MI Rewind: Discovering Value Investments w/ Vitaliy Katsenelson

0:00You're listening to TIP. On today's show, we've started to reshare some older episodes that are my favorites for a few reasons. One, we get a bunch of new listeners each week, so the new listeners may not have heard this episode before. Two, even if you've been listening for a while, you may have missed this episode when it originally came out. Or three, even if you've heard it before, it can be a great episode to learn from again. If you've already heard this episode or you're not interested in hearing it, feel free to just skip it. There's no harm in that. and you can pick up with our new episodes next week.

0:34All right, guys, that's all I had for you for this new intro. Everything going forward is going to be from the original show. Hope you guys enjoy it.

0:45On today's show, I sit down to chat with Vitaly Katsanelson. Vitaly is the CEO of Investment Management Associates and is the author of The Little Book of Sideways Markets. During the episode, I chat with Vitaly about how COVID-19 changed the game of value investing, what Vitaly looks for in the companies he invests in, how he thinks about the discount rate in his valuation process, why buying great companies might not be the best investment strategy, whether a portfolio of 100 % stocks can give investors a well-balanced portfolio, and much, much more. Without further delay, let's dive right into this week's episode with Vitaly Kassanelson.

1:26You're listening to Millennial Investing by the Investors Podcast Network, where your hosts, Robert Leonard and Clay Fink, interview successful entrepreneurs, business leaders, and investors to help educate and inspire the millennial generation.

1:46Welcome to the Millennial Investing Podcast. I'm your host, Clay Fink. And on today's show, I'm joined by Vitaly Katzenelson. Vitaly, welcome to the show. Clay, how are you? I am fantastic. I'm very excited to dive into today's topic of value investing. Before we dive in, could you tell our audience a little bit about your background and how you got to where you are today? So I came to the United States from Russia in 1991, which was December 4th, which has basically been here for 30 years and a month. And so we moved to Denver. And in my early 20s, I got very lucky because I realized that I want to be an investor.

2:25And because I was in my early 20s, I had the slayers of folks. I knew exactly what I needed to do. So I got my undergraduate degree in finance and graduate degree in finance from CU Denver. I live in Denver. Then I got my CFA. And from that point on, I enjoyed IMA in 1997. IMA is the firm I'm a CEO of now. So I've been here for 24 years. And over the last 10, 12 years, I kind of remade the firm to be what it is today. So we are basically a value investment firm. And our clients are high net worth individuals that come to us and say, here's my life savings, please don't screw it up. And I wrote a few investment books in the process.

3:06I think I wrote Active Value Investing in 2007. And then in 2010, I wrote The Little Book of Sideways Markets. If you were going to read one of my books, I would recommend The Little Book, just because it's a more elegant version of the Active Value Investing. It's a more simplified version of the Active Value Investing. You are a value investor, like many of us at TIP. Could you talk to us about how COVID-19 has changed the game of value investing? argue that it hasn't. The value investment principles have not really changed. And what is value investing? It's basically, I wrote this, what I call six commandments of value investing.

3:46So anyway, six commandments of value investing, I'll mention a few. When you buy stocks, you're buying businesses, not pieces of paper. This is important because now it turns you into an investor from speculator or gambler. You're looking for margin of safety, that hasn't changed. You have a long-term time horizon, that hasn't changed. And there are some other commandments. So that's what value investing is about. It's a set of principles. So the principles have not changed. What has changed, I would argue, is kind of economic landscape. It has shifted. But one thing that I myself was questioning in March of 2020, and now I'm fairly certain about that it has not changed, is the human...

4:28As humans, we want to be around other humans. So, like in March 2020, during lockups, I was questioning, are we going to have hugs and handshakes after the economy reopens? How is the economy going to change? Are we going to be kind of more digitized? I know it sounds silly now, but at the time, Bill Gates was on CNN, they were asking these kind of questions because people really were not sure, no matter what is going to happen with the virus, we still want to be around other human beings. And the reason it's important, because when you analyze companies, that's something you want to have in the back of your mind.

4:59But I'll give you a couple of examples where things might have changed and where things haven't. Think about travel. So the leisure travel, we know that hasn't changed. Once the economy normalizes, once we become more comfortable with the pandemic, leisure travel will come back to normal. What may change is the business travel. Because what we have discovered is that some of the business meetings now don't need to be in person anymore. They can take place over Zoom. If I owned airline companies, which I don't, I would be concerned about this because, yes, business travel is about only 12 % of the revenues, but it's a much larger portion of the profit pool because it's much higher margin dollars.

