Active value investing - Vitaliy N.
Katsenelson
INTERESTING SECTIONS
o Its not over until its over – here author explains the way to determine how long range
bound market will last based on earnings growth and starting and ending PE multiple
targets –
o QUALITY, VALUE AND GROWTH FRAMEWORK – EXCELLENT SECTION CHAPTER 8
o Chapter 13 on Risk and randomness is must read.
QUALITY, VALUE AND GROWTH FRAMEWORK – EXCELLENT
SECTION CHAPTER 8
QUALITY
HIGH COMPETIVE ADVANTAGE
A company without a competitive advantage may survive in the environment where the market
it serves is growing rapidly, as competitors are satisfied with growing sales in tandem with the
market. However, once market growth decelerates, competition intensifies and a company
without a competitive advantage will be crushed by competitors that put further downward
pressure on pricing and profits when they fight for their own growth.
A recognised brand is of no value, if company cannot increase price without losing some market
share.
MANAGEMENT
The two qualities that I would like to emphasize are integrity and a focus on long-term
shareholder value creation, even if it means displeasing the Street in the short run. How do we
judge the management team? Listen to conference calls, read press releases and annual reports,
talk to them, and get a sense of whether they are honest with shareholders and with themselves.
Why themselves? To recognize a problem, one needs to be willing to admit to oneself that there
is a problem.
Look for a management team that has the guts and the confidence to keep a long-term focus and
to make fewer cowardly, compromising decisions that hinder a company’s long-term
sustainable competitive advantage merely to serve a short-term hungry master.
PREDICTABLE EARNINGS
Companies that have high recurring revenue components usually exhibit lower sales volatility
and greater predictability of their earnings and cash flows, thus exhibiting less operational risk.
Recurrence of revenues is the number-one source of predictability. Companies whose
customers need to buy their products or services on a consistent basis usually exhibit less
earnings volatility and thus less risk than companies whose customers don’t.
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Timing is extremely important when buying companies that produce highly durable products
that have a very long useful life (houses, capital equipment, cars, etc.). These companies
compete against external competitive threats and their own past sales.
STRONG BALANCESHEET
High degree of total leverage (a combination of high operational and high financial leverages)
mixed with volatile sales is a recipe for disaster. Costs do not decline with sales, leading to
significant losses.
GROWTH
Buying out-of-favor stocks for which the market’s love affair was put on temporary hold is a
strategy of choice in the range-bound market (and any other market, actually), as it allows an
investor to buy shares in a high-quality company and a growing company at an attractive
valuation. However, this strategy brings another risk: that the supposedly temporary breakup
becomes a longer separation, turning the stock into dead money—staying undervalued and not
going anywhere for a long time. This is where growth comes in handy. A company that is
growing earnings and paying a dividend is compensating for the wait, substantially reducing the
dead-money risk. The Growth dimension encompasses both growth of profitability (expressed
as earnings or cash flows growth) and dividends (expressed as dividend yield).
Time is your best friend when a company’s earnings are rising and dividends are constantly
deposited in a brokerage account, but it turns into an enemy when that is not the case.
Growth is a very important value creator, as it helps to fight the P/E compression of the range-
bound market. It should not be approached in isolation (i.e., buying companies with the fastest
earnings growth and ignoring the Quality and Valuation dimensions), but it should be a very
important component of your analysis.
CIGAR BUTTS FATE WORSENS AS TIME PASSES, YOU NEED TO BE LUCKY TO
MAKE MONEY –STOCKS CHEAP, BUT NO QUALITY OR GROWTH
A company that scores high valuation marks but lacks growth or quality faces a different fate.
Time is like a ticking bomb stacked against this company. Those hoping for the value gap to
close—for the stock to go up—may find themselves lucky or not. The possibility of a low-quality
business suffering a stroke and dying increases proportionately to the time passed. Since this
stock scores low marks on the growth front, earnings growth and dividends will not come to the
rescue.
There are three possible combinations where two dimensions are at their highs and one is
lagging:
o Quality and growth are at their highs, while valuation is not. – No margin of safety.
