“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 »

The prelude to the current crisis began in the early 1990s, after Japan’s housing and stock market bubbles burst and its economy slipped into recession. For the next 20 years, using flashy names like Fiscal Structural Reform Act, Emergency Employment Measures and Policy Measures of Economic Rebirth, the government cut taxes, increased spending and borrowed money to finance itself. Today, Japan’s ratio of debt to gross domestic product stands at almost 200 percent, more than twice that of the U.S. and Germany and second only to Zimbabwe.

A country with ballooning debt needs to have an expanding economy to outgrow the burden. Economic growth is driven by two factors: productivity and population growth. Although the Japanese economy may continue to reap the benefits of productivity gains, population growth is not in the cards.

Japan has one of the oldest populations in the developed world — every fourth person is 65 or older — and its number is on the decline. The Japanese birth rate is one of the lowest in the world, a meager 1.2 children per woman. To maintain its current popu­lation level, the average woman in Japan would need to give birth to 2.1 children. (Of course, only economists know how a woman can give birth to a fractional child.)

The severity of the debt problem in Japan has been masked by the fact that government spending on interest payments has not changed over the past two decades, as the average interest rate paid on the country’s debt declined to 1.4 percent in 2009 from more than 6 percent in the 1990s. This is about to change. Historically, more than 90 percent of Japan’s government-issued debt has been consumed internally by its citizens, directly or through its pension system. But the savings rate in Japan, which was in the midteens in the 1990s, today is approaching zero and will likely go negative in the not-so-distant future.

The Japanese economy operates on the assumption, soon to be proved false, that the government will always be able to borrow at low interest rates. As internal demand evaporates, the government will have to start hawking its debt outside Japan — in a more realistic world, where interest rates are a lot higher. Japanese ten-year Treasuries currently yielding 1.3 percent will not stand a chance against U.S. or German bonds of the same maturity, which yield 3.5 percent and 3 percent, respectively. Japan will have to offer rates far in excess of its U.S. and German counterparts. Although they have their own set of problems, the U.S. and Germany still have much lower indebtedness and superior demographic growth profiles.

Higher taxes and the austerity measures that undoubtedly will follow, combined with higher interest rates, will further slow Japan’s economy and drive the country toward insolvency. Unlike Greece, which because of its size could be bailed out by Germany and friends — with a little help from the ever-willing International Monetary Fund — Japan is too big to be bailed out. Defaulting on its debt, especially when the majority of it is held by its own citizens, is a political impossibility. But unlike European nations that socialized their currencies and cannot print euros on their own, Japan has complete control over its currency printing press. And print it will! Decades of deflation will turn into hyperinflation, which will destroy the purchasing power of Japanese citizens’ savings and collapse the yen.

The consequences of the economy’s slow but sure unraveling in Japan will spill over to the rest of the world. Japan is the second-­largest holder of U.S. government debt, and most likely it will start selling Treasuries. To make matters worse, Japan will start competing with the U.S., not just in cars and electronics but for buyers of sovereign debt. As Japan exports inflation, interest rates around the globe undoubtedly will rise.

Timing bubbles — and Japan is in the late stages of an enormous debt bubble — is very difficult. They tend to last longer than rational observers expect. But as Japan’s debt continues to swell, the eventual bursting of the bubble grows more catastrophic.

Japan is proof that a country cannot borrow itself to prosperity. The U.S. and other developed nations still have a chance to make the politically difficult but right decision to cut fiscal spending and stop looking for government to be the source of sustainable growth — which it never is.

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.

Japan: Land of the Rising Debt

By Vitaliy Katsenelson

July/August 2010

Investors are understandably scared of the sovereign debt crisis unfolding in Europe. Amid their angst, however, they are ignoring a more likely, and significantly larger, debt catastrophe that is about to hit the nation with the second-largest economy in the world — Japan. Two decades of stimulative, low-interest-rate fiscal policy have made Japan the most indebted nation in the developed world, and as new Prime Minister Naoto Kan recently said, in his first address to Parliament, that situation is not sustainable. Japan has little choice but to raise interest rates substantially, with dire consequences far beyond its shores.

The prelude to the current crisis began in the early 1990s, after Japan’s housing and stock market bubbles burst and its economy slipped into recession. For the next 20 years, using flashy names like Fiscal Structural Reform Act, Emergency Employment Measures and Policy Measures of Economic Rebirth, the government cut taxes, increased spending and borrowed money to finance itself. Today, Japan’s ratio of debt to gross domestic product stands at almost 200 percent, more than twice that of the U.S. and Germany and second only to Zimbabwe.

A country with ballooning debt needs to have an expanding economy to outgrow the burden. Economic growth is driven by two factors: productivity and population growth. Although the Japanese economy may continue to reap the benefits of productivity gains, population growth is not in the cards.

Japan has one of the oldest populations in the developed world — every fourth person is 65 or older — and its number is on the decline. The Japanese birth rate is one of the lowest in the world, a meager 1.2 children per woman. To maintain its current popu­lation level, the average woman in Japan would need to give birth to 2.1 children. (Of course, only economists know how a woman can give birth to a fractional child.)

The severity of the debt problem in Japan has been masked by the fact that government spending on interest payments has not changed over the past two decades, as the average interest rate paid on the country’s debt declined to 1.4 percent in 2009 from more than 6 percent in the 1990s. This is about to change. Historically, more than 90 percent of Japan’s government-issued debt has been consumed internally by its citizens, directly or through its pension system. But the savings rate in Japan, which was in the midteens in the 1990s, today is approaching zero and will likely go negative in the not-so-distant future.

The Japanese economy operates on the assumption, soon to be proved false, that the government will always be able to borrow at low interest rates. As internal demand evaporates, the government will have to start hawking its debt outside Japan — in a more realistic world, where interest rates are a lot higher. Japanese ten-year Treasuries currently yielding 1.3 percent will not stand a chance against U.S. or German bonds of the same maturity, which yield 3.5 percent and 3 percent, respectively. Japan will have to offer rates far in excess of its U.S. and German counterparts. Although they have their own set of problems, the U.S. and Germany still have much lower indebtedness and superior demographic growth profiles.

Higher taxes and the austerity measures that undoubtedly will follow, combined with higher interest rates, will further slow Japan’s economy and drive the country toward insolvency. Unlike Greece, which because of its size could be bailed out by Germany and friends — with a little help from the ever-willing International Monetary Fund — Japan is too big to be bailed out. Defaulting on its debt, especially when the majority of it is held by its own citizens, is a political impossibility. But unlike European nations that socialized their currencies and cannot print euros on their own, Japan has complete control over its currency printing press. And print it will! Decades of deflation will turn into hyperinflation, which will destroy the purchasing power of Japanese citizens’ savings and collapse the yen.

The consequences of the economy’s slow but sure unraveling in Japan will spill over to the rest of the world. Japan is the second-­largest holder of U.S. government debt, and most likely it will start selling Treasuries. To make matters worse, Japan will start competing with the U.S., not just in cars and electronics but for buyers of sovereign debt. As Japan exports inflation, interest rates around the globe undoubtedly will rise.

Timing bubbles — and Japan is in the late stages of an enormous debt bubble — is very difficult. They tend to last longer than rational observers expect. But as Japan’s debt continues to swell, the eventual bursting of the bubble grows more catastrophic.

Japan is proof that a country cannot borrow itself to prosperity. The U.S. and other developed nations still have a chance to make the politically difficult but right decision to cut fiscal spending and stop looking for government to be the source of sustainable growth — which it never is.

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.

My nine-year-old son Jonah and I have been playing chess a few hours a day.  I never thought I’d enjoy playing chess as much, but I do.  In fact, over the past year I’ve probably played more chess than in my whole life.  I win every game!  When I win, I win.  When I lose I win – seeing your son (your student) beat you gives you an enormous satisfaction as a teacher.  In fact, I never thought I’d enjoy losing so much.   Jonah has this quality that I need to nurture in him – he never gives up.  Even a game that is a clear loser for him, he plays till the end.  What a great quality to have in life!
 
