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.

Continue reading it on Institutional Investor website…

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.

Continue reading on 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.

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.

China is slowly starting to face the consequences of its actions — loans grew over 30% a year over the last few years — and inflation is rising fast.  Inflation in developed countries is unpleasant, but it is tolerable.  For a developing country — and China, despite its size, is still a developing country — it can be catastrophic.  In developed countries, we spend two or three times less on food as a percentage of our income as do people in developing countries.  Therefore, though food inflation is unpleasant, we have a much greater tolerance (margin of safety) for it.  While food inflation the US can mean fewer trips to restaurants or no summer vacation, food inflation in China leads to hunger.

The Chinese government is desperately trying to put the brakes on the economy.  It is shutting off lending to land developers and has raised bank reserve requirements five times this year.  However, its success on the inflation front will likely lead to a slowdown of the economy and high unemployment.  Ironically, those were the issues party planners tried to cure when they stimulated the hell out of the economy over the last few years.

China bulls are arguing that the almighty Chinese government will be able to soft-land the economy. Unlikely, I’d say.  Forced lending was at the core of Chinese economic growth. Simply put, there is too much debt to go bad.   According to Ernst and Young, one-third of the $700 billion in loans taken out by local governments may face repayment problems.  The People’s Bank of China estimates that Chinese banks’ exposure to local government loans is 14 trillion yuan ($2.2 trillion), according to the June 17 South China Morning Post.  Once lending is cut off, property prices will stop appreciating (and likely collapse — that is what usually happens in a Ponzi scheme). Also, the overcapacity in the industrial sector and commercial real estate will come to the surface. And suddenly everyone will discover that the venerable emperor has no clothes.

I often hear the argument that China will not have a real estate crisis of US proportions because home and condo owners have to put 30-40% down when they buy.  So where do people get the money to buy a house that costs, on average, 8 times their annual income (a figure several times higher than in the US)?  Some of it comes from savings, and some comes from borrowing from relatives.

Let’s pause for a second.  In the 1990s, the Chinese banking system basically collapsed.  To revive it, the Chinese government took bad loans from banks’ balance sheets and put them into off-balance-sheet vehicles (Enron would be proud of that financial ingenuity).  Banks started to function as though nothing had happened. To finance the off-balance-sheet assets, the government set deposit interest rates at very low levels: 1% or so.  In a country with a very high savings rate and 5% inflation, this resulted in a 4% annual loss of purchasing power.

Chinese consumers were punished severely over the last 10 years for the banking crisis of the late ’90s.  And they’ll be punished even more soon.  Keeping money in the bank didn’t make that much sense, and investment alternatives were limited. However, they could invest in an asset that supposedly never declines in price – a house or condo.  So they did.  As China slams the brakes on the economy and as housing prices fall, the banks will lose plenty of money. But more importantly, it is the people who bought tremendously overpriced houses, and their relatives who lent them money, who will lose.  The wealth and hard work of more than one generation will be lost, and this kind of pain leads to political unrest.  That is the Chinese Black Swan!

• Also see presentation – China The Mother of All Grey Swans

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.

While attending the Berkshire Hathaway annual meeting I had the tremendous pleasure (for the second year in a row) to participate in the Value Investing Panel at Creighton University, joined by Whitney Tilson and two other value investors.  Ben Claremon, an owner of Inoculated Investor blog, took detailed notes .

I was on BNN (the Canadian version of CNBC) discussing sideways markets, in the company of two great Jeffs: Jeff Saut, Chief Investment Strategist of Raymond James, and Jeff Hirsch of Stock Trader’s Almanac.  (there are three segments.)

Finally, Dan Anglin took detailed notes of Jim Chanos’ terrific presentation/”dessert lecture” at VALUEx Vail 2011 – you can find them here (PDF link).

Finding Investment Treasures in International Markets

Simply stated, stocks should compete against each other for a place in your portfolio. The larger the pool of stocks you can choose from, the higher the bar—the opportunity cost—that a new stock has to overcome to make it into the portfolio.  International stocks need not be seen merely as a necessary evil for diversification—they should contribute in a real way to raising that bar, as they increase the quality of the investment pool. You don’t need to become the Indiana Jones of international investing by diving into developing countries like Zimbabwe or Afghanistan [or Russia] where the rule of law is still in its infancy. Start with the developed countries that are in your comfort zone and then tiptoe out from there.

The Little Book of Sideways Markets (Wiley, 2010)

Quality, Valuation, and Growth – these are the three attributes (dimensions) that we seek for companies in our portfolios.

A Quality company will have long-term-oriented, shareholder-friendly management, a competitive advantage that will protect the company’s future cash flows from competitors, a high return on capital, a strong balance sheet, and the business will have a high recurrence of revenue, which will result in stable cash flows.

In the Growth dimension we are not just looking for earnings growth but also seek stocks that pay high dividends.  Though stock price movements are responsible for all daily headlines, dividends were responsible for half of the returns from stocks over the last 100-plus years.  Dividends are extremely important in sideways markets, as in the past they were responsible for over 90% of the returns for investors. Dividends are also important for another reason: they usually improve a company’s quality by lessening the chances of capital misallocation. Canceled or missed dividends are mayhem for a company’s management and its stock. Management will cancel its country club membership before it suspends a dividend.  A significant dividend creates another fixed cost, therefore it imposes thriftiness on the company’s operation and often keeps management from doing something dumb with the company’s cash flows.

It is easy to find companies that meet our Quality and Growth criteria in any market environment, but for these companies to be good stocks they need to meet the third very important criterion – Valuation.  A stock needs to trade at a discount to its fair value, or in other words it needs to have a margin of safety. It is almost impossible to find a company that flawlessly meets Quality, Valuation, and Growth requirements (though we try).  However, with weakness in one dimension we always look for offsetting strength in the others.  For instance, if a company has volatile (cyclical) cash flows, we require an extra strong balance sheet – no debt, and a lot of cash.  Or, if a company lacks in the Growth dimension, we require a much higher margin of safety.

The US market overall is not cheap, and we expect it to get cheaper over time. Stock selection is further complicated by the adjustments we make due to the headwinds we see in the US and global economies (we’ve communicated to you about them over the years about positioning your portfolio to avoid them).  Here is our solution to the problem: fish in a bigger pond. Don’t limit your stock selection only to the US stock market but look in other countries, i.e., democracies that have stable political systems, the rule of law, and financial statements that are prepared in a way we can understand them and written in English (okay, British is as far as we’ll deviate).  International investing is not new to us here at IMA; a third of our portfolio today is invested in foreign companies that trade in the US and are known as ADRs (American Depositary Receipts). Their original (ordinary) shares are listed on foreign exchanges.  A US-based bank buys and holds foreign shares and creates a dollar-denominated equivalent that trades on US exchanges.  (BP, Total, Vodafone, and National Grid are all ADRs.)  Though ADRs reduce trading complexity, they only marginally increase our pond, since only limited numbers of very large foreign companies are traded as ADRs.

From this point forward we’ll also be buying ordinary shares of companies listed on foreign exchanges.  The bigger pond may change our daily routines a little due to the time differences –we’ll have to place trades early in the morning – but this should allow us to maximize each Quality, Valuation and Growth dimension, which hopefully will increase risk-adjusted return.  Buying stocks on foreign exchanges will increase transaction costs compared to US-listed counterparts.  We have found that it may cost roughly an extra 1% in total (in and out of the trade) to own foreign as opposed to domestic stocks.  Since we don’t trade a lot, this cost should not have a significant impact on returns in the long run.  By buying foreign-listed stocks we are not abandoning our principles; quite the opposite: we get the opportunity to maximize Quality, Valuation, and Growth.

Halfords PLC

The first, inaugural foreign stock listed on a foreign exchange to make it into your portfolio is Halfords PLC (symbol HFD on the London Stock Exchange).  HFD is a 109-year-old company in the UK.  HFD has 480 auto parts/bicycle stores in England and the Republic of Ireland.  It has sales of about £800 million ($1.3 billion) and a market capitalization of about £800 million.  About 60% of HFD’s sales come from auto-related products (windshield blades, car batteries, brakes, stereos, etc.) and the rest comes from bicycle sales (it is the largest bicycle retailer in the UK).  A significant portion of HFD’s sales come from its own private brands.

