Best Buy is not a retailer that missed a fad (stacked the shelves with wrong-color shirts, etc.) – those sorts of situations often present great buying opportunities, as the problems are easily fixed.  Best Buy is a retailer that so far has missed a structural change that may make its business obsolete.  It is only cheap if the “E” projected for next year will be there.  So far the market is betting that it won’t, and I have no insight that encourages me to disagree with the market.

Reminder: The VALUEx Vail conference is June 20-22 in Vail.  This is not your typical conference – think of it as the TED of value investing.  Though this is a not-for-profit event, I hope what you’ll learn from attending will generate profits for you.  You can find out more about VALUEx Vail here.
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.

This was the first year when we had season ski passes for me and the kids (my wife doesn’t ski).  Despite it being one of the worst ski seasons on record, we’ve managed to ski 20 times.  It is such a great joy to see my kids overcome their fears when they ski.  Last year Jonah was afraid to get on the ski lift up the bunny slope; last month he was pushing me to ski black diamonds.  I’ve skied more this year than I did in the previous ten years.  Last March we skied in Beaver Creek and Vail and stayed in the beautiful Cordillera Lodge (Kobe Bryant made it famous by having a debacle there with a maid).  We loved this resort so much that my whole family (including my brother’s family) is going there for a weekend in June to celebrate my father’s and stepmother’s 25th wedding anniversary.  We are also checking to see if Cordillera Lodge can host one of the VALUEx Vail dinners.

Last month my kids and I started taking ping pong lessons.  We go to practice twice a week, and other than riding my bicycle to work this is the only workout I get.  Ping pong is not a very popular sport in the US – I was told that not a single American is in the top 200 in the world. Therefore it was hard to find a place to practice. We lucked out and found a great but odd place to practice – a gym located in a church.  Our trainer is the pastor of the church, who happens to be the nine-time Mexican ping pong champion .

I keep thinking about it, and I have realized that the reason I keep pinching myself about my life, is that by doing all these activities I get to relive my childhood all over again, through my kids.  I get to do things that I wish I could have done when I was a kid, and I get to see my kids smile because we do things together.

On April 20th I’ll be attending and speaking at a very interesting conference in San Francisco, the FAME Value Investing Symposium, put together by students at San Francisco State University.  It has a great lineup of speakers, but in addition they’ll have a Security Analysis Competition, the judges of which include David Einhorn and Jeff Matthews. (Jeff writes a terrific blog that I’ve been reading for years and is the author of my favorite book on Buffett, Secrets In Plain Sight.)  The cost for students is $19, and professionals can attend for the steep price of $70.  You can register here.  I’ve been to San Francisco a few times, but this will be the first time I’m there with my wife.  We’ll make it a romantic getaway weekend – I’m looking forward to sushi, In-and-Out burgers, Napa wine tasting, cable cars, and just simply doing nothing.

I’ll follow up with another post about the Omaha schedule in a few weeks.

Reminder: The VALUEx Vail conference is June 20-22 in Vail.  This is not your typical conference – think of it as the TED of value investing.  Though this is a not-for-profit event, I hope what you’ll learn from attending will generate profits for you.  You can find out more about VALUEx Vail here.

Bull markets are Emerald Cities of our own making. In a bull market it is decreed that investors and the media shall wear green-tinted glasses. Suddenly, all economic news and fundamental facts turn green and glittery — there is no bad news, only shades of good.

In a bear market the mandate is different: Everyone is to wear red-tinted glasses. The Emerald City is no more. Now all news comes in three shades of Soviet Kremlin red: bad, ugly and downright devastating.

This happens because we are human. The pressure of rising prices in bull markets or falling prices in bear markets leads us to engage in backward analysis. Instead of first analyzing the events and only then forming an opinion, we look at the market reaction to the news and let it dictate what we should think.

In the long run, stock prices follow fundamentals like cash flow and earnings growth. In the short run — well, this old cowboy saying tells it all: “Nobody but cattle know why they stampede, and they ain’t talking.”

The danger of wearing glasses determined by the market is that reality will not be suspended forever, no matter the tint of your shades. By following the “color decree,” you are effectively taking advice from the market on how to analyze, what to pay attention to and what to buy or sell. This is the sure road to buy-high-sell-low despair. The market is the worst giver of advice — it’s prone to tell you what you should have done, not what you should do.

Before the market mandated green glasses in October, investors were wearing blood-red shades. They were dreading significant risks threatening the global economy. Let’s quickly run through them and see if much has changed.

European recession and debt crisis: Greece went through an orderly default, the European Central Bank pumped liquidity into the system, and European bond yields declined. But a recession precipitated by governmental austerity is not off the table, and the PIIGS (Portugal, Ireland, Italy, Greece and Spain) still have to figure out how they will deal with their debt and lack of economic competitiveness.

Continue reading on Institutional Investor

Reminder: VALUEx Vail 2012 will be held (as you’d expect) in Vail on June 20-22.  You can find more information about VALUEx Vail and how to apply, here.

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.

On the surface Xerox Corp. smells a lot like its Nifty 50 brethren, once-hotter-than-the-sun-but-now-bankrupt Eastman Kodak Co. and Polaroid Corp. Its stock has gone nowhere since forever. But Xerox was not your typical overvalued blue chip of the 1990s, like Cisco Systems, Johnson & Johnson and Microsoft Corp., whose earnings have tripled or quadrupled since then — the kind of stocks I have advocated in this column. Xerox was very pricey in the late ’90s, but its revenue and earnings per share have since declined. And to make matters worse, printing and copying is just so analog, so last century. It is hard to get excited about a company making equipment whose main trick is putting ink on paper. However, all these negative optics have resulted in one misunderstood company and a very mispriced stock.

Though we think of Xerox as a company that sells copiers, that represents only 20 percent of its revenue. About one third of revenue comes from selling toner and servicing copiers — a beautiful, high-margin, annuity­like business. Look around your desk, and you’ll still see plenty of paper; the death of printing and copying has been greatly exaggerated. It is very ungreen of us, but we still copy and print.

Xerox’s story gets better. About half of its revenue comes from services. Xerox is a giant in the document-outsourcing business, which provides about one sixth of its revenue. Corporate customers, sick of paper cuts and spilled toner, realize that managing copiers and printers is not their core competency, so they let Xerox take care of that. This has been a very nicely growing business, up 6 percent in the fourth quarter.

About one third of Xerox’s revenue comes from its business-process-outsourcing service. Xerox got into this business in 2010 when it bought Affiliated Computer Services. It paid fair value for ACS, but it had to issue a lot of undervalued stock to finance the purchase. ACS was touted as a transformative acquisition for Xerox; unlike most such acquisitions, which often destroy value, this one is turning out to be as good as Xerox’s management proclaimed it to be. Xerox helped ACS go international; ACS gave Xerox access to its domestic customers. This acquisition has resulted in several hundred new deals. The integration has gone smoothly. The CEO of ACS is still running the business, and new-contract signings are up by double digits.

Last year was not kind to Xerox. The company sources $2 billion worth of parts from Japan each year and got hit hard by the earthquake and tsunami, which created supply shortages. Xerox had to fly copiers to its customers to make sure they got them on time; its gross margins took it on the chin. In addition, the relentless ascent of the Japanese yen — up 50 percent against the dollar in three years — hurt Xerox’s cost of goods sold. But tsunamis are unlikely to become annual events, and the yen will probably decline in the long run given that Japan is the most indebted nation in the world, has one of the oldest populations and is very dependent on the health of the shaky Chinese economy.

Declining interest rates resulted in a lower pension discount rate and forced Xerox to contribute $200 million to pension assets. But pensions will turn from a headwind into a tailwind in the future: First, Xerox closed its defined benefit plan in 2011; second, though interest rates may decline further, in the long run they’ll likely rise, boosting Xerox’s cash flows.

At first blush, Xerox appears to have a very leveraged balance sheet, laden with $8.6 billion of debt. However, $6 billion of it is finance debt that is secured by equipment and leveraged 7-to-1 (if our banks had had this leverage, we would not have had a financial crisis). Xerox has $2.6 billion in corporate debt, which it can pay off in a little more than a year from its free cash flow.