I am also enjoying seeing my four-year-old daughter Hannah grow up.  We have yet to find an activity we both enjoy doing together (other than hugging to death), but we’ll get there.  She has almost learned how to ride a bike without training wheels; maybe we’ll do cycling together.  They’ve been going to a summer camp that is half a mile from my work and six miles from our house.  A few times a week, while I tug Hannah in a bike-stroller, Jonah and I ride our bikes 30 minutes to the summer camp, through the park. 

I envy my kids; they have the pleasure of spending time with their grandparents.  My grandparents lived thousands of miles away from me – I saw them once a year for a few weeks and that was it.  My wife’s and my own parents live just a few miles from us.  My father’s house is a block away from my office; I stop by a few times a week for breakfast before I go to work. 

My father gave Jonah a 50-state quarter collection for his birthday.  Now, every day before Jonah goes to sleep, he and his grandfather spend half an hour on Skype learning about each state; and once they are done with a state, Jonah puts the coin at the proper place in the board. They also play a game of chess on Skype chat. 

I gave a presentation last week at the Value Investment Seminar in Trani, Italy (here is a link to the PDF). I strongly suggest you visit their website in a few weeks, as it will have presentations and videos.  It was a terrific event; I learned a lot. 

I spoke about China, Japan, and our favorite stock idea: eBay.  I changed the title of the China presentation to “China, the Mother of all Grey Swans” (instead of “Black Swans”).  A while back, when I shared this presentation with my readers, I was corrected: China is not a black swan, because a black swan is a rare, significant, and unpredictable event.  However, the consequences of what is transpiring in China and Japan are for the most part predictable (especially if I am writing about it).  We don’t know when they will play out, but they are predictable. 

 Nassim Taleb, one of my favorite thinkers, who brought the black Swan to life in his books Fooled by Randomness and The Black Swan (I like both books, but Fooled by Randomness is my favorite, plus, it is by far an easier read than Black Swan), solved my dilemma with China by creating a new swan: “grey”– a rare, significant, but predictable event (though the timing is still unknown, or perfectly known only with the benefit of hindsight.)  

 I spent a few days at the seminar discussing and debating China with some very smart folks, who stirred up some random thoughts.

 What really amazes me is how people who would not trust the US or European governments to do their laundry, have unconditional faith in Chinese government involvement in its very complex economy. 

 The Chinese government brainwashes its people the same way the Russians and Soviets brainwashed theirs: by controlling and censuring media.  So I understand when Chinese people who live in China speak highly of their leaders – they are brainwashed (I have experienced this first-hand).  However, I am amazed that the Chinese government has been able to brainwash people who reside outside of China. 

 No, an economy in large part controlled by the state is not superior to ours.  Greater control over their economy allows the Chinese government to pull the economy out of recession a lot faster than in the democratic countries, but there is no free lunch.  Their actions will just lead to greater excesses and imbalances down the road. 

 It seems that as Westerners we have an inferiority complex when it comes to Asian cultures.  Chinese uniqueness is praised today the same way Japanese superiority was in the 1980s.  I even remember reading Russian newspapers in Russia, in 1989, praising the Japanese work ethic and their unique culture and spouting predictions of the continuance of Japanese dominance.  I can only imagine how the mainstream press in the US was caressing Japanese uniqueness in the late ’80s, especially as the Japanese were invading (buying) Times Square and the State of California. 

 What is very interesting about it is that today all those Japanese cultural advantages are looked upon as disadvantages.  For instance, “saving face” did not allow Japan to deal sufficiently with failed companies; their economy was full of semi-dead, zombie companies, which did not allow the healthy ones to prosper.  Their employment-for-life system that was praised to the heavens during the Japanese golden age is now killing productivity of the economy.  I recently read that 12-17 million people in Japan are employed who should not be employed (for an economy of 120 million people, these are huge numbers).  In other words 12-17 million Japanese show up for work every day and receive a paycheck, but add little or no value to their employers. 

 Back to China.  Even if the Chinese are harder-working and more entrepreneurial than Americans and Europeans, that doesn’t mean the laws of economics are somehow suspended in China – they are not.  The Chinese economy was geared for high global growth, while now much lower growth is in the cards. The excesses created by 14% of GDP being “stimulated” into the economy through a fire hose have led to significant overcapacity.  It will take time for these excesses to be dealt with, even in a country full of super-hard-working people. 

 A friend asked, “But what about Singapore; its government plays a significant role in the economy, and Singapore is thriving.”  The clear answer: government can only succeed in running very small and relatively simple economies.  Let me give you this example.  I have a game on my iPad called Flight Controller – my kids love it.  The point of the game is simple: you are an air-traffic controller and your job is to land planes.  Planes come in three colors, red, yellow, and blue, and each plane has to be landed on the runway matching its color.  The objective is not to have mid-air collisions.  I can land ten planes no problem, twenty gets more difficult, and forty I cannot handle (Okay, I played the game a few times).  The same is true for economies: the more complex the economy the more difficult it is to be centrally planned. 

 Government is not and never will be an efficient allocator of capital.  It empowers bureaucrats, which in turn leads to corruption, which further misallocates capital.  The size of the bribe or strength of the personal relationship decides the flows of capital instead of the invisible hand that funnels capital from low to high uses.  (A side point: Singapore is one of the most uncorrupt countries in the world; this may explain in part the government’s success.  China is not Singapore; it is infested with corruption).

 I often hear that you have to go to China to understand it.  But tourists who go to China don’t see the real China, the same way that tourists who go to Moscow don’t see the real Moscow.  I was in Moscow a few years ago, and I was impressed by how clean and beautiful it looked; in fact it didn’t look much different from the center of Brussels.  Of course, I was only in the center of the city, where you see fancy restaurants, gift shops, museums, theaters, etc.

 I went to see my college friend who lives in the real Moscow – I saw a very different picture.  The second you veer off the main road, it turns into pothole hell, and the streets are anything but clean.  My friend lives in a nine-story apartment building that has not been painted in decades; paint is peeling both inside and outside.  Interestingly, most of the sides of the buildings that face large streets in Moscow and in Murmansk (the city where I spent all my Russian life) are usually painted, but the sides that face small streets have not been painted in generations. 

 My friend – a lawyer – and his wife and kid have to live with his mother, as they cannot afford to live on their own.  But you won’t see this Russia if you are a tourist visiting Moscow.  People who visit China even multiple times harbor an illusion that they understand it – they don’t.  In fact they so overwhelmed by its grandness that they stop being rational in their analysis. 

 I keep thinking about the possible consequences of the Chinese overcapacity bubble pop.  It is relatively easy to understand what will happen in Japan: deflation will quickly turn into hyperinflation as government is forced to print money to service its debt and social obligations.  They’ll announce and may even execute austerity measures, but those will be a decade or two too late.  The Japanese yen will likely decline, though maybe not right away, as Japan owns a lot of US dollars and may be forced to sell them. 

 The Chinese situation is far more complex.  China has tremendous overcapacity, but overcapacity is deflationary.  It will drive prices for commodities down, and prices of Chinese-made goods will likely decline as well.  Demand for industrial goods will collapse, pushing their prices down.  But China will also have to deal with a lot of bad debt and will likely have to print money to do so – which is inflationary. 

 The popping of both the Chinese and Japanese bubble economies will lead to higher US, and likely global, interest rates. 

 Japan, as the title of my presentation suggests, is past the point of no return.  Internal consumption of its debt will likely turn negative very soon.  Its post office, which includes a postal savings system that was historically one of the largest buyers of government debt) announced recently that it will be a net seller this year.  The situation is out of the Japanese government’s hands.  It will probably not be able to intervene in the economy for much longer, so rates will rise and there will be little they will be able to do about it. 

 China is different from Japan.  Its government is trying to slow down lending, but at the same time we have started seeing news of possibly another multi-hundred-billion-dollar stimulus over the next few months.  The Chinese government’s actions are the wild card that will determine the duration and the magnitude of the bubble pop – the longer they intervene, the more dire the consequences will be.

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.

The software company will use the sales proceeds to repay short-term debt. If it was any other company I’d ignore this headline as a daily noise as this kind of things happens all the time. But Microsoft has $39 billion of cash and generates $16-$17 billion of free cash flows a year. Issuing short-term debt, for which Microsoft will surely pay higher interest than it receives on the pile of its cash makes absolutely no economic sense – zero.

