27 January 2022

Clay Finck chats with Vitaliy Katsenelson about how Covid-19 changed the game of value investing, what Vitaliy looks for in the companies he invests in, how Vitaliy thinks about the discount rate in his valuation process, why buying great companies might not be the best investment strategy, whether a portfolio of only stocks can give investors a well-balanced portfolio, and much much more! 

Vitaliy is the CEO of Investment Management Associates and the author of the Little Book of Sideways Markets. His contrarian articles on investing are often published in Barrons, Forbes, and Financial Times.



  • How Covid-19 has changed the game of value investing.
  • What Vitaliy looks for in companies he invests in.
  • How Vitaliy ensures that managements incentives are aligned with that of the shareholders.
  • How Vitaliy thinks about the discount rate in his valuation process.
  • Why buying great companies might not be a good investing strategy.
  • The importance of developing a process to challenge your own beliefs.
  • Whether Vitaliy believes that 100% stocks can give investors a well-balanced portfolio.
  • What Vitaliy thinks about China’s rise as a global powerhouse and how it might affect the financial markets.
  • And much, much more!




Disclaimer: The transcript that follows has been generated using artificial intelligence. We strive to be as accurate as possible, but minor errors and slightly off timestamps may be present due to platform differences.

Vitaliy Katsenelson (00:02):

The things that helped us in the past, those things will hurt us in the future. Like price to earnings. When they go up, it’s a loan, it’s not a gift. You have to pay it back. When you borrow money, it’s literally a loan. It’s not a gift. There’s going to be a lot of mean reversion. A lot of…

Clay Finck (00:23):

On today’s show, I sit down to chat with Vitaliy Katsenelson. Vitaliy is the CEO of Investment Management Associates and is the author of the Little Book of Sideways Markets.

Clay Finck (00:34):

During the episode, I chat with Vitaliy about how COVID-19 changed the game of value investing. What Vitaliy 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 a 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 Vitaliy Katsenelson.

Intro (01:03):

You’re listening to Millennial Investing, by The Investor’s Podcast Network. Where your hosts, Robert Leonard and Clay Finck, interview successful entrepreneurs, business leaders and investors to help educate and inspire the millennial generation.

Clay Finck (01:24):

Welcome to the Millennial Investing Podcast. I’m your host, Clay Fink. On today’s show, I’m joined by Vitaliy Katsenelson. Vitaliy, welcome to the show.

Vitaliy Katsenelson (01:32):

Clay, how are you?

Clay Finck (01:34):

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 your background and how you got to where you are today?

Vitaliy Katsenelson (01:46):

I came to United States from Russia in 1991, which was the 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.

Vitaliy Katsenelson (02:04):

Like in my early 20s, it’s kind of… I had [inaudible 00:02:07]. 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.

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Vitaliy Katsenelson (02:27):

Over the last 10, 12 years, I kind of remade the firm to be what it is today. So we are basically 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 up a few investment books in the process. 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 more simplified version of the Active Value Investing.

Clay Finck (03:03):

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?

Vitaliy Katsenelson (03:12):

So it’s kind of interesting. I would argue that it hasn’t. The value investment principles have not really changed. What is value investing? It’s basically… I wrote this, what I call Six Commandments of Value Investing. 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.

Vitaliy Katsenelson (03:36):

You’re looking for margin of safety that hasn’t changed. You have a long term time horizon that hasn’t changed. There are some other commandments. 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 the 2020 and now, I’m fairly certain about that it has not changed is the human…

Vitaliy Katsenelson (04:06):

As humans, we want to be around other humans. In March 2020, during lockups, I was questioning are we going to have hugs and the handshakes after the economy reopens? How is the economy going to change? Are we going to be more digitized? I know it sounds silly now, but at the time… [inaudible 00:04:22] was on CNN, they were asking this kind of questions because people really were not sure, no matter… What was going to happen with the virus. We still want to be around other human beings.

Vitaliy Katsenelson (04:32):

The reason it’s important because when you own these companies, that’s something you want to have in the back of your mind. But I’ll give a couple of examples where things might have changed and where things haven’t. Think about travel. The leisure travel, we know that hasn’t changed.

Vitaliy Katsenelson (04:47):

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, 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 much larger portion of the profit poll because it’s much higher margin dollars.

Vitaliy Katsenelson (05:19):

That would be an example. Another one I’m struggling with today is remote work. People going to work from home. Are they going to be working in the office? I’m so confused about this, but let me tell you how I think about it. I think a lot of the work in the past, if you work in the call center, now you have the tools, digital tools that you don’t need to be in a call center anymore.

Vitaliy Katsenelson (05:43):

If you think about call centers in general, basically, it’s a huge warehouse which has summer conditioning and you have thousands of people packed next to each other in cubicles and 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.

Vitaliy Katsenelson (06:02):

Another 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. I think you have this 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 number 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.

Vitaliy Katsenelson (06:35):

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, “You’re going to be four days a week from the office and one day to work from home.” I said, “Everybody gets so many days a year they come from home.”