Because 80 percent of Xerox’s revenue is an annuitylike stream, the company is a cash machine, spitting out about $2 billion of free cash flow a year. Management has been very specific on what it intends to do with the cash: pay down debt, continue to pay a dividend (the stock currently yields about 2 percent), spend about $1 billion on stock buybacks and make a few small tuck-in acquisitions. Xerox will be able to buy 8 to 10 percent of its shares outstanding this year.

The company’s service revenue should continue to grow 5 to 10 percent a year; assuming the copier business is flat, overall revenue should grow in the low single digits. As profit margins rise, Xerox should be able to grow earnings in the midteens without doing much heavy lifting. The best part is that the current valuation of less than six times free cash flow sets the bar very low for this company. It needs to show proof of life (of which it has plenty), not proof of growth.

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.

Reminder: VALUEx Vail 2012 will be held (as you’d expect) in Vail on June 20-22.  You can find more information about VALUEx Vail and how to apply, here.

VALUEx Vail is designed for serious investors to share ideas and learn from one another’s experiences, all while enjoying each other’s company and fun activities in the gorgeous Colorado mountains.

Here are my thoughts and pictures from VALUEx Vail 2011.

We’ll have about six brief presentations every evening (Wednesday, Thursday, and Friday) for about two hours, followed by dinner (we’ll alternate restaurants every night).  In addition will have a “dessert speaker” who will do an informal talk and Q&A on an interesting subject.  To conclude each day, the more adventurous types are welcome to join us at the bar for drinks.

Success of VALUEx Vail depends on participants’ presentations.  Therefore, all attendees will be asked to share ideas, whether they will be shared in a 15-minute presentation, in a “dessert talk,” or more informally late at night in the bar.  We’ll only have time for about twenty 15-minute presentations; therefore, while everyone should be willing to present, we’ll chose only twenty presenters.  The presentation could be on any investment topic, including but not limited to stock ideas (long or short), geopolitical discussion, sector or industry analysis, insights into the investment process, etc.  Once we finalize the attendee list, we’ll contact you about your presentation.

In the morning, if you can get up after the night before (!), please join the group for breakfast.  Sometime after breakfast we’ll do a fun activity.  Last year we did ziplining, had lunch at a ranch, and took a gondola to the top of the mountain (and got rained out and had lunch on top of the mountain).  The location of the group lunch will depend on which fun activity we choose.

VALUEx is a perfect opportunity for a family vacation.  Family members, including children of all ages, are encouraged to participate in fun activities during the day.  I’ll bring my whole family.

My family has been going to Vail for almost twenty years.  We spend a few weeks there every summer, riding bikes, going for long walks, riding the gondola to the top of the mountain, or simply doing nothing.  Here are a few pictures I have taken in Vail over the years

Accommodations: In late April or early May we’ll send a list of recommended hotels.  Mid-June is fairly slow in Vail, hotel prices are very reasonable, and you should not have a problem (with a reasonable lead time) finding a decent room.  Almost everything in Vail is within walking distance.  There are no cars allowed in Vail Village or Lions Head (the western side of Vail), so you either walk, ride the free bus (which comes along every 10 minutes), or ride a bike, which you can also rent nearby.

Dress code: very casual, comfortable clothes

Cost: This is a not-for-profit event.  There will be a nominal fee ($200) to cover organizational/activity expenses.  You have until May 1st to change your mind and receive a full refund; it will not be refundable after that.

 Attendees will be responsible for hotel, food, and activities.  It is important to note that we are not in the conference business.  All we are doing is taking your hard-earned money and transferring it to the even more hard-working service providers (restaurants, activity providers, etc.)  Last year the cost of exclusive use of the facility where presentations were held, plus food and drinks, averaged about $150 an evening per attendee.  As we get closer to the event we’ll send you a link where you’ll be able to prepay for dinners and activities.

How to apply: Since all content is attendee-generated, we are more concerned about the quality of attendees than about quantity (also, for best flow of ideas, we limit size to 40 attendees).  If you’d like to attend send me an email vk@imausa.com , and in a few paragraphs tell me about yourself, your experience, your areas of expertise, and a  topic/idea you’d like to discuss at the conference.  I understand that things may change in a few months, but this will give me a general idea.  It is important to note that you don’t have to be a professional value investor to apply.  Though we envision that the majority of attendees will be professional value investors, there is also value in a diversity of views, so if you are a die-hard nonprofessional value investor, please apply!

 Contact information: If you have questions, please feel free to contact Cristy Reid at cr@imausa.com or (303) 796-8333.

Take heavy-equipment makers Caterpillar, Deere & Co. and Joy Global. It is easy to love these deeply cyclical companies, which have benefited from the run-up in commodity prices over the past decade. Their stocks are up manyfold over that period, and for good reason: Their sales and earnings have tripled or quadrupled during that time.

The story only gets better. Earnings for Caterpillar, Deere and Joy Global are expected to continue to grow in the double digits well into this decade. In theory, these American icons should be a value investor’s paradise because, despite their past success and expectations of their future wonderful growth, they are trading at low-double-digit  P/Es. Cheap!

But before you run out and spend your hard-earned money on these darlings, let’s see what might be around the corner. The past few years were characterized by fairly robust growth of the global economy. Part of this was simply a recovery from the 2008 crisis; however, a significant part was spurred by global stimulus.

Let’s pause for a second and think about that. The 2008 global recession took place because of substantial borrowing from underreserved financial institutions that went into global malinvestment in fixed assets. That put a hurricanelike tailwind in the sails of deeply cyclical stocks. For eight years, until 2008, their sales and earnings grew as if Google were their middle names. Investors stopped treating them like cyclical stocks; they became deep seculars.

The global fixed-asset bubble burst painfully in 2008, and the deeply cyclical stock story should have been over. After all, if you build too many things that will last you decades, you will not need to make more of them for a long time, and thus you will need a lot fewer earthmovers from Caterpillar. This would have been a rational expectation — and it would have been wrong. The sales and profitability of Cat, Deere and Joy Global have already surpassed the levels they reached before the 2008 crisis.

Because of massive global government stimulus — turbocharged by China’s 12 percent-of-GDP mother of all stimuli, which was further amplified by off-the-charts leverage — the asset bubble has been reinflated over the past couple of years. The stimulus came at a significant cost: the increased leveraging of governments. Last year showed that there is an upper limit to how much developed-country governments can borrow, unless they are willing to borrow at double or triple their current rates.

We are very likely entering a third leg of global deleveraging. The first two were by consumers and corporations, and to a large degree took place at the expense of the governments that took over their debts. Now we are entering the most painful stage: government deleveraging, which will be destimulating to the global economy and cause a monstrous decline in fixed-asset investment.

Today investing in deeply cyclical stocks is not unlike a game of musical chairs. If you own these stocks, you are coining money while the music is playing. We know what will happen when the music stops: These stocks will plummet.

Caterpillar, Deere and Joy Global benefit from operational leverage. A large portion of their costs is fixed, and as their sales increase, their margins do too. Their earnings are high because their profit margins are at an all-time high, but once the global economy slows down and demand evaporates, sales will decline. Their operational leverage will start working against them because costs will not decline as fast as sales, and margins will do what they’ve always done: They’ll revert toward the mean and in this case collapse. The companies’ earnings power will be completely reset and will not resemble anything even close to what it is today. Suddenly, stocks that looked so cheap will show their true colors.

Of course, it’s difficult to know when the music will stop — tomorrow, six months from now or in two years. Bubbles don’t follow the timetables established by their prognosticators, even when their collapse is being predicted. However, the risk-reward of owning these deeply cyclical stocks has clearly shifted into unfavorable territory. If you think you possess perfect pitch and will hear the music stop and be able to grab a chair before everyone else, don’t kid yourself. The dot-com investors of the ’90s thought they could, and very few of them got to sit down gracefully.

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.