Microsoft has $1 and $0.75 billion of debt that matures in 2019 and 2039, respectively. Ironically, though this debt comes with higher interest, it makes sense if the company believes that we’ll have significant inflation and it will be paying off its debt with inflated dollars.

When you are sitting on pile of cash that earns nothing, borrowing short-term (three years is short-term) makes no economic sense. It seems Microsoft finance department suffers from the same problem many investors do, it cannot sit on its hands, it has to do something even if it is losing proposition for the company and shareholders.

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.

Investing in Range-Bound Markets by Vitaliy N. Katsenelson (published in NAPFA Magazine)

Here is what my plans are: 

Friday April 30th

• Arrive in Omaha at around 10 am. 
• 1 pm.  2nd annual Cheap Talk.  You Are Invited.  Last year we had a group of about 30 people, and it was a blast .  Nothing fancy: water (this year with ice) and a thoughtful conversation.  It will take place on campus of Creighton University at Billy Blue’s Alumni Grill (you can find directions here ).   
• 3:30 pm.  I will participate in the “Value Investing” panel discussion. I am privileged to share the stage with Bruce Greenwald and David Winters.  Attendance is free, and I extend an invitation to you on behalf of the organizers of this panel.  (Now you see why the Cheap Talk gathering is where it is).  You can find more information on the panel here. ) 
• 8:30 pm. Book signing at Dairy Queen.  This could only take place in Omaha. Several hundred people will pack into a Dairy Queen, where a dozen authors will be signing books.  If you show your Berkshire meeting badge, you’ll get a free ice cream.  I’ll stop by for a half an hour. 
• 9 pm or slightly later.  Whitney Tilson’s party at the Marriott (the party actually starts at 8:30).  I also have a hidden agenda there.  Bill Gates was spotted at the Marriott with his father a few years in a row.  If I see Bill I’ll ask him to sign my iPad.  

Saturday May 1st.

• Early in the morning till about 3 pm. Buffett/Munger show.
• Post-Buffett/Munger show party, again hosted by Whitney Tilson (you see a pattern, Whitney is a party animal) at the Hilton attached to Quest Center. 

Sunday May 2nd 

• 10 am.  Markel brunch at the Marriott.  Tom Gayner, CIO of Markel, made a terrific presentation last year.  It is worth the cost of admission (OK, it’s free and they serve free brunch, but I found Tom’s insights terrific). 
• 12 pm.  Book signing at The Bookwarm (official signing starts at 11:30, but I’ll be late).   8702 Pacific St., Omaha, NE 68114
• 7:20 pm.  Leaving Omaha.  I’ll spend a few hours with my kids and then …

 Monday May 3rd

• Taking a morning flight to attend the Value Investor Congress in Pasadena.  This is the 3rd congress I’ll be attending (I spoke at the one in 2008).  It is a great event, the quality of the speakers is first-rate, and I’ll have a chance to catch up with friends I’ve made there over the years. 

Wednesday May 5th 

• Right after the Congress I’ll take a taxi to Wesco’s annual meeting, which is a just a few miles away.  Charlie Munger, who also happens to be the CEO of Wesco (a poorly run conglomerate) gives a speech and answers questions for hours.  You don’t have to be a shareholder to attend.  Usually, few questions are asked about Wesco’s business.  If people own the shares they are probably too ashamed to admit it, and for good reason:  Wesco’s stock has not gone anywhere for years, it has a horrible return on capital, and earnings have stagnated since forever; in other words Wesco is a good example of how not to run a business.  (These comments guarantee that I’ll get a few angry emails defending  Mr. Munger and the stock).  I skipped last year’s Wesco meeting as I missed my kids too much and took an early flight home.  I’ll try to attend it this year, though, because Charlie does offer a lot of good insights. 
• Whitney Tilson is hosting a cocktail reception after Wesco’s meeting.

 July 13-14 – I’ll be speaking at the Value Investor Seminar in Molfetta, Italy.  This is my first time, but I’ve heard from friends who attended/spoke there that it is a one-of-a-kind event.

 July 20-23 (exact day to be determined) – I’ll be speaking at the Agora Financial Investor Symposium in Vancouver.   I’ll take my family with and we’ll make a vacation out of it.

More Random than Usual Thoughts

I have not written earth-shaking in a few months (rewriting the China article for Christian Science Monitor doesn’t count).  I don’t know whether I just haven’t felt inspired, did’t have any good ideas to share, or have simply suffered from a mild version of writer’s block.    I did however update my China presentation. 

Here are my random thoughts on the economy.  I read reports of this fairly robust economic recovery and I don’t know if I should praise human ingenuity and capitalism or the resourcefulness of  Uncles Sam and Ben.  Existing home sales are rising and new home sales are skyrocketing, up 27% in March; but these signs of recovery are likely to be false positives, since people are running to buy houses before the homebuyer tax credit expires in April.  

Consumers are behaving as if they didn’t read the memo on the new normal: they should be unemployed (or underemployed), scared, deleveraging, and frugally buying necessities – but so far the data is not supporting this.  AmEx reported a 16% growth in credit-card balances in the first quarter; and retail sales, though coming off a low base, are recovering.   (Capital One, however, saw a 6.8% contraction of card balances. I need to dig deeper to understand the differences.)   

I keep picturing the consumer debt-to-GDP chart, where debt as a percentage of GDP was gradually growing for decades until 2001, reaching about 60%; and then in less than a decade it skyrocketed to over 90%.  The market is a discounting mechanism; it spends little time dwelling on the past and focuses on the future. Maybe consumers are doing the same, looking past their current problems, and so their spending reflects tomorrow’s (expectations of) a robust job market.  Or maybe old habits die harder than we expected?  Of course if you fall into the 10% of Americans that are unemployed, or the 17% that are underemployed and can barely pay today’s bills, you may find it hard to spend the money you don’t have.  There is another (though slightly cynical) explanation: consumers are diverting their mortgage payments, which they are not making, towards their everyday purchases.  

Unemployment benefits muddy the economic waters.  Many unemployed have already exhausted their original unemployment insurance, which usually lasts just a few months, and have been receiving extended benefits courtesy of the US taxpayer.  The President just signed another $18-billion unemployment benefit extension into law.  For an average American who is unemployed, it makes little sense to look for a job if you can collect unemployment benefits.  The median income per family is about $54,000 a year,  or $27,000 a year or $2,250 a month per median person.  Unemployment benefits amount to, say, $1,600 a month.  Though the $650 a month (or $7,200 a year) difference between a paycheck and an unemployment check should encourage one to look for a job, it might not if you consider the cost of day care (especially if you have 2.7 kids), transportation to and from work, the cost of buying lunch, time not spent with kids, etc.  I know a few people who’ve been unemployed for longer than a year, collecting unemployment benefits, and are not looking for a job, or would only take a job as good as the last one they lost – they are satisfied with the unemployment benefits.  

I understand the need to extend the unemployment compensation during a very severe recession; however, continuous extension of unemployment benefits creates strong disincentives for people to work, it neuters creation of new businesses, prolongs unemployment, and leads us towards higher government debt and taxes.  This is exactly what has been taking place in Europe for decades.   I have a simple solution: every time unemployment benefits are extended, reduce them by 20% or 30%.  This should telegraph the right message, that over time the gap between paycheck and unemployment check will increase, and preparing people for the inevitability that unemployment benefits will not be extended forever. 

Uncle Ben went off quantitative easing in the mortgage market in late March, or, in plain language, the Federal Reserve stopped buying mortgages of Fannie and Freddie in the open market, which had been keeping mortgage rates artificially low.  Of course, the Fed stopped doing this after going through a trillion dollars (billion doesn’t impress anyone, not anymore).  I am watching mortgage rates closely, because the Fed’s sudden absence from the mortgage market should, in theory, drive interest rates up.  Practice so far disagrees with theory: mortgages rates ticked up a little in early April and then declined again.  Mortgage rates are extremely important to the housing market, as they determine housing affordability – higher interest rates, in the 6-7% range, may reignite a double dip in the housing market. 

