Saturday, April 30, 2005

The Good, The Bad, and The Ugly - US Bank

April 30, 2005 -
This is what I want to see from a bank in our portfolios: growing assets – a source of loans, growing checking accounts – a source of free (cheap) funds, growth of fees – provides stable income, which is not sensitive to interest rate volatility. In addition I would like to see expenses as a percent of revenues (efficiency ratio) constantly declining – gratitude of operational leverage, which a banking business has plenty of.
Oh, and I would like to get a nice, fat return on assets and return on equity. On top of all that, I want that bank to be well capitalized and not be in the practice of giving out loans to people that don't pay them back. Is that so much to ask?
On the surface US Bank (USB) met Street’s estimates of $0.57. However, a quick under the hood look shows that the results were very mixed at best.
  • The Good: Asset growth was 4.2%: retail loans were up 9.5% (nice growth), commercial loans were up 7.3% (I like it), and investment securities declined 4.3%. I am willing to ignore the decline in investment securities and focus on a big picture - loan growth.
  • Fee revenues are up 4.9%. Credit card fees are up 8.5%, consumers are not giving up. European acquisition contributed about half of the growth in this segment (not as good as it appears).
  • Non-interest expense is down 8.5% - great news. However, a big chunk of it was driven by a change in valuation of MSR (mortgage servicing rights). Also in the Q1 2005, USB took a charge for early debt repayment. Excluding the charge and MSR, expenses were about flat.
  • Lower charge offs – loan charge off declined. Net charge offs inched 3bp higher, but it is still very close to an all-time low level of 0.55% of average loans. Overall credit quality is improving. This trend is very consistent across most banks. However, charge offs are likely to increase as interest rates rise.
  • Acceleration of deposit growth, however, non-interest bearing deposits declined 2.1% where most growth came from time deposits greater than $100,000.
  • Tier 1 ratio is at 8.6%, though 3 bp lower than it was last year but still a very solid number.
  • Returned 108% of earnings to shareholders in the form of dividends and share buy backs. The dividend yield stands at an already high 4.3% and share buy backs added another 3.1%, resulting in a 7.4% return to shareholder yield.
  • Efficiency ratio has declined to 41.7% - one of the lowest ratios I have ever seen – very good news.
The Bad: Interest margin has declined 21 bp:
  • Part of it was attributed to the flattening of the yield curve. This got me thinking: further decline in the dollar and the Chinese possible de-linking their currency is likely to send U.S. interest rates higher, normalizing the yield curve. Another question, does the Fed really have control over interest rates?
  • The rest was due to increased competition. Did USB originate that nice loan growth by undercutting competition?

The Ugly: There was nothing ugly in this quarter - I just like the title. But that is what is so great about USB - investors are unlikely to see anything ugly from this company. On another hand, half of “the good” bullets should be in the “the mediocre” column. I really like seeing asset growth, but I don’t put as much value on that growth when it comes at the expense of net interest margins. USB has one of the lowest cost structures in the industry, a big plus considering this is a commodity cut-throat business. Thus being a low cost producer allows the company to compete on price.

Very few positives in this quarter were organic. I am not accusing USB of using pesticides, but there is limit to the ‘non-organic.’ There were plenty of ‘one time’ items that helped to deliver the bottom line growth. The problem with one time items – they are non-recurring and they don’t provide great visibility into the future.

On a positive note, this quarter performance was a significant improvement from last quarter and last year’s. Deposits, loans and net interest income stopped declining and showed a sign of growth. I cannot really tell if the current performance is a fluke or if USB has been resuscitated. As ugly as the chart looks, USB doesn’t scare me. It seems that downside risk is minimal in this stock: it trades at 12 times 2005 earnings and is yielding 4.2%. It is very likely that interest margins will decline in the next quarter, as spreads are still very low. Contrary to common perception in the long-run interest rate spreads have little correlation with banks’ profitability (see chart below).