Here are some pictures (I took close to 1,300 only a dozen or so are worth sharing) from my November trip to Spain (Barcelona and Madrid/Toledo) and South Africa (requires facebook login).   On our way to Madrid, my brother Alex and I had a (intentionally long) layover in Atlanta.  My friend Aaron Edelheit picked us up from the airport and took us to one of my favorite places in the world – Stone Mountain park (here are some pics, facebook login required).  Imagine an enormous granite boulder 800 feet above ground, surrounded by a picturesque forest and a lake. And of course, the largest relief sculpture in the world, the size of two and a half football fields that pictures three Southern generals (in the South you still often hear the Civil war called the “War of Northern Oppression”).  It took almost 60 years to complete it.

Funny thing happened.  Here I am in the middle of this paradise and my iPhone keeps beeping and vibrating with emails.  Every time it beeps I diligently checked my email, deleted it, and put it back in my pocket.  Aaron, being a good friend, said “Vitaliy I used to do that too.  If you are not careful this little device will turn you into a Pavlov’s dog.  I figured out a trick, turn off the sound and vibrating on your phone.  This way you can check your emails on your time and the impulse to check email will go away.”  I followed Aaron’s advice and killed email notification on both my iPhone and iPad.  I have to tell you it is extremely liberating.  Now I go through the whole dinner at home without checking email once!   I hope you do the same.

Finally I wanted to wish you a very happy, healthy and prosperous 2012. – Vitaliy

Vitaliy Katsenelson on Krugman’s Missed Call

We spoke with Vitaliy on December 20, 2011.

Paul Krugman wrote about China in his New York Times column last Monday.  That’s a topic that you have researched closely.  He said that “China’s story just sounds too much like the crack-ups we’ve already seen elsewhere,” referring to the financial crisis in the US and the Japanese lost decade. Do you agree with his assessment?

Yes.  You can draw a lot of parallels between the Japanese and US real estate bubbles.  But China’s bubble is much larger; it spreads beyond residential real estate to commercial real estate, the industrial sector, and infrastructure.  Also, though there were government fingerprints on the US and Japanese real estate bubbles, the Chinese real estate bubble was directly and entirely caused by the Chinese government.

The Chinese bubble has been inflating for years.  It should have popped during 2008 recession.  But China fire-hosed a stimulus equal to 12% of its GDP into its economy and was able to keep the bubble growing.

When is it going to pop?  It has already begun.  You see sales volumes and prices plummeting at double-digit rates in second-tier cities.

I agree with Krugman’s assessment.  What perplexes me is why the Nobel Prize-winning economist wrote this column now, when the problems he describes are plain for all to see, and not a few years ago.  You’d think he would have been alarmed over the consequences of monstrous government intervention in an economy the size of China’s.  But perhaps Krugman, who describes himself as a liberal economist, secretly hoped that the Chinese government would be able to manage the economy better than the free market.

But even over the last few years China’s growth has remained relatively strong – certainly as compared to the rest of the world – just not as strong as it was in the years prior to that.

It was completely driven by fixed-asset investment and the bad loans that came with that – not a sustainable type of growth.

One of the things Krugman pointed to was the lack of reliable data from the Chinese government. To what extent does that cloud your analysis, and how certain can you be in your forecast and your analysis, given the uncertainty, or unreliability, of Chinese government data?

He is right. When you look at Chinese government data, it has a couple of biases. Number one is in the way they collect data: it comes from municipalities and local governments that are given growth targets. The federal government says, “You need to grow, let’s say 10% of GDP per capita, for your municipality.”  The local bureaucrat has to get that growth.  The easiest way to do it is to build, and that is why they have had a real estate bubble.

But the problem is, if the local bureaucrats fail to deliver the growth they know they’ll lose their jobs. So they start cooking the numbers, and they start sending numbers to the top that are falsified. That is the number one bias.

The second bias is that this is a government that is very concerned about its image. It is very good at propaganda. The government puts people in jail for writing anti-government articles.  The economic statistics are the output of a propaganda machine. You truly can’t trust the data coming from the government.

But that is wh

y you look at anecdotal evidence, and the data points they can’t or just don’t bother to cook. During the 2008-2009 recession, the global economy was contracting and the Chinese government was showing that GDP was growing at a fairly healthy pace.  However, other data points, like the tonnage of goods shipped through railroads, were down by double digits. Electricity consumption declined too.

Eventually, we started seeing empty cities popping up here and there.

What made it easy for me to understand China is that I was raised in Soviet Russia for the first half of my life.  This experience helped me to understand how inefficient, dysfunctional, and corrupt an economy that is run by the government can be.  You start seeing and piecing together the small bits of anecdotal evidence.  You build a framework that helps you to understand their economy.

Are there any policy options that are still available to the Chinese government, for example, stimulus measures that it could take to avert the kind of crisis that Krugman predicts and that you say is already occurring?

I am fairly certain that, once the pain of economic slowdown is felt, the government will do what it did in 2008: It will try to re-inflate the bubble.  But that will add another layer of future problems on top of the existing ones.  For instance, according to Pivot Capital, toxic shadow banking, which was almost nonexistent in 2008, is estimated to be $250 billion in 2011.  The Chinese government may manage to keep the bubble from bursting for a little longer, but at some point the basic laws of economics will assert themselves, and there is absolutely nothing the Chinese will be able to do.

Continue reading at Adviser Perspectives…

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.

eward with very reasonable risk.

Microsoft was the bright light in the tech firmament in the 1980s and ’90s. Then it got too successful, overconfident, lazy and uncreative, and started making bad products and wasteful acquisitions. Worthy competition eventually emerged from the likes of Apple and Google, and Microsoft had to fight for its existence and relevance.

Despite doubling its earnings in the past five years, Microsoft has seen its stock go sideways as the market has viewed it for what it is: a sleepy, often arrogant monopolist that is being beaten up by the agile, paranoid and equally financially well-off competition. Microsoft’s price-earnings ratio—which ended the ’90s at a bubbly valuation of 50—has fallen to a level most of us never thought we’d see, recently trading at less than 7 times earnings if you take out the $6 a share in cash on the company’s balance sheet.

Apple (and more recently Google with its Android operating system) has attacked Microsoft on the Windows front. The iPhone and iPad showed everyone what cell phones and tablets should look like. The iPhone killed Windows phones, while the iPad killed netbooks (low-powered, cheap laptops) as a product category and caused a first-time-ever decline in the sales of Windows.

Even a company with Microsoft’s thick skin can take only so much before it starts to fight back. The upcoming launch of Windows 8 indicates that the software giant is waking up. Windows Vista was a horrible product made by a lazy monopoly. Windows 7 was really just the Vista-fixed edition. But when I watched the demo for Windows 8 a couple of months ago, I caught myself saying, “Wow!” Windows 8 is an uncharacteristically innovative operating system made for PCs and tablets. (Microsoft is making a separate version for phones.)

But an exciting operating system needs to be married to great hardware. Apart from the Xbox, Microsoft has never made hardware; its partners have. In the world of PCs and laptops, that setup did not hinder Microsoft, but it does now.

This brings us to Nokia Corp. The Finnish company used to own the cell phone market, but it too got fat and lazy. In contrast to Microsoft, Nokia was great at hardware but not at software.

In September 2010, Nokia hired a new CEO, Stephen Elop, who joined from Microsoft. Elop killed Nokia’s effort to develop its own operating system and signed a deal with Microsoft in which Nokia committed to make phones that would run exclusively on Windows. Like conquistador Hernán Cortés, who in 1519 ordered his troops to burn all their ships when they invaded Mexico to ensure that they had to conquer the Aztecs to capture their boats and get back to Spain, Nokia has burned all its boats.

Microsoft could have done something stupid and tried to buy Nokia. Taking the Cortés analogy further, instead of burning their boats, Nokia employees would have felt that if they failed, there would be a huge cruise ship with an all-you-can-eat buffet waiting for them (a fat severance package backed by $60 billion in Microsoft cash).

