Interview with author Vitaliy N. Katsenelson | Value Investing News

Interview with author Vitaliy N. Katsenelson

I am pleased to announce that Vitaliy N. Katsenelson, sponsor of this month's Value Investing News members contest and author of Active Value Investing, has agreed to particpate in an interview with me here at the Value Investing News Forum.

Vitaliy N. Katsenelson, CFA, has been involved with the investment industry since 1994. He is a portfolio manager with Investment Management Associates, where he comanages institutional and personal assets utilizing fundamental analysis.

He is also an adjunct faculty member at the University of Colorado at Denver, Graduate School of Business where he teaches a Practical Equity Analysis and Portfolio Management class. Finally, he is owns a blog called Vitaliy's Contrarian Edge.

Please refrain from posting on this thread until the end of my interview with Vitaliy. You can then either post questions in this forum thread or submit them using the contact form below.

Vitaliy, welcome to our forum, and thank you for taking time out of your schedule to answer some of our questions.

I've read that you have studied finance since you first started college. When did you discover that you were a value investor?

I don’t think I can pinpoint a specific moment; it was a gradual process as I started out as a GARP (Growth at Reasonable Price) investor. Stocks I owned were high quality companies. They were growing earnings, most paid dividends, but they were fairly valued and thus earnings growth and dividends were the main source of the return. What I discovered over time was that the growth is a lot more elusive than I realized. Also, if the growth was very predictable you had to pay-up for it.

For high quality companies, the ones that had a strong sustainable competitive advantage, maintaining high return on capital (on existing projects) usually is not an issue, but finding new, incremental projects that have high return on capital became more difficult over time – they already have high market share, the industry growth slows down with time and the law of large numbers kicks in.

I realized that in the long-run to generate superior returns earnings growth and dividends should be supplemented by the P/E expansion.

What motivated you to write Active Value Investing: Making Money In Range-Bound Markets?

As most key things in my life, including the birth of my kids, writing AVI was an accident. An instigator was an initial chapter that I wrote for a book that was compiled by an acquaintance. However, by the time I was done with that “chapter” it had the length of five chapters.

I compare my brain to a Caesar salad where ideas are like croutons mixed together with a lot of lettuce. Writing forces me fish out those croutons (insights) and organize them. This is in part why I like writing, often I don’t know how the article (or in this case the book) would look at the end. Over the preceding years I accumulated plenty of interesting insights through research, writing hundreds of articles and teaching. After the idea of the book was born, I was really excited to systematize, pull all my knowledge into a framework.

What were some of your biggest challenges in writing Active Value Investing?

The first one was logistical. Writing a book is like writing a couple hundred articles that are logically interconnected. Keeping the connection going was a bit hard, as two months into the writing I could not remember if I already mentioned something or not. Also, while writing a first draft I was concerned that I would not have enough material for the whole book thus I was very liberal with words - the first draft was dripping with verbal fat and repetition. In hindsight, it was a good problem to have as cutting is easier than writing. All I had to do was create a fairly detailed outline and do a lot of cutting and pasting.

The second issue was the prediction dilemma. In the first part of the book I make a prediction that over next dozen years or so we’ll be in a stagnating market that goes nowhere. I did not want to use “it happened in the past, thus it will happen in the future” argument; on its own it is fairly weak. I knew if somebody made that argument to me, I would not buy it – it is too simplistic. As I said in the book: “history is prolific about the past but is mute about the future.” However, after looking a great deal into 100 years worth of detailed data I realized that there is a very good reason why range-bound markets take place.

Finally, I realized that even the future will play tricks on us, and a very high probability event – the range-bound market – may not take place (i.e. long-term market trend will be bull or bear). The strategy I describe in the book should still do well or better than other strategies. It has the lowest cost of being wrong!

From my experience, I know I often learn a lot by writing. What did you learn as a result of writing your book?

Writing forces you to synthesize. Writing AVI forced me to learn from the good decisions, but more importantly from the bad ones. In fact, learning from the bad decisions is harder as revisiting these decisions brings plenty of pain.

Do the market's current actions confirm to your thesis that we are in a range-bound market?

This is a very important question. In the past secular range-bound market of 1966-1982, we have five small bull markets, five small bear markets and one small range-bound market. At the end all these markets cancelled out each other and the slope of overall market was fairly flat. In other words, if you bought a market index in 1966 (though at the time I don’t think they had an index fund yet), you would go through a very exciting rollercoaster ride, you’d collect stock dividends but at the end of 1982 your stock portfolio would be at roughly the same level as it was in 1966.