Quality and growth has to overcompensate risk of PE contraction in a range bound
market.
QUALITY AND VALUATION ARE AT THEIR HIGHS, WHILE GROWTH IS NOT.
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o Require increased margin of safety.
Time is not your best friend, when a company has no growth. The longer the time it
takes the market to realise its true value, the lower the annual CAGR you will earn. So
require a very high margin of safety.
o Look for a catalyst—an event that would close the margin of safety gap within a specific
time frame.
o How certain are you that the catalyst will take place?
o Will the catalyst attract enough investor interest to drive the price of the stock to
fair value?
VALUATION AND GROWTH ARE AT THEIR HIGHS, WHILE QUALITY IS NOT.
This is the most dangerous combination of all: A company is growing earnings at a fairly fast
rate and/or paying a dividend; it is attractively priced (at least relative to the growth rate), but
has a quality flaw. Its competitive advantage may be thin, it is overleveraged, its return on
capital may be below the cost of capital, or revenues may NOT BE RECURRING (that is company
sells products which are highly durable and hence there are no repeat customers for long time
and every time company needs to find new customers)
A heavily leveraged company cannot afford to make even a small mistake, as the consequences
could be dire, and even a huge margin of safety may not provide a safe haven if disaster strikes.
The investor’s focus should be on severity (depth) and diversity of the quality issues. One
quality flaw should be overcompensated by the strength of another quality factor. For instance,
a company’s volatile or unpredictable revenues should be compensated for by having as low
operating fixed costs and/or as little interest-bearing debt as possible.
Little could help a company that has no competitive advantage. A strong balance sheet
may prolong its life expectancy, but it will not save the company from its less than happy
fate. Even if a company has high return on capital, it is likely to be a temporary
phenomenon, as a competitive moat is not there to protect the return on capital from
competitors encroaching on the company’s turf.
Each of the Quality, Valuation, and Growth dimensions is an important source of value creation.
Valuation and growth (as Warren Buffett put it) are joined at the hip, being the source of
returns, whereas quality makes sure that the company is still around to collect the fruit of its
work.
THE LONG-TERM RISE IN THE MARKET OBSCURES THE REALITIES THAT
AFFECT ALMOST EVERY INVESTOR
Soar into space, and the earth loses its distinctive features: the Himalayas flatten; the Grand
Canyon appears no deeper than a ditch. . . . [The view from space] gives few, if any, clues to the
harsh geographical and financial realities that you should face walking across the earth’s
surface. . . . If you take a long-term view on the stock market, perhaps fifty or seventy-five years,
it becomes a beautiful blue chip market. But the long-term rise in the market obscures the
realities that affect almost every investor. —Ed Easterling, Unexpected Returns (Cypress House,
2005).
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However, akin to looking at Earth from space, looking at history only over the long run may
inadvertently distort one’s perspective, sending you onto the wrong investment path, as the
often harsh realities of stock investing appear smoothed and distorted.
To expect the long-term average return from any market, at any valuation, over any investment
time horizon, and at any time is wrong. And contrary to common perception, strong economic
growth doesn’t always lead to positive stock market returns. Stock market returns to a
significant degree are a function of starting valuation (P/E) at the time of investing.
SECULAR RANGE BOUND MARKET
During secular range-bound markets, every bull market becomes nothing more than a short-
lived cyclical bull market that lasts a couple of years at the most (sometimes only months),
followed by a declining cyclical bear market, which in turn may be interrupted by a cyclical
range-bound market (as if things were not confusing enough). This cycle has been replayed in
different variations over and over again.
In a range bound market, markets have significant upside gains as to downside losses.
In a range bound market in US, dividends have contributed more than half of returns and in bull
market almost 20% of total returns over the last 100 years.
Growth is a very important value creator, as it helps to fight the P/E compression of the range-
bound market. It should not be approached in isolation (i.e., buying companies with the fastest
earnings growth and ignoring the Quality and Valuation dimensions), but it should be a very
important component of your analysis.
In the range-bound market you should employ an active buy-and-sell strategy: buying stocks
when they are undervalued and selling them when they are about to be fully valued (as opposed
to waiting until they become overvalued).