In 2010 HFD bought the largest independent auto service company in the UK, which has about £80 in sales.  Let’s take a look at HFD through the Quality, Valuation, and Growth lenses, and you’ll see why we believe it is a stock worthy of your portfolio.

Quality

This is a business with a high return on capital: return on equity is pushing 30% and return on capital has improved over time.  Management has done a terrific job managing the business, return on equity, profit margins, free cash flows are up, and net debt is down.  The company is also a good steward of capital: it raised its dividend in April; after a significant stock decline (it missed an earnings forecast due to extremely cold winter in the UK) it announced a buyback of 9% of its outstanding shares; and finally, the latest acquisition to its auto service business was made at a very reasonable price and makes sense.  HFD has stable cash flows and a decent balance sheet – it can pay off all of its net debt in a bit more than a year if it chooses to do so.

Growth

HFD’s auto service business, with 220 shops, will be an important source of growth.  Until 2003 British law prohibited non-dealer auto repair shops from servicing cars that were still under manufacturer warranty – it voided the warranty.  Though the law has now changed, most consumers are not aware of that.  HFD has rebranded its auto service stations to Halfords and just started a national campaign to alert consumers that they can save a lot of money (usually 30-40%) by servicing their cars at Halfords shops.  In addition, HFD will begin opening about 30 new service stations a year. Auto service will likely contribute a few percentage points of growth a year.  Same-store sales in retail stores (which in England are called like-for-like sales) will add another few percentage points.  HFD will also continue to buy back stock; this should add 3-5% to earnings growth.  Finally, HFD pays an almost 6% dividend, which will likely rise over time with earnings.

Valuation

This is a very cheap stock.  HFD generates about £100 of free cash flows, giving a very modest 8x free-cash-flow multiple.  Comparable companies in the United States with a fraction of the dividend yield and a similar growth profile trade at close to double HFD’s valuation.

As you can see HFD fulfills our Quality, Valuation, and Growth criteria with flying colors.

Lost (and Found) in Translation

One final but an important issue we need to address is currency.  Portfolios of stocks will always have exposure to currency fluctuations, it is unavoidable.  US-based companies have currency exposure on two fronts: first, from sales overseas – for instance, 65% of HP’s sales come from outside the US.  In the case of HP, a strong dollar would hurt its earnings. And second, there is exposure from purchasing goods outside the US.  For instance, all of Walgreen’s and CVS’s earnings come from the US; however, a weaker dollar will decrease their purchasing power, making their foreign purchases more expensive.  If they can pass cost increases to customers then they are fine, if not they’ll have a problem.

When it comes to foreign-listed stocks, we are exposed to the two currency risks noted above, plus an additional one: the risk that the dollar will appreciate significantly against the currency in which ordinary shares are traded, and in the translation into US dollars we’ll get fewer of them.  Take HFD, for instance: since all of its sales occur in the UK, a strong dollar against the pound would hurt our returns.

Currencies are a guessing game and we rarely have a strong opinion about their long-term direction (the Japanese yen being an exception – it makes little sense for the yen to be close to multi-decade highs while Japan has the worst debt profile in the developed world, is trapped in ultra-low interest rates, and has a rapidly aging population).  However the British pound doesn’t scare us.  In fact, we like it slightly more than the euro.  Britain is not on the hook for the bailout of the PIIGS (Portugal, Italy, Ireland, Greece and Spain) from the massive debts they’ve accumulated.  The British government is embracing austerity (at least for now), while our government is in “easing” mode (the Fed may decide to let quantitative easing expire in June; however, we get the feeling the Fed might embark on QE3, 4, 5 6 if the stock market meaningfully declines). The UK has as much debt-to-GDP as the US, which is not good; but in today’s post-Great Recession world, currencies are priced on a “less-bad” basis.  The UK and its currency are, in our estimation, doing as badly or maybe even a little less badly than the US.

We’ll watch carefully the geographic and currency exposures in our portfolio.  Overall currency movements should cancel out in the longer run and should not significantly add or subtract from returns.

Finally, we want to make two more important points: (1) this excursion into foreign markets is NOT a deviation from our Active Value Investing process; we are just extending the universe of stocks we look at to increase reward and minimize risk of stocks in the portfolio.  (2) Our core portfolio will still likely be dominated by “made in America” stocks.

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.

Here are pictures from the conference.

Once I started to download my thoughts from the conference onto paper, I couldn’t stop, and my writeup got to be eight pages long.  I’ll break it up into two emails.

Every day (Wednesday through Friday) we met at 5 pm at a different restaurant, where for two hours we listened to six 15-minute presentations, with 5- to 10-minute discussions following each.  From 7 to 8 pm we had dinner, and from 8 till the restaurants kicked us out (usually around 10) we had a “dessert lecturer” and a lively discussion.  All of us would gather around and the “dessert lecturer” would discuss a topic and answer questions.  I’ve attended a lot of conferences, and I’ve learned that the goal is not to get an “actionable” investment idea, but to be stimulated by new thinking and the rethinking of old ideas.

This is how Paul Brophy, one of the participants, described this conference:

“I think I was expecting something more like the standard get together that focuses on everyone providing an idea or two.  Instead, it was just as you said, a place where smart, interesting people talk about markets, politics, families, and yes, a stock pick or two over breakfast, late-night drinks, and waiting for the next zip line ride.”

The first day’s lecturer was Sizhao Yang (he goes by Zao).  Zao is not a traditional value investor, in fact he openly admits that he is still learning about value investing; it is more like a hobby for him.  However, in his non-hobby time he started the company that created Farmville, one of the popular games on Facebook, with over hundred million users, which he later sold to Zynga.  Given his experience, I asked Zao to speak about social networks.  I tremendously underestimated the breadth of Zao’s knowledge, which extends far beyond social networks.  His granular understanding of technology companies was breathtaking.  Here are some thoughts from Zao’s talk.  Most are his, and some are mine, triggered by our discussion.

Groupon will be facing an uphill fight in its business, not just from Google but more importantly from Facebook.  A majority of Groupon customers came from Groupon’s advertisements on Facebook – the Facebook users.  Now Facebook, which has much more granular information about its users (e.g., location, education, likes/dislikes, etc.), will be going after Groupon’s customers.

Groupon may also have another problem: the user experience is poor because Groupon  is “too successful” at bringing new clients to the merchants.  This business model suffers from the “be careful what you wish for” curse.  Merchants are overwhelmed with the new demand and thus the quality of service declines.  My wife bought a service on Groupon that requires six appointments.  She went once and was told she had to wait three months until the next appointment because, thanks to Groupon, the service provider was overbooked.  It seems that my family will not be using Groupon or that service provider again.

Zao mentioned that bargain-hunting customers often don’t turn into repeat customers, and therefore, though the cost of acquisition of the customer may not be high, the total value of the customer (purchases over lifetime) is low.

Facebook and gaming. Most people access Facebook during work.  Social games (e.g. Farmville) are predominantly played by women.  These games lend themselves perfectly to the Facebook (play at work) environment, because you need to “check” on them a few times a day – unlike traditional games they don’t require continuous, uninterrupted play and you don’t need to install 10-gigabyte, graphic-intensive software on your employer’s computer.  For the above-mentioned reasons, social networking games (like Farmville) don’t usually compete with the likes of World of Warcraft or Call of Duty, which are predominantly played by men.

“Something else”. This brings up a very interesting point.  In the past the impact of the internet on “analog” businesses such as newspapers was fairly symmetric.  For instance, newspaper classified sections were losing customers to Monster.com, Craigslist.org, etc.  The average user spends 30-plus minutes a day on Facebook – that is the time they don’t do something else.  So the first casualty of Facebook (the “something else”) has been daytime soap operas.  It is very possible that viewership had been on the decline for a while, but women spending more time on Facebook was likely the last nail in the soap opera coffin.  As investors, we need to be aware of asymmetrical threats that are posed by technological innovation.

