Recently I had the chance to interview Vitaliy Katsenelson, author of the recently released The Little Book of Sideways Markets: How to Make Money in Markets that Go Nowhere. Vitaliy and I discussed his investment theory, today’s sideways markets, and some anecdotal examples of Vitaliy’s favourite stocks to own and when to sell…Elliot Turner: How did you come to start refining IMA’s investment approach and what made you want to quantify it in terms of QVG (Quality, Value, Growth)?
Vitaliy Katsenelson: When I joined IMA, we were GARP investors (Growth at a Reasonable Price) and that investment strategy worked very well throughout the 80s and 90s. It generated consistently strong returns and made for a lot of very happy clients. With GARP, you look for high quality companies that grow earnings and are trading at a reasonable price. In other words, your expected return does not necessarily come from price-to-earnings multiple expansion, but really from the earnings growth itself.
The GARP strategy helped keep us away from the Dot.com bubble (NASDAQ:QQQQ), but in the aftermath of the bubble popping, the strategy stopped working and I became frustrated. I was trying to figure out why our returns slowed because, after all we owned high quality companies that grew earnings year after year. At around that time, I went to a conference where a speaker argued that every time the Dow Jones Industrial Average got to a number with zeroes behind it (for example 100, 1,000, etc.) it stagnated for decades. The speaker didn’t explain to us why it happened and didn’t provide a strategy that I could relate to myself, but seeing this illustrated on a chart alerted me to something new and significant.
After that conference, I started to look at market history in order to dig deeper into this phenomenon. Yes, every time the Dow Jones (NYSE:DIA) got to a number with zeroes behind it, it stagnated, but what was interesting is that it had nothing to do with ones and zeroes. Each time the market stagnated for a long period of time it had been in the aftermath of a very long bull market. This happened because at the end of the bull market stocks got overvalued (P/Es were too high) and it took time for stocks to become fairly valued, and eventually undervalued once again – P/Es needed plenty of time to decline. Typically, the process of multiple compression took a decade and a half or so and at that point it hit me that (this was in the early 2000s) we were at the beginning of one of those periods.
Therefore the way we invest had to change. The Growth at Reasonable Price approach was not going to work well in this environment anymore. So we took the framework we already had in place and made a few important modifications. One of the modifications is that we decided that we had to increase the margin of safety. The stocks to buy have to be undervalued and that’s where the margin of safety comes in. Owning a reasonably priced stock alone would not be good enough anymore.
Elliot: How would you explain your addition to the value investing field above and beyond what Graham and Dodd laid out in Intelligent Investor? Would it be wrong to label this as a Graham meets GARP sort of approach?
Vitaliy: I am flattered that you mention my work in the same sentence with Graham and Dodd. I guess I introduced the concept that thevalue investment strategy needs to be tweaked for the long-term market cycle we are in.
To answer this question we have to briefly take a look at sources of returns for stocks. In the long run, stock prices go up for two reasons: an increase in earnings and/or a rise in the P/E ratio. Add in dividends and you have all the variables responsible for a stock’s total return. GARP investors, in general, are looking to own high quality companies that are reasonably priced (not dirt cheap, but not overvalued either) and are expected to grow their earnings over a long period of time.
When I analyse stocks I tend to look at them from three dimensions: Quality, Valuation and Growth (QVG). Quality describes a company with significant barriers to entry in their line of business, a high return on capital, a strong balance sheet, and good (shareholder friendly) management. Growth focuses on the growth of earnings/cash flow and dividends. These days, dividends are by far the most under-appreciated source of return. Over the last hundred years they are responsible for a little less than half of the total returns from the stock market; however, in past sideways markets they have been responsible for the majority of returns.
Lastly is the Valuation dimension – which could really be described in three words: “margin of safety” – what is the discount to a stock’s fair value. GARP investors spend most of their time in the Q and G dimensions, but as a GARP-turned-value investor I learned to appreciate all dimensions equally.
More importantly, I learned to appreciate the interdependency between Quality, Valuation and Growth. In fact, in the Little Book I spent four chapters on the three dimensions for a reason. The bottom line here is this: weakness in any one dimension has to be over-compensated for by strength in another. For instance, if you are looking at a very slow (or no) growth high quality company, you want to buy it at a much greater discount to its fair value than a faster growing company of the same quality.
Elliot: One of my favourite elements of your approach is the margin of safety inherent in the broader strategy— the way in which you build a margin of safety into your portfolio in addition to doing so for each individual stock. More specifically, I like how if we enter a new bull market, you’re exposed to the long side, if we stay sideways, you own quality companies, and if we go down, well, you have a comfortable margin of safety anyway so you can preserve capital without too much pain. Is that something you had in mind when you put together your approach to sideways markets?