5:41So that would be an example. Another one I'm struggling with today is remote work. People are going to work from home. Are they going to be working in the office? And I'm still confused about this, but let me tell you how I think about it. I think a lot of the work in the past, like so if you work in a call center, now you have the tools, digital tools that you don't need to be in a call center anymore. And if you think about call centers in general, right? It's just basically it's a huge warehouse, which has summer conditioning, and you have thousands of people packed next to each other in cubicles.

6:16And it's a very noisy environment. And there is very little value in all these people being in the same place. That's one extreme. On the other extreme, if you are a company that's very creative, and a lot of value is created, is when people bump into each other in the hallways, then there is actually value in being together, right? So I think you have these two extremes. And I think the truth is going to be somewhere in the middle. Maybe some jobs where interaction between employees is not very important, you're going to have a lot more of those jobs than work from home. A lot of creative jobs, it's either going to be a hybrid environment, or it's always going to be like, you have to come to the office.

6:57And even at my company, my folks said, well, we kind of would like to be a work from home sometimes. And I found a very interesting compromise. Instead of saying, we're going to be like four days a week from the office and one week from home, I said, everybody gets so many days a year, they can work from home. It's a great benefit because if somebody goes on vacation, and they want to spend another three days on vacation, they can just work remotely. That's how we think about it. But my point is, when you are analyzing today's economy, you want to be very nuanced about it. Because some things have changed, some things haven't.

7:30And when you break things up into little bits and be nuanced about it, I think I look at each company and say, how has the business changed? I think that's the right approach. That's how we're adjusting our strategy in today's environment. How has the trend to work from home affected the businesses you're looking at? Is it certain industries that are being affected or are there specific businesses where this comes up? You know, it came up when we were looking at office real estate. And to me, I put it into too difficult a category because first of all, we already had overcapacity in office real estate just before the pandemic.

8:08The prices were sky high. we had plenty of overcapacity. And now we know that demand will be less. However, one thing I started to see is that they started to convert some of the better locations into apartment buildings. So it's going to be one stock at a time analysis, but so far I have zero investments in that space. But that would be one example. I'm sure there are plenty of others. Now, the value investing principles in theory seem very simple, but in practice, I think it's very difficult for a lot of people, myself included. You'll hear over and over again from people like Warren Buffett and other value investors to buy great businesses at reasonable prices.

8:50I'd like to dig a little bit deeper on that idea with you and its two key parts, great businesses and reasonable prices. Could you tell us what it takes for a business to qualify as a great business for you? So in the beginning, I talked about value investment principles, think of it as those are philosophical principles. A lot of times, value investing is confused with buying statistically cheap stocks. In other words, if you finish kindergarten and you know how to count 10, then you can be a value investor because all you have to do, statistical value investor, because all you have to do is buy companies that trade at less than 10 times earnings.

9:29I wish it was that simple. It's not. So Ben Graham, the father of value investing, when he started out, there was a lot less competition, there was a lot less IQ in the market, and there was a lot fewer computers, probably no computers at the time or very few computers. So he could be a statistical value investor and do absolutely great. I think being a statistical value investor, all this computing power made this impossible. So therefore, what you have to do, you have to default to the principles. and the whole point is that you want to buy companies that are undervalued. However, let's talk about this.

10:04Let me give you two examples. I'm going to oversimplify them just for simplicity. So you can poke a lot of holes in these examples, but again, I'm oversimplifying just to make a point. You have a no growth company. The trades are$5 and it has$1 of earnings today. And three years from now and five years from now, it's going to have$1 of earnings. So, you think that the fair value of this company is$10, so it should be trading 10 times earnings, right? So in other words, if you buy this company$5, at some point it will get to$10. David Pyshenko The problem is you don't know when. If it happens today, like in one year, you're going to have a 100 % return.

10:39If it happens in 10 years, again, I'm oversimplifying, you're going to have a 10 % a year, I'm ignoring compounding. If it happens over five years, so would you discover that the time is not on your side? The faster that happens, the more money you're going to make annualized. Now, you have another company that's trading at, it's a$10 stock, and it has a$1 dollar earnings, but it's growing earnings, let's say, 20 % a year. Again, let's oversimplify it. So again, in five years, it would have$2 of earnings. Earnings would double. So from that perspective, the first company doubles in five years, and this company doubles in five years, you should not really care.