This less than spectacular performance placed USB on my probation list. If deposits, non-interest income and assets don’t start showing a more meaningful growth next quarter, I’ll have to part with USB. In the meantime, I welcome suggestions for a better bank with high a dividend, attractive valuation and great quality. Vitaliy N. Katsenelson, CFA Copyright 2005

Friday, April 29, 2005

The Good, The Bad, and The Ugly - AJ Galagher

April 29, 2005 - Minyanville

As “the Ugly” and “the Bad” dominated the performance for Arthur J Gallagher & Co (AJG) this quarter, at least on the surface, and as such we will address them first:

The Ugly:

  • Only 4% of the 12% revenue growth was organic, the rest came from acquisitions.
  • In the brokerage segment, organic revenue growth was only 1%. Though the organic growth looks awful, it is largely a reflection of softening of the insurance market. The volumes (number of contracts) are increasing; the dollar amount of transactions is declining. On the glass half full side of the equation, customers are increasing their coverage as the same dollar amount now affords them a better coverage (i.e. lower deductible and/or larger policy). This should mitigate some of the weakness in sales caused by a decline in premiums. The big question is when?
  • Operating margins contracted by 3% versus the first quarter last year. It was driven by: 1.3% due to new hires, 1.2% increases in stock options and medical expenses. Where is the other 0.50%? (don’t know). Margin compression – we have seen it before - AJG simply grows out of it. That is what I truly like about AJG’s management. They are not managing the business for the short-term. As much as it pains Wall Street, AJG’s management is indifferent to the whims of the quarterly-oriented analysts. Margins are likely to come back to their normal levels in the future. Also, the first quarter is usually seasonally the weakest for AJG, thus margins will improve gradually throughout the year.
  • AJG lost a $175 million breach of contract lawsuit with Headwaters. This is a very significant amount for AJG. AJG has a very strong balance sheet (no net debt) and ample cash flows. AJG is selling some of its non-core assets to pay for that lawsuit, in the short run it may have to tap into a line of credit to pay the $175 million (the actual net payment will be less after taxes). This large sum will not hinder either current or future growth. The only consequence that I can think of, could be AJG postponing some of the stock buy back. AJG will appeal that ruling, so $175 million payout is not a certainty, at least not just yet.

The Bad:

  • AJG took a charge of $35 million to reserve for possible settlements on contingent commission issue with different states. Actually once these settlements are reached it will be very good news for the stock, since it is another uncertainty that is hovering over the stock.
  • The end of contingent commissions. As of January 1, 2005, AJG stopped putting a contingent commission clause into their contracts. However, they will be collecting contingent commissions for contracts that were written last year. Contingent commissions only accounted for $20 million, a small portion of revenues, thus their disappearance will not be as painful for AJG as it is for other brokers. However, gradual winding down of contingent commission should have a negative impact on the bottom line, since they carry a very high profit margin. On the positive side, in the long run insurance brokers (including AJG) will likely recoup the contingent commission fees through rate increases.

The Good:

  • AJG’s Gallagher Basset division showed very respectable revenue growth of 13%, all of which was organic. In addition, margins expanded 4% fueling 27% of earnings growth. This business segment is somewhat sensitive to the economy, especially to the employment level as Gallagher Basset administers a lot of worker compensation claims.

Growth by acquisition. Usually I am not jumping up and down when a company’s growth strategy is based on acquisitions. Organic growth is usually less risky and cheaper and thus more valuable to shareholders. That being said, AJG’s acquisition strategy makes sense, especially in the soft insurance market, since AJG can buy companies at lower prices. Acquisitions are never large, it buys small brokerage firms whose corporate culture has a good fit with AJG (very important for acquisitions to work). And instead of trying to fully integrate them (usually a source of problems in an acquisition) AGJ helps them grow faster and more profitable buy linking them into its existing network and increasing the acquired companies’ product offering.