About asymmetric threats. I’ve been noodling lately on whether the internet distractive force will spill beyond music and book retailers.  Today’s smart phones allow you to scan a barcode instantly at a store and in an instant get the comparative prices of local and online retailers.  While shopping for a projector for the conference at Micro Center, a local retailer, using RedLaser, a free app on iPhone, I found that Best Buy online (which will deliver to the store for free) had it $50 cheaper.  All I had to do was show the screen of my iPhone to the sales clerk and the price was matched.

Best Buy stock looks statistically cheap, trading at about 10x earnings; but I keep wondering if its business model will need to change dramatically to adjust to the disruptive properties of instant comparison shopping, which puts it head to head with online-only retailers.

Gamestop is another stock I have watched from afar.  It seems only logical that in the future more and more PC and console games will be downloaded, not bought on DVDs.  Therefore, no DVDs to buy, no games to trade, and no reason to visit the store.

Some companies have done a good job adjusting to disruptive technologies; Netflix has done a great job, Blockbuster not so much.  Or think how brilliant Jeff Bezos of Amazon was willing to undercut their core book business by coming out with Kindle.  It comes down to management and their willingness to disrupt their current (profitable) business for the future but not yet profitable opportunity.

DNA. When Zao talked about technology companies he emphasized the importance of corporate DNA, which is usually implanted by the company’s founders.  The more creative and more dynamic is the business, the more important DNA becomes.

Research in Motion (RIMM) has engineering DNA, and it has done a great job making highly sophisticated, very secure smart-phones for the business market.  Apple has design DNA and thus has created terrific iPhones for the consumer market.  However, the smart smart-phone market is converging towards the consumer side.  Business people want to use the same cell phone for business and pleasure, and the design – an easy-to-use (iPhone-like) interface – becomes very important.  In fact I see many of my friends who work for large companies carrying both Blackberries and iPhones, or dropping their Blackberries altogether in favor of iPhones (I guess their employers find that the iPhone is secure enough).

Does that mean a firm with engineering DNA cannot create good consumer products, or vice versa?   No, but you want to handicap probability of success, because a DNA mismatch makes it an uphill battle.  Come to think of it, this explains Cisco’s blunder in consumer products, because selling to consumers is not part of its DNA.

Zip lining. On the second day of VALUEx Vail, on Thursday, we took our significant and insignificant others to the beautiful, Colorado-picturesque 4 Eagle Ranch.  Some family members relaxed at the ranch, while the rest went zip lining. My kids (Jonah, 10; Hannah, 5) expressed a keen interest in zip lining, and to my great surprise my wife did not object.  To my even greater surprise my 78-year-old father decided to join us.  So a dozen VALUEx’ers and my family went zip lining.  My kids loved it, and so did I. I normally have a mild fear of heights, but for some reason when you fly several hundred feet in the air on the zip line you don’t get have time to be afraid of heights!  Afterwards we all had lunch at the ranch.  Next year we’ll have to kick up it up a notch and go whitewater rafting.

Later in the day Jim Chanos made a presentation, explaining why he is short for-profit education companies, and he was our dessert lecturer as well.  Jim is the Warren Buffett of short selling; he runs the largest ($7 billion) short-sale-only fund in the world.  When you see Jim on CNBC he comes off as this very negative person – after all, he is a short seller – and in his interviews he usually explains why he believes certain stocks will decline in price, talks about corporate fraud, or why a certain Asian country may have some big problems, etc.  However, in person Jim is anything but negative.

When he talked about for-profit colleges (here is a link to Jim’s presentation), I kept thinking how, despite being a symbol of capitalism, for-profit colleges are anything but.  There are few incentives for them to care about the quality of education, job placement, or affordability, not to mention the default rates that follow when students are overburdened with loans in the hundreds of thousands of dollars.  As of right now their business is broken – their business model cannot exist without government subsidy, which provides 80% of the loans.  The government backstops the losses from the loans students take out to attend these institutions.

I am a believer in capitalism and the free market, but government involvement in loan guarantees turns this industry into asymmetric capitalism: Gains are harvested by for for-profit education companies – their earnings have gone up over the last decade as if Google were their middle name; however, losses from the government-backed loans, which are in the billions, are socialized (absorbed) by taxpayers.

Jim commented that if the for-profit colleges are so proud of their service, they should underwrite the loan losses, not the taxpayers.  I asked Jim which for-profit colleges he was short.  He answered, “Let’s just say we are not short DeVry and Strayer; they provide more technical training.”  (I read Strayer’s annual report a month ago, and I liked the CEO’s letter to shareholders.  It was not just another “puff” piece.)

China. In his “dessert lecture,” Jim laid out his case for believing that China is in the midst of a bubble of enormous proportions, and answered questions.  He often gets criticized for never having been to China.  His response is that you did not need to live in Miami to know there was a bubble in Miami real estate.  I don’t blame him for not visiting China.  It could be a bit scary to be arrested for jaywalking in a country that cares little about the rule of law but does care deeply about its image.  Suddenly, jaywalking might become a capital offense.

In fact, a few years ago, before my trip to Russia, I was going to publish a fairly negative article about Mr. Putin.  I wrote the article but did not publish it.  Why tempt the fates?  There is a 99% chance that nothing would have happened, but why take the 1% chance with a fairly nasty negative outcome?  This is also the reason why I too will not visit China for a long, long time. However, while Jim has never visited China personally, his team has been there several times.  After their last visit he told me he was not bearish enough about China.  (I’ll share my new thoughts on China later).

Value traps. I broke my presentation into two parts: on the first day I talked about Rules of Engagement Investing, and on the second day I discussed our recent investment in the UK auto parts and bicycle retailer Halfords (I’ll share my presentation and Halfords’s write up in next email).  In my first presentation I talked about the two main causes of permanent loss of capital:

a)      Earnings power is permanently impaired (e.g., goes from $5 per share to $1).  Suddenly the $50 stock is not trading at a P/E of 10, but 50 – also known as a value trap.

b)      The P/E collapses.  The stock was purchased at such a high multiple (P/E) that it will take a long, long time for earnings to offset multiple compression (e.g. Cisco in the late ’90s).  Also known as a growth trap.

To my surprise, Jim noted that he finds disproportionately more ideas in the value-trap than in the growth-trap basket.  During the dotcom era he did not short dotcoms but was short Lucent, for instance, which was cooking its books and favored the unsustainable business model of lending to customers to buy its routers, when they had little means to pay for them – ever.

After the VALUEx Klosters conference I appreciated even more the importance of international investing (you see this in the letter we wrote to our clients last quarter; I’ll include it in the next email).  This conference made me think a lot about value traps, which are basically hell for investors.

Friday. On Friday we decided not to tempt the mountain gods, and opted for a less dangerous event: we took the gondola to the top of the mountain, where we had lunch.  Though at first it was sunny, as soon as we stopped eating (it was almost like the weather was waiting for us) it started to rain and snow.  But I don’t think anybody minded (in Colorado fashion it only lasted half an hour or so), and we took some great pictures.

Presentations. We had a lot of other excellent presentations; here is just a sample:  Josh Tarasoff discussed the importance of pricing power (link), not just the ability to raise prices with inflation, but to raise prices above the inflation level (think of it as a hidden asset).

Jake Rosser made a compelling case for Oshkosh (link).  Dan Amoss presented a long (Endeavour Intl.) and a short (The Pantry) idea (link).  Barry Pasikov made a strong case for Telular (link).  Dante Albertini, who travelled all the way from Peru, in his “Bottom Fishing in Cyclicals” presentation discussed Cemex (link).

Brian Bosse, our token Canadian participant and a great guy, discussed shale gas and fracking (link ).  Brian’s presentation made me think that I’d like to own service companies in that space.  Also, here is a very good video that shows the fracking process.  At my request, Dan Anglin, who runs a fund of funds, discussed his manager selection process (link).