11:17However, the time is on your side if you own the growth company. Because if you own it for 10 years, now you're making 20 % a year. If you own the first company or you own it for 10 years, the longer you own it, the less money you make per year. So the point I'm trying to make is that the second company, the growth company appears to be overvalued on the surface, or it appears to be statistically less cheap. In reality, there is a value in the growth of those earnings. And that was basically transition of Warren Buffett from no growth companies to identifying companies that have three characteristics, basically.

11:56They have a significant competitive advantage, they have high return capital, and they have a long runway for growth. He was buying them at a discount to their fair value, though they might have looked more expensive on the surface if you look at this year's earnings, but if you look far enough, they weren't expensive. So the way we deal with this at IMA, what we do, we always look, when we analyze companies, we look at the earnings four to five years out. And we do that so both companies, no growth company, growth companies could fit into our framework. Because that means the company that's not growing earnings, for it to be attractive, we would have to buy it maybe not a 50 % discount fair value, but maybe 70 % discount.

12:39Therefore, if it takes a longer period of time to come to fair value, then we'll get compensated extra for the risk. Let's take a quick break and hear from today's sponsors. Even Einstein had blind spots. That's why modern science is built on the idea of peer review. Investing may be more art than science, but that doesn't make peer feedback any less valuable. The tricky thing is finding qualified people who are interested and willing to help vet your investment ideas. That's why we built the Intrinsic Value Community. It's a place to connect, share ideas, learn, and get feedback. Nobody ever wishes they'd spent more time buried in spreadsheets, but connecting and building relationships with others who may be smarter on a topic than you, but who are also schooled in value investing, that's valuable.

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15:10The course covers 10 different sections, beginning with the basics of what a stock actually is and how the stock markets work, to strategies to optimize your retirement savings, how to pick great companies for the long-term, what to look for in ETFs, and how to monitor your investments, plus so much more. To begin getting smarter about investing, just visit theinvestorspodcast.com slash get started with stocks. That's theinvestorspodcast.com slash get started with stocks. And for a limited time, you can use code stocks15 for a 15 % discount at checkout. All right, back to the show. So given that the world is moving as fast as ever, have you found it more difficult to ensure that the companies you are buying have a sustainable competitive advantage?

15:57That is a great question. I think it requires a lot more research. And it requires for you to have more complex models, like mental models. But then we also look at things that don't change. Some things do change, but a lot of times we start with what things won't change. So I'll give you an example, and we'll talk about it later again. But the own defense companies, that's not going to change. There will be changes inside the sector, but because of the industry structure, these companies, they will be spending less money on one type of warfare, but we're spending more money on another type of warfare, and that business is still going to be based in those companies.

16:38So it is an example. So we're looking for things that won't change, and things where they will change, we need to have a much, much greater discount. And we try to focus mostly on companies where things will not change very much. So what are the most important metrics you look at when you're analyzing a company? So from a high level, what we want to do, we want to buy high quality businesses, we want to buy them under value. What does it mean, high quality? Again, high level. It means It's a company that has significant competitive advantage, company that has strong balance sheet, and company that has great management.

17:17And when I say great management, I have to break it up again. It's a management that's good at allocating capital and running the business. And so what I find, and this is, I'll give you a little nuance. When you look at smaller companies, I spend a lot more time on how well they run the business. When I look at larger companies, I spend more time on how well they allocate capital. Again, I'm just giving you extremely generalized answers, right? Because it's really going to be different from every single company. If it's a company that's not growing much, capital allocation becomes a lot more important.

17:51So I wish I could say, this is the number. This is the formula. But there isn't. It's really just you have to organize business, kind of one business at a time. And for each business, something else, what's important for one business will not be important for that. Robert Leonard You mentioned looking at the incentives of the management. How do you ensure that management's incentives are aligned with shareholders? Robert Leonard I think the ownership of the stock is very important. When I see a company where the CEO owns 20 % of the company, I know that whenever they make another acquisition, they're spending his money.

18:30When we talk internally about management. We talk about professional management, which is a little bit oxymoron because it's somebody who comes in, who has a great degree, who looks perfect for the annual report. And that's the guy who probably will make the acquisition that's going to destroy value because his time horizon is how long he's going to be in the CEO seat. A lot of times, three to five years, and the problems will come five or 10 years later, and kind of own an operator. and we would love to own companies, and we have owned a lot of them that's run by owner-operators kind of guys.