Today’s stock market action confirms my thesis; currently we are in a cyclical bull market. How long will it last? Will the next leg be cyclical bear or range-bound? I don’t know. I am not attempting to time the short-term cycle of the market, as I say in the book, ‘time (price) individual stocks’. Buy stocks when they are undervalued and sell them when they are fairly valued. And repeat this over and over again. Keep an eye on the (stock) ball, not the bowling alley (stock market).

Please describe a typical day in your life as a professional value investor.

I don’t really watch much TV, CNBC is usually muted in the background. Though lately I’ve been watching Fox Business channel. I try to read as much as possible. I find that I get easily distracted when I listen to conference calls, plus I am easily annoyed by analysts questions that focus on trees but don’t see the forest, thus I read conference call transcripts. This way I read it on my own terms (while listening to music) and I skim over analysts absurd questions.

I actively trying to avoid distraction, though that doesn’t always work (but I am trying). I build models, read newspapers, annual reports, and corporate filings. Talk on the phone or by instant messenger to my circle of trust. I usually take work home, read more after I put the kids to sleep. I always try to measure my emotional state, if I feel overconfident I look on the wall where I have an annual report of a company I lost a boat load of money on framed (no, it is not Enron or Worldcom).

What advice would you provide someone interested in becoming a professional value investor?

I cannot say it better than I said in this article which I wrote for Financial Times, and which is in the book as well. It is about the process. Look at your decisions in the context of the process. Of course it is also about controlling your emotions, not following the crowd – but you knew that.

In Active Value Investing, you describe an absolute PE valuation model you developed. Would you mind walking through an example of how you value stocks using your absolute PE model?

It is very straight forward. I forecast earnings growth rate over the next five years, using the reverse growth pyramid that I described in the growth chapter. I forecast the company’s dividend yield and based on a lot of fundamental analysis determine its business and financial risk factors and earnings visibility. Pulling this analysis together, I determine the company’s fair value P/E, required margin of safety which leads me to buy P/E. I adjust fair value P/E by a fundamental return (earnings growth and dividend) and get a sell P/E. All this supplemented with DCF and relative valuation analysis.

As you know from my review, I found Chapter 12: Sell Process - Make Darwin Proud to be one of the key chapters in Active Value Investing. In this chapter, you describe several methods for Darwinian style stock selling. Which of the techniques are you specifically using currently in your stock selling decisions?

I am using all the techniques I mentioned in that chapter. I set a target sell valuation at the time I buy a stock. I have a buy, hold and sell valuation for every stock in our portfolios. I don’t delegate sell decisions to someone else, but when my partner at my firm thinks we should sell a stock I recommended he has a super vote (for the stocks he recommended I have a super vote). I am a proactive seller; I try to sell before problems escalate. I sell stocks when they reach predetermined valuation target, in fact over the last several months we sold a handful of stocks and only bought one stock.

I believe the Sell chapter rivals importance with the Valuation chapter. I called the book Active Value Investing to emphasize the importance of sell discipline. In the secular bull market not to sell decisions were rewarded, as valuations were pushed into irrational extremes. Secular bull markets program us to be buy and (not sell) hold investors. However, during range-bound markets we need to actively think about selling.

We are all about finding and reading financial news here at Value Investing News. What news reading and tracking tips do you have for other members of the VIN community?

Read VIN!

You just made me blush. Thank you for the vote of confidence on Value Investing News. It's good to know that the site is useful for both individual and professional value investors.

Do you have any plans to write another book in the future?

I downloaded all the knowledge I accumulated over last 12 years into this book. As of today, I don’t envision writing another book for a long time. I spent evenings and weekends working on it, while keeping a day job and teaching a graduate finance class. To be honest I missed my kids. I don’t want to miss them growing up. I’ll write articles from time to time but that is far as I think my writing will go for now.

Thank you for your responses to my questions. Now we will open it up for questions from other members of Value Investing News.

George and Vitaliy thank you for making this interview possible. We're lucky have the opportunity to pick Vitaliy's brain. A few questions:

How do you measure your investing performance? How often do you reevaluate the intrinsic value of your positions? What are your thoughts on repurchasing a company after large drops in price? In what industries or companies do you currently see the most value?

Thank you,
-Nick

Nick, my pleasure.

On performance. We have a software program that tracks the performance of our portfolios. Our past performance is not representative of the Active Value Investing strategy as in the past we were more GARP managers. Also a lot of our taxable accounts have stocks with a very low cost basis which we could not sell and they have hindered our performance for some time.

We constantly monitor the companies we own by watching news flow. But on a quarterly basis we analyze their financials, listen to conference calls (actually read conference call transcripts) – the usual stuff. Before we buy a stock we identify value creators and destroyers for the company, which in turn drive the company’s valuation (i.e. sales growth rate, profit margins, return on capital etc…). We constantly monitor these important variables and adjust valuations accordingly.