I know my opinions about the conference are ridden with bias, so discount what I say by 50%.  It was an amazing, fun, learning experience.  Vail in summer is an underdiscovered treasure.  It is beautiful, peaceful, and very European-like (without the Greek debt crisis and everything priced in dollars); even the policemen pretend they are in Europe, driving Volvo SUVs.  Cristy Reid, our Director of Operations at IMA, who played event coordinator, did a great job selecting restaurants and hotels, and making the whole conference a flawless experience.  Investing is a solitary vocation, but it doesn’t have to be a boring one.  Learning with and from each other while enjoying good food and drink and outdoor fun with people who speak your (value) language is a very fulfilling endeavor.

Yes, there will be VALUEx Vail 2012.  June 13-15th , 2012.  Mark your calendar.

Creighton Value Investing Panel

Efficient Markets?!
May 31, 2011

“Markets are efficient, or so we’ve been told. I am not here to put a rebuttal to this academic nonsense, but let me give you one of the core reasons why markets are and will remain inefficient: because human beings are efficient. To function in everyday life, our brains are used to simplifying complex problems, through pattern recognition. We become accustomed to drawing straight lines when we see two points, and if we get a third or fourth point that fits the line, our confidence about the longevity (continuity) of the line increases exponentially. We become excited, even certain, about prospects of the company we’ve invested in when its stock has gone up for a long period of time, while we often dismiss stocks that have declined or flat-lined, especially if that happened for a considerable period of time.”

. . . Vitaliy Katsenelson, CIO of Investment Management Associates

I met Vitaliy Katsenelson, professor, portfolio manager, and author of “The Little Book of Sideways Markets,” years ago at a Minyanville Festivus gathering. We became kindred spirits, for it was following the September 1999 Dow Theory “sell signal” that I opined the stock market was likely going to trade sideways, in a wide swinging trading range, for years just like it did between 1966 and 1982 following the secular bull market of 1949 – 1966. That is the history of equity markets, for after e-v-e-r-y secular bull market the indices have always traded sideways for a very long period time. While the 1966 – 1982 stock market sojourn sure didn’t “feel” sideways at the time, an index investor still failed to make a dime over that 16-year period. Obviously, the past 11 years have demonstrated the same point in spades. However, that does not mean you can’t make money in a sideways market. Indeed, just like Peter Lynch compounded money at better than 20% per year in the 1966 – 1982 affair, our annual Analysts’ Best Picks list has compounded money at better than 19% per annum over the past 10 years. The “trick” is to be more proactive (or tactical) in your investment approach, be sector and stock specific, and cut your losses quickly.

I revisit this sideways market theme today for a number of reasons. Firstly, because despite all the market’s shuckin’ and jivin’ over the past few weeks, the S&P 500 (SPX/1331.10) has not traveled more than 13 points either side of 1330 on a closing basis (read that as sideways). Secondly, the “sell in May and go away” crowd has become emboldened by softening economic statistics, the sideways stock market, and the fact that every week in May has been a down week. Yet as the insightful Bespoke Investment Group writes:

“So what does the S&P 500 do following a month where every week is down? Looking at average returns, the S&P 500 tends to rally over the following one and three months, with above average returns compared to all [other] one and three month periods.”

Thirdly, I got into a heated discussion last week with a portfolio manager (PM) who insisted markets are efficient and that you can’t “time” the markets. As Vitaliy writes, “I am not here to put a rebuttal to this academic nonsense, but let me give you one of the core reasons why markets are and will remain inefficient: because human beings are efficient.” Indeed, if markets were always efficient, you would not have had Select Comfort (SCSS/$16.19/Strong Buy) selling for $0.25 per share in January 2009. Manifestly, at major inflection points markets are anything but efficient. Vitaliy goes on to use Cisco (CSCO/$16.46/Market Perform) as an example:

“Cisco has shattered the dotcom dreams of many investors in the years following 1999, when it hit $80 a share and, for a brief moment, was one of the most valuable companies in the world, sporting a modest P/E of 100+.  Since then, gravity has caught up with Cisco’s stock, and it has declined almost 80% from its highs, to $17.  Most investors who bought the stock since ’99 either lost or made no money.  Draw a straight line through its chart (you have more than a decade’s worth of data points), and you see it’s either going to zero or at least will continue to go nowhere.  Now, you add to this performance a few quarters of disappointing Wall Street guidance, and you have an untouchable, un-recommendable stock.”

To be sure, at downside and upside inflection points, stocks are anything but efficient. As my father says, “The stock market is fear, hope and greed only loosely connected to the business cycle.” Yet, to be a successful investor, one must also be able change their views for the changing causal relationships. Sticking with the Cisco example, over the past few years Cisco has made a huge strategic mistake by moving into the data center business. Before that Cisco was known for its prowess in the switching and router business. When a customer wanted servers, Cisco used Hewlett Packard (HPQ/$36.96/Outperform), or some other manufacturer. Not so anymore. Cisco went on an acquisition binge and now competes with many of its previous customers and in the process has alienated them. Accordingly, some of them have gone into Cisco’s business. Hewlett Packard is a perfect example. HPQ bought 3Com and now competes head-to-head with Cisco’s switching/router products. Meanwhile, Juniper (JNPR/$37.05/Market Perform) is also taking market share from Cisco. As Vitaliy concludes, “Draw a straight line through its chart and you see it’s either going to zero or at least will continue to go nowhere.”  ….

To function in everyday life, our brains are used to simplifying complex problems, through pattern recognition.  We become accustomed to drawing straight lines when we see two points, and if we get a third or fourth point that fits the line, our confidence about the longevity (continuity) of the line increases exponentially.  We become excited, even certain, about prospects of the company we’ve invested in when its stock has gone up for a long period of time, while we often dismiss stocks that have declined or flat-lined, especially if that happened for a considerable period of time.

Imagine an analyst bringing a “fresh” stock idea to a portfolio manager at a large mutual fund.  He’d say something among these lines: Cisco is a buy, it has a bulletproof balance sheet with $25 billion of net cash (cash less debt), the stock is cheap – trading at 9 times earnings (excluding net cash), it’s providing double-digit returns on capital, and it is a dominant player in the industry, which is poised to grow at a faster rate than the economy, since, thanks to iPads, Androids, Kindles, Hulus, and Netflixes, we’ll all continue to consume digital content.

I can just see the portfolio manager’s smile, his laugh and comment that “This stock is a value trap, it has gone nowhere in more than a decade.”  I’m glad I’m not that analyst, as I’d have a huge burden to overcome.  After all, Cisco has shattered the dotcom dreams of many investors in the years following 1999, when it hit $80 a share and, for a brief moment, was one of the most valuable companies in the world, sporting a modest P/E of 100+.  Since then, gravity has caught up with Cisco’s stock (it always does), and it has declined almost 80% from its highs, to $17.  Most investors who bought the stock since ’99 either lost or made no money.  Draw a straight line through its chart (you have more than a decade’s worth of data points), and you see it’s either going to zero or at least will continue to go nowhere.  Now, you add to this performance a few quarters of disappointing Wall Street guidance, and you have an untouchable, un-recommendable stock.

However, fundamentals – take any metric: revenues, earnings, cash flows – will tell a very different story: they either tripled or quadrupled since 1999.   Through no fault of its own, Cisco’s stock was too expensive in 1999, and it took time for the stock to catch up to its fundamentals.  Of course, as usually happens, investors get overexcited on both sides of valuation.   The same investors who could not get enough of Cisco at over 100 times a little more than decade ago, don’t want touch it at 9 times earnings with a ten-foot pole. (Here is efficient market for you).  The dark shadow of the stock performance hides an attractive investment.

Cisco is not a spring chicken anymore, it has over $40 billion in sales.  It will likely see some margin compression as parts of its business mature.  Its revenue and earnings will grow at a slower rate than they did over the last decade.  But at its current price Cisco doesn’t have to do anything heroic to justify its valuation, it just needs to show that it has a pulse.

It is very difficult to get a unique insight into Cisco’s business or that of any large-cap stock; after all, they are followed by a small army of analysts (Cisco is followed by some 40 analysts).  Some sell-side analysts undoubtedly know what John Chambers’ (Cisco’s CEO) favorite cereal is, and can recite the model number of every Cisco router by heart.  Most of us cannot compete with that, nor do we need to.

