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/2011/10/08/on-cnbc-making-money-in-sideways-markets/ http://ContrarianEdge.com/2011/10/08/on-cnbc-making-money-in-sideways-markets/#comments Sat, 08 Oct 2011 21:18:39 +0000 Vitaliy Katsenelson http://ContrarianEdge.com/?p=3021 CNBC interview discussing sideways markets, Xerox, HP, Vivendi

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.

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.

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.

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.

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.

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.

“Some investors expressed concerns about Mr Sokol’s actions. ‘Any time you buy stock in a company which your employer then buys [it] just does not smell right,’ said Vitaliy Katsenelson, chief investment officer of Investment Management Associates.”

This quote slightly misstates my view, as the issue here is more complex.  Sokol was the CEO of MidAmerica and NetJets (subsidiaries of Berkshire); it is not his job to look for companies for Berkshire to buy – Buffett and Munger are in charge of Berkshire’s capital allocation decisions.  Sokol bought Lubrizol for his own account because he liked the business and thought it was attractively priced.  If he had never mentioned Lubrizol to Buffett, there would be no controversy today.  But he did, while disclosing that he owned the stock.  Buffett expressed little interest in Lubrizol.

Where this situation gets tricky is when Sokol starts communicating with Lubrizol’s CEO.  Lubrizol’s CEO (and the board) perceive him as the agent of Berkshire – even though Buffett at the time still had little interest in the company, because he was spooked, quite deservedly, by Lubrizol’s very high profit margins.  At dinner with Sokol, Lubrizol’s CEO discussed internal forecasts for 2015, which at the time must have been material nonpublic information, information that would not be shared with David Sokol – the private citizen, but was shared with David Sokol – the left-hand man (Munger being the right-hand man) of Buffett, who might have wanted to buy Lubrizol.  Only after this meeting was Buffett convinced to buy Lubrizol.

The magnifying glass of the media is now zooming in on Sokol, but the focus should be directed at Buffett as well.  Unfortunately, reputation is often destroyed by appearances.  We know Buffett cares deeply about his reputation.  To remove the appearance of impropriety, he could have ordered Sokol to sell his shares of Lubrizol in the public market, or to Berkshire.  Sokol would have obliged.

When you act on the behalf of someone else (be it a portfolio manager running someone else’s money, or an executive of a public firm) appearances are as important as the legality of one’s actions. You are like Caesar’s wife; you must be above suspicion.  You never want the true intent of your actions to be second-guessed, but unfortunately that is exactly what happened in this case.

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.

I am a very nervous flyer.  Whenever there is a little bit of turbulence, I look out the window, see shaking wings, and start to wonder whether they’ll keep holding the plane up.  Then my rational self kicks in, and I tell myself that statistically it is safer flying than driving, that the pilot’s incentives are aligned with mine (it is not like he has a private parachute). Eventually the turbulence subsides and I go back to whatever I was doing.  That said, I do like flying, as it is probably my most productive time, since there are so few distractions. I put on my headphones and start typing (this is how I think).  I wrote two chapters of the Little Book on the plane to Italy this past summer.  The iPad made my travel experience even more productive – unlike a laptop, an iPad has a 10-hour battery life.  I cannot type on glass, thus I bring an external keyboard.

On Monday, my brother Alex and I are flying to the VALUEx conference in Zurich/Davos, then on February 7th I am giving a half-day seminar at the Value Investing Center in Frankfurt.  I am not going to be writing another book for a long, long time (if ever), and I don’t have any new thoughts for another article, so to keep my brain cells going I came up with this idea: email me your questions, and I’ll try to answer them while I spend 20 hours in the air (I did Q&A with FT readers last year; it was a lot of fun).  I don’t promise to answer all questions, but I’ll give it a try.  I’ll post the answers online and will also send them out in my next email.

One last thought. The Little Book was light on tables and charts, so I have come up with supplemental tables, charts, and even a spreadsheet of how Tevye valued Golde (sorry, you have to read the big or the Little Book to know what I am talking about), and you can find them here.

Set the Bar High

The world today is riddled with unique economic, political, and demographic risks.  Finding attractively priced assets that will perform well in spite of these challenges is excruciatingly difficult.  For investors, though, one segment of the market – the highest-quality stocks – still offers attractive risk-adjusted returns.

First, it’s important to understand the risks that make most other asset classes perilous in the current environment.