Though the bulk of revenue growth in the current quarter came from acquisitions the balance is likely to shift back to organic growth as the insurance market stabilizes. This quarter was riddled with a lot of one-time items, an unusual development for AJG. Between softening of the insurance market, the contingent commission controversy, losing of a very large lawsuit, contracting of margins – there was not much to like in this quarter. Patience is required in this juncture. However, all the bad news appears to me to already be priced into the stock (not advice). The Headwater issue is fully reflected and may only get better (at least not worse) if it gets overturned on the appeal. There is some risk that actual settlements with the states will be higher than $35 million reserved by AJG. However, knowing AJG management, it is likely to err on the side of caution. In addition, Aon (AOC) which is eight times larger than AJG set a reserve of $50 million. AJG’s valuation appears very appealing. At 14 times this year’s earnings, 11 times free cash flows and a super nice 4% dividend yield – this stock looks very attractive to me (again not advice). Our discounted cash flow model puts the valuation of the stock a lot higher. There is plenty of room for valuation expansion, AJG doesn’t have to do anything heroic in terms of earnings growth to deliver a decent total return, since it already pays a nice dividend. On the surface, the growth in earnings doesn’t appear around the corner, at least after looking at current quarter numbers. I believe it is. In the short-run, growth may be mitigated somewhat by the winding down of contingent commissions, however, as I mentioned above, AJG is likely to recoup that loss by charging a higher brokerage fee. Vitaliy N. Katsenelson, CFA Copyright

Tuesday, April 26, 2005

Don’t compromise in investment dating game

April 26 2005 - Financial Times
For a company to find a place in our clients’ port­folios it has to have three crucial ingredients: growth, quality and value. Not compromising, and thus avoiding marginal investments, is a true test of discipline – I would opt to hold cash over a marginal stock any time. As with dating, a marginal stock may prevent an investor marrying a truly good stock when it comes along. First Data is a one of the good ones, the rare stock that possesses all three ingredients. Growth: The company’s largest segment, payment services, represents nearly half of operating income and is carried out under the Western Union name. Although Western Union is one of the oldest and most respected corporate brands, its agent network is still fairly new. When the company bought Western Union 10 years ago it had only 30,000 agents. It now has 225,000 and is still growing. More than 80 per cent of its locations are less than five years old. As with drug stores, it takes at least five years for a new location to reach full profitability. As the new agent network matures, same-store sales should become a very important factor behind growth. There is plenty of inter­national growth left – less than 3 per cent of sales come from the fast-growing markets in China and India – while sales grew by more than 50 per cent in the last quarter. The cost of bringing a new agent online is about $1,500; First Data’s goal to sign up 30,000 agents in 2005 will cost the company approximately $45m, a drop in the bucket considering that its operating income was$1.3bn in 2004. Western Union’s revenues rose a respectable 14 per cent last quarter. However, higher interest rates hit the value of its bond portfolio sending interest income into negative territory and depressing profit margins. Although it is unpleasant, this development has no consequence on First Data’s long-term fundamentals; interest rates fluctuations have neutral impact on profitability over the full interest rate cycle. Western Union’s biggest competitor is MoneyGram, with a network of 79,000 agents. The money transfer business is driven by price and convenience. The network size provides a significant competitive advantage of economies of scale, awarding Western Union the lowest cost structure in the industry. In addition, it allows the company to charge a premium for the convenience of being closer to its customers. Western Union’s operating margin of 34 per cent, about twice that of MoneyGram, reflects its market dominance. The second largest segment is merchant services, processing debit and credit-card transactions, which represents close to 40 per cent of operating income. Last year, McDonald’s started to accept credit and debit cards in its restaurants. Although McDonald’s size will help drive the transaction volume, the benefit to the industry will spill far beyond. It forced all other fast-food restaurants to accept credit cards. More important, it changed the public perception of credit and debit cards. Debit cards are taking market share away from cash and cheque payments. First Data is positioned to ride the wave of this change. Debit card use is up thirty-fold in the last 15 years and growth is not likely to stop. Last year First Data acquired Concord, with its large debit card network, which secured First Data’s key position in the business. The company’s smallest segment, credit card issuing, is the slowest growth segment – with 3-6 per cent long-term growth. However, the spectacular growth of the two largest segments should mitigate its impact on the top line growth. In the long run, First Data is well positioned to deliver consistent and predictable revenue growth. Quality: First Data has a very strong balance sheet, with no net debt. Since its businesses are not very capital intensive, the company generates a very strong and stable free cash flow (operating cash flows less capital expenditures). FDC is returning free cash flows back to shareholders through a small, recently tripled, dividend 0.65 per cent and a massive share buyback, which should help accelerate EPS growth. While I would like to see a higher dividend, buybacks at these valuations make sense. Valuation: First Data is cheap. A discounted cash flow model shows very little growth priced into the stock. On relative valuation, it trades at sizable discount to its past and is significantly cheaper than its peers. With a forward price-to-earnings multiple of 16 and free cash flow of 15 times, I would marry FDC to our portfolios without a pre-nuptial in a heartbeat. Vitaliy N. Katsenelson, CFA