First of all, you need to have a time horizon longer than Wall Street’s.  Wall Street is very short-term-oriented, and mutual fund managers are judged and compensated on their monthly and quarterly performance.  Sell-side analysts are there to serve their buy-side masters, and thus expend their energy analyzing the next quarter, not the next five years.  Therefore a time horizon longer than Wall Street is significant competitive advantage in itself.   Cisco’s earnings three, five years from now are likely to be significantly higher than they are today.

It is also important to understand that even a much-followed stock like Cisco will suffer from inefficiency (which as a value investor I welcome), due to investors confusing the lousy stock with the company’s fundamental performance.   That is how you find high-quality companies at bargain-basement prices.

Understanding what happened in the past is important, not because it is the precursor to the future, but because it helps to build the analytical bridge, through our own analysis, from today into the future.  Be inefficient – don’t draw straight lines.

(position in CSCO)

This article was published in Institutional Investor Magazine.

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 “Paris Flower Market” by my father Naum Katsenelson

See also:

• Microsoft Just Pulled Another “Microsoft” with its Purchase of Skype »
• I am back! »

Copyright Vitaliy N. Katsenelson 2011.  This article may  be republished only in its entirety and without modifications.

We are only sending out this letter to a small number of people since the venues (restaurants) have limited room.  Space is limited to fifty people, so I encourage you to sign up quickly.  Once fifty people are registered, latecomers will be put on a waitlist.  

VALUEx Vail was designed to replicate the very successful  VALUEx I attended in Zurich/Klosters in February 2011.  Saying that it was a terrific event is an understatement (here are pictures from this event).  It was created by Guy Spier and John Mihaljevic, they succinctly spelled out the core principles of VALUEx in three paragraphs, which are at the heart of what I am trying to accomplish as well:   

VALUEx is inspired by three bedrock principles.  

 1. Berkshire Hathaway, Wesco, Warren Buffett, Charlie Munger, Ben Graham et al.

A place(s) where like-minded individuals can develop their worldly wisdom, learn to be better investors, and become better people in the process. 

 2. Wikipedia / Linux / Firefox and the Open Source Revolution

No one individual either owns or controls it.  The endeavor is not for profit.  Leadership comes from the group of individuals who are in the best position to contribute and who can best understand and develop the mission and the goals. 

 3. Chris Anderson / TED / Ideas Worth Sharing

Content and speakers are selected using the same principle applied at TED, where the most successful talks are delivered by inspiring speakers in an inspiring way.  A strict time format ensures that the speakers deliver their most valuable ideas promptly.  The focus is on “Ideas worth sharing,” rather than pitching products / companies / one’s own services. 

 We are still finalizing the agenda, but let me share with you what we have in mind.  We’ll have presentations every evening (Wednesday, Thursday, and Friday) for about two hours, roughly from 5 to 7 pm, then we’ll have dinner at the same restaurant right after presentations.  

A presentation should be about 15 minutes long.  Everyone is encouraged to present, but presentations are not mandatory.  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 you register we’ll contact about presentations.  

 Presentations will be followed by dinner (we’ll alternate restaurants every night, though).  After dinner the more adventurous types are welcome to join us at the bar for drinks. In the morning, if you can get up after the night before (!), join the group for breakfast.  Sometime after breakfast, we’ll do some of the following activities: hiking,  bicycling, whitewater rafting, Turtle Tubing, Frisbee golf, GPS Scavenger Hunt, and ziplining  The location of the group lunch will depend on which activity we do during the day. 

 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: 

Sonnenalp

One of Travel & Leisure’s Top 100 Hotels in the World 2010, it has such a unique “Vail” feel to it, it epitomizes, to me, no pretenses, just warmth and friendliness in beautiful surroundings.  Each room is rather unique and does not have the standard hotel feel at all and it is located right in the Village.  The fireplace in the spa is one of my favorites!

http://www.sonnenalp.com/

 The Lodge at Lionshead

For an option that includes having a kitchen, a condo may be more for you.  The Lodge at Lionshead is a short walk from the Village in Vail. 

http://www.lodgeatlionshead.com/

 Arrabelle

This is a brand new resort in Lionshead, or Vail Square, which is what I believe the town is thinking of changing the name Lionshead to.  It has European-inspired architecture that really complements Vail and the service is wonderful.  Some of the larger suites do have a kitchen and look more like a condo, while other rooms are more like upscale hotel rooms with beautiful balconies that afford fabulous views of the mountains.

http://arrabelle.rockresorts.com

 I’ll be staying with my family at the Lodge at Lionshead.

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. 

 Dress code: very casual, comfortable clothes 

 Cost: This is a not-for-profit event.  There will be a nominal fee ($100) to cover organizational/activity expenses.  Attendees will be responsible for hotel, food and activities payable directly to restaurants or activity providers. 

Registration deadline:  May 18, 2011

To register: send me (vk@imausa.com) a few lines describing your occupation and I will provide you a link to registration page.  This conference is only for professional investors. 

Robert and I did a 30-minute Q&A, and then we let Whitney have the stage.  When asked what is the cheapest asset class, both Robert and I had the same answer: high-quality large-cap stocks.  Robert went further and said that owning that asset class for the last 10 years was a very painful experience, but he is not throwing in the towel on it, because these stocks have got to insanely cheap valuations (I am paraphrasing).  I wrote an article about this asset class in the latest issue of Institutional Investor magazine (I’ll send it along in a few days).

About a month ago we had a potential client stop by our office.  He brought his portfolio to take a look at.  His advisor/broker bought stocks about 12 years ago and had not sold a single stock, and so the million-dollar portfolio was now a $700k portfolio – he owned Pfizer, Medtronic, Cisco, Microsoft, Abbott Labs, J&J, etc.   Amazingly, his portfolio that was constructed a decade ago looked like the portfolios of our clients today, though we bought most of those stocks in the last few quarters, and all of them in the last few years!  In the late ’90s investors loved these high-quality companies to death – they were great American icons.  It was almost a patriotic thing to own them then (though I believe that only stocks that have a margin of safety are the patriotic ones to own).  Fast-forward 12 years, and these companies have matured, some more gracefully than others (I am thinking about Microsoft as I type this – more on it later), but their earnings have generally tripled since then, and their P/E’s have declined from absurdly high to absurdly low levels.

I have to tell you, if you are a value investor and you don’t go to Omaha for Buffett’s weekend, you are shortchanging yourself (I can write this freely: I already reserved a room for next May and am not afraid of competition for hotel rooms).  It is really not about Buffett, it is about going to idea lunches and dinners with other value investors (I have a dozen stock ideas from those, including one we may actually buy soon), making new friends (while standing in line at 6 am on Saturday to get into Qwest center for the “main event”), attending presentations and small conferences, and eating a lot of DQ ice cream (since Berkshire owns DQ, when you eat ice cream in Omaha the cholesterol and sugar you consume come with reduced guilt).

One thing that Buffett said in the Berkshire meeting stuck with me.  When he was asked what businesses do best in an inflationary environment, he answered, “The ones that have royalty on someone else’s revenue.  You don’t have to invest any more capital, no receivables, no fixed costs.  Your revenues keep growing with inflation as long as the product remains viable.”  Here are some businesses that came to mind that for the most part fit that criterion: McDonalds (they receive a percentage of franchisee sales; in fact almost any company that receives significant income from franchising fits that category), credit card companies like Amex and Discover, and payment processors like Visa and Mastercard (Amex and Discover are actually both a credit card and a payment processor), and companies that just own brands, like Iconix Brands and Cherokee, etc.