Where to begin? China, the world’s second largest economy, is facing an enormous overcapacity bubble in commercial, industrial, and residential real estate.  Japan, the world’s third-largest economy and second-most-indebted nation (Zimbabwe holds that title) is in a debt bubble, addicted to unsustainably low interest rates and able to borrow at rates normally reserved for near-riskless borrowers. However, its significant indebtedness and horrific demographic profile (every fourth Japanese is over 65 years old) should barely qualify it as a subprime borrower.

Although the US economy is steadily recovering (unless you are unemployed), the rate of growth in this recovery is unsustainable, as it is propelled by government intervention (such as QE2) and stimulus – neither of which can be relied upon as a long-term driver.

These are the top three global economies, and all face huge challenges going forward, which is why I’ve been skeptical about the health of the global economy for a while now (and I haven’t even mentioned Europe being rampaged by PIIGS).

It is hard to tell if we’ll have inflation, deflation, or both; but problems in China and Japan will likely lead to higher global interest rates, since they are the largest foreign holders of the US debt, and as their respective bubbles burst they’ll be forced to become net sellers.  Over the next few years, global GDP growth will be lower than in previous decades, as consumer deleveraging will be followed by government deleveraging, which will also force higher taxation.

There is no safe place to hide; every shelter carries a different risk.  Bonds will do great if we have deflation, but they will be decimated in case of inflation.  Gold is not a cash-generating asset, and nobody really knows what it is worth. (“Higher price” is not a valuation metric.)  China is the incremental buyer of industrial commodities (here is a factoid: it is responsible for two-thirds of global demand for iron ore), so even if we have inflation, commodity prices will still decline with plummeting demand when China cuts back.  Exposure through bonds or equities to the countries that have fared the best so far – the likes of Canada, Australia, and Brazil – will not protect you in the future, since those countries have been the primary beneficiaries of the Chinese bubble.

Before I depress you further, don’t despair and reserve a space in a cave, stocked with canned food and ammo.  Instead, this is the time to own high-quality stocks – no, the highest-quality stocks – with strong balance sheets, so higher interest rates will not dent their profitability.  Their businesses need to have a competitive advantage and the power to raise prices for their goods or services in case inflation hits, or maintain their prices in case of deflation.

And they need to be noncyclical businesses. Let’s pause for a moment, because this point is paramount.

For a long, long time, the street yawned at cyclical stocks – they never received high valuations; in fact, the only time they would trade at above-market P/E is when declines in earnings (usually during recession) outpaced declines in price.  The street’s indifference was understandable: if the company in question was a commodity producer its fortunes were at the mercy of a very volatile commodity; if it was a capital equipment maker it went through feast-and-famine cycles of the economy.  However, in the late 2000s the market perception towards cyclical stocks changed – they had grown earnings at double-digit rates for six years, and even in 2008 – the year the US economy entered the Great Recession – their earnings still went higher.  They were not marching to the drum of the US economy, but to the beat of the Chinese drum.  They were no longer priced as cyclical stocks, but as secular “growth” stocks.  They sported high valuations on top of very high earnings, with profit margins at multi-decade highs.  The global financial crisis changed the street’s perception of them briefly; but today, only a few years and a few trillion in stimuli later, these companies are reclaiming their “growth” status, and high valuation that comes with it.

I cannot recall a single instance in history when the same bubble was reinflated twice in a row, but this is exactly what has happened to cyclical stocks: the pre-Great Recession bubble is being reinflated today.  Coordinated global stimuli will do that.

Take Caterpillar, the maker of big tractors and giant earthmovers.  CAT is at a higher price today than in 2008.  It is trading at 16 times its 2011 earnings of $5.80 a share, the highest earnings in its history, and its profit margins are close to an all-time high.  Caterpillar is a great company, but it is not a high-quality stock –   It is highly cyclical, has large amounts of debt ($15 billion of net debt), and, like a home builder, the products it sells today have a very long life and compete with tomorrow’s sales.  In a slower-growth global economy, or a world in which China will no longer be able to afford to build empty cities, the world will need a lot fewer earthmovers. Suddenly investor will discover that CAT’s earnings power is not $5.80 but $2 or $3, and the stock is not worth $90, but $30.  In the past, deeply cyclical stocks like CAT were never considered high-quality stocks, but today they are mistakenly considered as such.