The Good, The Bad, and The Ugly: Kimberly Clark

March 26, 2005 - The Good:

  • Sales were up 6% (excluding sales from Neenah paper which was spun off recently), on constant currency sales that were up 3%.
  • Days sales outstanding is down to 2 days due to an investment in SAP software – that will help cash flows.
  • KMB returned back $500 mm to shareholders: $301 through share buy- back, and $200 in the form of dividends. In addition, the company raised its dividend 13% this year.
  • Sales in emerging markets are growing at a double digit rate. Emerging markets are about 23-24% of total sales. At some point, they will be providing the bulk of KMB’s growth (more on this later).
  • KMB maintained its sales guidance of 3-6% (constant dollar) for the year, management stated that sequential quarter performance showed signs of improvement. Sales in healthcare (8% of total sales) showed very respectable growth in the mid single digits.

The Bad:

  • Operating margins were under pressure from higher material costs, $100mm in the quarter, though partially offset by cost cutting ($45mm)
  • Higher commodity prices trimmed operating earnings growth by 4.3% (my estimates).
  • Gross profit grew 4.1% - impacted by the aforementioned reason.
  • Operating profit grew just 2.3% - due to higher promotional spending.
  • Personal care’s constant currency sales growth was very disappointing. That being said, things are likely to improve going forward.

Price increases - Following Proctor & Gamble (PG) and the lead of generic manufacturers, KMB instituted commensurate price increases across all product lines, passing the cost of commodities onto consumers. The fact that KMB is following P&G’s lead, takes out the risk that price increases would have be retracted (if P&G did not follow).

This is a very positive development. However, it will take time before price increases will trickle down to KMB’s bottom line, as inventory has to be worked out and contracts have to be re-written. Thus, next quarter numbers are unlikely to benefit from price increases, which will partially show up in the third quarter numbers.

On the tissue front, KMB figured a tricky way to raise prices and increase consumption at the same time. KMB is raising tissue count per box in their Kleenex product line. The cost per box and per sheet should increase as well. KMB feels this will drive sales as consumers will increase Kleenex inventory at home, which in turn will lead to higher consumption (this may actually work).

The Ugly:

Competition intensified in Europe, as sales were down 4% (despite a 6% benefit from a weaker dollar). In other words, constant dollar sales in Europe were down 10%. KMB is working on a turnaround of its European operations. Europe in general is a very tough market due to very little population growth. However, KMB has a product that will probably have a strong appeal to an ever-aging population (i.e. Depends - diapers for elders). The incontinence market is a faster growing market that should benefit from these demographic trends.

In developed countries, the diaper business is mainly driven by population growth. The tissue business is impacted somewhat by the severity of a flu season. However, sales in emerging markets are driven by the gradual rise in economic affluence. In emerging markets, or less affluent societies, diapers and Kleenexes are not staple items. Those markets are roughly in the same stage where the United States was thirty years ago. Folks in those countries are washing their handkerchiefs and cloth diapers.