Vitaliy Katsenelson (06:51):

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. When you break things up into little bits and be nuanced about it, I think I’d look at this company and say, “How has a business changed?” I think that’s the right approach. That’s how we kind of adjusting our strategy in today’s environment.

Clay Finck (07:23):

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?

Vitaliy Katsenelson (07:33):

It’s came up when we were looking at office real estate. To me, I put it into two difficult category. Because first of all, we already had over capacity in office real estate, just before the pandemic. The prices were sky high. We had too much, plenty of over capacity. Now, we know that demand will be less.

Vitaliy Katsenelson (07:54):

However, one thing I started to see is that they started to convert some of the better locations into apartment buildings. 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.

Clay Finck (08:12):

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 Buffet and other value investors to buy great businesses at reasonable prices.

Clay Finck (08:28):

I’d like to dig a little bit deeper on that idea with you and as two key parts. Great businesses and reasonable prices. Could you tell us what it takes for business to qualify as a great business for you?

Vitaliy Katsenelson (08:40):

In the beginning, I talked about value investment principles. Think of it as like 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 statistical value investor because all you have to do is buy companies that trade at less than 10X earnings. I wish it was that simple. It’s not.

Vitaliy Katsenelson (09:09):

So Ben Graham, the father of value investing, when he started out, there was lot less competition, there was a lot less IQ in market and there was a lot fewer computers. Probably low computers at the time or very few computers. He could be a statistical value investor and do absolutely great. I think being a statistical value investor, kind of all this computing power made this impossible.

Vitaliy Katsenelson (09:32):

Therefore, what you have to do, you have to default to the principles. The whole point is that you want to buy companies that are undervalued. However, let’s talk about this. Let me give you two examples and I’m going to oversimplify them just for simplicity. You can poke a lot of holes in this examples, but again, I’m over simplifying just to make a point. You have a no growth company. The trades are $5. It has $1 of earnings today. Three years from now and five years from now, it’s going to have $1 of earnings. You think that the fair value of this company is $10 or should be trading 10X earnings, right?

Vitaliy Katsenelson (10:07):

In other words, if you buy this company $5, at some point, it’ll get to $10. The problem is you don’t know when. If it happens today, like in one year, you’re going to have a 100% return.

Vitaliy Katsenelson (10:17):

If it happens in 10 years, again, I’m over-simplifying, you’re going to have a 10% a year. I’m ignoring compounding. If it happens over five years. So what you discover is 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 one dollar of earnings, but it’s growing earnings let’s say 20% a year.

Vitaliy Katsenelson (10:41):

Again, I’m oversimplifying it. In five years, it would have two dollars of earnings. Earnings would double. From their perspective, the first company doubles in five years and this company doubles in five years, you should not really care. However, the time is on your side if you own a growth company, because if you own for 10 years, that will be making 20% a year. If you own the first company or you own it for 10 years, the longer you own, the less money you make per year.

Vitaliy Katsenelson (11:10):

The point I’m trying to make is that the first, 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. That was basically the transition of Warren buffet from kind of no growth companies to identifying companies that have three characteristics basically.

Vitaliy Katsenelson (11:34):

They have significant competitive advantage. They have higher return capital and they have a long runway for growth. And he was buying them at 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.

Vitaliy Katsenelson (11:52):

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 in maybe not a 50% discount fair value, but maybe 70% discount. Therefore, if it takes longer period of time to come to fair value, then we’ll get compensated extra for that risk.

Clay Finck (12:24):

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?

Vitaliy Katsenelson (12:35):

That 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 we feel a lot of times we start with what things won’t change.

Vitaliy Katsenelson (12:53):

I’ll give an example and we’ll talk about it later. Again, but we own defense companies. That’s not going to change. There will be changes inside the sector, but because of the industry structure, this companies, they will be spending less money on one type of warfare, will be spending more money on another type of warfare and that business is still going to be based in those companies. So it is an example.

Vitaliy Katsenelson (13:17):

We are looking for things that won’t change. And things where they will change, we need to have a much, much greater discount. We try to focus mostly on companies where things will not change very much.

Clay Finck (13:31):

So what are the most important metrics you look when you’re analyzing a company?

Vitaliy Katsenelson (13:37):

From a high level, what we want to do, we want to buy high quality businesses, we want to buy them undervalued. What does it mean, high quality? Again, high level. It means company that has significant competitive advantage, company that has a strong balance sheet and company that has a great management. 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.

Vitaliy Katsenelson (14:03):

What I find, and I’ll give you like 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 how well they allocate capital.

Vitaliy Katsenelson (14:15):

Again, I’m just giving you extremely generalized answers. Because it’s really going to be different from every single company. If it’s company that’s not growing much, capital allocation becomes a lot more important. So it’s a… I wish I could say it, this is the number. This is the formula, but there it’s really just… You analyze business, one business at a time. And for each business, something else, what’s important for one business will not be important for that.