For a company to be truly high-quality, its business has to be insensitive to the health of the global economy.  Interestingly, historically there was usually a premium built into high-quality company valuations, as investors are willing to pay more for their high returns on capital, strong balance sheets, lower risk, and the certainty of their cash flows. Deeply cyclical stocks have traditionally traded at a discount to the market.  Not today – low quality is expensive and high quality is cheap. Dirt cheap!

By way of example, what follows are a few companies that I consider to be highest-quality, and I own these stocks in our accounts. The first two are in healthcare.  Though the uncertainty that Obamacare brought is behind us and its impact on the industry will be relatively small, healthcare stocks did not get the message.  Pfizer (PFE), the largest pharmaceutical company in the world, is trading at less than eight times earnings.  It is generating enormous cash flows, pays a 4.5% dividend (which it just raised), and will be debt-free in the not too distant future.  Yet the market puts zero value on its enormous pipeline of drugs in development and the $10 billion PFE spends annually on R&D.  Medtronic – the maker of pacemakers – is trading at 10 times 2011 earnings.  If you look at its stock chart for the last decade, you’d think MDT’s business had stagnated; it has not.  MDT has grown sales and earnings 14% a year over the last 10 years.  Both PFE and MDT have an enormous tailwind behind them: baby boomers around the world will be consuming more drugs and more medical devices over the next three to five years, no matter what happens in China or Japan.

We recently bought Cisco Systems (CSCO) and Computer Sciences (CSC).  Cisco – the maker of internet plumbing – disappointed Wall Street, gave lower guidance, and its stock suffered huge losses as a result.  Today it is trading at about 11 times next-year’s earnings, or less than nine times if we adjust the price for the $25 billion of net cash it has on its balance sheet.  Though there is some cyclicality to Cisco’s business, as we consume more data and video over the Internet, the demand for Cisco’s products will increase more than enough to overcome the business cycle.

Finally, the most boring of this bunch is Computer Sciences, an outsourcing company for large corporations and the federal government.  It is trading at nine times next year’s earnings, and the company has announced a stock buyback of close to 12% of its shares.  It is a very stable and growing business, as the trend toward outsourcing non-core functions continues.  CSC has about $1 billion of net debt that it can pay off in about a year if it chooses.  CSC is the only public business in its field: due to the attraction of high recurrence of revenues, every public competitor has been bought by someone else – Affiliated Computers by Xerox, Perot by Dell, EDS by Hewlett Packard.  Though our CSC purchase will work out without it, in the world of QE2 and (artificially) very low interest rates, CSC becomes an easy acquisition target.

I am asking you to see things that have not happened yet, because success in investing comes not from drawing straight lines, but from the ability to see around the corner.

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.

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

But they may be headed for the history section.

A new little book is threatening to turn all that sage advice on its head.

We’re talking about Vitaliy Katsenelson’s “The Little Book of Sideways Markets.” Katsenelson says this decade’s big money won’t get made by riding bull markets, holding on to quality companies, or preparing for The Black Swan.  Source: CNBC

“The stock looks cheap, trading at about 8.2 times expected forward earnings, but the company’s 10% long-term-earnings growth rate is below the industry average…

At 8.2 times earnings, the market prices in zero growth.  If any growth is produced, even half of its “below-industry-average” growth, the stock will not be trading at 8.2 times earnings, but at a much higher valuation.  Ironically, today’s low valuation gives MDT earnings a yield of 12%.  If MDT remains at this valuation for a long time, it can buy back 12% of the company year after year, and this in itself would result in 12% earnings growth.

“… and it carries a fair amount of debt….

The amount of debt seems high at first, at $10.5 billion; but the company has $3.9 billion in cash and short-term investments, thus net debt is closer to $6.6 billion.  MDT generates $3.4 billion of free cash flows – it can pay off ALL of its net debt in less than two years.  Also, don’t confuse MDT with low-quality, highly cyclical stocks that were in vogue in the first half of 2010.  This is a company that maintained a return on capital of over 20% for decades – an indication of a significant moat.  Its revenues are extremely predictable, cash flows are very stable, and thus debt levels are very reasonable.  Medtronic’s stock was punished with a 10% decline for lowering its guidance by an astonishingly minor 2%.