The good news is that it will not take thirty years for consumers in emerging markets to become westernized - as a very contagious western influence spreads at the speed of light through the internet and TV screens. Though gradually, but not in the so-distant future, today’s highly discretionary products will become societal staples. As that happens, growth in consumption of those products will accelerate as population growth in emerging countries is growing at a much faster rate than the western world. A note of caution: primarily discretionary income has to grow for this transformation to take place.

As unexciting as the numbers above appear, KMB stock still has some juice in it (not intended as investment advice).

  • KMB generates enormous free cash flows (operating cash flows – capital expenditures) of $2.1 billion.
  • Pays a very decent dividend, yielding about 2.9%
  • Very strong balance sheet, it can payoff all of its debt from operating cash flows in less than 2 years.

Overall it has very strong brands, resulting in nice margins of 12% and healthy return on capital of 22%

In the long run, it has all the ingredients to produce a stable 6-8% earnings growth rate. Between the sales growth and cost cutting, KMB should see margins expand 40-50 basis points a year for at least couple years.

KMB is buying back its stock like it is going out of style, purchasing close to 10% of its shares back in the last five years. KMB said they’ll buy back $1 billion (with a B) of their stock this year. At current valuation levels - that makes a lot of sense in my view. Stock buy backs will be accomplished from free cash flows, not from leveraging up the company.

Thus, let’s go through the composition of long-term EPS growth: Sales growth 3-5% + margin expansion 1% + share buy-back: 2-3% = EPS growth 6-9% + 3% dividend = 9-12% total return

There is some risk to the assumption that margins will expand, and though it's probable that they will, there is the risk that any improvement in margins will be competed away. In the worst case, in the absence of margin expansion, KMB total returns will range 8-11% range. KMB’s P/E (17 times 2005 estimates) has some room for expansion, but the margin of safety is not spectacular. My discounted cash flow model seconds that observation. It is hard to get excited about KMB after a quarter like this. However, it deserves a place in our portfolio as a defensive stock (not a recommendation), especially in the absence of other defensive plays at reasonable valuations. If another consumer staple comes along that has the quality of KMB, with faster growth and a lower valuation, we may re-think our position in KMB.

Vitaliy N. Katsenelson, CFA Copyright

Thursday, April 14, 2005

Abbott - Gotta Love It!