Vitaliy: Yes. What happens during sideways markets is that the price/earnings ratio, instead of being your friend as it is in secular bull markets, turns into your enemy. This is so because price to earnings is compressing in a sideways market, therefore you want to increase your required margin of safety in order to err on the side of caution. In the past, you might be looking to buy a dollar for 70 cents on the dollar in order to sell it at a dollar, at its full value. In a sideways market, maybe the market will price it at 80 cents. As a result, buying at 70 cents on the dollar is not good enough. So now you need to buy this company for more like 50 cents on the dollar in order to sell at 80 cents. In other words, to overcome a constant P/E compression you need to increase your margin of safety.
Elliot: Within today’s secular sideways market, are we in a cyclical bull right now or are we in a cyclical bear?
Vitaliy: I have no idea. Let me say that we clearly were in a cyclical bull. Are we still in it? I have no idea. I’m not a very good market timer. The one thing I will tell you is that right now we are having a hard time finding enough good stocks to buy. When that happens, our cash balance tends to go up as we sell into strength as the market heads higher. So now we have about 35% in cash and while that’s not an indication that we think the market will roll over next week – because I have no idea what’s going to happen next week – it is an indication that I think there are just far fewer opportunities in this market than I would like to find.
Elliot: Do you even concern yourself much with where we are in the cycles or do you look primarily at the bottoms up company particulars and whether those companies meet the QVG standards?
Vitaliy: We do look at the economy, but I think it’s very difficult as investors to time the market. In timing the market, you have to get a couple of things right: you have to get the economy right, but most importantly, you have to get the reaction of the stock market to the economic events right. I’ll give you an example as to just how difficult that is. In the early summer of 2007, we had the subprime crisis unfolding. Bond markets had already frozen for a couple of weeks, but the stock market didn’t even care. The S&P (NYSE:SPY) went on to make all-time highs after the subprime troubles became very serious. Even if you got the economic picture right, the stock market continued to go up.
What you really want to do is to value each individual stock. Don’t get me wrong, you do want to be aware of what’s going on in the economy. In fact, in the book I argue that you have to do both the bottom up and top down analysis, but I just think it’s far too difficult to time the market.
Elliot: You first wrote about sideways markets and active value investing in 2005 and have been a believer that we are in sideways markets for some time now. At this point in time, how far along do you think we are on the timeline of sideways markets? Do you think we made enough progress in contracting the P/E multiple, or do you think we are still in for sluggish sideways multiple contraction moving forward?
Vitaliy: If you look at the market’s P/E ratio based on 10 year trailing earnings we went from far, far above the historical average to a little above average, which is where we are right now. In 2001 the market was trading at a 48 times 10 year earnings multiple. The long term average is about 18. Today, even after several years of sideways markets, stocks are trading at about 22 times the 10 year trailing earnings. Sideways markets end when trailing earnings go from above average historical ratios to below average, usually trading at something like 11 to 13 times trailing earnings. Considering we are at a 22 P/E right now, we’re still far from the end of this sideways market and we probably have another 10 years until the sideways market ends.
One problem though and this is where it gets very tricky, is figuring out what exactly gets us to the below average multiple level. The price doesn’t have to drop to get there. Prices fluctuate up and down a lot, but what happens is that earnings grow at the same time that P/E is contracting. If you have slow earnings growth then it will take longer for us to reach the approximate 13 times trailing earnings level.
Elliot: Your earnings estimate for the S&P 500 in the book calls for $75 a share in 2010 and you wrote this in the summer when the short-term outlook was looking particularly bleak. Do you think the strong third quarter earnings and upward revisions of earnings estimates changes things at all? I’ve seen estimates for earnings around $86 a share in 2010?
Vitaliy: Well, the problem today is that these earnings estimates factor in very high corporate profit margins. I talk about this in my first book, but it’s important to note that profit margins cannot stay above average for a very long time. So I’d argue that especially in a low economic growth environment the competition intensifies and this will ultimately lead profit margins to decline, broadly speaking. Profit margins are one of the most mean-reverting variables in finance.
These days, I am very sceptical of cyclical companies from which people expect a very high rebound in earnings. Even if earnings do rebound in the near-term, they won’t stay there for long because the profit margins for a cyclical company can’t stay this high for a sustained period of time.
Elliot: In the book, you seemed to lay out the Bear case for the U.S. and global economies, yet you call for sideways markets. You touched on this already about how it’s not necessarily that price must go down, but that multiples contract while earnings grow and price moves sideways. Could you just go into a little more depth as to why you think sideways is the inevitable outcome and not a secular Bear market?
Vitaliy: Let us differentiate between a sideways market and a Bear market. Sideways markets and Bear markets both happen when you start with high multiple valuations. Let’s say you are at the end of a bull market and the price to earnings ratio is high. What really matters is whether the earnings of the economy are going to grow over the long run or not. If earnings are going to contract over the next decade, then you’re facing a Bear market. If you have earnings growth then you’re facing a sideways market. The earnings growth is ultimately the difference between us and Japan.
Japan had a huge bubble in a very expensive market in late 80s and early 90s. Near the end of the Bull run, earnings stagnated and then collapsed leading into a Bear market. In the U.S., our earnings went down, then back up, down again and back up one more time. Despite this cyclical volatility earnings grew over the last decade. Here is where I make an important assumption: earnings will continue to grow over the next decade. If you disagree with this assumption and think earnings will be declining then you might as well prepare for the prolonged Bear market. The market valuations are still too high for the prolonged Bull market to develop.