19:04And if you can find a company that has a strong competitive advantage, high return capital, high growth runway, and run by owner-operator, then you can basically buy this company and own it for a long, long time. So in other words, my self-discipline is going to be a lot more relaxed. Again, it doesn't mean I'm not going to have one, But I'm going to give them a much longer leash than if it's a company run by professional management. Again, I'm generalizing. What you'll find about life and investing, nuance is very important. Now let's dive more into the valuation side. One of the most difficult parts of valuing a business is determining a discount rate.

19:51Do you use a discount rate in your stock valuation process? And if so, how do you determine that discount rate? Without going into specifics, what we do, our discount rate is really a function of company's quality. The higher the quality of the company, everything else being constant, the lower the discount rate, and the lower the quality, the higher discount rate. Because if it's a very high quality company, fewer things may go wrong. And therefore, we have a high confidence in this company's earnings power. The lower the quality, the larger discount we need because there are more things may go wrong with the earning out, more risk.

20:27And the earnings power is at risk as well. But again, we focus on high quality companies in general. So difference between high quality and lower quality for us is much lower. So if it's a crappy company, maybe just don't buy it. That makes sense. And I came across this idea when doing research on you in the past. You've talked about how buying great companies might not be a good investing strategy. Why do you believe that to be the case? Well, it's a first level thinking and second level thinking. First level thinking is something that's basically almost comes to automatic. I'll give you a company and you say, great company.

21:08Amazon, great company. Microsoft, of great company, PayPal, and keep going. And the problem is everybody knows that, that those are great companies, and therefore they're usually priced accordingly. But the problem is those companies may be great companies. In other words, you would want to work for them, but it doesn't mean that you want to own them as investments. And the reason for that, because for them to be great stocks, they have to offer you good long-term return. And the return comes from two factors, right? It's the, I'm going to put dividends aside for a second, but it's for the stock price.

21:42It's really earnings growth and change in price to earnings. If those companies are very expensive, and a lot of the earnings growth will be consumed by price to earnings compression at some point. Over the last 10 years, they didn't matter because price to earnings only went up. But at some point, we already saw this happen to a lot of great companies. We are talking over Zoom, and Zoom is down, I don't know, 70 % since its highs. Even though it's still a good company, it's just, it wasn't a great stock when it was at much higher. And I'm not even sure if it's still good stock today or not. So you have to differentiate between a good company and a good stock.

22:20And a good stock is basically has to do with what's the expected return when company's growth rate kind of normalizes. The first company that comes to my mind is Tesla. I think some people will just buy Tesla stock just because they believe that Tesla is a great company without realizing the level of success that they'll need to achieve in the future in order to give investors even a reasonable return. See, I have a Tesla car, a Tesla Model 3, and we have another one on order. And I got to tell you, I love the car. Every single time I drive it, I receive joy from it. Actually, I wrote a kind of a mini book.

23:02If your readers want to look it up, they can find it on Amazon. It's$3. But when I bought my Model 3, I basically was so impressed by this car that I ended up doing a lot more research. And this was two years ago. And I realized that electric cars are the future. To me, there's no question in my mind. And then one thing I did not know at the time, who are going to be the big players. And at the time, I wasn't even sure that Tesla's future was not guaranteed. I knew the company would be around, but as an investment, it was losing a lot of money, and it was very path dependent. Could you tell our audience about the importance of developing a process to challenge your own beliefs?

23:44That is such a great question. Seneca, the Roman philosopher, he has this saying, which I love, time discovers truth. And that applies to investing so much because whenever I'm buying a company, I'm basically betting on a certain version of the future. And time will basically discover it for me. So my goal is to be right and to make money. And if facts over time change, then the future will change. And then you really want to be as objective as possible. And let me give you this analogy from chess. If you ever watch very good players analyze their games, at some point, they stop saying, like myself versus another player, they're going to say white versus black.

24:33And the point is, they stopped linking the whites to them or blacks to them. And now they're just looking for what are the best moves. So they're looking for that objectivity. So when you look at your portfolio and you basically say, okay, when I bought it, this is what I expected from the economy or whatever, or from this company. Now I'm looking at it again. Is that my assumption still correct? Et cetera. So that is extremely, extremely important. And we try to do this all the time. You're a big advocate of having a more balanced investment approach that is able to weather all storms. What investments have you found that you expect will be able to hold its buying power if inflation persists through the coming years?