April 14, 2004 - Minyanville
Blockbuster drugs have changed the risk profile of many pharmaceutical companies. But then again not all pharmaceutical companies are created equal. The only pharmaceutical company that we hold company wide is Abbott Labs (ABT). It has all the characteristics of the major pharmaceutical company: very strong balance sheet, great cash flows, nice fat profit margins and return on capital to die for. Though Abbott has some debt, it could pay off all of its net debt (debt minus cash) from one year’s operating cash flows. In addition to all those nice qualities,
ABT has something that very few large pharmaceutical companies possess – product diversification. As very apparent from the table below, its largest drug Bioxin accounts for only 6.1% of total sales. I bet if it was recalled tomorrow it would not even make it into local news. ABT meets all of QVG criterions. All of the aforementioned qualities make it a very high quality company.
Growth ahead is likely to be consistent and predictable, with very few hiccups of small drug expirations. ABT is not facing many major drug expirations, a majority of drug expirations will happen in the second half of the next decade. Q1 2005 gave a very good indication that there is plenty of growth ahead. Though 16% sales growth was a little bit deceptive as it was helped by a weak dollar, ABT still manifested 13.4% constant dollar sales growth. The most impressive part of the report was that sales growth was company wide. There were only two weak spots in first quarter’s performance: Ross Product’s sales have only grown 1.7% in the quarter. The company’s explanation was that very strong sales in the previous quarter caused a build up in inventories at the wholesaler level. Management indicated that sales in that segment should normalize next quarter. A note of caution, as I learned from past experience, these kinds of events should never go unchecked. If this repeats in the future, it may be an indication of channel stuffing. The second weak spot was the gross margins which declined by 2.2% to 53.1%. According to the company, gross margins were impacted by two factors: unfavorable product mix and sales of lower margin Mobic rose 185% and restructuring charges of 0.5%. I’d like to see gross margins go up, but the negative product mix argument makes sense. The lesson learned from first quarter performance, ABT is firing on all cylinders. The company is properly positioned to benefit from baby boomers desire for a healthy life, a loathing of physical exercise and a constant pursuit to out-eat their neighbor at McDonald's (MCD).
In addition, there is an invisible warrant attached to ABT’s sales that has gotten very little attention so far. ABT has a drug eluting stent (aka DES) in the works that should make its way to the market sometime in 2007. If the drug eluting stent becomes a success it could create a nice boost for ABT’s sales.
Also, last year the FDA lifted a consent decree (a fancy word for barring products from the market) from ABT’s U.S. diagnostic business, another catalyst for higher sales growth. In fact, in Q1, the U.S. diagnostics business grew 27.2%. My conservative expectation for long-term revenue growth is about 8-10%; margin expansion and share buy back should add another couple of percentage points bringing earnings growth to 10-12%. Add a 2.2% dividend and we are talking about nice growth with very little risk.
Value: A quick 411 on the discounted cash flow model. I use a discounted cash flow model as an indicator of direction of the value. It is not a precise tool by any stretch of the imagination. Discounted cash flow models are extremely sensitive to a multitude of assumptions, and there are plenty of those, thus expecting precise answers from the model is impractical. As Keynes said: “I would rather be vaguely right, than precisely wrong”. I am looking to be on the vaguely right side when I am using discounted cash flows.
Also, discounted cash flow models work very well in the extreme circumstances. For example, it would have kept investors away from Cisco (CSCO) and Sun Microsystems (SUNW) during the 90s bubble. Even if investors discounted their cash flows using the risk free rate (as if they had a license from U.S. government to print money, thus making basically default risk-less entities) it would show investors that expectations that were built into the bubbly stocks were not from this planet.
I find that the process of thinking through the assumptions that go into the model is as important as the final outcome. Going through the process puts me into the investor state of mind, putting things into the right perspective, forcing to evaluate my assumptions, and most importantly raises the questions that have to be answered before the stock is purchased.
My magic discounted cash flow model shows that ABT is undervalued (not advice). The expectations that are priced into the stock are for a mid single digit sales growth rate. ABT could do much better than that. Looking at historical P/E ranges, ABT is trading at one of the lowest levels ever.
ABT is unlikely to return to the glory days of the late 90s but its relatively low risk profile, predictable double digit EPS growth rate, and above average dividend lends it to an above market multiple. It is currently trading at 19x 2005 earnings and only 17x 2006 earnings. Sometime in August, Wall Street will start looking at 2006 EPS in evaluating ABT, I want to be there when they do, because the stock is very cheap on a 2006 estimates basis.
Vitaliy N. Katsenelson, CFA Copyright