The Nokia-Microsoft alliance will extend beyond cell phones to tablets; after all, as Apple taught us, a tablet is a big cell phone, not a small laptop. Despite dropping the ball on the operating system front, Nokia is the king of cell phone hardware. Working very closely with Nokia will provide Microsoft with a more holistic software-hardware design platform and give it a fair chance of creating an iPad-quality tablet. In addition, Microsoft will benefit from Nokia’s still-strong brand name and tremendous global distribution network.

Before Windows 8 hits the market in 2012, Microsoft will benefit from ultrabooks—powerful, light and thin Windows-running laptops that were inspired by Apple’s MacBook Air and envisioned by Intel Corp. Windows’ sales will likely accelerate for another reason: Microsoft will discontinue support for Windows XP in 2014, forcing upgrades by businesses that were still using it because of their disgust with Vista.

Many Microsoft shareholders are fatigued. I am too. But despite the market’s pessimism, the company’s earnings power should rise over the next decade. Its depressed valuation offers a significant margin of safety, and P/E expansion should become a significant source of returns. Considering the high quality of its business, 40 percent return on capital and cash-rich balance sheet, Microsoft should trade at a significant premium to the market, not at a discount.

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.

]]> http://ContrarianEdge.com/2011/12/15/3041/feed/ 1 http://ContrarianEdge.com/2011/11/11/why-hewlett-packard-is-today%e2%80%99s-most-hated-stock/ http://ContrarianEdge.com/2011/11/11/why-hewlett-packard-is-today%e2%80%99s-most-hated-stock/#comments Fri, 11 Nov 2011 21:46:53 +0000 Vitaliy Katsenelson http://ContrarianEdge.com/?p=3032  There is a good reason John Lennon wrote “All you need is love.” We want to be loved and usually gravitate toward people and things that others cherish. But when it comes to investing, love is not cheap. The trick is to identify misplaced (or mispriced) hate that will turn into love. This brings us to the most-hated stock today: Hewlett-Packard Co.

It all started with the August earnings call, during which HP’s then-CEO, Léo Apotheker, unveiled a new vision: HP would transition into a software company. At first, Wall Street and yours truly were in disbelief; we thought we had simply misunderstood Léo’s soft German accent. But when on the same call HP announced a possible spin-off of its PC business and the acquisition of U.K.-based software company Autonomy Corp., for which HP will dish out more than $10 billion, valuing it at 40 times earnings, Wall Street realized the CEO was serious, and HP’s stock dropped like a rock.

Hey, everyone loves software — it’s not capital-intensive, and there are high margins and a high return on capital. The problem is that HP is not a software company. More than $100 billion of its sales come from hardware: printers, servers, PCs, storage devices and routers. Software represents just 2 percent of sales. Also, the transition would have required more acquisitions with Autonomy–like price tags.

It is hard to tell whether it was the sound of the HP founders spinning in their graves or HP stock sinking 30 percent, to 4.5 times earnings, that tipped the board off that there was something very wrong with this strategy. The messenger was appropriately (if only figuratively) shot — well, Apotheker was paid $13 million not to show up to work anymore — and a new CEO was installed. The board appointed Meg Whitman, ex–EBay CEO, onetime California governor hopeful and HP board member.

Wall Street is not happy with the choice. You hear “HP needs a visionary,” “She is not a techie,” and “She has never run a company of HP’s size.” But Wall Street is wrong. Whitman is a talented and highly respected executive who took EBay, an obscure start-up with barely $4 million in annual sales, and turned it into a $4 billion-in-revenue Internet giant. HP doesn’t need a visionary; it needs a good manager — a mother figure, if you like — who will make the employees feel safe, provide clarity and stop the exodus of talent.
Whitman is also an excellent communicator. She has clarified what Apotheker meant when he talked about a software future: HP will remain primarily a hardware company; it will grow its software business organically by a few billion dollars, mainly to help hardware sales. Hallelujah! HP will decide what to do with its PC business as soon as possible, but the decision will be driven by one factor: maximizing shareholder value.

Whitman’s incentives are properly aligned. Being CEO of one of the U.S.’s largest companies is a win-win proposition: If you succeed, you make a lot of money; if you fail, you still make a lot of money (as her predecessor learned). But Whitman has little interest in money. She is a billionaire. She spent $140 million on her California gubernatorial campaign. She is interested in a new challenge, and if she succeeds, she’ll make a lot of money on 1.9 million HP stock options.

HP, despite being everyone’s most-hated stock, has a great brand and is either No. 1 or a very formidable presence in every business in which it competes. Wall Street doesn’t like its PC business, but PCs are only 15 percent of operating profits.
Of course, Wall Street will not let you forget that HP has had the most dysfunctional board of directors in corporate history. The key is “has had” — nine out of 14 members joined the board in January 2011 and were not involved in previous scandals, nor did they hire Apotheker.

The value of any asset is the present value of its future cash flows, a boring but fundamental truism of investing. But the truism comes with an asterisk — that something semismart will be done with the cash flows. No matter how great the business or how much cash it generates, if management burns cash flows through poor capital allocation, the business will not be valued on free cash flows but on the ashes of its cash flows.

Today, HP is valued on burnt cash flows, and though for a while Wall Street was right, the company doesn’t deserve this method of valuation any longer. Whitman’s most important task is not to do anything dumb with HP’s ample ($10 billion) cash flows. She and the board already have publicly committed to no more expensive acquisitions. The risk of capital destruction has been completely taken off the table. If Wall Street were to value HP on free cash flows, it would realize that today’s price discounts a 10 percent decline in free cash flows over the next ten years. That is an unlikely scenario.

Copyright Institutional Investor … 

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.

]]> http://ContrarianEdge.com/2011/11/11/why-hewlett-packard-is-today%e2%80%99s-most-hated-stock/feed/ 3 http://ContrarianEdge.com/2011/10/26/a-few-simple-rules-for-money-managers/ http://ContrarianEdge.com/2011/10/26/a-few-simple-rules-for-money-managers/#comments Wed, 26 Oct 2011 19:17:47 +0000 Vitaliy Katsenelson http://ContrarianEdge.com/?p=3029 One of the biggest hazards of being a professional money manager is that you are expected to behave in a certain way: You have to come to the office every day, work long hours, slog through countless e-mails, be on top of your portfolio (that is, check performance of your securities minute by minute), watch business TV and consume news continuously, and dress well and conservatively, wearing a rope around the only part of your body that lets air get to your brain. Our colleagues judge us on how early we arrive at work and how late we stay. We do these things because society expects us to, not because they make us better investors or do any good for our clients.

Somehow we let the mindless, Henry Ford–assembly-line, 8:00 a.m. to 5:00 p.m., widgets-per-hour mentality dictate how we conduct our business thinking. Though car production benefits from rigid rules, uniforms, automation and strict working hours, in investing — the business of thinking — the assembly-line culture is counterproductive. Our clients and employers would be better off if we designed our workdays to let us perform our best.

Investing is not an idea-­per-hour profession; it more likely results in a few ideas per year. A traditional, structured working environment creates pressure to produce an output — an idea, even a forced idea. Warren Buffett once said at a Berkshire Hathaway annual meeting: “We don’t get paid for activity; we get paid for being right. As to how long we’ll wait, we’ll wait indefinitely.”

How you get ideas is up to you. I am not a professional writer, but as a professional money manager, I learn and think best through writing. I put on my headphones, turn on opera and stare at my computer screen for hours, pecking away at the keyboard — that is how I think. You may do better by walking in the park or sitting with your legs up on the desk, staring at the ceiling.

I do my best thinking in the morning. At 3:00 in the afternoon, my brain shuts off; that is when I read my e-mails. We are all different. My best friend is a brunch person; he needs to consume six cups of coffee in the morning just to get his brain going. To be most productive, he shouldn’t go to work before 11:00 a.m.

And then there’s the business news. Serious business news that lacked sensationalism, and thus ratings, has been replaced by a new genre: business entertainment (of course, investors did not get the memo). These shows do a terrific job of filling our need to have explanations for everything, even random events that require no explanation (like daily stock movements). Most information on the business entertainment channels — Bloomberg Television, CNBC, Fox Business — has as much value for investors as daily weather forecasts have for travelers who don’t intend to go anywhere for a year. Yet many managers have CNBC, Fox or Bloomberg on while they work.

