manual of ideas interviews vitaliy katsenelson

Value-oriented Equity Investment Ideas for Sophisticated Investors

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Investing In The Tradition of Graham, Buffett, Klarman

Year III, Volume XI December 27, 2010

When asked how he became so successful, Buffett answered: “We read hundreds and hundreds of annual reports every year.”

Top Five Ideas In This Report

Compton Petroleum (Toronto: CMT, OTC: CMZPF) …. 32

Corinthian Colleges (Nasdaq: COCO) ………………… 36

Global Cash Access (NYSE: GCA) …………………….. 52

Penson Worldwide (Nasdaq: PNSN) …………………. 64

Winn-Dixie Stores (Nasdaq: WINN) …………………. 80

Also Inside

Editorial Commentary ………………. 4

Superinvestor Update ………………. 8

Vitaliy Katsenelson Interview ……… 9

Stock Price Losers of 2010 ………… 14

Micro-Cap Underperformers ………. 19

Favorite Value Screens ……………. 88

This Month’s Top Web Links ……… 98

About The Manual of Ideas

Our goal is to bring you investment ideas that are compelling on the basis of value versus price. In our quest for value, we analyze the top holdings of top fund managers. We also use a proprietary methodology to identify stocks that are not widely followed by institutional investors.

Our research team has extensive experience in industry and security analysis, equity valuation, and investment management. We bring a “buy side” mindset to the idea generation process, cutting across industries and market capitalization ranges in our search for compelling equity investment opportunities.

HOLIDAY ISSUE

2010 LOSERS, 2011 WINNERS?

► Drilling down on the stock price losers of 2010

► 17 companies profiled by MOI research team

► Proprietary selection of Top 5 candidates for investment

► Plus: Superinvestor holdings update

► Plus: Favorite stock screens for value investors

► Plus: Exclusive interview with Vitaliy Katsenelson

Companies mentioned in this issue include Aegean Marine Petrol, AgFeed Industries, Agilysys, Allied Irish Banks,

Alphatec, Amedisys, American Apparel, American Caresource, American Dairy, Apollo Group, A-Power Energy, Arena Pharma,

Aviat Networks, Bank of Ireland, Barnes & Noble, BPZ Resources, Brooklyn Federal, Builders FirstSource, Cano Petroleum, Charming Shoppes,

Cincinnati Bell, Community Bankers, Compton Petroleum, Comstock Resources, Consolidated Water,

Corinthian Colleges, Cowen Group, Crimson Exploration, Cybex, Dean Foods, Diamond Offshore, Doral Financial, Energy Conversion,

Farmers Capital, First BanCorp, Flagstar Bancorp, FreeSeas, FuelCell Energy, General Maritime, Global Cash Access, GMX Resources, GSE Systems,

H&R Block, Hercules Offshore, Hutchinson Technology, Jackson Hewitt Tax, Majesco, National Bank of Greece, Navigant Consulting, Navios Maritime,

Net1 UEPS, NGAS Resources, OceanFreight, Omega Navigation, Orchids Paper, Penson Worldwide, Petroleo Brasileiro, PremierWest Bancorp,

PrimeEnergy, Princeton Review, QKL Stores, Quantum Fuel Systems, RELM Wireless, Revlon, Salem Communications, Santarus, Seanergy Maritime,

Sharps Compliance, SmartHeat, Sterling Construction, SUPERVALU, TORM A/S, Unisys, Vermillion, Willbros Group, Wilmington Trust,

Winn-Dixie Stores, Yadkin Valley Financial, YRC Worldwide, and more.

(analyzed companies are underlined)

* A FREE book is available to members who receive The Manual of Ideas in the mail each month.

HAPPY HOLIDAYS!

Request your FREE copy* of Katsenelson’s The Little Book of Sideways Markets

Email your wish to support@

manualofideas.com

Inside:

Exclusive Interview with Vitaliy Katsenelson,

CIO of Investment Management Associates and Author of The Little Book of

Sideways Markets

With compliments of The Manual of Ideas


© 2008-2010 by BeyondProxy LLC. All rights reserved. SUBSCRIBE TODAY! www.manualofideas.com December 27, 2010 – Page 9 of 101

Exclusive Interview with Vitaliy Katsenelson

We recently had the pleasure of interviewing Vitaliy Katsenelson, CFA, chief investment officer of Investment Management Associates, a Denver, Colorado-based value investment firm. Vitaliy is also author of the acclaimed books Active Value Investing and The Little Book of Sideways Markets. The latter was published in December 2010 and has been one of the best-selling investing books on Amazon.com. Vitaliy graduated from the University of Colorado at Denver and has taught undergraduate and graduate investment classes there.