Today, you’ll have a hard time finding a bank that wants to originate and keep fixed-rate mortgages on their books when interest rates are at 5% (this is why almost all mortgage originations are backed by Fannie or Freddie).  First of all, they don’t want to expose their balance sheets to significant interest-rate risk if/when rates rise, which is a common expectation, but they can hedge that. Second, and most importantly, at 5% you are not charging enough for risk; and finally, why bother with extra paperwork if you can borrow at close to zero percent and buy risk-free (or so we truly hope) government bonds instead?  Higher, free-market-set long-term rates may change this behavior. 

This was not your typical garden-variety recession caused by excesses in the corporate sector, it was a consumer-driven recession, thus the recovery should be different as well.  So far economic data points to a typical economic recovery; however, the stimulus that went into the system to jumpstart this economy was not your typical garden-variety stimulus either.  Thus sustainability of this recovery is questionable.  

If you positioned your portfolio for a less-than-robust recovery, the tape was not on your side over the last few months.  I am writing the following as much for my sanity as well as for you, my dear reader: the stock market is a marathon not a sprint, and there will be periods of time when the strategy (temporarily) stops working and the best thing to do is to do nothing.  Last week a few of my stocks reported what I thought were terrific earnings, and the market either yawned or took the stocks out and shot them (that is what has happened to eBay).  Instead of letting market get to me, I took a day off, went with my kids to the museum, and didn’t think about the market. 

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.

We are pleased to invite you to an upcoming International Executive Roundtable on Thursday, April 15, 2010 to be held from 12 noon to 1:30 PM.  Vitaliy Katsenelson will address the topic “China—The Mother of all Bubbles and Japan—Past the Point of No Return”.   

Vitaliy Katsenelson is director of research and a portfolio manager at Investment Management Associates, Inc., a value investment firm based in Denver. He is the author of the book “Active Value Investing: Making Money in Range–Bound Markets”.  He also taught the graduate business class, Practical Equity Analysis, at the University of Colorado Denver for seven years.  A native of Murmansk, Russia, he holds undergraduate and graduate degrees in finance from the University of Colorado Denver.  

This roundtable will be held in the XMBA Auditorium in the CU Building, located at 1250 14th Street, Suite 150.  Lunch will be provided by the Institute for International Business.  Please RSVP for this event by Tuesday, April 13 via email to melanie.ellison@ucdenver.edu or by calling 303-315-3710.  Space is limited, and reservations will be taken on a first-come, first-served basis. 

Facebook

I created a new Facebook profile where I only have a few dozen friends, and I’d like to keep it that way.  However, if you just want to follow my random thoughts and have a discussion online, I created a new page on Facebook just for that: http://bit.ly/vnk-fb .  Also, here is my Twitter page: http://twitter.com/vitaliyk . 

Vodafone

Vodafone (VOD) stock is finally starting to show signs of life.  I’ve discussed it a few times in the past (in these interviews with TechTicker and Barron’s); also here is a one page summary of our thinking on the company.   In short, Verizon (VZ) has two businesses – a wireline business and Verizon Wireless.   Verizon owns 55% of Verizon Wireless and Vodafone owns 45%.   Verizon Wireless has not paid dividends to Vodafone since 2005 and thus the street puts almost zero value on Vodafone’s stake in Verizon Wireless.  There is the misperception that Verizon, the majority shareholder, is trying to royally screw a minority shareholder.  This perception is utterly wrong.  

Verizon Wireless was building out its network aggressively since 2005, thus tens of billions in cash flow were reinvested back into the wireless business for which it is reaping rewards today.  Also, a few years ago Verizon Wireless bought Alltel and borrowed around $30 billion to finance it, a good chunk of which came from the Verizon in intercompany loans.  Verizon Wireless did not pay dividends to Vodafone because it was paying down debt, which will be done within a year or so.  

The street is missing a very important factor: VOD has a veto power over Verizon/Verizon Wireless intercompany loans and large acquisitions;  thus Vodafone’s acquisition of Alltel and the intercompany loan that followed to finance acquisition were approved by Vodafone, and were in Vodafone’s best interests.  

But even if “evil” Verizon wanted to screw minority shareholder Vodafone and hoard the dividend forever, it could not.  After the Alltel intercompany loan is paid off, the only way for Verizon to get a hold of Verizon Wireless cash flows is for Verizon Wireless to pay a dividend to Verizon and Vodafone. 

 Verizon does need the dividend from Verizon Wireless, as Verizon’s wireline business doesn’t generate enough free cashflow to cover Verizon’s (the public company) dividend payments.  Verizon Wireless is the cash cow, generating about $10 billion of free cashflow a year, and is responsible for a large portion of Verizon’s free cashflow.  

VOD’s stock came to life yesterday after it was reported that Vodafone was putting pressure on Verizon to either pay out a dividend, merge with Vodafone, or spin off Verizon Wireless.  Every one of these scenarios would put appropriate value on Vodafone’s stake in Verizon Wireless.

 Russia

A friend found the very first interview I ever gave. It is very short, less than one page long (here is a link to PDF).  In 1997, I worked for a few months at Lipper Analytical.  Lipper interviewed some of their new employees in the company’s newspaper. 

 What it is interesting to me is how wrong I was about Russia in the interview.  I thought Russia had great potential in the 21st century because of its highly educated workforce and natural resources.  What I did not realize at the time was that natural resources are not a blessing but a curse for a developing economy, even if it is commodity-rich.  Capital gravitates to the highest, most efficient use.  Since return on capital in the Russian oil and gas industry when commodity prices were high far exceeded the returns in non-commodity industries,  capital was sucked out from non-commodity industries and flew to oil and gas.    

Although through government efforts defense industry production increased, most other industries either stagnated or weakened over the last ten years.  On top of that, commodity exports drove up the price of the Russian ruble, making non-commodity industries less competitive in the global market.  The software or other high-technology industries I fantasized about in 1997 never meaningfully developed.  Russia is a trick petrochemical pony.

 A joke comes to mind here, especially appropriate today since we are in the middle of Jewish Passover:  It took Moses 40 years to find a place in the Middle East that has no oil.  Now, if you think about that in the context of Russia, the lack of natural resources was a blessing for Israel, as it was forced to develop a high-technology industry.    

Randoms

•  I had an article (re)published in Financial Planning Magazine (here is a link).  In the article I make a case for strenuous regulation or breakup of too-big-to-fail financial institutions. 
•  If you did not see it, here is my article in the Christian Science Monitor: “China: the coming costs of a superbubble.”
•  An excellent article in BusinessWeek describes what is taking place in Venezuela (here is a link).  If you had hopes that government intervention could make things better for the economy, read this article.  I was reading and vividly recalling images of supermarkets in Soviet Russia: the government was the economy, prices for everything were centrally set, grocery store shelves were empty, there were long lines to buy poultry, meat, and even toilet paper, etc.  I remember my mother running to another part of town on a tip from a neighbor that a store had a delivery of chickens.  So if you think government will do a better job in the US running healthcare, I wouldn’t be too sure about that. 
•  And here’s a terrific white paper about the Chinese bubble, by Edward Chancellor of GMO (here is a link to the PDF).

My firm, Investment Management Associates, is looking to partner with financial planners/advisors to offer our unique portfolio management services to their clients.  We don’t do any financial planning, all we do is value investing.  You may contact me here.

 China: the coming costs of a superbubble

China may seem to have defied the recession and the laws of economics. It hasn’t. When China’s bubble bursts, the global impact will be severe, spiking US interest rates.

By Vitaliy N. Katsenelson

The world looks at China with envy. China’s economy grew 8.7 percent last year, while the world economy contracted by 2.2 percent. It seems that Chinese “Confucian capitalism” – a market economy powered by 1.3 billion people and guided by an authoritarian regime that can pull levers at will – is superior to our touchy-feely democracy and capitalism. But the grass on China’s side of the fence is not as green as it appears.

In fact, China’s defiance of the global recession is not a miracle – it’s a superbubble. When it deflates, it will spell big trouble for all of us. 