I took a very early flight out of Omaha to Denver, spent three hours with my kids, then grabbed my wife and we flew to Amsterdam. I’ve been to Amsterdam three times and every time I love it more.  I don’t have a particular affinity with the red-light district or the legal marijuana, which you can smell quite often as you walk the streets.  (In fact – and this is the honest truth – I have never smoked a single joint in my life!  I do have a very addictive personality: I smoked for seven years from age 14, almost two packs a day.  So knowing my limitations, I never dared to try pot.  And yes, I’ll admit the stock market is my current addiction.)  I love Amsterdam for its canals and Van Gogh Museum.  When I go to an art museum I usually rush to the Impressionist section; and if I’m lucky I’ll find a dozen paintings by other Impressionists and one or two by Van Gogh.  The Van Gogh museum in Amsterdam has the largest collection of his paintings in the world.  We spent three hours there and did not want to leave.  Also, Amsterdam must be the bicycle capital of the world.  You see people of all ages riding bikes: an eighty-year-old woman is riding a bike full of groceries with the elegance and grace of a 20-year-old; a teenager is taking his girlfriend on a date as she is sits balanced on the frame etc…

My wife and I spent two days in Amsterdam, then rented a car and. with our final destination being Frankfurt, drove through Den Haag, Bruges, Antwerp, and Brussels.   (This also gave me an opportunity to see European retailers).

Den Haag is only an hour from Amsterdam.  It has a terrific Mauritshuis museum.  My wife and I rented an audio guide, and to our surprise even the most innocent-looking, unsuspected paintings carried some kind “amorous” meaning!  Our favorite painting was by Peter Paul Rubens, “Old Woman and a Boy with Candles.”  According to the museum, the painting is about an “old woman who reflects at night on lost opportunities for love. Perhaps she is the crone portrayed here, who passes light to the boy, thus urging him to enjoy love before it is too late.”  (Here is my wife Rita looking at that picture).

When we drove into Antwerp, where we intended to spend the night, to our great surprise our hotel was in a neighborhood full of orthodox Jews – it felt like we had found a little Israel in the middle of Belgium!  As I discovered from almighty Wikipedia, after NYC, London, and Paris, Antwerp has one of the largest orthodox Jewish communities outside Israel, with a population of 15,000, and they are mostly involved in the diamond trade.  We went to a kosher restaurant and had one of the best meals of our whole trip.  After this meal, my wife (who is an incredible cook) almost apologetically told me that she’ll have to get some new recipes.

My son asked me once if I enjoy driving a car.  I had to think about it, and I replied “Sometimes.”  I have little patience for traffic and the rude behavior of other drivers (in Denver we say that they must have come from California), so in general I am an unenthusiastic driver.  However, driving in Europe, especially in Germany, was a pleasure.  The roads (especially the autobahn) are flawless, there is no speed limit to worry about, and drivers follow a strict etiquette – leaving the far left lane for very, very high-speed vehicles and passing – and to top all that, the scenery was absolutely incredible: early May is a magical time of the year, with the fields yellow with rape flower.  Our Audi A6 topped out at 109 miles an hour (I got the feeling, however, that Sixt, the car rental agency, had installed a governor to limit my enthusiasm).  I thought I was going fast, until I found myself being passed by car after car.  Unfortunately, at the beginning of our trip my Nikon camera died – the lens refused to come out – so most pictures on this trip were taken with my iPhone 4.  Here are some more pictures from Europe.

I hated Germans for a good portion of my life.  I was not alone; I shared the hate with generations of Russians after WWII.  Probably two-thirds of the movies made in Russia after WWII were about WWII.  Though hate is not an emotion that should propagated, I  completely understand its source: tens of millions of Russians were killed by Germans.  Being Jewish and knowing what was done to my ancestors only added extra hate towards Germans.  Hate was an emotion that was just dormantly there; I never acted on it, never really gave it much thought; it was just a normal part of me.

However, over the last few years I’ve met Germans at different value events, and I detected an inner conflict: though I was programmed to hate them, I did not.  I could not connect the dots between Nazis and the people I met, especially since all of them were born after the war.  On this trip I saw another side of German people, which really touched me.  I was one of the speakers at the conference in Frankfurt.  The last point on the agenda of the conference was a tour.  Dr. Claudia Giani-Leber – the wife of the conference organizer, Dr. Hendrik Leber – was our tour guide.  I thought she’d be showing artwork on the Goethe-Universität campus, where the conference was held.  She did not.  As I learned, during WWII, what is the university campus was the location of an I.G. Farben chemical factory that used Jewish slave labor.  Instead of showing us artwork, Claudia led us to the memorial of Norbert Wollheim (spend some time on this site, watch the interviews) – a German who grew up in an assimilated Jewish family and played an important role in transporting Jewish children to England. He also filed a lawsuit against I.G. Farben.  Claudia spoke for half an hour, describing the suffering of the Jewish people and what the Nazis did to them.  She even read part of the testimony from the trial that described in graphic detail the living conditions and suffering inflicted on the slaves.  This tour looked like an act of self-lynching.  This group of a few dozen people (none of them alive during the war) were purposely reliving the pain and shame of acts that their ancestors had perpetrated on Jews.  They don’t hide from it.  I realized that these Germans hate Nazis as much as I do, even if many of their grandfathers were those Nazis.

We left our car in Frankfurt and took an overnight train to Prague – the most beautiful city in Europe (yes, Paris, move over).  We took a bike tour of Prague, and our guide told an interesting story.  A very old building that used to be a musical conservatory had statues of thirty European composers on its roof (here is a picture of it).  During WWII the Nazis turned it into their headquarters.  However, they discovered that one of the statues on the roof is of the Jewish composer Felix Mendelssohn.  The Nazis could not allow a statue of a Jewish composer to remain on the roof of their headquarters. But the problem was that the statues were not named – and the Czechs refused to identify Mendelssohn.  In a stroke of genius, the Nazis sent two soldiers onto the roof to find the statute with the biggest nose and knock it down.  They did.  However, it was later discovered that Mendelssohn’s statue was untouched but Richard Wagner’s statue was knocked down.  (Side note: Wagner was Hitler’s favorite composer.)

My wife and I flew to NYC on Monday, May 9th.  The next day I gave a presentation at the Hard Assets conference, on China and Japan (my updated slides can be found here), which was extremely well-received, and a few dozen people nearly mugged me with questions when I got offstage.  I was a bit surprised, as the theme of the conference was “hard assets” – the stuff I argue will come back to earth fast when the Chinese bubble bursts.

A few hours after my speech I finally got to see our kids – my brother-in-law had brought them from Denver.  For the next two and a half days my wife, kids, and I were tourists in NYC (here are some pictures).  We went to see the Statue of Liberty, Ellis Island, went on top of the Rock – an incredible view of the city! – rode bikes in Central Park, and then rented a boat – my son learned how to row.

On our last day in NYC I took my son to the Yahoo studio, where I taped a show hosted by my friend Jeff Macke and Matt Nesto (I met Matt for the first time, a very nice guy); and wonderful Aaron Task, who hosts Daily Ticker on Yahoo, joined us.  (Here is a link to the show.)  We talked about China, Microsoft, and Cisco.  Jeff, despite being my friend, did not pull any punches regarding Cisco and Microsoft – I did not expect any less of him.  Jeff even wrote “R.I.P.” on Cisco’s chart.

We own both stocks; Cisco we bought recently, Microsoft a few years back. We own Microsoft despite its management.  I strongly believe Steve Ballmer needs to be replaced, but the business is too good (it is still a monopoly) and the stock is too cheap.  But we own Cisco because of the management.  I’m in the minority, but I am a big fan of John Chambers; I believe he has done a terrific job running the company.  Since he came on as CEO in 1996, Cisco’s revenues and earnings per share are up about 10-fold.  But, as any successful company, it got too happy and too fat.  Recognizing this is half the battle, fixing it is the other half.  I encourage you to listen to Cisco’s last conference call (or at least read the transcript) – John Chambers gets it.  He said they’ll streamline operations  (cut out bureaucracy), cut $1 billion of costs, refocus the company on core business through divesting underperforming and non-core units, and continue to buy back stock (at today’s valuation they can create a tremendous value).  He admitted that at the high end their switches are not as good as competitors’ – they’ll fix that.  Switches are about 30% of sales, and sales were down 9%; but other sales of other business were very healthy.

P.S. Painting “Handyman” by my father Naum Katsenelson

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. .

Copyright Vitaliy N. Katsenelson 2011.  This article may  be republished only in its entirety and without modifications.