The Manual of Ideas: You have been credited with some of the most illuminating analysis on the topic of sideways markets. In fact, you coined the term “cowardly lion” for markets that seem to go nowhere for years or even decades. Can you discuss the investor psychology and expectations that prevail in sideways versus bull or bear markets?

Vitaliy Katsenelson: Secular (long-term) sideways markets consist of mini (cyclical) bull and bear markets. For instance the last sideways market of 1966-1982 had four mini-bull and five mini-bear markets. Investor psychology for the most part tends to reflect the market cycle we are in at the time. My first book came out in 2007, and as I spoke to investment groups about sideways markets right after it was published, my message was dismissed because everyone was bullish, since we were in year four of a cyclical bull market. In 2008 and early 2009, when I spoke to groups of investors around the world about sideways markets, the reception was quite different. Everyone was scared and people were actually grabbing desperately at my message, because the idea of a sideways market sounded a lot better than the Great Depression II school of thought.

However, after several of these multi-year market swings, investors finally lose hope. The next bull market just needs not to come a few times before they throw in the towel, and this is when the next secular bull market will begin.

MOI: In your books Active Value Investing and the just-released, must-read Little Book of Sideways Markets you provide an analytical framework for evaluating a stock market that seems to be stuck in neutral for a long time. What are the economic, business and valuation conditions necessary for a sideways market? Please contrast them with the conditions that tend to prevail at the beginning and end of bull and bear markets.

Katsenelson: So let’s clarify I am talking about secular, long-term market cycles, the ones that last longer than five years, actually more like a decade or longer. Historically, sideways markets took place when had you a combination of two things: high starting stock valuations (this is why they always happen at the end of a long-term bull market) and average earnings growth. During sideways markets P/Es decline from above-average, to average, and then to below-average levels. Thus all benefits of earnings growth are wiped out by constant P/E compression.

“Today the stock market is still not cheap. If you look at

today’s valuations on ten-year trailing earnings, they are still over 20% above the

average P/E.”



Bear markets, on the other hand, start when valuations are high and the economy has stagnated for a long, long time. Think of Japan from the 1990s to today: Japanese stocks were extremely expensive and the economy has stagnated for a long period of time. Earnings growth was not there to lessen the impact of P/E compression, in fact it only added oil to the fire as they declined, and thus Japanese stocks declined 80% off their highs.

Secular bull markets happen when you have two things in place: low (below-average) starting valuations and prolonged earnings growth.

MOI: The U.S. has gone through a decade of stagnant equity prices. At what juncture of the sideways market are we today? Why are equities likely to go nowhere for another relatively long period of time?

Katsenelson: The current sideways market started at very high valuations, in fact the 1982-2000 secular bull market ended at the highest valuation ever! Today the stock market is still not cheap. If you look at today’s valuations on ten-year trailing earnings, they are still over 20% above the average P/E. Unfortunately, stocks usually go from one extreme to the other, thus we need to pass from above-average, through average, and then spend some time below average. We are not there yet.

Also, it is earnings growth that takes us there: stock prices don’t change much in the long term, but the P/E is compressed by a constantly rising E. Both the U.S. government and the American consumer are overleveraged, and they’ll be deleveraging (though government is taking its sweet time and leveraging up right now, which just means higher taxes and higher interest rates down the road). Deleveraging leads to lower earnings growth. So you have high valuations and lower earnings growth, which means this sideways market will likely last longer than most. Not just sixteen years, maybe twenty.

MOI: How should investors position — and re-position — their portfolios assuming an expectation of sluggish overall equity market returns?

Katsenelson: In short, they need to become more active. Not day traders, but more active buy-and-sell investors. Selling discipline needs to be kicked into higher gear. Buy and hold should be put on hold. They need to increase their required margin of safety. In the absence of good stocks to buy, they should not be afraid of holding cash.

MOI: Could you illuminate your investment strategy by way of an example of a company that meets your criteria today?