I’m arguing that we are likely to have earnings growth, it’s not going to be as robust as the earnings growth preceding 2007-08— a 5 or 6% rate. I think we will have something around 2% or 3% nominal earnings growth moving forward. If that’s the case, then we’re far more likely to be in a sideways market than a Bull or Bear. If earnings turn negative and stay there for a long period of time then yes, we’re going to Bear market territory.
And let me make clear that I’m not trying to hedge myself. One thing I realised after I wrote my first book I created a framework which allows you to put in your own assumptions and adjust accordingly. I’m operating under the assumption we will have earnings growth and therefore we’ll be in a sideways market. If somebody has better insight and strongly believes that we won’t have earnings growth for the next five to 10 years then that person should be preparing for a Bear market.
Elliot: When you’re looking at specific companies, do you think growth gets undervalued in today’s market because people think in a broader sense that economic growth will be sluggish, therefore, growing companies need to be valued lower? I gather from your argument about sideways markets that earnings growth is one of the undervalued assets in today’s market because people are thinking so broadly about how we’re not going to have this great bigger picture growth. Does that make sense?
Vitaliy: Yeah. OK, so let me answer your question by not answering your question. I think cyclical earnings growth gets overvalued in today’s market. Cyclical companies are basically fully valued or actually even overvalued today. These are the companies that we spoke about earlier enjoying very high margins right now. And by the way when I look at these companies their future performance is tied not just to our economy’s growth, but also emerging markets like China (NYSE:FXI). When China slows down the earnings for these companies will inevitably decline.
At the same time—and this is very important—the right companies that you actually want to own in today’s environment are the one whose earnings will grow even in a sluggish economy. Ironically this type of company is actually significantly undervalued in today’s environment.
Let’s look at an example. This is not a company I own, but look at Wal-Mart (NYSE:WMT). Wal-Mart grew its earnings, I don’t know, 10 to 13 per cent a year for the last decade and the stock basically stayed at the exact same level the entire time. This happened because Wal-Mart was extremely overvalued in the late 90s, but through the function of high earnings growth and P/E multiple contraction we have an attractive company today. The Wal-Mart-like companies are very, very cheap today and these are the types of situations that investors should look to own in this highly uncertain environment. Again, this is actually not an argument for Wal-Mart per se, it just illustrates my broader point. Companies that have had tremendous earnings growth over the last decade with P/E contraction look intriguing today. So while I think the cyclical companies are overvalued, at the same time I think high quality stable companies should do well regardless of broader economic performance.
Elliot: And so what are some free cash flow beasts that are amongst your favourites right now? I’ve seen you lauding eBay and Pfizer in the recent past, are those still companies you like today?
Vitaliy: Actually, I sold eBay (NASDAQ:EBAY) a couple of weeks ago. It’s had a huge run and reached my fair value target, so we sold it. We still own Pfizer (NYSE:PFE), as it is a very attractive company. Everybody hates it for the same obvious reasons: Lipitor, its largest drug is going off patent next year and that accounts for a large portion of Pfizer’s revenue. When we did our analysis, we found that even if every single drug that Pfizer produces goes off patent and the revenues for all of those drugs drop by 90%, we still think Pfizer is worth over $20 per share. And by the way, this analysis makes the assumption that Pfizer’s $10 billion in R&D produces no new drugs.
So we’ve been looking at it like this: when we buy Pfizer today, it’s undervalued, plus we get a free call option that comes from $10 billion dollars spent in R&D every year. They have over one hundred drugs in the pipeline and I have no idea which drugs will be successful or not, but I do feel comfortable to say that something likely will come out of it and that will just be a bonus for us at its present valuation.
Elliot: I think the example you give with eBay opens up a good question about your selling strategy, which is an important part of active value investing as you describe it. When you say you sold eBay because it reached your full value, is this the full value that you set when you bought eBay? Or were you adjusting your thesis along the way to accommodate for changing events and then at that particular moment in time you saw a price that seemingly reflected its full value to you?
Vitaliy: That’s a good question. It was actually both. We bought eBay (NASDAQ:EBAY) in the middle of the crisis and I think my fair value target at that time was about $27 per share. After that, the company sold Skype for a larger amount than I thought it was worth. That bumped up my fair value of the company by a little. Then, their core business stabilised faster than expected so that added a little bit more to the fair value estimate. At that point, we readjusted our fair value target to $30 per share, up from the original $27. Then when it got to $29 we sold it.
When I sell stocks, I don’t need to know that I sold it at the highest price. It’s enough to know that I sold it for what I think is fair value and I don’t really need to squeeze every last penny out of it.
Elliot: Aren’t we all. Thanks for taking the time to speak with me Vitaliy!
Vitaliy Katsenelson is the author of the recently released The Little Book of Sideways Markets: How to Make Money in Markets that Go Nowhere.
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