On drops in price. This is a hard one. If a stock declines because of a short-term issue, something that has little impact on the long-term value of the company, we buy more stock. This is what we did recently with Jackson Hewitt. Sometimes a price drop is driven by a significant change in fundamentals. This was the case with Telecom New Zealand. When we purchased the stock the company enjoyed a cozy monopolistic environment. It was hard for competition to enter the New Zealand market as the market size was fairly small and territories were large. However, the NZ government went on a quest to open the market to competition – thus the industry dynamic has changed. We lost our insight into the business, not overnight but over several months period. We could not comfortably look into the future and even vaguely forecast what NZT’s profitability will be five years down the road. We sold the stock at a loss, but we maintained sanity.

Where do I see the most value. It is hard to pinpoint a specific sector where I see a lot of value. If you read my blog, you’ll see the type of stocks I’ve been buying - they are all over the lot.

Thank you for your thoughtful response to my questions. I might responsd again, but I finished my MBA application and took my daughter trick-or-treating last night so I'm thinking clearly enough for full response.

One thing did stand out to me:

"Also a lot of our taxable accounts have stocks with a very low cost basis which we could not sell and they have hindered our performance for some time."

I recently reread Buffett's Partnership Letters and he was responding to the tax concerns of a vocal partner. If I remember correctly he thought that purchase and sale decisions should never be made for tax reasons. If the capital would be better deployed somewhere else you should sell and redeploy. You can never avoid taxes, only defer them, and that the ultimate goal was the highest after tax rate of return, not the lowest tax burden. (This is just from my foggy memory- I could be wrong)

I understand that part of your job at your firm is tax management, but what are your thoughts? Long-term would your clients be better off if you had sold and redeployed that capital in your new ideas? Since you mention the low cost basis I assume that this wasn't a short-term vs. long-term capital gains tax (1 year holding period) problem.

Thank you,
Nick

Nick, you are absolutely right. Unfortunately it was very hard to convince clients that saw a huge portion of their wealth created by those companies that it is time to let them go and pay Uncle Sam for the privilege.

Thanks so much for the interview so far- very informative and I look forward to reading the book!
2 Simple Questions:

1. What does your daily reading look like? Newspapers, publications, etc?

2. You have the CFA designation; How important do you feel that is for future value investors who are interested in becoming value analysts and eventually managers?

Thanks a ton!

The usual: WSJ - I read it online though, I don’t like reading the paper version as I really hate jumping from page A5, to page B8 to read a full article; FT – get a better global perspective and I love James Altucher’s column; BusinessWeek – it is probably my favorite magazine, though I don’t look at it as a source of stock ideas but a source of company ideas. Reporters (and this is true to most business magazines) rarely make a distinction between a good company and a good stock – it is not their job. This is the reason why very often BusinessWeek’s cover story articles are contrarian indicators – they tell you how great or bad the company is, but it is already in the stock by that time; Barron’s – if I could only subscribe to one weekly publication, Barron’s would be it; Fortune, Forbes and Economist – I glance through them; FAJ (Financial Analysts Journal) – we get that in the mail, but it is usually too academic, I glance through it; blogs; VIN; Minyanville.com – most of the content macro oriented, there is also a lot of trading noise (website is created for traders), but often I pick very interesting insights about the economy. Stock specific articles written by Jeff Macke and Fill Zucchi are a must read. Full disclosure I contribute to the site.

Obviously I have a bias as I have a CFA designation. CFA is a great program. It is the most practical course of study you can find; it covers from accounting to company analysis to derivatives to statistics. I did MS in Finance at University of Colorado and it was a walk in the park comparing to a CFA program. Is a graduate degree more important than a CFA designation for future analysts or portfolio managers? Unless you receive a graduate degree from an IV league school, CFA designation is superior. Employers prefer CFA to a graduate degree because it tells them two things about the candidate: 1) determination - it is very hard to receive the designation and 2) body of knowledge – CFA program is universal it is the same in China as it is Chicago. Finally, it is much cheaper than getting a masters degree, it will run you couple thousand vs. tens of thousands for a graduate degree. Of course most of the knowledge you receive from studying for CFA you can obtain by simply doing a lot of reading on your own.

Can you comment how the value investing technique will fare if the US goes into a recession or an inflationary environment of elevated oil and soft commodity prices? Will value outperform growth or other techniques in either situations?

Thanks.

If the US economy goes into recession the industry selection will become very important. Staples – the stuff we need to buy no matter how economy is doing should do a lot better than companies that sell discretionary and capital goods. Large companies usually do better than smaller ones as investors feel more comfortable in larger “safer” names. If recession sends the stock market into a tailspin (which could happen) cheaper stocks should do better than more expensive stocks. So in other words, you want to own non-cyclical, large, value stocks.