“The stock is also a historical underperformer, turning in losses year-to-date, as well as in the last one-, two-, and five-year periods that are greater than its peers in the Dow Jones U.S. Medical Equipment Index and the overall market….

This argument fails to draw a distinction between fundamental performance and stock performance.  Over the last ten years, MDT grew both sales and earnings per share at 14% a year.  It increased dividends 17% a year.  These are not the vital signs of an “underperformer.”   As the article pointed out, MDT’s stock has gone nowhere over the past decade – that is true, but not because MDT was mismanaged or failed to grow, but rather because at the turn of the last century MDT was trading at almost 50 times earnings.  Medtronic is a typical sideways-market stock: it was severely overvalued at the end of the secular bull market, thus its earnings and cash flows grew while P/Es contracted.  This happened to a battalion of stocks, from Wal-Mart to J&J to Pepsico.  In fact when I hear the statement that a stock has “not gone anywhere,” I immediately start looking at the stock to see if it is a buy.

“Nor do there seem to be any new products in Medtronic’s pipeline that will reach the market in time to reverse the company’s near-term lackluster sales.”

I was surprised to read this because Barron’s is usually one of the few investment publications that has a time horizon beyond “near-term.”  Over the last several decades MDT has demonstrated its ability to innovate and come up with viable new products.  Will that happen again “near-term”?  Don’t know.  Longer-term? Likely.

The Barron’s article painted Medtronic as a bad company and a bad stock.  It is neither.

My firm has a position in MDT.

Vitaliy N. Katsenelson, CFA, is a portfolio manager/director of research at Investment Management Associates in Denver, Colo.  He is the author of “Active Value Investing: Making Money in Range-Bound Markets” (Wiley 2007).  To receive Vitaliy’s future articles by email, click here.

• Summary of my speech at Agora conference
• Japan: Land of the Rising Debt »
• On BNN: Range-Bound Markets, eBay, Pfizer, Vodafone »
• Musings on Kids and Asia »
• Microsoft Debt Issuance Makes Zero Economic Sense »

Most investors agree with Buffett’s criticism of Kraft’s decision to buy a fairly valued (or overvalued) Cadbury at 22 times earnings (over the past 15 years, its average price-to-earnings ratio has been 21), using Kraft’s undervalued stock.  Cadbury runs a global, noncyclical confectionary business that, if properly managed, should have a very high return on capital.  Buffett, a shareholder of Kraft, was very public about his dismay – he said he felt poorer when Cadbury accepted Kraft’s increased offer.

But though many agree with Mr. Buffett’s assessment of the Kraft/Cadbury deal, investors and media are completely ignoring Berkshire’s own, $30-billion-plus acquisition of a very cyclical, capital-intensive, not terrifically high-return-on-capital business – Burlington Northern.  A railroad for which Mr. Buffett’s Berkshire will lay out 18 times earnings (over last 15 years its average P/E was 15); and to make it even worse, part of the deal will be financed by issuing what Buffett recently called “cheap” Berkshire stock.  Burlington stock is not cheap, it is fairly priced at best, and likely overpriced.  Also, Buffett owning Burlington Northern will not make the railroad business any more valuable.  There is little value to be unlocked in this business, and Buffett will practice his usual hands-off approach.

Though Mr. Buffett said all the right words – “I am betting on the recovery of the US economy” – there are some rays of hypocrisy shining through Buffett’s statements about other companies (e.g., Kraft) and his own actions.   He felt “poorer” when Kraft made the acquisition – well, BRK’s shareholders should feel poorer, too.

Vitaliy N. Katsenelson, CFA, is a portfolio manager/director of research at Investment Management Associates in Denver, Colo. He is the author of “Active Value Investing: Making Money in Range-Bound Markets” (Wiley 2007).  To receive Vitaliy’s future articles my email, click here.

• Speaking, Travel and See you in Omaha »
• Even Capitalist Pigs Should Love Bank Regulation »
• Chinese Quest for Shortcut to Greatness »
• The case for Pfizer »
• Welcome to Another Lost Decade »
• Barron’s: Economic Steroids Are Toxic, Too »

• It is down significantly from the Viagra-high it reached in 1998.  Yes, Pfizer is the maker of Viagra, the drug that spawned a slew of commercials that made TV unwatchable (especially if you have little kids who ask you if they or you need this medicine that makes people on TV hug each other, or ask you “What is reptile dysfunction?”).
• Pfizer’s earnings have not gone anywhere for years.
• As with almost anything medical-related, Pfizer is exposed to the political risks of Washington DC.
• Finally, it is facing patent expirations of its major blockbuster drugs like Lipitor ($12 billion of sales) and a few others that will hinder PFE’s future growth for years.