You may think you’re able to filter the noise. You cannot; it overwhelms you. So don’t fight the noise — block it. Leave the television off while the markets are open, and at the end of the day, check the business channel websites to see if there were interviews or news events that are worth watching.

Don’t check your stock quotes continuously; doing so shrinks your time horizon. As a long-term investor, you analyze a company and value the business over the next decade, but daily stock volatility will negate all that and turn you into a trader. There is nothing wrong with trading, but investors are rarely good traders.

Numerous studies have found that humans are terrible at multitasking. We have a hard time ignoring irrelevant information and are too sensitive to new information. Focus is the antithesis of multitasking. I find that I’m most productive on an airplane. I put on my headphones and focus on reading or writing. There are no distractions — no e-mails, no Twitter, no Facebook, no instant messages, no phone calls. I get more done in the course of a four-hour flight than in two days at the office. But you don’t need to rack up frequent-flier miles to focus; just go into “off mode” a few hours a day: Kill your Internet, turn off your phone, and do what you need to do.

I bet if most of us really focused, we could cut down our workweek from five days to two. Performance would improve, our personal lives would get better, and those eventual heart attacks would be pushed back a decade or two.

Take the rope off your neck and wear comfortable clothes to work (I often opt for jeans and a “Life is good” T-shirt). Pause and ask yourself a question: If I was not bound by the obsolete routines of the dinosaur age of assembly-line manufacturing, how would I structure my work to be the best investor I could be? Print this article, take it to your boss and tell him or her, “This is what I need to do to be the most productive.

Copyright Institutional Investor

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.

European monetary union was a great experiment that made a lot of sense on paper. Europe, which had roughly the same size population and economy as the U.S., was at a competitive disadvantage, as dozens of currencies embedded extra transaction costs in cross-border trade and each currency separately had little chance to compete with the U.S. dollar for reserve currency status. Germany — the largest country in Europe and one of the world’s biggest exporters — was at a disadvantage too: The strong deutsche mark made its products more expensive and less competitive in the rest of Europe

There were also no-less-important noneconomic considerations. Germans were haunted by their past; they had started two world wars in the 20th century, and a united Europe was their way of lowering the chances of future European wars.
EMU sounded like a very logical marriage of all the significant powers of post–World War II Europe. But the arrangement was never really a marriage; it was more like a civil union. EMU members combined their currencies into one, the euro. They agreed to use the same central bank and thus implicitly guaranteed one another’s debts. They signed treaties that spelled out the rules of the union (the prenup), but unlike most prenups, in which the rules of divorce are spelled out, the EMU did not determine what would happen if a member fell upon financial hard times.

The grooms and brides never moved in together; their fiscal policies were never consolidated. Though treaties put limits on budget deficits (which, ironically, Germany was the first to break), each country went on spending its money as it wished. Some were relatively frugal (Germany); others (the PIIGS: Portugal, Ireland, Italy, Greece and Spain) went on spending binges like newly hitched college students who had just gotten their first credit card, with irresistibly low introductory rates and a free T-shirt.
Predictably, like many college students, the PIIGS went over their credit limit, but they had ceded control of their currency to the European Central Bank, so they could not arbitrarily increase their spending limits by printing more money. Governments that cannot afford to make their interest payments or roll over their debt and don’t have the key to the printing press are left with only one option: default.

EMU members were so eager to consummate the union that the issue of divorce was not addressed. To kick Greece out of the EMU, a new treaty has to be written and all the partner countries have to unanimously vote to approve it (which means Greece would have to vote for it too). For more on the economic and political costs of such a scenario, check out the terrific recent report by UBS Investment Research titled “Euro break-up — the consequences.”

It is very unlikely that Greece would leave the EMU of its own accord. All of its government and corporate obligations are in euros, and on the day it announced its departure from the European Union and a return to the drachma, its banking system would collapse. All depositors would run to their banks to withdraw their euro-denominated deposits. The drachma would trade at a steep discount to the euro, and while the government would be able to print drachmas at its leisure, the bulk of the corporate sector’s debts would be in steeply appreciated euros and its income in collapsed drachmas. The failure of the corporate sector would follow that of the banks.

Logically — though logic is a very significant assumption in this discussion, considering that politics is often emotional and illogical — Greece will not get out of the EMU on its own, and unless treaties are broken, which would set an enormous negative precedent for the rest of the EMU, Greece will not be kicked out of the union.

This brings us to a very probable solution: a full or partial bailout of Greece by the “strong” EMU countries (that is, Germany and France). It is in their best interest. Greece is a sovereign EMU nation, so German and French banks have not had to put up significant reserves (if any) against Greek debt, though they have more than $100 billion exposure to it. A disorderly (Lehman-like) collapse of Greece would send a profound shock through the European banking system, and instead of bailing out Greece, the German and French banks would need a bailout themselves. At the end of the day, someone will get bailed out. By bailing out Greece, Germany and France are indirectly bailing out their own banks, but with an added bonus: a preserved union.

A logical question comes to mind: Facing all these costs, not to mention a popular distaste for financing the exuberant, nontaxpaying Greek lifestyle, why wouldn’t Germany break treaties and get out of the EU itself? If Germany left the EMU, its economy would not be unscathed — the deutsche mark would likely skyrocket against an even-more-weakened euro. Germany’s exporters, which are vital to its economy, would lose competitiveness in European markets, and its economy would enter into a prolonged and very painful recession. The rest of the European economy would weaken, and Germany would have no one to sell its goods to. (This sounds a lot like the China-U.S. relationship.)

Yes, the pain the German economy would suffer would be a lot less than the pain that would be felt by Greece if it exited the EMU; however, schadenfreude would give the Germans little satisfaction. And although in today’s modern, civilized world, wars are not fought among developed Western countries, a broken Europe increases that probability.

Paraphrasing Rahm Emanuel, this is too good a crisis to waste, and over time it will bring the EMU closer and eventually push it toward the logical next step: marriage — a United Countries of Europe. Giving up one’s fiscal policy and sovereignty is very difficult, and national pride will require significant subjugation, but Europe will have little choice.

The Greek crisis will soon be yesterday’s news and forgotten, but in the meantime it provides the EMU with a wake-up call that the prosperity-only setup is not a sustainable long-term model. The EU needs a default bailout (TARP-like) mechanism to deal with adversity. The good news is that while Greece is by far the most dysfunctional economy in the EMU, it is the smallest of the troubled PIIGS.

Germany is paranoid about inflation. It suffered through one of the worst-ever inflations in the early years of the last century, but a centralized bailout mechanism big enough to deal with the PIIGS will likely leave the ECB no choice but to rev up the printing presses. Given the alternatives, Germany will have little choice but to accept that reality. Inflation (unless it is hyperinflation) will be a more democratic and more politically acceptable solution than Germany and France’s underwriting the PIIGS’ debt.

Copyright Institutional Investor …

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.

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.

Segment 2: China

• They are not objective analyzing their company and thus not objective in share buyback. In majority of cases they think their stock is a buy all the time. Why? Because they spend long hours trying to grow the business, they keep telling their customers how great their products are, they keep telling their board and Wall Street about the bright future of the business etc… They start believing their own spin.
• Most CEOs don’t know the difference between a good company and a good stock. Often good companies make a horrible stock.
• Since they own a lot of stock options they have an inherent bias to be bullish and a tremendous bias to drive EPS growth at any cost (i.e. Colgate buying its stock through late 90s and 2000s at 30 plus times earnings is an example of that). In fact since their stock options are linked to the stock price (not the total return to shareholders) the bias is always to buy back stock than to pay a dividend.

Buffett is not a typical CEO, in fact he is very hands off CEO. He doesn’t have stock options, he owns a lot of Berkshire (BRK) stock and has a very long-term time horizon (an important difference). He has a tremendous track record as an INVESTOR (capital allocator) and is trusted the market and the perceived value of Berkshire stock. A combination of all of the above means that when Buffett comes out and says we’ll buy back BRK stock, the market takes this as THIS stock is really cheap.  At roughly 1x book, there is no Buffett premium priced into the shares.