To understand the Chinese economy, consider three distinct periods: “Late-stage growth obesity” (the decade prior to 2008); “You lie!” (the time of the financial crisis); and finally,  “Steroids ’R’ Us” (from the end of the financial crisis to today).

Continue reading it …

Then I shared my concerns about the Chinese economy – it has tremendous overcapacity in the commercial and residential real estate and industrial sectors (see this presentation: “China – The Mother of All Black Swans”).  As the Chinese economy painfully readjusts and chews through the excesses, Chinese demand for industrial, energy, and commodity goods will be significantly lower.  Thus in our portfolios we have reduced our exposure to these sectors.  

And finally, I explained our views on Japan.  As you’ll see from charts in the attached presentation (“Japan – Past the Point of No Return”), Japan has an enormous amount of debt (second only to Zimbabwe), a stagnating economy, and the oldest population in the world (this explains why the savings rate has declined from the teens towards zero).  These factors will lead to significantly higher interest rates.  

As an unbiased analyst it is hard to come to any other conclusion about Japan, and I am going to put it lightly: Japan is screwed!  As a consequence, we believe higher interest rates globally are unavoidable, as Japan, now the largest foreign holder of the US Treasuries (together with  China, the second largest holder), turns from buyer of Treasuries to net seller.  So in our portfolio we are making sure that our companies have strong balance sheets and/or significant free cash flows to pay off debt, if (more likely when) interest rates rise.   

With every country mentioned the potential investor got paler and paler; and before I got to the EU, a union that was created, as my friend John Mauldin put it, for prosperity not adversity, he exclaimed, “You are Dr. Doom!” 

I don’t have a PhD, thus I can only be called Mr. Doom – but I am not that either.  A joke told by Warren Buffett comes to mind: a patient, after hearing from a doctor that he has cancer, tells the doctor, “Doc, I don’t have enough money for the surgery, but maybe could I pay you to touch up the x-ray?”  Hope and self-deception are not a strategy.  I analyze and accept the conclusions of my analysis, no matter how painful they may be, and adjust my actions according to my findings.   I am neither a pessimist nor an optimist, I am a realist. So at my firm we look at risks and constantly ask ourselves: What can we do to avoid them (or benefit from them) in our clients’ portfolios?  So don’t call me Mr. Doom, call me Mr. Realist. 

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.

We flew in on Sunday, and were due to fly out to Bermuda from JFK Wednesday morning (my presentation in Bermuda was on Thursday evening).  Tuesday, I was visiting with my friend Marshall at Citigroup in downtown Manhattan.  At 3:40 I get a call from my travel agent that all JetBlue flights out of JFK to Bermuda on Wednesday are cancelled due to snow.   My travel agent tells me there is a flight leaving JFK to Bermuda at 5:30 (in one hour forty minutes). 

 I call my wife Rita, who is midtown (48 & Lex), a few blocks from our hotel.  I tell her, “I’ll pick you up in 20 minutes, pack up and be ready.”  I hail a cab and run the situation down to the cabby.  He says, if we go to midtown we are not going to make it to the airport.   I call my wife and ask her to take her own cab to the airport. 

 At 5pm that day I was supposed to be on Fox Business with Cody Willard.  I called Cody, explained the situation, and apologized for having to cancel.  Cody, being a gentleman, wished me good luck.  Lesson 1:  Don’t cancel your appearance on Fox Business, even if you have to catch an earlier fight; it won’t lead to anything good (as you’ll see). 

 We are in separate taxis, heading to the airport, when Rita’s cell phone battery dies.  I never get a chance to tell her that we are taking an American Airline flight from terminal 8.  I am at JFK at 4:45pm, run to the American Airlines counter, explain the situation.  I do the paperwork to buy tickets, but the tickets are on hold until Rita shows up (if she is late I don’t have to buy them).  I am trying to reach her but her phone won’t answer. I am running to every cab, looking through the windows for her – she’s not there.  I’ve been told 5:05 is the deadline.  It’s 5:15, and the lady at the American Airline counter is giving me a look – your time is up, but I’ll wait.  Lesson 2: Always be nice to the people at the airline counter. 

 I get a call from a phone number I don’t recognize.  It’s Rita.  She’s at Terminal 3, where she has borrowed a phone from a stranger.  With the little information she had, she had to assume we were flying out on JetBlue.  The American Airline woman sympathetically explains that Terminal 3 is at least 10 minutes away; Rita has to take the train to Terminal 8.  The plane will not wait another 10 minutes for just two people.  We did not make the Bermuda flight.

But my travel agent has a backup plan.  There is a Delta flight leaving from Boston at 8:30 the next morning (on Wednesday).  Boston is not expected to have bad weather, so it is the closest and safest bet.  We take what is supposed to be a 9pm flight from NYC.  The plane is delayed, and we board at 10pm.  It starts snowing.  Now we are in line to be de-iced.  Then we are in line to take off.  The 37-minute NYC-to-Boston flight takes a lot longer than that, and we check in to the Boston airport Hilton at 2am.  I check, and our 8:30am flight to Bermuda is still on.  We get barely 4 hours of sleep, show up at the airport, and find out that our Bermuda flight is cancelled – the tail of the storm that is hitting the Northeast is creating strong winds (that are only expected to intensify) way down in Bermuda, and the airport there is closed. 

 I call the organizer of the conference and we decide not to take a chance on tomorrow’s weather – we cancel the conference.  Despite the calm weather in Boston, a lot of flights are cancelled due to plane shortages, and planes from NYC and DC never arrive, so it’s impossible to fly from Boston to Denver (normally a 4-hour hop).  A very nice lady at the Delta counter finds me a flight from Boston to Denver.  The only problem is, it’s Boston-Orlando, Orlando-Atlanta (we have a 3-hour layover there), Atlanta-Denver – a 12-hour commute.  But the alternative is worse – being stuck 3 days in Boston.  (Lesson 2 applies here.) 

 I call my friend Greg in Atlanta to see if he wants to do a spontaneous dinner at the airport.  He says he’d love to.  Of course, our plane is ten minutes late to Orlando, so we miss our flight to Atlanta – but we get standby and make it to a flight that leaves 40 minutes later.  Our layover in Atlanta is shortened, but Greg picks us up from the airport, we go out for Sushi, great dinner, conversation – the first decent food we’ve had in 24 hours.  Lesson 3: Have a lot of friends in different cities.  The flight from Atlanta to Denver was uneventful. 

 This trip was very frustrating, but it is full of good lessons. 

 Lesson 4: Have a good travel agent.  I am a fairly computer-savvy guy.  I know how to use Orbitz, but I always use a travel agent – Alex Acherkan.  And he is always there to protect my back.  He brings very valuable experience that human-less (though, I am sure, extremely efficient) Orbitz doesn’t. 

 For instance, when I was buying the NYC-Bermuda flight at the counter in JFK, he warned me to make sure to tell them we needed a flight from JFK to Bermuda through Boston; otherwise they’d charge us $850 per ticket instead of $260.  He was right.  Ticketing should make sense, but it doesn’t. At the counter, the Delta person said, “Your ticket will be $850.”  I relayed her what my agent told me, and magically the $850 turned into $260.  If  you travel a lot, and sometimes I do, having someone to rely on when things go wrong – and they often do – is very comforting.  I know this: without Alex’s help we’d still be stuck somewhere.  Now, at least, we are spending time with the kids.  (Here is Alex’s contact info: aleks.acherkan@frosch.com (303) 910-5299.)

 Lesson 5: When life hands you a lemon, , be thankful that life did not hit you on the head with a brick.  There was a lot of frustration, running, waiting, boarding, and unboarding of planes, a little bit of worrying (people at the other end depended on me: 220 people in Bermuda were going to come to hear me speak.  I also hated cancelling Fox Business interview and putting Cody in a bind). 

 But through all this Rita and I made the choice (and it was a choice) to maintain a good attitude.  I heard some people at the Delta counter who were upset at their cancelled flights saying that it was the worst day of their lives.  It made me think.  I shared this with my friend Marshall, and his comment was, “I wish that was the worst day of my life!”  He is right!  Our kids were safe with their grandparents. We had each other.  We were not hungry, not cold, there was a roof over our heads.  We were alive.  Believe it or not, we were laughing throughout this whole adventure and that made all the difference in the world.  