There is not much one can do about TV commercials except cancel cable or watch less TV (I did both).  Nor there is not much one can do about the stock-price decline over the last ten years – maybe the only thing to do is learn not to buy hype; after all, Pfizer was trading at over 50 times earnings in the late ’90s.

I don’t want to dismiss the political risk, but it seems that due to extensive lobbying efforts by pharmaceutical companies, political risk has turned into only a slight inconvenience.  Pharma companies have agreed to $80 billion of price concessions over the next ten years, but at the same time they’ll benefit from a larger customer base, as more people will have access to health insurance.

Instead of being mesmerized by huge drug expirations, we can do the value-investor kind of thing – estimate the impact of drug expirations on PFE’s cash flows and value the stock using discounted cash-flow analysis based on these assumptions.

So let’s value Pfizer:

No New Drugs Scenario:  At the end of 2009 Pfizer acquired Wyeth (WYE), a large pharmaceutical company.  I’ll address this very important acquisition in a bit, but first, let’s look at Pfizer on a pre-Wyeth basis.  The fewer optimistic assumptions we use, the less likely the future will disappoint us.  Applying this logic, let’s assume that soon after a drug-patent expiration, as the generic version hits the market, revenue from that compound declines 90% and stays at that level indefinitely.  So, for instance, Lipitor’s revenues would drop off from around $12 billion to $1.2 billion after its patents expire in 2011.

Let’s also assume that the $8 billion Pfizer spends on R&D is completely wasted, and that over the next 5 years Pfizer will not come up with a single new drug.  We estimated and discounted  Pfizer’s cash flows over next five years. Based on these assumptions , it is worth about $15-18 a share.  The difference in this range is accounted for mostly by assuming various inflation rates (price increases) on existing drugs.
Wyeth Acquisition Was a Stroke of Genius:  Pfizer took advantage of the financial market meltdown when it offered to buy Wyeth in the spring of 2009.  PFE paid $60 billion for a company with earnings of about $4.5 billion, or about 13 times earnings.  This is a very attractive price, considering that historically acquisitions in this industry have been done at much, much higher valuations (i.e., P/Es in the high teens and low twenties).

There are plenty of redundancies between the two companies in manufacturing, sales force, etc., so Pfizer is expected to save $4 billion on cost redundancies in three years, but even if costs savings are half what Pfizer expects, earnings power of the combined entity has increased by $6.5 billion ($4.5 billion from WYE’s earnings and $2 billion from cost savings).  In other words, Pfizer’s actual acquisition valuation of Wyeth was less than 10 times earnings – incredibly cheap!

It Gets Better: Pfizer bought an asset (Wyeth with added cost savings) that had an earnings yield (the inverse of the P/E of 10) of 10% and financed a third of it with stock, a third with debt issuance, and the rest with its own cash.  Though PFE’s stock was undoubtedly cheap (not an ideal currency for acquisition), billions of dollars of cash on its balance sheet were earning the company almost nothing; also, it was able to issue debt with an after-tax cost close to 4%.  This combination of Wyeth’s bargain-basement purchase price and advantageous financing has created about $4 a share of value for Pfizer’s shareholders.

I have to admit, at first I was skeptical of the Wyeth acquisition – $60 billion is a lot of money, even for Pfizer; and historically, huge acquisitions have rarely solved companies’ problems or created shareholder value, in large part because companies overpaid for their targets, but that is not the case here.

The Bottom Line Is This: If Pfizer (including Wyeth) doesn’t come up with a single new drug, after spending $11 billion on R&D (Wyeth spent $3 billion a year), Pfizer’s stock is worth between $19-22 a share, based on discounted cash-flow analysis.

New Drugs Are Free: Drug discovery is not a linear process – serendipity, perseverance, and financial might are the essential ingredients required for success in this costly endeavor.  Pfizer has the latter two; the first one is an act of God kind of thing.  But we are not buying this stock and praying: Pfizer has 100 drugs under development, 25 of which are in late-stage (phase 3) trials.  Wyeth has an additional few dozen drugs in the pipeline, as well as 7 drugs in late-stage trials.