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.

Secular sideways markets are comprised of many cyclical bull and bear markets [take a look again at the chart below].  Though cyclical bull and bear markets can provide great buying and selling opportunities, our emotions will try to get in the way between us and the right decisions. Markets will constantly try to brainwash us into doing the opposite of what we should be doing.  I hope [excerpt from] this chapter provides an antidote to this as it contains two missives.  Read the first one [You Are Not as Dumb as You Think] during cyclical bear markets and the second [You Are Not as Smart as You Think, which I did not attach] during the cyclical bull markets.  Good luck!

You Are Not as Dumb as You Think
(Psychotherapy for Cyclical Bear Markets)
Lately I’ve been getting this nagging feeling that everything I touch turns to dirt. Every time I buy a stock that is already down a lot, the one that my analysis leads me to believe is cheaper than dirt, it declines more. Did I completely lose my ability to value stocks? Did I start ignoring Will Rogers’ advice to buy stocks that go up, and if they don’t go up, don’t buy them?

No, I didn’t get dumber, and my stock-picking skills haven’t diminished. I was simply a willing participant in the latest cyclical bear market. Bear markets make you feel dumber than you are, the same way bull markets make you feel smarter than you are.

Feeling dumb makes you do the opposite of what you should be doing. Fear and pain—yes, continued losses cause a lot of pain—are dangerous things because they can make you and me panic, lose confidence, and do the opposite of what we should be doing. To alleviate pain we sell, we react, we default to the only asset that made us money so far in the bear market—cash! Cash is only king when other assets are princes. When you cannot find a stock with a long-term superior risk/reward profile, then cash is King with a capital K. However, during a cyclical bear market, cash is slowly demoted to a prince as great companies are thrown out the window with the junky ones. You have to actively remind yourself of the eight-letter word T-O-M-O-R-R-O-W!  Yes, tomorrow.  Think of the lyrics from Annie:

When I’m stuck with the day that’s gray and lonely
I just stick out my chin and grin and say, ohhh 

The sun will come out, tomorrow
So you gotta hang on’ til tomorrow

 Of course, we don’t know if tomorrow is really tomorrow or five years from now. But investing is a marathon, not a sprint, and do not let the bear market turn you into a sprinter. First of all, remind yourself that you are not as dumb as your portfolio makes you feel. You have occasionally bought a stock that made you money. This is what I do: I pull out a chart of a stock on which I made a boatload of money or one I sold for the right reasons before it declined.  I do this with pleasure, trying to relive my smart days. We all have these stocks, the ones we nailed. We tend to forget about them during the bear market phase. But I suggest you remember them now, when you feel lonely and miserable, so you’ll have more of these names to remember in the future, since cash will not bring the pleasure of victory in the long run. The cyclical bull market is still there; it is just hiding under the ugly sentiment of the cyclical bear market. Believe me, it will show its happy face. It is just a matter of time.

In a bear market, it is easy to forget about buying. Selling is a much easier decision to make. Every time you buy a stock you look dumb because it usually goes down afterward. I recently bought a couple of incredibly cheap stocks and, of course, they declined. I don’t feel smart about these buys right now. However, a while back I analyzed these companies, figured out what they were worth, determined an appropriate margin of safety, and got my buy prices. The stocks declined but fundamentals had not changed, so I bought the stocks.

You cannot worry about marking the bottom in every buy. My objective is not to buy at the bottom and sell at the top. No, my objective is to buy a great company when it is cheap and sell it when it is fairly valued. I suggest you do the same. Will Rogers’ advice is great, but unfortunately I have yet to meet a human being who has figured out how to apply it in real life. No, you are not as dumb as bear markets make you feel.

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.

Undermines confidence 

Sir Alan Greenspan, who, after he left the Fed, suddenly turned into a rational and comprehensible person, was on The Charlie Rose Show in June, where he said that businesses don’t want to invest because they are concerned about the future.  I agree.

Ironically, it is the Fed’s intervention in the free market and arbitrarily setting short- and long-term interest rates at insanely low levels that is responsible for this uncertainty, as it enables and propagates speculation, not investing (two distinctly different activities) and erodes confidence about the future.  Usually, in investing, liquid capital is turned into illiquid  by committing it to a higher, more productive long-term use.  Ability (read: confidence) to forecast after-tax cash flows and discount rates (which are a function of interest rates/inflation/risk premium) is the key here.  However, these concepts are foreign to speculators who are indifferent to what asset they hold (junk or quality).  Their time horizon is much shorter, and they are just looking for a greater fool to unload their stuff on.  The next tick in price is the only variable that matters.

Speculators are the ones driving stock prices up (and down) in the short run, but they leave as fast as they arrive.  It is the investors who stick around, but because of Bernanke, they choose not to come.

 Declared a war against the wrong statistic

The health of our economy has been measured based on the wrong statistic: unemployment.  It’s a political number that everyone pays very close attention to, but it’s not as important to the health of the economy as it appears to be.  Statistically, 9% unemployment is high, but most of the unemployment is in low-paying jobs. Unemployment among people with a bachelor’s degree is 5.4%, while among those who don’t have a high school diploma is almost 15%.  Workers with a bachelor’s degree make almost three times more than those who didn’t graduate from high school.  Thus, the impact of unemployment on the economy is a lot less pronounced than the headline number may indicate.  The trend in unemployment is more important than the number itself.

 Fixing unfixable

I feel for the people who don’t have a job, but the Fed and the government are trying to fix a problem that only time can fix.  After all, the bulk of current unemployment is structural, it is not caused by too little money in the economy or interest rates being too high – the Fed took care of that, and it still didn’t make a difference.  The 9% unemployment is caused by overcapacity in the housing sector (Mr. Greenspan, in Charlie Rose’s interview, agreed with that point), which took two-thirds of a decade and a lot of bad loans to create and thus will take time and population growth to self-heal.

Focusing on the wrong statistic and using the government’s balance sheet (i.e., debt) to cure the incurable is dangerous.  The statistic the Fed should worry about is the one it worries about the least, as it feels it can control it.  Yes, interest rates.  They are more important for our economy than unemployment: as our debt grows, interest payments are becoming a greater portion of the federal budget; thus our budget deficits will become more interest-rate-sensitive, which in turn will impact tax rates.  The housing market is tethered to interest rates as well.  Having taken short- and long-term interest rates to all-time lows, the Fed was not able to lift the housing market – we simply got too addicted to low interest rates.  However, if interest rates go up to levels we have not seen in a few decades, they will tank the housing market.

The Fed is desperately trying to mess with interest rates through QEs, but at some point it may lose control over them.  Recently we saw yields of Italian bonds jump to 6% – and Italy is a first-world nation.  The market is more powerful than the Fed and is not stupid.  It will not let the US government borrow at first-world-nation rates while behaving as a third-world country (like the ones we used to preach to about how to run their government finances).  Also, China and Japan, the largest foreign holders of US Treasuries, have their own sets of problems and may have a lot less demand for our less-than-excellent debt in the future.

Until we hit the wall we are not willing to take the needed pain, i.e., significant budget cuts across the board (we simply cannot afford the government we have) and some higher taxes.  Unfortunately we are so impressed with the Ivy League vocabulary the Fed heads use and are so scared that our economy will cease to exist without the Fed’s help (i.e. QEs), that we play along.  But our economy really needs to get off Fed (and government) steroids and start functioning on its own.  However, judging from Bernanke’s latest testimony to Congress, that is not likely to happen, as the Fed will use the US economy as a laboratory for “untested” measures, which will go down in history as QE3.  Prepare for higher interest rates and higher inflation.

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 Institutional Investor 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.

HP will buy Autonomy, a UK software company, for $10 billion. I understand $10 billion doesn’t sound like a lot of money in today’s post-trillion-dollar-bailout world, but it is plenty for HP, especially considering what that money bought.  There are many ways to illustrate how expensive and meaningless to HP’s future this acquisition is: $10 billion is about a fifth of HP’s market capitalization, while Autonomous will contribute 0.7% to HP’s revenues, and 2.7% to its earnings; and HP paid 10x revenues and about 25 times earnings.