 Lesson 6: No could have, no should have.  We were constantly making decisions with imperfect information.  As in the stock market, hindsight provides the perfect clarity that you lack at the moment when you decide.   Knowing what I know now, I should have just left for Bermuda a day earlier.  Or left for Denver directly from NY (direct 4-hour flight), instead of going to Boston.  But I did not know what I now know. 

I received a last-minute invitation to a very interesting investing conference in Miami next week, so I am there Wednesday through Friday – the weather gods willing. 

We’ll reschedule the Bermuda presentation for some time in March. 

 I hope you are having a wonderful time even if you are stuck at the airport, snowed in, or your trip to someplace warm(er) has been cancelled (happened to few friends of mine already).

China – The Mother of All Black Swans – By Vitaliy Katsenelson
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But the comment that really drew my attention was not about the collusion, but what the best banker in the country – Jamie Dimon, the head of JPMorgan – thinks about the Chinese banking system.  In this excerpt, an employee who was present at the meeting sums up Jamie’s thoughts on China:  

Considering to buy a stake in a bank in China and asked if it makes sense to do so at current prices. Jamie replied that the concept is ok, but not now, too expensive, adding that so far “in China it is a one way street” with them wanting to get all and letting you get nothing, and that there will be more and better opportunities when China has a downturn. 

Also, too difficult to know what you are buying: many of them do not yet have integrated systems, possibly a meaningful amount of political loans, etc. [emphasis added] 

Jamie is not your typical banker; he doesn’t dance (like Chuck Prince) just because the music is playing.  His caution, long-term thinking, and contrarianism (he cut off risky lending before everyone else) made JPMorgan a  victor in the recent financial meltdown, at least in relative terms.  The stock price is still down from the pre-crisis level, but it is not in single digits or the teens, like Citigroup (C ) or Bank of America (BAC).  I’d be listening carefully to what he is saying about the soundness of the Chinese banking system. 

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 my future articles by email, click here.

•  A Few thoughts on the Burlington acquisition »
• 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 »

 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 »

 I’ll be giving a talk about Active Value Investing to the Bermuda CFA Society on February 11th.  On the way to Bermuda my wife and I will spend three days (February 7-9th) in NYC.  Then, as a Valentine’s present to each other, we’ll spend four days (kids-free) in Bermuda.  I have to thank Skype for my wife agreeing to leave the kids (girl, 4 and boy, with their grandparents for a week. 

I’ll be speaking at the CFA Institutes’s conference on March 9th, in Phoenix. 

I am going to the Berkshire Hathaway annual meeting.  The main event is on Saturday morning (May 1st) till about 2pm.  The quality of the main event improved substantially last year as the questions asked focused on business/economy not on “what is your relationship with Jesus?”  This was due to a change in the Q&A format.  But let’s make it clear that the trip to Omaha is not really about listening for six hours to Buffett and Munger.  In fact you could save time and money by reading transcripts of the Q&A sessions on the internet.  The trip to Omaha is a chance to spend a few days around like-minded value investors – I get to talk to people who speak the same “value” language.  This is why I’ll arrive early Friday morning (April 30th) and leave late Sunday evening (May 2nd).   

Last year a few friends got together at the Doubletree hotel for cheap talk and drinks (mostly water, no ice) and we had a terrific time.  We’ll have an informal get together in Omaha again, exact time (most likely around 1pm on Friday) and place yet to be determined.  You are invited.    

I fly back to Denver on Sunday, spend a few hours with my family, and then the following Monday (May 3rd) I fly to Los Angeles to attend the Value Investing Congress, which actually takes place in wonderful Pasadena.  I’ve attended the Value Investing Congress the last two years (presented in 2008).  It is a great continuation of the Berkshire weekend.  Again, you can get the list of stocks presented at the congress on the internet, but the interaction experience is difficult to replicate.  Also, right after the congress adjourns, the buses take you to Wesco’s annual meeting, where Charlie Munger holds nothing back (no political correctness there) and tells you what he really thinks.  

More information on my travels and speaking engagements can be found on my website.

Lack of tight regulation in the TBTF space leads to the worst economic system of all: asymmetric socialism. The enormous gains are reaped by employees and shareholders, but losses are socialized and paid by taxpayers.  That is simply immoral. 

Letting companies fail is at the core of capitalism’s DNA, and I still stand by that.  However, what we’ve discovered over the last few years is that if we  let TBTF banks go bankrupt, their failure may take down other healthy (interlinked) financial institutions and derail the real (nonfinancial) economy.  We saw glimpses of that about to happen when Lehman went bankrupt.  If the government hadn’t stepped in to guarantee money-market funds (and almost everything else on earth), the real economy would have stopped in a few days, with massive withdrawals of funds from money markets and a shutdown of the commercial paper market, which in turn would cut off healthy companies like IBM from regular day-to-day activities like financing their inventories and paying their employees.

Our financial system operates on the assumption of continuity: we assume tomorrow will arrive and that we’ll be able to get our money out of the banks if we want to.  A failure of large financial institutions is akin to an earthquake of magnitude 9 on the Richter scale taking place in NY, but with aftershocks of 7 magnitude ripping throughout the country; and at the end of the day (or the week) the whole country ends up in ruin.

I could be wrong, and the failure of a large bank might end up being not such a significant event, but we will NEVER find out, as the cost of being wrong is too high.  So we end up with the imperfect world we live in – the big banks will not be allowed to fail. 

This imperfect world leads us to two realistic solutions:  (a) create incredibly strenuous regulations that will require significantly higher equity-to-debt ratios than for smaller banks and severely restrict the activities of TBTF institutions.  Basically, they need to be turned into regulated utilities, like your local gas and water companies.  Permit their “God’s work” to be limited to only very transparent traditional banking activities – so they cannot fail.  Separate the leveraged hedge fund (the proprietary trading operation) and the bank (the institution that takes deposits and makes loans).  In other words, bring back a more sophisticated version of Glass Steagall act.

Or we have option (b): break them up, either by making their lives unbearable through the strenuous regulation described in option (a), or simply by legislating it, as was done with AT&T in the 1980s. 

There are upsides and downsides with each solution.  I personally believe regulations of complex systems often fails, as Wall Street always figures out how to game the system.  Fannie and Freddie had a single regulator, OFHEO, whose sole job was to insure their viability.  That didn’t work out well.  Of course Fannie and Freddie also had a conflicting goal: they had to report to HUD that they were providing enough financing to low-income households.  (Canada, on the other hand, is dominated by just a handful of very large banks that are strenuously regulated and were almost unscathed by the recent financial crisis.)

Breaking them up is what makes the most sense to me.  Break them into small enough pieces that their failure becomes a non-event for the economy as a whole.  That way failure will not be socialized, but borne by those who were to reap the rewards, rather than your regular Joe and Jane Six-Pack having to fork over a chunk of their paychecks to “bail out” the TBTFs so they can keep their jobs. 

Intense regulation of TBTF institutions will slow economic growth, but to its natural, sustainable level.  As we have learned, the other type of growth, though fun for a while, has a price tag that only increases with time. 

Regulation may even stiffen innovation. I love innovation; I buy anything that has an “i” in front of it – I may even buy Apple’s iPad.  But Wall Street and our economy as a whole would have been better off if, over the last decade, Wall Street was less “innovative” and employed fewer mathematicians with PhDs.  Their latest & greatest innovations – the financial products that through sophisticated, ingenious, mind-boggling formulas (that often lacked common sense) showed their bosses how to create higher financial leverage on top of already high financial leverage – were responsible for the bombs that were at the heart of many recent blowups.

Breaking up TBTF will face the criticism that smaller banks will be less efficient and thus borrowing costs will be higher for consumers and corporations.  This would be true if TBTF banks did not come with marble conference rooms, million-dollar executive offices, fleets of corporate jets, and $100-million compensation packages.  The bottom line, if you compare the financial metrics: smaller banks are not any less efficient than the large ones.

A greater government involvement in the financial sector is not something I thought I’d ever ask for, but it has turned into a necessity in order to preserve, not destroy, capitalism.  

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).