I have no idea what drugs will be successful, but I don’t have to because, first of all, we are not paying for them, since today’s stock price discounts no new drugs.  Second, though it is human nature to believe that “Everything that can be invented has been invented,” as (a fictional) patent office official believed when he submitted his resignation in the late 1800s, that is unlikely to be the case.

Here Is How We Look at Pfizer: Pfizer also fits the profile of a stock that should do well in our steroidally challenged economy, as its revenues are unaffected by economic cyclicality.  In case of inflation it has significant pricing power to pass cost increases to consumers (yes, and even the government).  In case of deflation it should be able to maintain prices, and its ample cash flows will allow Pfizer to pay off its debt in a few years, if it chooses to.  It is priced like a very safe bond with an embedded nonexpiring, free call option, yielding 4%.  If Pfizer doesn’t come up with a single new drug its price will not change much; it will be where it is today.  Any new drugs are just an added bonus.

Disclosure: own Pfizer

Vitaliy N. Katsenelson, CFA, is a portfolio manager/director of research at Investment Management Associates in Denver, Colo. He is the author of “Active Value Investing: Making Money in Range-Bound Markets” (Wiley 2007). To receive Vitaliy’s future articles my email, click here.

So this company, which has virtually no competition, has barriers to entry impossible for a new entrant to overcome, and a cash printing machine will be sold for about 12 times free cash flows. Over the past year we’ve seen much lower quality companies being sold for much higher valuations than this.  Most recently, Burlington Northern Santa Fe, which has a significant competitive advantage but has far inferior return on capital and free cash flow generation than IMS, is to be purchased by Mr. Buffett for about 20 times earnings and 30 or more times free cash flows. IMS Health’s management and board have a history of making dumb capital allocation decisions, but this one may go down in history as their dumbest.

We own these shares and will probably hold on to them in the hope that shareholders will refuse this offer.

Vitaliy N. Katsenelson, CFA, is a portfolio manager/director of research at Investment Management Associates in Denver, Colo. He is the author of “Active Value Investing: Making Money in Range-Bound Markets” (Wiley 2007). For more information click here.

P.S. Here is a PDF of my recommended book list for 2009.

I was on BNN (a Canadian version of CNBC) today (click here to watch), discussed American Express (AXP). Why it is a good company, but a fairly valued (at best) stock.

It’s almost impossible to value big financial institutions like Citigroup (C), Bank of America (BAC), or Goldman Sachs (GS) — they’re a lot like hot dogs — you don’t really know what’s inside of them; for the most part, they’re leveraged hedge funds.

They may appear to be cheap on a price-to-book basis, but the book is an illusive concept when it comes to financial stocks, especially when leverage, a deteriorating economy, and accounting assumptions may transform the book into a pamphlet in a New York second.

There are very few financial companies that one can actually analyze and thus value — American Express (AXP) is one of them, and I believe it’s a great proxy for other financial stocks. American Express’s financials are transparent, thus you can make some fairly reasonable assumptions of its normalized credit losses (net write-offs), borrowing costs, fixed costs, etc… and come up with a ballpark earnings power.

In 2007, American Express earned $3.26, however, at the time, its net write-offs of its credit-card portfolio were hovering at an all-time low of 3.3%.

American Express was benefiting from the temporary impact of a new bankruptcy law passed in 2005 (people rushed to file for bankruptcy before the stricter law went into effect, which lead to lower bankruptcy filings in 2006 and 2007), in addition to easy access of credit through home equity loans, low unemployment, and expanding economy.

The 3.3% net write-offs are not coming back anytime soon, so $3.26 of earnings (which implies a price-to-earnings ratio of 10 at today’s price) is a number we can dream and fantasize about, but won’t see for a long, long time.

Fast-forward to today: American Express’s losses almost tripled, approaching 10% (though this number is a bit exaggerated by American Express proactively cutting available credit to its customers). Wall Street expects the company to earn $1 per share in 2009. However, similar to $3.26 earnings per share, this number is not really meaningful either – bad times, as good times, will not persist forever.

To figure out American Express’s normalized earnings power, you need to make an assumption of its normalized net write-offs, among other assumptions (borrowing costs, new level of fixed costs, size of the portfolio, growth of discount fees, etc…) with which I’ll not bore you here.