Katsenelson: Medtronic (MDT) fits my criteria perfectly. It is a very high-quality company that has grown earnings at about 14% a year over the last ten years. It has a strong balance sheet — about a billion dollars of net debt that it can pay off in a few months from free cash flow, if it decides to do so. It also has a high return on capital, it trades at nine to ten times earnings, and has very capable management. It has a very strong pipeline of products, but investors have become impatient with its prospects over the next few quarters. So you have the “pain arbitrage”: if you are patient and can withstand a few quarters of nothingness, then you’ll do fine. Also, there is some “headline risk” with Obamacare, though I think it is for the most part behind us. Medtronic pays almost a 3% dividend, the company is buying back stock, and the demand for its products, like pacemakers, will only be higher three years from now.

“Medtronic fits my criteria perfectly. It is a very high-quality company that has

grown earnings at about 14% a year over the last ten years. It has a strong balance sheet

[and] a high return on capital, it trades at nine to

ten times earnings… It has a very strong pipeline of

products…”



MOI: How do you generate investment ideas?

Katsenelson: Number one, I have a watch list — a few hundred stocks that I researched at some point in time, some of which I owned in the past, and which I want to own when they hit my price target. I look at the list weekly.

I screen.

I learn what other investors I admire own. I have a good circle of friends who are value investors; we share ideas.

I look at stocks that are making 52-week lows.

None of these things are earth-shattering. Before I buy a stock I need to figure out what the street is missing. With very few exceptions, I find little value in street research. I read it on occasion but mostly to find out the consensus.

For instance, we own Vodafone (VOD). When we bought it a little more than a year ago, I read street research to see the consensus view on VOD’s very sizable stake in Verizon Wireless. The street basically put almost zero value on it; I thought it was worth north of $45 billion.

MOI: It seems that one of the greatest “risks” of accepting the notion of a sideways market is the possibility of missing a major turn and ending up with either too much or too little equity exposure. For example, if an investor sells stocks when they appear to be close to their “ceiling,” the investor could be left with little equity ownership just as the market embarks on a new bull run. Similarly, an investor buying stocks at “floor” valuations assuming a sideways market may become overly exposed at the onset of a potential bear market. Is this a valid concern, and if so, how do you mitigate it as part of your investment strategy?

Katsenelson: If we were to embark on a raging long-term bull market, the strategy should do fine, but it will not knock the lights out like some other, more aggressive strategies. The cash will hurt. But if you don’t want to have large cash balances, increase the pond in which you fish for ideas; start looking overseas — not China or Afghanistan, but in other developed countries where there is a rule of law. In fact, today we see a lot of ideas in Europe. Some investors I respect are starting to see a lot of ideas in Japan — though I am a bit nervous about Japanese equities, because even if they get the fundamentals right, the currency, which today is making multi-year highs against the dollar, will kill them if the yen depreciates significantly, which I think it will.

I look at this small underperformance in case a secular bull market comes upon us as a minor insurance premium I am willing to pay in case lower-probability scenarios play out. I put a 5% probability on a new bull market, 80% on a sideways market, and 15% on a bear market. Valuations are high today, so half of the recipe for a bear market is there, if earnings stop growing for a long time then we’ll enter in a secular bear market.

MOI: The Federal Reserve policy of money printing — or QE, as it is sometimes lovingly called by Fed insiders — has introduced a wildcard into the investment equation. Many prominent value investors have warned of the risks of accelerating inflation or even hyperinflation. Such a scenario could exacerbate volatility in the stock market and perhaps strengthen your thesis of a sideways market. On the other hand, runaway inflation could also lead to large

“Some investors I respect are starting to see a lot of ideas

in Japan — though I am a bit nervous about Japanese

equities, because even if they get the fundamentals right,

the currency, which today is making multi-year highs

against the dollar, will kill them if the yen depreciates

significantly, which I think it will.”



nominal appreciation in equity prices, even as equities stay flat or decline in real terms. How do inflation expectations affect your longer-term market outlook?

Katsenelson: Both inflation and deflation will lead to lower future P/Es, but inflation will lead to higher nominal earnings growth and it may shrink the length of the sideways market. Deflation will have the opposite effect. Think about it this way: you have a train leaving the high-P/E station and going toward the lower-P/E station. Both deflation and inflation will move the lower-P/E station further away from the high-P/E station, i.e., it will drive ending P/Es down. However, higher inflation will increase the speed of the train, so it will get to the low-P/E station faster, while deflation will slow it down, prolonging the length of the journey.