• Chinese Quest for Shortcut to Greatness »
• The case for Pfizer »
• Welcome to Another Lost Decade » 
• Barron’s: Economic Steroids Are Toxic, Too »
• Q&A with FT:Investing in Range-Bound Markets »
• Dubai’s Shot to the Moon »

To understand what’s taking place in China today, we need to rewind the clock about a decade. At that time the Chinese government chose a policy of growth at any cost. To achieve that, it kept its currency (the renminbi) at artificially low levels against the dollar — this helped already cheap Chinese-made goods become even cheaper than its competitors’. The US and global consumers were eager to buy them. China turned into a significant exporter to the US. Normally, if free-market economic forces were at work, the renminbi would have appreciated and the US dollar would have declined. However, if China let its currency appreciate, its exports would have become more expensive and the demand for Chinese products would have declined, and its economy wouldn’t have grown at 10% a year.

But China isn’t your local democracy, and it needed to grow at any cost. So instead, through the government-controlled banking system, China accumulated a couple trillion dollars of foreign reserves in US dollars and euros.  This had an unintended consequence: It helped keep US interest rates at very low levels, and lent a friendly hand in the financing of a huge consumption binge by the US consumer (i.e., China’s largest customer).

The more China sold to the US, the more dollars it accumulated, and thus the more US Treasuries it bought, driving our interest rates down. The US consumer was in turn happy to leverage its future (through the “always” appreciating asset, its house) and delighted to consume cheap Chinese-made goods. (I’m not dismissing the role in what took place of many other factors, like lack of financial regulation; missteps by rating agencies, the Fed, and politicians; securitization; etc., but I don’t want to steal the spotlight from China).

This symbiotic match made in heaven between China and the US consumer worked great as long as housing prices kept rising and the financial machine kept multiplying dollars. But all good things come to an end, and great things come to an end with a bang. The financial meltdown erupted upon us, the US and global banks started dropping like flies … well, you know how that story played out.

So now let’s fast forward a year. Today the global economy is stabilizing, thanks to Uncle Sam and various other “uncles” around the world. But the consumers of Chinese-made goods are overleveraged and now deleveraging, unemployment is high, the banks have got religion and aren’t lending, and there’s not much demand for loans anyway (except from the US government).

Despite this, the Chinese export-based economy, a manufacturer to the world, has clocked growth of 8.7% in 2009. The rest of the world looks at the Chinese growth miracle with envy; it seems that China has got economics figured out. But don’t hurry to trade your democracy for an authoritarian system. The Chinese grass is not as green as it appears. First, China lies. One shouldn’t believe all the economic numbers that are put out by the Chinese government. This is the government that magically managed to report 6% to 8% GDP growth in the midst of the financial crisis, when its exports were down more than 25%, tonnage of goods shipped through its railroads was down by double digits, and its electricity consumption was falling like a rock. It’s hard to manufacture 8% more widgets with a lot less electricity, and no, China didn’t suddenly become energy-efficient during the financial crisis: Electricity consumption rebounded in a few months once the stimulus kicked in.

Despite reported rosy GDP growth, the Chinese economy was contracting during the economic crisis. But don’t be surprised, this is a government that will go to great lengths to maintain appearances to keep its ideology going.

Second, China will do anything to grow its economy, as the alternatives will lead to political unrest. A lot of peasants moved to the cities in search of higher-paying jobs during the go-go times. Because China lacks the social safety net of the developed world, unemployed people aren’t just inconvenienced by the loss of their jobs, they starve (this explains the high savings rate in China) and hungry people don’t complain, they riot. Once you look at what’s taking place in the Chinese economy through that lens, the decisions of its leaders start making sense, or at least become understandable.

Unlike Western democracies, where central banks can pump a lot of money into the financial system but can’t force banks to lend or consumers and corporations to spend, China can achieve both at lightning speed. The Chinese government controls the banks, thus it can make them lend, and it can force state-owned enterprises (one-third of the economy) to borrow and to spend. Also, because the rule of law and human and property rights are nascent in its economic and political system, China can spend infrastructure project money very fast — if a school is in the way of a road the government wants to build, it becomes a casualty for the greater good.

China has spent a tremendous amount of money on infrastructure over last decade and there are definitely long-term benefits to having better highways, fast railroads, more hospitals, etc. But government is horrible at allocating large amounts of capital, especially at the speed it was done in China. Political decisions (driven by the goal of full employment) are often uneconomical, and corruption and cronyism result in projects that destroy value.

Infrastructure and real estate projects are where you get your biggest bang for the buck if your goal is to maintain employment, because they require a lot of unskilled labor; and this is where in the past a lot of Chinese money was spent. This also explains why, in 2009, new floor space constructed was up 100% and residential real estate prices surged 25%. And this explains why they keep building skyscrapers even though the adjacent ones are still vacant. To make things worse, before the financial crisis and enormous stimulus, China was already suffering from what I call late-stage-growth obesity, inefficiencies that are a byproduct of high growth rates sustained for a long period of time. Though Chinese growth in the past was high, in its late stages the quality of growth has been low.

For example, in an echo of past Chinese government asset-allocation decisions, China built the largest shopping mall in the world, the South China Mall, which is 99% vacant years after construction. China also built a whole city, Ordos, in Inner Mongolia, on spec for one million residents who never appeared.

The inefficiencies are also evident in industrial overcapacity. According to Pivot Capital, Chinese excess capacity in cement is greater than the combined consumption by the US, Japan, and India combined. Also, Chinese idle production of steel is greater than the production capacity of Japan and South Korea combined. Similarly disturbing statistics are true for many other industrial commodities. The enormous stimulus amplified problems that already existed to financial-crisis levels. China is a less shiny but more drastic version of Dubai.

There is speculation that the Chinese consumer will pick up the demand slack for the US and European consumers who are deleveraging and buying fewer Chinese-made goods. This may happen, but it will take decades. The US and European consumers are two-thirds of much larger economies. The Chinese consumer is only one-third of the Chinese economy, and its purchasing power is significantly undermined by the undervalued renminbi.

We look at China and are mesmerized by its 1.3 billion people, its achievements of the last decade, its recent economic resiliency, and its ability to achieve spectacular results on the fly. But we have to remember that economic bubbles are usually just a good thing taken too far. This was the case with railroads in the US in the late 19th century: The railroads were supposed to change the landscape of the US, and they did, but that didn’t prevent a lot of them from going out of business first and investors losing money. The Internet was supposed to change how we communicate, and it did, but in the process it generated a tremendous bubble, followed by the loss of wealth for many. The Chinese economy is no exception. Its long-term future may be bright, but in the short run we’ve got a bubble on our hands.

Everyone wants a shortcut to greatness, but there isn’t one. It would be great if the word (economic) cycle only existed in a singular form, and the only cycle we had in the economy was happy expansion. If there were no cycles, there would be no painful recessions. But as heaven couldn’t exist without hell, or capitalism without failure, economic expansion can’t exist without recession. China has been trying to bend the laws of economics for awhile, and with the control it exerts over its economy it may seem, at least for a short while, that the laws of economics work differently in China. But this is only a temporary mirage, which must be followed by huge pain and drastic consequences. No, there’s no shortcut to greatness, in anything, not in politics, not in personal life, not in economics.

P.S. The last paragraph on “shortcuts to greatness” doesn’t just apply to China (though China, through much greater control of its economy, took it to a new level); it applies to the US, Europe, and Japan as well.  Over the last several decades our respective governments intervened in free markets and actively tried to manage the business cycle – only expansions, or just mild recessions – and for this we are paying today.

More articles on China can be found here. 

• The case for Pfizer »
• Welcome to Another Lost Decade » 
• Barron’s: Economic Steroids Are Toxic, Too »
• Q&A with FT:Investing in Range-Bound Markets »
• Dubai’s Shot to the Moon »

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.

•  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.

Welcome to secular (long-lasting) range-bound markets or, in the tradition of giving pet names to market cycles, what I call the Cowardly Lion market, whose occasional bursts of bravery lead to stock appreciation, but are ultimately overrun by fear that leads to a subsequent descent.