Leo Apotheker, HP’s CEO, bragged about Autonomy:

“Autonomy has grown its revenues at a compound annual growth rate of approximately 55% and adjusted operating profit at a rate of approximately 83% over the last 5 years.”

Keith Backman, a sell-side analyst from BMO Capital, asked a very pertinent question about Autonomy:

“… metrics that you threw out for Autonomy, particularly on top-line growth, included a lot of acquisitions for Autonomy. What’s the organic growth rate that Autonomy has achieved lately?”

Leo did not have an answer, whereupon HP’s stock started to drop.  HP had reported an OK quarter, expectations were already low (its stock was at about 6x times 2011 estimates, which remain intact), and Dell had already lowered guidance a day before; so no one was surprised when HP lowered its revenue guidance for 2011 by a few percentage points.  Management said that since it will pay for Autonomy from cash on the balance sheet, it will not be buying much of its stock in the near future, and then they mentioned that this acquisition will be accretive.  Yes, accretive!  Nothing to worry about.  This transaction is accretive only for illiterates in economics and those short on common sense.

HP is using cash on the balance sheet to pay for this transaction, and thanks to the Federal Reserve this cash yields zero and thus brings zero income.  As long as Autonomy’s income is greater than zero (I am oversimplifying a little) then it will be accretive (at least on a cash basis).  However, this assumes that HP’s cost of capital is equal to the return it receives on its cash.  Which is not the case, as that would ignore such minor details as the time value of money, inflation, the risk premium (after all, unlike the US government, HP cannot print money and doesn’t have nuclear weapons) and, simply, opportunity cost.

Any investment HP makes today should be compared against an opportunity set that includes its own stock, which at 6x times earnings results in about a 16% yield (cost of capital).  In fact, if HP used $10 billion to buy its own stock, its earnings per share and dividend would jump by 16%.  Autonomy will not be able to match this return, by a long mile.

I don’t need to have a great imagination to envision another conference call in August 2015, where a new CEO decides that the software business is too difficult, and HP needs to come back to its roots (maybe going back to making calculators) and will spin off the software business into a new company, take an enormous charge, and then maybe announce an acquisition that the same highly pedigreed board will rubber-stamp.

HP’s valuation has not changed that much – the PC business only represents about 16% of operating profit, so even if HP gives it away, earnings power will not decline greatly.  HP should still be able to get a decent price for it, as there has got to be a Chinese company out there swimming in US dollars that wants to put them to work before they become worthless.  HP’s core businesses, will be slightly impacted by the global economic weakness, but the company should maintain its earnings power largely intact.  Autonomy reduced HP’s value by about $3; but with my lack of confidence in management, I’d not buy HP at a P/E higher than 10, which would bring the stock to the mid to high 40s.

HP’s stock sold off not because the company disappointed Wall Street but because Wall Street grew tired of the overpriced “must-have” acquisitions.  Wall Street has smartened up and assumed that this acquisition, as with many other “transformative” acquisitions, will do nothing of the sort.  And so, today we are faced with a decision: buy, hold, or sell.  At 4.6 times earnings HP is not a sell; but considering that the company is still trying to figure out what it wants to be when it grows up, it is hard to add to our holdings of the stock; so unfortunately this company has turned into a hold.

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.

Fundamental: AA+ is the new AAA.

The Fed and the FDIC set bank reserve requirements; they decide what is quality and what is not on banks’ balance sheets.  To little surprise, a few hours after the downgrade, the Fed and FDIC announced that AA+ US debt is as good as AAA, and thus banks’ reserve requirements will not change and bank lending should not change either.  Though we’ll probably get a few downgrades of financial companies holding US treasuries, the direct impact on financial institutions should be negligible.

The indirect impact of the downgrade is worrisome, however, because unknowns are simply … unknown.  The AAA government debt rating is a foundation stone of the world financial system, and when it shifts, even a little, other things may shift as well.  Unintended consequences may be surprising. For instance, until Lehman collapsed it was hard to imagine that the Reserve Fund (the first US money market fund) would see its price decline a few pennies bellow the dollar, causing a massive exodus out of money market funds and a resultant freezing of the commercial paper market – the lifeblood of corporate America.  The federal government had to step in and guarantee all money markets to stop the bleeding.

Scandinavian countries and Switzerland are probably the only true AAA nations left, but their economies are not big enough for them to field reserve currencies, and in fact Switzerland is trying to devalue its currency, as its exporters are hurting from the highly appreciated Swiss franc.

The US’s cost of borrowing is unlikely to increase, not yet, not while PIIGS (Portugal, Italy, Ireland, Greece, and Spain) are rampaging through Europe.  The US still has the largest, most robust, most diversified economy, and despite our problems we are in better shape than Western Europe, which is chained to a common currency and whose banks are overleveraged through their exposure to PIIGS.

The only downgrade that will really matter to our cost of borrowing in the long run is the one imposed by the bond markets.  Credit agency ratings are important in the short run, because their ratings are deeply embedded in the financial system by regulators (and governments), but in the longer run it is the markets’ own ratings that will matter.  Markets will perform their own credit analysis of countries and will do their own debt downgrading, i.e., they’ll demand higher interest rates.  Japanese debt was downgraded to AA- in January 2011.  It was a nonevent.  Despite being the most indebted developed nation, Japan is still borrowing at the same pre-downgrade rates, which are half of the rates the US government pays on its debt.  On the other hand, Italy’s 10-year bond rates jumped to 6% in August without any downgrade by credit agencies: the markets did their own credit analysis.

The chance the US will default on its debt in a traditional sense is zero. Yes, zero.  All of our obligations are in US dollars. Governments that can print their own currencies don’t go through traditional default, they default through the printing press (i.e., by inflation).  It will take a few more dollars to buy bread, vodka, potatoes, and cigarettes (I am going authentic here) year after year.  The US government will honor its obligations in nominal terms (ignoring inflation), meanwhile defaulting on its debt in real terms (adjusted for inflation).

Emotional Consequences

I was going to write a note on this topic before the S&P downgrade, so I’ll expand it a bit further.  I was on a radio show on Friday, and I was asked why the markets declined 7% this week.  I said, “Markets were ignoring bad news for a while and now decided to stop ignoring it.”  I sounded smart; I even patted myself on the back.

But a few hours later I was driving home and started thinking what baloney that was.  The market declined because it declined.  There is no need for an explanation, because there really is not one.  We don’t need an explanation why the market goes up, we consider it our birthright.  But a market decline seems somewhat unnatural to us.  Financial TV explains to us in great detail the market’s tick by tick movements. For example, on Friday the jobs report came out – the US economy added 117,000 jobs.  The Dow went up 150 points or so right away, as financial TV explained that the market was expecting a worse number, so this was a good surprise.  Then, two hours later, the market declined 250 points (that is, down 400 points from the opening high); and the explanation we heard was that the job number was not really that good, after all, because we needed 150,000 jobs or so just to maintain our current same employment level, because of population growth, so in reality employment had declined by 33,000 jobs.

I understand why financial TV does this.  You are not going to stay tuned to financial TV all day long if all you hear is that the market went up 150 points because it did, and then declined 250 points because it does that from time to time.  This would be some boring TV.

In reality, market movements – including intraday, daily, and monthly movements – are largely random and not predictable.  Explaining what they do tick by tick on a continuous basis has as much value as trying to come up with a rational explanation why the ball landed on the 9 on the roulette table in Bellagio instead of 10.

This brings me to the question of how markets will react to the downgrade.  I have no idea.  If they were to decline, I would not mind, as we have a little bit less than 30% cash, and I want to put it to work (we bought a few stocks last week).  Also, a bulk of the companies in our portfolio are actively buying back a meaningful amount of their stock in the open market, and I want them to buy their stock cheaper, as it will raise their earnings power.  But if you are an investor you need to have a time horizon longer than a week or a month.

Political Consequences

Hallelujah!  Last week I wrote about the Pyrrhic victory of the debt-ceiling debate:

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.”   Dictionary.com

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).