Monday, April 11, 2005

Few accept slower growth gracefully

April 11 2005 - Financial Times
Most of the latest accounting scandals have taken place with successful and highly regarded companies, not the John Does of the corporate world, but the icons of corporate America. Is that a coincidence? Not at all. We live in a finite world where infinite supernormal growth of earnings is not possible, at some point even the most successful company will reach a size at which a supernormal growth rate is not possible. The law of large numbers is as inevitable as gravity, setting in slowly but surely. Many companies defy the law of large numbers by constantly going after new markets or branching out into new industries. However, the inevitable can only be postponed but not escaped, the longer and the faster past growth lasted, the more difficult it is to repeat. Most companies facing the music of slower growth are thrown into a spiral of denial. Few have the courage to face the new reality and lower their growth expectations, since stock will pay the price of price/earnings multiple contraction. On a behavioral level, admission of inability to deliver the past growth will disappoint shareholders expectations that were anchored on past growth, and are difficult for corporate managers as they often look at it as personal failure. Often sub-par performance has to last for awhile, several generations of management changes need to take place, and a lot of capital needs to be wasted to "reinvigorate the company" before the more realistic growth rate is set. It took Coca-Cola more than seven years and several management changes for the company to set a more realistic and achievable growth rate target and to admit that the past growth rate is not repeatable. The latest darlings that joined the club of financial statement offenders are AIG and MBIA. Both are the largest players in their industries, both exhibited consistent, respectable earnings growth and had the highest debt rating possible (AIG got downgraded last week). Though it appears the size of restatements is insignificant in relation to their enormous net incomes, the risk profile of both companies just went off the charts for the following reasons. It is hard to know if the discovered offences are the exceptions or just the tip of the iceberg. In the absence of other information, the fact that restatements dated back to late 1990s, raises the likelihood of discovering an Everest-size iceberg. The degree of assumptions used to create financial statements varies from industry to industry. To create financial statements as insurance companies, AIG and MBIA have to make a large number of assumptions from the size, probability and timing of the future liabilities to the expected rate of return received on investments far into the future. Their financial statements are complex, and to makes things worse, net income is extremely sensitive to those assumptions. Investors have to have faith that assumptions made to construct financial statements reflect economic reality. It is hard to have that confidence, since the same management that was involved in accounting tricks is in charge of making those assumptions. In general, companies resort to illegal shenanigans after all legal avenues for maintaining growth have failed. The fact that AIG and MBIA may have intentionally succumbed to illegal accounting and business a warning sign that true earnings growth rate is likely to be slower in the future, resulting in a permanent contraction in p/e multiple. As is often the case with corporate hallmarks, they trade at a premium valuation to their industry peers. That certainly was the case with AIG, it always commanded a higher valuation to other insurance companies. Debt downgrade by credit agencies will result in a higher cost of funds for AIG thus reducing its profitability. Though debt downgrades are unpleasant, AIG should be able to survive a series of small downgrades. However, that may or may not be the case with MBIA. MBIA's business model is heavily dependent on its ability to use its AAA-rated balance sheet to cosign [insure, act as guarantor of] bonds issued by municipalities. A loss of trust in MBIA's financial strength could result in MBIA's demise. Again, it is impossible to assign probability to that event, but it is clear that probability is higher now than ever before. Bear (as well as bull) markets tend to be great educators for those who are willing to learn. The recent one taught investors an important lesson: in the event of even the slightest appearance of intentional financial or business shenanigans sell first and think later, as bad news hates loneliness and never travels alone. Vitaliy N. Katsenelson, CFA Copyright Fincial Times 2005