Today, while in NYC still playing catchup with the jet lag from the European trip, I read a headline: “Microsoft is near a deal to buy Skype for $8.5 billion.”  Microsoft is pulling another “Microsoft”, though this time it may actually succeed.  Private equity and eBay, which still owns 30% of Skype, may actually sell, unless Google or someone else rushes in with a competitive bid.

Microsoft had the chance to buy Skype for a long, long time.  eBay would have parted with Skype for a fraction of $8.5 billion as recently as 2009; in fact it did, it sold 70% of it to private equity, valuing Skype at $2.8 billion, a third of what Microsoft is offering today.  Skype only generates $800 million in revenues, putting today’s price tag at over 10x revenues and some much, much larger multiple of earnings – a very lofty valuation.

Microsoft falls into the broad category of high-quality stocks that were incredibly expensive in 1999 and have not gone anywhere since (and have often declined, as is the case with Microsoft).  But most stocks in that category – take Wal-Mart, Cisco, Medtronic, etc. – have seen their earnings and revenues triple and P/E’s collapse.  So before we run to crucify the management of these companies and call them “value traps,” we should actually take a careful look at their fundamental performance.  Management did what it was hired to do: it increased shareholder value by growing the business while maintaining or increasing the moat.  It is the shareholders who overpaid for those stocks in the ’90s.  Management is not at fault for that, human greed is.

However, ten years ago Microsoft was an icon, it was a star, it was the company that any self-respecting software engineer wanted to work for.  Today, with current management’s help, it is slowly becoming a has-been.  In fact, when I think of Microsoft I often think of a quote from Warren Buffett (Bill Gates’ best friend), who said he wants to own a company whose business is so good and whose moat (competitive advantage) is so wide that it could be run by a monkey, because someday it will be.  Buffett, though he’s the Oracle of Omaha and all, probably did not know at the time that he was talking about Microsoft (bing it: “Steve Ballmer Monkey“).

Today Microsoft is suffering from the too-successful company syndrome: it was too successful for too long, and the success corrupted management thinking into a belief in entitlement.  Management started to forget what made them successful in the first place –hard work, paranoia about competition, and a little bit of luck (which is random; one could hope for it but never depend on it).

I vividly remember in 2007 Apple was introducing its iPhone, a touch phone, and Microsoft was introducing a touch table (see it for yourself).  Steve Ballmer publicly dismissed the iPhone as a very expensive gadget.  Today, after Microsoft’s market share in cell phones went from respectable to nonexistent, and with the iPad (a device that is a barely a year old) killing netbook sales, Microsoft is a shadow of its former self.  The number of consumer gadgets that have the Apple insignia is rising at a much faster rate than Microsoft’s (my family has two iPhones, two iPods, one iPad – I am writing this on it – one Mac mini, and two Windows PCs).

The moat is still there; Microsoft still dominates in desktops, servers, productivity (office), and even gaming; and that is why, despite Mr. Ballmer antics, earnings are much higher today than they were 10 years ago.  But when a company is run by a proverbial Buffett’s monkey, no matter how good the business is, the moat will grow shallow and then cease to exist.  Even five years ago one would have been fairly comfortable projecting rising Microsoft cash flows ten, fifteen years out.  That confidence  is much lower today.

From my conversations, people who work for Microsoft love the company but hate the environment.  Microsoft has become a highly bureacratic, extremely political timeocracy.  (A timeocracy is the opposite of a meritocracy: people get promoted not based on their talent or performance (merit), but on the time they’ve been at the company.  This type of environment is great for Google and Apple, as it creates a fertile ground from which to cherry-pick talent.  It is very difficult to fire a person at Microsoft who doesn’t perform (I’ve heard it takes a year to dump someone).  This is good if you a nonperformer but horrible for the company, as it creates an undynamic, zombie-state working environment with horrible productivity.  Managers are afraid to hire full-time workers and thus hire temps.  In other words, to some degree Microsoft is becoming the un-unionized GM of the West Coast (though in all fairness, due to its moat, it still produces a 30% return on capital, high margins, and a healthy balance sheet).

Microsoft’s past success, $40 billion net-cash balance sheet, and the $20-plus billion in cash it generates each year gives management a false sense of security.  But success has it side effects.  It takes away the need to be paranoid, competition is dismissed, focus is lost – there is no project (even the touch table) that is not off limits when you think you have limitless resources.  Steve Jobs once said that focus is not what you choose to do, it is often what you choose not to do.  Cisco’s three-decade success also went to management’s head; however, CEO John Chambers woke up to that a few weeks ago and wrote a memo to employees admitting his mistakes and outlining steps to refocus the company.

It is difficult for management to admit their mistakes (they are human, and we are not good at that), and for the board to fire current management while the company is increasing its revenues and earnings.  A company needs to hit the proverbial wall for that to happen.  Microsoft is far from that wall.

Instead, Microsoft is making another acquisition, and Skype will likely be as wasteful as the ones it did in the past.  I am fairly sure, a few years down the road, Microsoft will take a “one”-time charge to write down the goodwill for this acquisition, not unlike eBay a few years ago, after their purchase of Skype.

Skype has a terrific product, which I use a lot.  My son plays chess with my father on Skype daily (despite my father living only seven miles away).  But unless I use Skype to make phone calls (which I do when I travel outside of the US), Skype makes no money on me as a customer.  I find that I use Skype as a VoIP product less and less when I travel outside of the US, because almost everyone I want to talk to has Skype on their phone or computer (this is how I communicate with my partner Mike when I am outside the US).  The minute Skype decides to start charging for video-to-video service I’ll switch to another free provider and so will my friends and relatives (ironically, we’ve been conditioned that video-to-video communication should be free).

So why, after everything I wrote, do I masochistically own shares of Microsoft?  Because the business is still too good and the stock is incredibly cheap.  Microsoft is trading at about eight times next year’s earnings if you take out cash.  However, as I write this I pause.  What if Microsoft (Steve Ballmer, to be exact) keeps pulling “Microsofts” and continues to buy the Skypes of the world?  With the Skype acquisition Ballmer will likely destroy 60 cents of Microsoft’s value.  ($8.5 billion roughly equates to $1 per share for Microsoft.  Skype is worth closer to $3 billion, 40 cents a share.).  In our estimate Microsoft is worth around the mid-30s, so with this upside we can tolerate a few Skypes, but not many.  I truly hope that other shareholders and employees start a jasmine revolution in Microsoft and vote Steve Ballmer out of office. But that is only a dream.

P.S. Despite my being critical of Steve Ballmer, the deal Microsoft signed with Nokia was brilliant.  Microsoft is a software company and doesn’t make hardware; its partners do.  Though in the bulky world of PCs and laptops that setup did not hinder Microsoft, it does now.  Apple’s control of both hardware and software allows the iPad to have a 10-hour battery life.  On my flight from Prague to NYC my Dell ran out of juice in less than 2 hours, and I had to use the iPad for the rest of the trip (an external keyboard helps a lot).

Nokia’s new CEO came from Microsoft.  My friend Tero Kuittenen described him as a Manchurian candidate: it appears almost as if he was implanted into Nokia by Microsoft – the Microsoft-Nokia deal is by far more favorable to Microsoft than Nokia.  The new CEO looked at Nokia’s operating systems (Symbian and MeGo) in development and realized he didn’t have many options other than creating an alliance with Microsoft. (Go figure!)  Nokia could have used Google’s Android, which is free, but it is difficult to differentiate in that crowded space.  So Nokia hung its future on the Windows operating system.  And it makes logical sense that the alliance will go 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 a more holistic software-hardware design platform and give Microsoft a fair chance to come up with a decent, iPad-level tablet.

Purchase of Big Lots

Big Lots (BIG) is a closeout retailer with about 1,400 stores in the US.  If you visit one of their stores, you’ll probably be less than excited about this purchase.  But don’t be discouraged – you are not BIG’s target customer, as it caters to lower-income, cash-strapped consumers who are looking for ultimate bargains in household items and care little about ambiance.  In fact, soon after we made this purchase, a client mentioned that his wife would never shop at Big Lots.  Our “clever” response was, we bought BIG so she would not have to.  As investors we have to realize that, though it is easier to buy stocks of companies whose products and services we use, that is not always going to be the case.