PE EXPANSION OF LOW PE STOCKS DURING RANGE BOUND MARKET
The P/E of the average stock dropped from 29.3 in 1966 to 14.6 in 1982. That portfolio
generated a total annual return of 8.6 percent. The lowest-P/E quintile, to my surprise, had a
P/E expansion of 34.8 percent. Yes, you read it right. The P/E of the average stock in my lowest-
P/E quintile actually went up from 11.8 to 15.8 throughout the range-bound market. That
portfolio produced a nice bull market–like total annual return of 14.16 percent, although this is
counterintuitive—you’d expect the P/E to decline or at best remain the same. The 1966–1982
range-bound market started after a great 1950–1966 bull market. As usually happens during
bull markets, growth stocks got all the glory (this explains the very high P/Es of the high-P/E
quintile), but value stocks were as popular as last month’s news, with valuations about one-
third of those of growth stocks. It was simply value stocks’ time to shine.
The range-bound market is brutally toxic to high-P/E or so-called growth stocks.
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ITS NOT THE ECONOMY WHICH DRIVES RETURNS
Are bull markets driven by superfast economic growth? Are range-bound markets caused by
subpar economic growth? The answers are no and definitely not, respectively. Though it is hard
to observe it in the everyday noise of the stock market, in the long run, stock prices are driven
by two factors: earnings growth (or decline) and/or price-to-earnings expansion (or
contraction).
If earnings growth remains consistent with the past, P/E is the wild card that is responsible for
future returns.
PROFIT MARGINS ARE MEAN REVERTING
Profit margins are probably the most mean-reverting series in finance, and if profit margins do
not mean-revert, then something has gone badly wrong with capitalism. If high profits do not
attract competition, there is something wrong with the system and it is not functioning
properly. —Jeremy Grantham, Barron’s
Although profit margins may settle at the mean, that is not what the concept of mean reversion
implies; it implies direction of the movement. Assuming the center point of a given ratio is still
the center point, the ratio should revisit the other extreme while going through the mean. If
profit margins are in the area above the mean, they at some point should revisit the area below
the mean, and vice versa. The same logic applies to other mean-reverting measures (e.g., return
on capital, P/Es, etc.).
Companies that don’t have a sustainable competitive advantage (a metaphorical moat around
their business, as Warren Buffett puts it) will not get to keep the benefits of increased
productivity. These benefits will get competed away, and their margins will decline. Do you own
one of those companies? I strongly recommend you take a look at the companies whose margins
are hitting all-time highs, and examine their competitive landscape and their business for
sustainable competitive advantage.
PE IS INVESTORS BEST FRIEND
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P/E expansion was the source of returns, the tailwind in the sails of the bull market boosting
stock returns. It was solely responsible for sending returns for stocks into double-digit territory.
P/E turned into a headwind in range-bound and bear markets, solely responsible for paltry
returns of stocks in range-bound markets. P/E contraction during bear and range-bound
markets was the payback for excessive returns that came from the P/E expansion of the
preceding bull market.
P/E is the investors’ best friend, as its expansion turns into a source of returns (adding to
earnings growth and dividend yield). However, if stocks are purchased when the P/E is above
average (greater than 16), the P/E turns into a foe, as its compression diminishes returns.
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Competitive advantages must, do not compromise on this at any cost.
Management integrity is very important. Never invest with a questionable management.
TIME ARBITRAGE AND CONTRARIAN MINDSET ARE GREAT
COMPETITIVE EDGE IN THE STOCK MARKET
Though time arbitrage is not a riskless opportunity, odds are that if you have the contrarian
mind-set and are not afraid of being on the lonely side of the fence (owning a stock that is not
loved by Wall Street at the time or that may be dead money for a while), you have a great
opportunity to take advantage of Wall Street’s habitual and recurring irrationality.
INVESTMENT PROCESS
DOCUMENT YOUR RESEARCH IDEAS
To keep a sane head, independent of the direction in which the crowd is marching, write down
your basis for every investment, identifying value creators and destroyers and your
expectations for them. Similar to recording a valuation target for a stock at the time of purchase,
an investment thesis committed to paper at the time of investment represents the unemotional
you, made at a time when you were thinking clearly and rationally. It will provide you peace of
mind.