Saturday, April 02, 2005

Introduction to Minyanville

April 2, 2005 -
Editor's Note: With this article Minyanville is proud to welcome Vitaliy Katsenelson to the 'Ville. Mr. Katsenelson holds a CFA and has worked in the asset management industry since 1995. He is currently vice president and portfolio manager with Investment Management Associates Inc., a private portfolio management firm based in Denver, where he manages portfolios for individual and corporate clients. “This American system of ours, call it Americanism, call it capitalism, call it what you will, gives each and every one of us a great opportunity if we only seize it with both hands and make the most of it" Al Capone My Russian accent and my Russian first name may mislead readers into thinking that I am an expert on Russia. I hate to disappoint folks, but I am not. I have not been to Russia since my gracious exit in 1991. And I’ve never looked back since. Quite frankly, I did not have any reasons to. This great country gave me everything I ever wanted and more. Initially, when I got nostalgic about Russia, I found a quick visit to a U.S. post office served as a great antidote. Its long lines, smile-less faces and atmosphere of human indifference cured any symptoms of nostalgia in a New York second. I don’t have any intentions to offend an army of mailmen; after all I want all my junk mail to be at my door on time. Their behavior is not a byproduct of personal qualities - not at all - but rather a result of an inefficient, semi-socialistic system where perpetual employment is guaranteed no matter what performance is, as long as one shows up to work. In Russia, another criterion was added to the guarantee of perpetual employment - employees had to maintain soberness through out the day. "History suggests that Capitalism is a necessary condition for political freedom." Milton Friedman
Next time your kid asks you about the pitfalls of the large government and / or socialism just take him on a field trip to a U.S. post office. As you can tell, from the above comments I think like a “capitalistic pig”; well, I am one. I truly believe that the United States has the best political and economic system, and although far from being perfect, it is truly the best there is. For subscribers that may not be familiar with my work, let me discuss more about how I look at the investment world. What is your investment approach? At Investment Management Associates, Inc. we are long-term investors. This is really a reflection of an attitude, not a time horizon. We have a long term time horizon, but so should anybody who invests in stocks in our view. If an investor cannot part with his / her money for five years or longer, they should not be involved in stocks. The long term view is also a reflection of our approach to analysis. We patiently wait for the stock price to misrepresent the true value of the company we own for a considerable period of time as long as we get compensated for this with earnings growth and dividends. We look for three elements in every company: Quality, Value, and Growth (QVG). All three elements have to be present for a company to secure a place in our portfolios. Unfortunately this market’s high valuation makes it very difficult for us to assemble an all-star team of stocks that meet all three criterions. Unwilling to compromise, we often have to resort to cash as we believe it is a better alternative. Do you use broker research? I find broker recommendations fairly useless. It is still very difficult for brokers to maintain objectivity in their advice since they are very close to the companies they cover. Sometimes broker research may make an interesting and informational read. However, I care less about their recommendations. We do our own research and when we make mistakes, they are our mistakes; we own them and learn from them. What are your thoughts on the market? First, in the constant search for new stocks and we are having a hard time finding new stocks to buy. It is payback time; this market will be paying for the excesses of the last bull market for a long time. We expect the stock market to go nowhere with plenty of volatility and micro bear and bull markets in the interim. Market valuation is likely to get more expensive as corporate America starts expensing stock options this June. This market will require some fine-tuning to the investment strategy for even a long-term investor. I will discuss those fine-tunings in my future articles.
Second, rising interest rates are likely to become a problem for overleveraged consumers. This is an area of a definite concern and we are staying away from stocks that have benefited in the past from low interest rates and high housing prices. Consumers are very exposed to rising rates as variable rate loans gained popularity. We are avoiding home improvement stocks and financial stocks that derived a large portion of earnings from refinancing. Higher interest rates will likely poke a nice hole in the real estate bubble. Unlike the stock market bubble, deflation of that bubble will take awhile.
Third, I think China is a wild card. I don’t think anybody really has a good read on the Chinese economy, since it is a black box. Economic numbers released by the Chinese government are as trustworthy as Soviet era press releases that were trumpeting Soviet productivity. Using history and human behavior as a guide, China is very likely to be over invested and a correction is likely coming in the not so distant future. In my mind it is a question of when, not if. Fourth, oil may become a problem for the economy in the short term as an increase in oil and gasoline prices should temper economic growth. However, in the long run oil prices are not likely to go higher. I remember reading in the late ‘90s definitive studies that oil would become a $6 commodity. The argument sounded so logical and so convincing that I had to constrain myself not to mortgage my house and short oil. As convincing as the $100 / brl oil argument sounds today, there a lot of reasons I can think of that would make that argument fall apart (i.e. weakness in China and India, hybrid cars, alternative energy etc.). The longer oil prices stay at a high level, the greater the certainty (in my mind at least) that they’ll decline to much lower levels, as prolonged high oil prices stimulate an increase in supply.
I look forward to joining the Minyanville team and adding my contributions to the site. Toddo (Todd Harrison) has assembled a truly all-star team which I feel privileged to be a part of. I hope readers will find my longer term investment perspective helpful and I certainly welcome any feedback.
Vitaliy N. Katsenelson, CFA
Copyright Minyanville 2005