I understand the arguments for both inflation and deflation. I think to a large degree whether we have deflation or inflation will depend on future intervention of the government in our economy. Unfortunately, our society has become pain-intolerant. This explains why the number-one prescribed drug in the U.S. is Vicodin [a narcotic analgesic product used to relieve moderate to severe pain]. So I fear our government will keep trying to fix the economy through higher government spending, perpetual extension of unemployment benefits, and endless tax cuts (I love lower taxes but not the ones that result in higher government borrowing).

If we keep doing this then we’ll turn into Japan — it has debt-to-GDP of over 200%, interest expense consumes almost a quarter of tax revenues, and it cannot afford higher interest rates. But interest rates will rise as internal demand for its debt dries out, and it will have to start shopping its debt outside of Japan where countries with much, much better credit profiles are paying double or triple on debt with the same maturity. If the yield on Japanese debt doubles, the increase will exceed Japan’s spending on defense and education combined. So this country that was on top of the world only two decades ago will go from twenty years of deflation to high inflation.

MOI: In your writings you have shared anecdotes about your father and growing up in Russia. How has your background influenced your view of the world and, by extension, your investment philosophy?

Katsenelson: It made me appreciate capitalism and distrust government intervention in the economy (thus it helped me to understand better what is going on in China). It probably made me a little bit cynical, and definitely added some sarcasm to my personality. I appreciate my wonderful life here in the U.S. I pinch myself every day when I come to work, and when I see my wife and kids and feel how great it is that we got here.

MOI: You have recently expressed a rather cautious view of China’s economic and political prospects. What concerns you most about what you’re seeing there?

Katsenelson: Interestingly, China is a communist country without socialism. The government uses communist ideology as a means to control people, but at the same time there is a very flimsy social safety net in China. Ironically, if this was the only criterion, the absence of the social safety net would make China more capitalistic than the U.S.

“If the yield on Japanese debt doubles, the increase

will exceed Japan’s spending on defense and education combined. So this country

that was on top of the world only two decades ago will go

from twenty years of deflation to high inflation.”



Of course, the Chinese government controls one-third of the economy (this includes the banking sector, too), and it is concerned that economic slowdown will result in high unemployment and political unrest. Thus it has chosen a policy of growth at any cost. This policy is interleaved with corruption, of which China has plenty, leading to massive misallocation of capital and overcapacity in the industrial sector and commercial and residential real estate. It is that simple.

During the crisis China firehosed 12% of GDP into its economy, which took things to a new level of financial insanity and resulted in inflation. The government is now trying to put the brakes on the economy to fight inflation, but I have little trust in their ability to manage an economy of such size. What really amazes me is how we Americans tend to mistrust our government’s ability to do things right, but feel the Chinese government will do a terrific job managing its economy.

MOI: What is the single biggest mistake that keeps investors from reaching their goals?

Katsenelson: We let the outside world influence us too much.

In The Little Book [of Sideways Markets] my favorite chapter is “Born Again Value Investor.” This past May I let the market get to me. I felt like everything I was doing was wrong. The stocks I bought declined; the ones I sold went higher. But I was judging myself on a very short time frame.

I forced myself to write about it (this is how I think, through writing). We need to shield ourselves from the outside world. I am not advocating moving into a cave with no electricity. No, but we should not allow the outside into our lives unchecked. I found the most productive time I have is on airplanes, because I can write and think for hours, there is little interference by the outside world.

I usually try to read newspapers and otherwise keep up with the news before I get to the office. Then I try (this is still an effort) to turn off the Wi-Fi switch on my laptop — this kills the internet, including email, Skype, IM, and RSS feeds. I try to recreate a plane-like environment at work. I don’t turn on the TV during the day. And when I do tune back in I try to listen to more podcasts, and watch PBS more and business TV less. So to answer your question, I think we should create an environment where the outside world doesn’t change (shrink) our time horizon.

Oh, and this is very important: I really try hard to only check the prices of my stocks a few times a day. I have not perfected this yet — we all have bad habits that it takes time to break. But if we are aware of the negative influences the outside world can have on us, there may be hope for changing our behavior.

MOI: Vitaliy, thank you very much for your time and insight.

“What really amazes me is how we Americans tend to mistrust our government’s

ability to do things right, but feel the Chinese government

will do a terrific job managing its economy.”

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manual of ideas interviews vitaliy katsenelson

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