Over the last 200 years, every long-lasting bull market (and we just had a supersized one from 1982 to 2000) was followed by a range-bound market that lasted about 15 years or so (the only exception was the Great Depression).   Despite common perception, secular markets spent a lot more time in bull or range-bound phases, roughly half in each, and only visited a bear cage on very rare occasions.  This distinction between bear and range-bound markets is seldom made but extremely important, as you’d invest very differently in one versus the other.

Let me explain why this takes place.  Though it is hard to observe in the everyday noise, in the long run stock prices are driven by two factors: earnings growth (or decline) and/or price-to-earnings expansion (or contraction).  Take a careful look at the two tables and you’ll be hard pressed to find an economic metric that was responsible for a stock market cycle. Though economic fluctuations were responsible for short-term (cyclical) market volatility, as long as longer-term economic performance was not far from the average, secular market cycles were either bull or range-bound.  Valuation – the change in price to earnings, its expansion or contraction – was mainly responsible for markets being in a bull or range-bound phase.

Prolonged bull markets started with below- and ended with above-average P/Es.  This vibrant combination of P/E expansion (a staple of bull markets, a great source of returns) and earnings growth, which doesn’t have to be spectacular, just more or less average, brings terrific returns to jubilant investors.

Range-bound markets follow bull markets. As clean-up guys, they rid us of the high P/Es caused by bull markets, taking (reverting) them down towards and actually below the mean.  P/E compression (a staple of range-bound markets) and earnings growth work against each other, resulting in zero (or nearly) price appreciation plus dividends, though this is achieved with plenty of cyclical volatility along the way.

The 1982-2000 the bull market ended at the highest P/Es ever! Thus it will take longer for earnings growth to deflate them.  Though continued economic growth appears to be a wildly optimistic assumption, given what is taking place in the economy, it is not particularly unrealistic to assume that we will see nominal economic growth over the next decade.  The Fed and our government are working very hard to achieve that, at any cost.

Bear markets are range-bound markets’ cousins; they share half of their DNA: high starting valuations. However, where in range-bound markets economic growth helps to soften the blow caused by P/E compression, during secular bear markets the economy is not there to help. Economic blues (earnings decline) throw water on an already dying fire (the compression of high starting P/Es) and bring devastating results to investors.

A true, long-lasting bear market has not really taken place in the US, but occurred across the pond in Japan, where stocks declined gradually, and not so gradually at times, falling over 80% from the late 1980s until today.  If the US economy fails to stage a comeback with at least some nominal earnings growth over the next decade, what started as a range-bound market in 2000 will turn into a bear market, as high valuations are already in place.

Let’s try to figure out the earnings power of the S&P 500.  The current 2010 estimates of its operating earnings are $75.  I am skeptical of these numbers for several reasons:

First, they are double those of reported 2010 earnings estimates of $45. The percentage difference between reported and operating numbers is the second highest since 1988.  (2008 holds the record.  During the 2001-2003 recession the difference was about 50%.  “One time” write-offs are responsible for the difference.  It is very likely that these “one-time” charges are not really “one-time;” thus operating estimates overstate the true earnings power of the market.

Second, 2010 estimates are only slightly below the all-time high earnings the S&P achieved in 2007, when our economy was under the influence of several bubbles, which at the time severely inflated corporate profit margins, to unprecedented levels.  Also, the bulk of excesses in margins came from the financial, materials, energy, and industrial sectors – the ones that are struggling today and will continue to do so for a long time.

Finally, if earnings were to be as projected, we’d be following the last recession’s recovery path, which is unlikely.  The last recession was corporate, while the current one is riddled with debt-laden consumers.  Deleveraging the excesses of the housing bubble, in the face of higher future taxation and likely higher interest rates (both byproducts of large deficits) will be a lengthy process.  The recovery will be slower and real earnings growth will be lower than in previous recessions.

It is hard to know the exact earnings power of the S&P 500, but it likely lies somewhere in between operating and reported earnings estimates, and thus closer to $60, putting the P/E of the S&P 500 at about 19.

Since 1900, stocks have spent very little time at what is known as a “fairly valued” P/E of 15, spending less than 27% of the time between P/Es of 13 and 17 (2 points above and below their “average” level).  They only saw a P/E of 15 when they went from one extreme to another.  Most importantly, they’ve never stopped at the average and gone the other direction: they’ve continued their journey to the other extreme.

During secular bull markets, investor optimism, bundled with constant reinforcement from rising prices, takes stocks to above-average valuations, causing P/Es to expand beyond their long-term average.

P/Es can shoot for the stars, but they don’t get there: at the late stages of the secular bull market P/Es stop expanding. As earnings growth becomes the sole source of returns, disappointed investors start diversifying away from stocks into other asset classes (real estate, bonds, commodities, gold, etc.) – and a range-bound market ensues.  As the range-bound market marches on, unmet expectations reinforce disappointment in stocks, and P/Es are compressed to the other extreme.

Keeping this in mind, note that stocks are still not cheap, and thus range-bound markets still lie ahead of us.

I should mention the role interest rates and inflation play in market cycles.  They are secondary to psychological drivers, but important.  They don’t cause the cycles but help to shape their duration and the valuation extremes stocks achieve.  For instance, if at the end of the 1966-1982 range-bound market interest rates and inflation had not been in the mid-teens,  the range-bound market would have ended sooner, at higher P/Es.  On the other hand, if in the late 1990s interest rates and inflation had not been scraping low single digits, the bull market would have ended sooner and at lower P/Es.  The higher inflation and interest rates that are around the corner will take their toll on the duration and final P/E of this market as well.

In range-bound markets, as P/Es compress they turn against investors; thus investment strategy in this very different and difficult environment needs to be adjusted for the new investment reality:

-         Become an active value investor.  Traditional buy-and-forget-to-sell (hold) strategy is not dead but is in a coma waiting for the next secular bull market to return; and it’s still far, far away.  Sell is not just another four-letter word; sell discipline needs to be kicked into higher gear.

-          Margin of safety needs to be increased.  Typically, value investors seek for margin of safety to protect them from overestimating the “E”.  In this environment it needs to be beefed up to accommodate the impact of constantly declining P/Es.

-          Don’t fall into the relative valuation trap.  Many stocks will appear cheap based on past valuations, but past secular bull market valuations will not be in vogue for a long time, thus absolute valuation tools such as discounted cash-flow analysis should carry more weight.

-          Though timing the market is alluring, don’t – it is very difficult to do it consistently.  Value individual stocks instead. Buy them when they are undervalued and sell them when they become fairly valued.

-          Increased margin of safety and stricter sell discipline will lead one to have a higher cash position at times.  Don’t invest for the sake of being invested, because this will force you to own stocks of marginal quality or ones that don’t meet your heightened required margin of safety.  Secular bull markets taught investors not to hold cash, as the opportunity cost of doing so was very high.  However, the opportunity cost of cash is a lot lower during a range-bound market.

And what if a range-bound market isn’t in the cards? If a bull market develops, active value investing should do at least as well as buy-and-hold investing or passive indexing. In the case of a bear market, your portfolio should decline a lot less.   (For  charts /  presentation / speech on this  subject visit this page).

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.

AS THE NEW YEAR OPENS, THE

The global economy, however, is like a marathon runner who ran too hard and hurt himself. This runner has been injected with some industrial-quality steroids, and away he goes. As the steroids kick in, his pace accelerates, as if the injury never happened. He’s up and running, so he must be OK, judging from his speed and his progress.

We may think the runner has recovered from his injury, but steroids have their costs. They exaggerate true performance and mask pain, and the longer an athlete takes them, the less effective they are. Addiction is likely.

The world’s economy suffered severe injuries last year, and to keep it going governments have injected massive doses of economic steroids called stimulus. It’s everywhere, but the U.S. is one of the biggest users.

To help the auto industry, government — more specifically taxpayers — subsidized the purchase of cars through the cash-for clunkers program, creating artificial demand. Uncle Sam also seems to be pumping lots of money into GMAC — the credit company that provides mortgage and auto financing and insurance and which formerly was a GM unit, but now is majority owned by Cerberus Capital and the federal government. 

Read more on Barrons’s website

[ Also read: Our Steroidaly Challenged Economy ]