Though American Express’ credit card portfolio losses may go even higher in the short run, in the long run they’ll decline toward their historical average of 4.5% to 5.5%. In this case, the company’s earnings will be somewhere between $1.9 to $2.3, thus creating a price-to-earnings ratio of 14 to 17 times, turning American Express into a fairly valued stock. (If the “new” norm for net write-off will settle at a higher number, my earnings estimates are off. FYI: 0.5% of higher write-offs reduces earnings power by about 20 cents a share).

Today’s American Express price reflects a return to a normal environment – to which we have not returned yet – and the road to that goal may be longer than we expect and bumpier than we’d like (unemployment – the most important factor driving credit card defaults – is still rising).

But even if American Express has earned its normalized earnings today, the stock would be fairly valued at best. What’s the upside? The same is true for many other financial stocks.

Vitaliy N. Katsenelson, CFA, is a portfolio manager/director of research at Investment Management Associates in Denver, Colo.  He is the author of “Active Value Investing: Making Money in Range-Bound Markets” (Wiley 2007).  To receive Vitaliy’s future articles my email, click here.

In his healthcare proposal President Obama is using a tactic described in behavioral finance as anchoring. Here’s a real life example from my married life. Let’s say I buy an expensive toy (usually a geeky one like an electronic gadget) for $300. My wife will ask me how much it is, and I’ll respond with $600. With a stunned look on her face, her reaction is typically “You paid $600 for this?” I then come back with, “What would you say if it was $300?”

Her answer is usually something like “Ok, that would be a good price,” and I’ll finally admit I lied and that it is $300. She’s not upset with me anymore and everyone wins. I anchored her at the higher price ($600) and then the lower ($300) now seems like a bargain.

Mr. President is doing the same thing. He asked in his healthcare bill a lot more than he knows he could possibly receive. So anytime he is giving up something, like insurance companies’ right to exist, he is “compromising” and republicans and taxpayers claim a small victory. This is important. The President knows he won’t receive everything he asked for. He knows that the public option (a government insurance competitor – an Oxymoron if ask me) was a “no go” from very beginning. And thus he’ll “compromise” it away with cooperatives.

As dust around the healthcare bill begins to settle, we are seeing hints that health insurance companies will not be euthanized and in the worst case, they may have to compete with cooperatives. Let me tell you this. As a guy who spent half of his life in Russia and has seen cooperatives, this is an antonym to competition. I have yet to meet a person who adores his HMO, but for-profit HMOs are a better evil and more importantly, more efficient than not-for-profit cooperatives. I am buying HMO stocks.

If you would like to receive my articles by email (usually couple days before I post them to this website) click here. You can follow me on twitter @vitaliyk

IMS Health (RX)

The company lowered earnings guidance for the year by 10 cents, though this is not uncommon in today’s environment, but the management was pounding the table only last month that $1.70 was a set-in-stone number. As of today the set-in-stone number is $1.60 (lower side of the guidance). Wall Street obviously did not like that and took down the stock.

But here is how I look at the quarter. First of all, the company did not change free cash flow guidance for the year – $380 million ($320 if you take out the one-time stuff). That is good news. Also, the company is going to cut costs by $80-85 million by 2011. In other words, they’ll be rightsizing the company for a new operating environment. Things are not improving in the pharmaceutical sector. We knew that, but the pharmaceutical sector worldwide is not falling off the cliff.

Another thing to consider, the most revenue decline at RX is taking part in the lower margin consulting business. Thus, as we saw this quarter, the impact on the bottom line is a lot lower than the top line would lead you to believe.

Finally, this quarter’s performance reminds me of eBay’s (EBAY) performance a couple of quarters back. It seemed then that there was no end of bad news in sight. Consumers were retrenching and sales declines were accelerating. eBay reported numbers yesterday and suddenly investors realized that its business has a fairly high competitive advantage and high recurrence of revenues and was not completely destroyed by Amazon (AMZN) and the economy. RX shares these qualities too, to an even greater degree.

I don’t know when (do you ever really know?) but in the not so distant future IMS Health will likely be turning around and its numbers will be less bad. Then they’ll become better and then good. At today’s valuation – IMS is trading at 7.8 times earnings. I am not particularly worried about when they’ll become less bad, as long as they don’t turn horrible – which my research leads me to believe is an unlikely scenario.