And this is what S&P delicately wrote about our politicians:

Our opinion is that elected officials remain wary of tackling the structural issues required to effectively address the rising U.S. public debt burden in a manner consistent with a ‘AAA’ rating and with ‘AAA’ rated sovereign peers.

An AAA-rated nation doesn’t threaten a default to achieve its political agenda; this is what you’d expect a banana republic to do.  I really hope the downgrade was the slap on the face our politicians so badly needed.  Both parties represent a class, not Americans who share the same sky and constitution, but rich and poor.  Each party wants to solve the debt problem at the expense of the other class.  Unfortunately, we have a government we cannot afford, thus both “classes” need to share in the pain: the ones that have the money need to pay higher taxes, and the less-rich need to have less government.

When I told my wife at the dinner table on Friday that the US debt had been downgraded from AAA to AA+, my five-year-old daughter asked if AAA batteries were still good.  I said they were.  The age of innocence. My daughter still believes her father can fix any problem.

The S&P, as usual, is too late to downgrade.  The US has not been a AAA-rated nation in the absolute sense for a while.  Will this downgrade really change anything?  In the long run, that is, beyond the uncertain short run, it will either have almost no effect or be a slightly positive event, as it should serve as a wake-up call we all badly need.  It is too easy to put all the blame on politicians –if we are really honest with ourselves, we have to remember that we’re the ones who reelect them, term after term.

P.S.  My father once told me a joke that may be pertinent:  A Jewish gentleman created a lot a political havoc in Soviet Russia.  The authorities thought long and hard about what to do with him, and decided the easiest way to shut him up was to ship him out of Russia.  They said, “Here is a globe.  Pick a country, any country; we’ll buy you a one-way ticket to the destination of your choice.”  The gentleman looked the globe over very carefully and said, “Do you have another globe?”

P.S.S.  I wrote this on Saturday and was pleasantly surprised that Sir Alan Greenspan and Mohamed El-Erian, PIMCO’s CEO, made similar points on Sunday.

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.

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.

Risk of growth by acquisition

Very significant portion of Brown & Brown’s (BRO) growth in the past came from acquiring brokers.  I am naturally skeptical of sustainability of this type of growth as it comes with the following risks:

• Integration risk. Although well managed companies can reduce this risk by creating strong processes to integrate acquisitions, to achieve the same percentage growth year after year BRO has to buy larger agencies or larger number of smaller agencies.  Either way integration risk increases every year as BRO gets larger.  I’ve seen this happen with banks that grew by acquisition – they were successful at buying and integrating smaller banks until they were not.
• Overpaying for acquisition and the value of BRO’s currency (stock). I don’t know a single management team that calls themselves an “undisciplined” acquirer, BRO team is no different.  Thus instead of taking management’s word for it, I looked at the price paid / revenue acquired (the only metric I could find consistently disclosed since 2003).  It increased but not sufficiently to indicate that management was an undisciplined acquirer.Also, kudos to management for using its stock to pay for acquisitions when stock was expensive: between 2000 and 2003, when BRO’s stock was trading between P/E of 21 and 26, BRO increased share count by almost 30%).  Since 2004 as P/E contracted BRO has not issued much stock and paid for acquisitions from free cash flows.Though based on company’s history, I believe this risk is small, the longer the soft insurance market drags on the greater are the chances that management (out of frustration, it has not grown earnings for years) will overpay for an acquisition and/or use cheap stock to pay for it (if acquisition is large) and thus destroy shareholder value.
• Sellers are selling their agencies that they’ve spent decades to build, for a reason - they want to monetize their single biggest asset and retire (not because they want to work for someone else).  After earn out period is over sellers’ motivation to grow the business lessens, especially since the sale turned them into multi millionaires.  This in part explains why BRO’s return on capital has been on constant decline since 2000, even before insurance industry entered soft market (ROA down from 26.9% in 2000, to 15.6% in 2006, and 10.5% in 2009).
• Nothing to buy. It is hard for sellers and buyers to agree on the price during the soft insurance market.  Though soft insurance market will not last forever, since acquisitions are at the core of BRO’s growth strategy protracted soft market will result in continuation of slow earnings growth (this problem is only compounded by impact soft insurance problem has on organic growth.)
• Growth by acquisition is not cheap. Over the last 5 years, BRO generated $1.135 billion of cumulative of free cash flows (operating cash flows less capital expenditures).  During the same time it spent $926 million on acquisitions.  Thus true (distributable) cumulative cash flows to investors were only $208 million, $171 million of which was paid out in dividends.(Also, free cash flows stagnated since 2005.   On the surface, $926 million spent on acquisition brought ZERO return to shareholders – this in part explains why ROA was on decline since 2005.  However, this on the surface analysis ignores a very important factor – negative organic growth of the core business, more on it next).

Margins

BRO margins are far superior to its competitors as it focuses on the small and lower end of the mid market customers where as AJ Gallagher, Marsh, AON and others are mainly concentrating on (higher end) mid and large markets.  Smaller customers require less service and thus are more profitable.  In addition, in small markets a significantly larger portion of broker’s revenues comes from commissions instead of fees.  In the long run brokers make more money charging commissions as commission rates are higher than fees, however, commission revenues decline more during soft insurance market.  This also explains why BRO’s margins were historically higher than competitors.

Higher composition of fees as percent of revenues is the main reason why competitors’ revenues faired so much better in this challenging economic environment than BRO’s.  In addition, significant portion of BRO”s revenues comes from markets (Southeast) that were significantly impacted by housing bubble burst and suffer high unemployment (less assets to insure).

I get a sense that small businesses are struggling more than large companies that are better diversified and have access to cheap capital.

Valuation

Combination of all these factors makes BRO’s future growth extremely sensitive to the growth of the economy.   In fact, BRO’s earnings power is completely at the mercy of the economic recovery.

If the economic recovery we are seeing today is real (not a foregone conclusion in my mind, considering an enormous amount of stimulus in the system), then insurance market will harden and BRO’s earnings will rise.  In the absence of economic recovery, or if economic recovery doesn’t lead to harder insurance pricing, margins will compress further and earning will decline.

Since 2006, soft insurance market eroded BRO’s revenues by about $255 million and earnings by between $40 to 50 million. In the absence of soft market (if pricing remained flat since 2006) BRO would have earned about $1.45-$1.50 a share, putting today’s valuation (stock price at $19.5) at about 13-13.5 times earnings – still not excitingly cheap.

Consider that if insurance prices rise 10% above 2006 level (and assuming BRO doesn’t make new acquisitions and 19% net profit margins), its earnings power will be around $1.70.  For this to happen, revenue has to rise 30% from today’s level.  If investors price the stock at 15 to 17 times $1.70 earnings, its price will be between $26 and $29 (30% and 50% upside). A lot of stars have to align perfectly for this scenario to play out.

In other words, at current valuation for this stock to deliver significant return, economic recovery has to be very robust and valuation multiple has to be rich.  (One factor worth considering that will be beneficial for BRO’s revenues – high inflation.  High inflation will inflate insurable assets and thus drive prices higher).

This stock is priced for growth! There is no margin of safety in the stock if high earnings growth doesn’t materialize.  There is also a significant risk of P/E compression, as BRO trading at 17 times 2011 estimates.  BRO’s competitors offer much higher dividend yields and are not priced for growth.  For instance, Willis (WSH) is trading at 11x 2011 earnings, has dividend yield of 3.2% (double of BRO’s).  AJ Gallagher (AJG) is trading at 15 times 2011 earnings and has a dividend yield of 5.1%.

Though BRO historically traded at premium valuation to its competitors, BRO’s lower dividend yield, inability to produce organic growth or to find suitable acquisition targets may erode the P/E premium.  If BRO’s P/E declines to Willis’s level stock will drop to $13.

Discounted cash flow model shows that today’s stock discounts about 12% revenue/cash flow growth over next 10 years (using 10-12% discount rates) – a fairly ambitious assumption.

This company doesn’t generate significant free cash flows as it is addicted to acquisitions, which bring their own set of risks as I discussed above.

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.