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Interview With Vitaliy Katsenelson


A little Q&A action...


Editor's Note: The following is an interview of Professor Katsenelson byThe CFA Society of Colorado, who features a different member in each of its upcoming newsletters in an effort to highlight the achievements of its local colleagues.

CFA Colorado: Vitaliy, thanks for agreeing to be our first featured member. You do it all - you're a portfolio manager at Investment Management Associates, an instructor at CU Denver and contribute articles to The Financial Times, Minyanville and The Motley Fool. You've even got a book coming out next Spring! Not to mention that you have a wife and two young kids at home. You must be very passionate about investing. How do you do it all?

Vitaliy: Outside of my home, investing is my passion. I don't see it as a job; it's more like a hobby. And the writing comes naturally. It is an extension of my analysis, a part of the research process. To understand a company, I write about it. This makes me intellectually honest. But rather than write research reports, I write articles. Plus, I do tend to work long hours, including at home after the kids are asleep. My writing and teaching help me to become a better investor. It's a trifecta. Each one makes the other better. I teach and write about what I'm investing in.

CFA: Tell us about the class you teach at CU Denver.

Vitaliy: I teach a graduate class in Practical Equity Analysis. Besides the enjoyment I find in teaching, it's like a lab for my investment ideas. It helps me refine my investment process.

CFA: How so?

: I came up with a concept I call "Absolute PE" that I first introduced to my students and have since integrated into my investment process.

CFA: Absolute PE?

Vitaliy: Yes. My students asked, "What is the right PE?" I thought about PEG but realized that it's ineffective: it assumes a linear relationship between PE and earnings growth rate (it would imply that a 3% grower deserves a PE of 3 – not very practical), in addition it assumes all stocks are homogenous. The Absolute PE model is subjective but allows me to come up with a number that I am more comfortable with. It has five components:

Growth Rate: I start with a no growth PE and then add PE points for growth. As growth rates get higher, incremental PE points get smaller as higher growth usually carries higher risk. Dividends: I add additional PE points for dividends, something the traditional PEG model ignores. This gives me a base PE number for an average company. Then I add or subtract PE points based on the following risk metrics:

  • Business Risk.
  • Financial Risk.
  • Earnings Visibility. The further out you can forecast, the more valuable the company.

I get a lot of benefit just going through the model as it makes me focus on the value creators and distracters for each company. I quantified this for my students and find that it is very important in my work. In fact, I've devoted one-third of a chapter in my book to this concept.

CFA: How did you start teaching?

Vitaliy: I had just finished the CFA program and was looking to fill an intellectual void, not to mention the hours I'd just gained in my day! But I love it and can't wait to get to the classroom. After all, I do have a captive audience!

CFA: And all this intellectual stimulation led to a book deal.

Vitaliy: The book was an accident. I wrote an article for called "Place of No Returns" and a follow up article for The Financial Times. My thesis was that we are in the midst of an approximately 15-year range-bound market. I call it a "Cowardly Lion Market." There will be bursts of bravery followed by periods of cowardliness.

CFA: Tell us more.

Vitaliy: The post bull phase is a phase of long-term PE compression. PE's tend to overshoot on the upside and downside. We tend to think of Bull and Bear markets but the long-term range bound happens a lot more often than long-term bear markets. In fact, every protracted bull market in the 20th century was followed by a range bound market with one exception – the Great Depression. Secular range-bound markets are the bear markets of P/Es, where secular bear markets are the bear markets of P/Es and earnings – a very important distinction.

Anyway, I was asked to expand upon this for another book and by the time I was done writing, I had finished three chapters, instead of the one that was requested. So I kept writing and Wiley will be publishing my book in June 2007.

CFA: Can you give us a preview?

Vitaliy: Sure, Part 1 will make the case for a range bound market. I look back at historical examples to relate to the current situation. In Part 2, I present my strategy for investing in a range bound market. I am basically saying that traditional fundamental analysis is still very much alive but requires some tweaks to work in range bound markets.

Relative PE analysis needs to be used with caution as it benchmarks to the bubbly valuations of the bull market. So I use DCF analysis to provide a rough guide to the company's value. I then use the Absolute PE to tighten my range. Margin of safety is important and I look at three areas: the growth rate, the overall company quality and the required rate of return for the investment.

Buy and hold or index investing does not work in a range bound market because of the constant PE compression of the overall market. It's important to have a strict buy and sell discipline. I set my sell targets at the time of purchase and then sell at my target price regardless of whatever else is happening. It helps to have a large watch list and there are about 200 stocks that I am considering at any time. When its PE reaches my target, I will consider a stock for my portfolio.

CFA: Care to sum up your thoughts on the current market?

Vitaliy: We are in the midst of a range bound market. I expect volatility to be fairly even to the up and downside for the duration. The current PE is only about 2 points above the average but the profit margins are at all time highs. However, profit margins are mean reverting so the market is not as cheap as it appears. Also, historically at the end of range bound markets PE has settled at single digits – much below average.

I'm pretty skeptical about the consumer's power to keep this economy running at full steam. Hence, I'm avoiding consumer discretionary stocks and anything that was driven by the easy money from home equity loans. I look for three things: quality, valuation and growth. As an investor, they are all interrelated.

CFA: Since you brought it up, do you have any picks for us?

Vitaliy: Sure. I see large cap growth as "the new value." Late 1999 and early 2000 marked the end of the renaissance era for large-cap growth stocks – they were overpriced. Most of them either have gone down or drifted sideways since. Time is the great healer, especially when earnings are growing. These companies have more than doubled their earnings since the late 1990s. Those higher earnings have combined with lackluster stock performance to create very attractive valuations. Recently my firm was buying Microsoft (MSFT), Wal-Mart (WMT) and 3M (MMM). 3M may be up about 40% since 2000, but its relative and, more importantly, absolute valuations are still cheap; EPS grew faster than prices. Wal-Mart is large, politically incorrect and boring – my firm loves it. It can grow its earnings in the low teens and will keep raising its dividends. Plus, its valuation is very attractive. Another stock is Microsoft. They're launching Vista and Office 2007 early next year. It should be factored into the stock price but it isn't. It's an example of how the market is not rational. We were buying it a couple of months ago at 22 when the stock was trading at 13 times earnings (if you exclude cash).

Most of these stocks have exhausted the bulk of their margin of safety with the latest market run up, so I'd be taking my time with entry points. However, my favorite pick, a smaller company that still has plenty of margin of safety despite its recent run up, is Jos. A. Banks (JOSB). It has a strong balance sheet, is a fast grower, has a great and improving return on capital and again, Wall Street hates (misunderstands) it - my firm loves it! It is a $30 stock that, in my estimates, will make $4-5 per share in a couple of years.

CFA: The CFA Society of Colorado thanks you for your generosity.

Thank you!

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