However, as a stock’s price rises and the company becomes fairly valued, a trailing stop-loss
strategy may allow you to capture extra return from the awakened interest Selling a portion of a
position when it reaches its fully valued level (target price) captures the paper profits (into
cash). Letting the rest of the position have an opportunity to be driven higher by those less
sensitive value market participants may allow you to capture additional profits that could
otherwise often be left on the table.
The largest pitfall of this strategy—emotions—can turn against you, and trying to capture
additional profit from “growth investors gone wild” may lead to making an unpleasant round
trip in the stock—it may decline considerably, wiping out your earlier paper profits.
We should buy stocks with an intent to marry them forever (the Warren Buffett approach), but,
knowing that there is a chance that it may not work out, at the time of marriage (purchase) we
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should sign a prenuptial agreement detailing on just what terms the marriage will be ended
(stocks will be sold).
SELLING DECISION IS AS IMPORTANT IS BUY DECISION
Selling is difficult. It is difficult because it often forces us to admit that we made a mistake, or we
tend to resist parting with a stock that made us money and thus made us feel good. Sometimes
we don’t want to experience the regret of selling too soon, or selling requires the further stress
of a subsequent (buy) decision that we are not prepared to make. But selling is the seal of
success of our buy decisions. The range-bound market requires both disciplined buy and sell
strategies. Therefore, you need to become a vigilant seller. Sell when a stock reaches your prior
determined valuation level. Sell proactively before fundamentals deteriorate. In other words,
sell when a company stops scoring high marks on all dimensions of the QVG framework. Do not
hold and hope!
TECHNICAL ANALYSIS ALONG WITH FUNDAMENTAL ANALYSIS
WORKS BECAUSE OF HUMAN EMOTIONS
Being a value-sensitive investor, I tend to be agnostic to technical analysis in its pure sense with
complete disregard to fundamentals. The stock that “broke out” (i.e., went up) is a less appealing
investment to me than the stock that has “broken down” (declined). That said, I have come to
respect support and resistance levels, as over time I’ve found that they are driven by, and then
drive, human emotions. As a stock recovers from a prolonged decline, when it comes back to
retest the previous highs (resistance levels), many investors who owned the stock last time it
approached these levels and failed to sell it will now try to unload the stock in an effort to feel
good (or less bad) about themselves. A similar effect occurs in a stock that retests previous lows
(support levels). Investors who failed to buy it the last time it hit a previous low will anchor
their buy decision at that level; thus they are likely to scoop up the stock once it retests the lows,
feeling they are lucky to get a second chance at a perceived bargain. Although there is nothing
logical about support and resistance levels, as long as humans and not computers are in charge
of making fundamental buy and sell decisions, their power is likely to persist.
HOW TO DEAL WITH COMPANIES EXPOSED TO BLACK SWAN EVENT
The first option is avoidance mode—not to be there when a random event strikes. In this case,
that means you can avoid oil stocks altogether. The second option is a bit more complex but is
often the one that looks at risk as an opportunity. Minimize the impact of randomness through
the Quality, Valuation, and Growth framework. QVG is a very useful tool, especially from the
perspective of managing the impact a random event could have on individual stocks. A high-
quality company will be able to take a beating better than a lower-quality, overleveraged
company. Its strong balance sheet will carry it through tough times. And its deeper management
is likely to respond more smartly.
DIVERSIFICATION
Uncorrelated stocks needed in a portfolio to eradicate individual stock risk, but the number is
usually given as somewhere between 16 and 25 stocks. This is another case where being
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vaguely right is better than being precisely wrong. I found that a portfolio of around 20 stocks is
manageable and provides an adequate level of diversification; at this level, the price of being
wrong is not too high, but every decision matters. A properly diversified equity portfolio should
consist of stocks from different industries, of various sizes (from large-capitalization to small-
capitalization), growth rates, valuations, and countries.
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