BIG’s stores were poorly managed until arrival of new CEO Steven Fishman about six years ago.  He completely transformed the company.  Every single operating metric from margins to inventory turnover to return on capital improved substantially.  Mr. Fishman refused to open new stores, he argued real estate prices were too high (instead he focused on improving existing stores).  This is exactly what we want to hear from a CEO: he is not focused on growth for growth’s sake, but wants only profitable growth with return on capital well in excess of its cost.  Today, after a severe recession and a few high-profile bankruptcies – Circuit City, Borders, Linens ’n Things – BIG is able to find real estate at prices that make economic sense.  It will open about 90 stores this year.

BIG has a debt-free balance sheet.  It doesn’t have to do much to achieve reasonable low-double-digit earnings growth: about 3% will come from opening new stores and another 1-3% from same-store sales; their profit margins are still below their competitors’, so they have some room to expand, contributing a few percentage points to earnings growth a year; and finally, management was not shy about buying back stock with its ample cash flows.  At the time we purchased the stock in the majority of our accounts it was trading at about 10 times earnings.

In early March, to our surprise, rumors circulated that BIG put itself up for sale and hired Goldman Sachs as an advisor.  The company would not comment on rumors, a common practice.  The company’s stable and growing cash flows and debt-free balance sheet make it a likely candidate for a private-equity buyout.  In our estimate, if the company is taken private it will be done at about $55-60 a share.

Purchase of Abbott Labs (ABT)

We owned ABT in the past, and were patiently waiting for the opportunity to own it again.  Think of ABT as a smaller version of Johnson & Johnson  (without weekly product recalls – we’ll touch on that issue later in the letter) – a diversified healthcare company that makes pharmaceuticals, children’s formula, stents, diagnostic products, etc.  ABT is very similar to other super-high-quality companies in our portfolio (we own plenty of that kind): it is being OVER-penalized for its overvaluation in the late ’90s (see attached article on Cisco where Vitaliy expands on this).  At the time of the purchase ABT was trading at a little bit less than 10x times earnings (in the late ‘90s it was sporting a P/E close to 30x).  ABT has high return on capital, terrific management, reasonable amount of debt (especially considering the stable nature of its cash flows) it can pay off its debt within two years if it decides to do so, and it has almost 4% dividend yield.  Over the last decade ABT’s earnings per share have almost tripled, and though we don’t expect that to happen, we still think it can comfortably grow earnings in high single digits.

Purchase of BP

The Japanese tragedy has made global society question the safety of nuclear energy.  Already, Germany is “temporarily” suspending nuclear reactors, will likely shut down older ones, and is stress testing new ones for earthquakes and terrorist attacks.  China has suspended approval of new nuclear power plants.  Nuclear energy is not going away anytime soon; however, getting approval for new reactors will become a more difficult and time-consuming process.  We believe this will increase demand for other sources of energy, natural gas in particular.

We looked at energy names and found BP to be the most logical choice.  Though we still have the vivid images of the sunken Deep Horizon rig and gushing oil from the Macondo well in the Gulf of Mexico, the well is capped and the impact on nature appears to be a lot less than everyone feared.  We did not buy BP in the midst of the crisis, because it was very hard to estimate the longevity of the problem and the impact it would have on the environment and thus on BP.  We bought Total instead, at the time.  It had declined as much as BP and had no significant exposure to the Gulf of Mexico.  A year later, though BP stock is up from lows it hit at the height of the crisis; it is still down substantially from its highs.

BP will continue to pay for losses, but these expenses appear to be very manageable, running a few billion a year (you have to take this statement in the context that BP has revenues of over $300 billion and profits in excess of $20 billion).

Over the last few months BP reinstated the dividend it suspended last year, and the yield today is slightly less than 4%.  The stock trades at about 7 times earnings.  BP’s leverage is not alarming (it can pay off its debt in one year), but management has announced they want to reduce it further.  Today BP’s stock is still tainted by the Macondo spill – its significant discount to its competitors clearly reflects that (Exxon, for instance, trades at a 70% premium to BP), but as time goes by and memories of the spill fade, the discount to peers will shrink.

Johnson & Johnson – why we still own it

J&J is probably one of the most respected companies in the United States, thus it is the last company you’d expect to recall a product every other week – it has recalled 22 products since September 2009. On the surface it appears that J&J lost control over its manufacturing, doesn’t care about its customers, and that the old white-glove J&J is gone.  At least that is what the headlines would have you believe.  But if you carefully look at the nature of the recalls you’ll see that quite the opposite is true.  The majority of  recalls came from the US consumer division McNeil, the one that manufactures Tylenol, Motrin, and some other well-known drugs.  J&J had manufacturing issues at that plant that ranged from (nontoxic) chemicals used to clean wooden pallets leaking into the bottles and creating nauseating odors, to metal and wood particles found in packaging.  J&J closed the McNeil plant a year ago, and went back and inspected products it manufactured at the plant over the previous year or so.  In typical J&J fashion, it erred on the paranoid side (as it should) and recalled almost everything under the sun that this plant manufactured.  So the recalls we are hearing about in the news are of products that were manufactured quite a while back.  It is important to understand that even after the McLean manufacturing problem has been put to rest, J&J will still have an occasional recall.  J&J is a giant healthcare conglomerate, making  everything from Band-Aids to stents to medical equipment to artificial hips.  Though it would be ideal if it had zero recalls, humans will make mistakes, and the more products you make, the higher the likelihood of mistakes.

The recalls have hurt J&J, as revenues in the US consumer business have experienced double-digit declines; however, this segment represents only 8% of total revenues.  J&J is not a broken company; its brand is so strong that it is unlikely to be tarnished by these recalls – aside from discomfort, the faulty products issued caused few problems, and certainly no fatalities.  J&J has a pristine, cash-rich balance sheet, double-digit return on capital, dividend yield of 3.6%, and is trading at about 12 times earnings.  We believe our patience will be rewarded.

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. .

Copyright Vitaliy N. Katsenelson 2010.  This article may  be republished only in its entirety and without modifications.

• 12:30 to 3 pm on Friday. I’ll hold my third annual CheapTalk – You are Invited! It will be held on the campus of Creighton University at Billy Blue’s Alumni Grill (you can find directions here). This is the same place where we held it last year.  As always, nothing fancy, water and thoughtful conversation. It should be a lot of fun.
• 3:30 to 5 pm on Friday, I’ll participate on the Third Annual Value Investing Panel, hosted by Creighton University, with my friendWhitney Tilson (T2 Partners), Patrick Brennan (partner at RBO & Co), Michael Green (owner of Evergreen Capital and Management in Omaha); and the panel will be moderated by Mark Mowat (managing director at Frontier Capital LLC). It is basically down the hall from Billy Blue’s Alumni Grill. Last year the panel was followed by drinks and food (not sure if that will be the case this year). Here is a link to the brochure.
• 6 to 8 pm on Friday.  Book signing with a lot of interesting authors, including two of my favorites, Jeff Matthews of Pilgrimage to Omaha fame and Pat Dorsey (The Little Book that Builds Wealth), and a very long list of other good authors (you can find more information here).  Note that the location has changed from the Dairy Queen to Mammel Hall, at the corner of Pine and 67th Street on the University of Nebraska at Omaha campus.

I am taking a 7am flight out of Omaha to Denver on Sunday, meeting my wife at the Denver airport, and taking a flight to Amsterdam (just the two of us!).  We’ll spend two days in Amsterdam and then drive to Den Haag, Bruges, Brussels, and Frankfurt (it’s only a 400-mile drive).  I’ll give a talk on Friday in Frankfurt, then we’ll take a train to Prague, spend the weekend there, and fly to NYC.

I’m giving a speech at the Hard Assets conference in NYC on May 10th (admission is FREE with pre-registration).  My brother-in-law will fly out our two adorable children, who will be missed dearly by that time, and we’ll all spend a few days being tourists in NYC.  I’ve been to New York many times but never been to the Statue of Liberty.