Clay Finck (14:44):

You mentioned looking at the incentives of the management. How do you ensure that management’s incentives are aligned with shareholders?

Vitaliy Katsenelson (14:53):

I think the ownership of the stock is very important. When I see company where the CEO owns 20% of the company, I know that if they make another acquisition, they’re spending his money.

Vitaliy Katsenelson (15:07):

It’s [inaudible 00:15:08], when 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 pedigree who looks perfect for the annual report. That’s the guy who probably will make the acquisition that’s going to destroy the 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. The problems will come five to 10 years later and kind of own operator. We would love to own companies and we own a lot of them that’s run by own operators, kind of guys.

Vitaliy Katsenelson (15:43):

If you can find a company that kind of has a strong bit of advantage, higher return capital, high growth runway and run by own operator, then you can basically buy this company and own it for a long, long time.

Vitaliy Katsenelson (15:59):

In other words, my cell 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 much longer leash, that company, 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.

Clay Finck (16:19):

Now, let’s dive more into the valuation side. One of the most difficult parts of valuing a business is determining a discount rate. Do you use a discount rate in your stock valuation process and if so, how do you determine that discount rate?

Vitaliy Katsenelson (16:36):

Without going into specifics, what we do, our discount rate is a really function of company’s quality. The highly quality of the company, everything else being constant, lowers the discount rate and the lower the quality behind discount rate, because if it’s a very high quality company, fewer things may go wrong. And therefore we have a high confidence in companies’ earnings power.

Vitaliy Katsenelson (16:58):

The lower the quality, the larger the discount we need because there are more things may go wrong with the [inaudible 00:17:04] and more risk. 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 than… If it’s a crappy company, we just don’t buy it.

Clay Finck (17:22):

That makes sense. 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?

Vitaliy Katsenelson (17:37):

Well, it’s a first level of thinking and second level of thinking. First level thinking is something that’s basically almost comes to automatic. I’ll give you company and you say, “Great company.” Amazon, great company. Microsoft, great company. PayPal, and keep going. And the problem is everybody knows that, that those are great companies and therefore they usually priced accordingly.

Vitaliy Katsenelson (17:59):

But the problem is those companies may be great companies. Those, 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. The return comes from two factors. I’m going to put dividends aside for a second, but it’s safe for the stock price. It’s really earnings growth and change in price to earnings.

Vitaliy Katsenelson (18:24):

If those companies are very expensive and a lot of their 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. They’re talking over Zoom and Zoom was down 70% since it’s highs. Even though you’d say it’s still a good company, it wasn’t a great stock when it was at much higher.

Vitaliy Katsenelson (18:52):

I’m not even sure, if it’s still good stock today or not. You have to differentiate between a good company and a good stock. A good stock is basically has to do with what’s expected to return when companies’ growth rate kind of normalizes.

Clay Finck (19:08):

The first company that comes to my in 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.

Vitaliy Katsenelson (19:26):

See, I have a Tesla car, a Tesla Model 3, and become in the other one on order. And I’ve got to tell you, I love the car. Like every single time I drive it, I receive joy from it. Actually, I wrote a kind of a mini book. If you readers, want to look it up and they can find it on Amazon, it’s $3.

Vitaliy Katsenelson (19:44):

But when I bought my Model 3, I basically was so impressed by this car that I ended up doing a lot more research. This was two years ago. 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 past dependent.

Clay Finck (20:16):

Could you tell our audience about the importance of developing a process to challenge your own beliefs?

Vitaliy Katsenelson (20:23):

That is such a great question. Seneca, the Roman philosopher, he has this saying, which I love, “Time discovers truth.” That applies to investing so much because when I’m buying a company, I’m basically betting on a certain version of the future. Time will basically discover it for me.

Vitaliy Katsenelson (20:45):

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. Let me give you this analogy from chess. If you ever watch a very good players analyze their games, at some point, they stop saying, “Myself versus another player,” they’re going to say, “White versus black.”

Vitaliy Katsenelson (21:11):

And the point is they stop linking the whites to them or blacks to them and now they’re just looking for what are the best moves. They’re looking for the objectivity. 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. Are my assumptions still correct, et cetera?”

Vitaliy Katsenelson (21:38):

That is extremely, extremely important. We try to do this all the time.

Clay Finck (21:44):

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?

Vitaliy Katsenelson (22:02):

Our approach is somewhat different from mutual funds or many other investors, because people come to us and say, “Here’s my life savings. Don’t screw it up.” I’ll give you an example. I have a client who is a doctor and he literally gave us 1.5 million of his wealth. That’s all he’s ever going to make.

Vitaliy Katsenelson (22:20):

When I make this investments for him, it’s a very different approach because all I’m trying to do is to grow his wealth through any environment. The approach is different. So I think it’s a much higher… It’s not a 100% certainty, but much higher probability that we are going to have inflation, that inflation we have today will persist into the future. The rate inflation, I don’t know what it’s going to be. You can argue that some of the inflation we have today is temporary.

Vitaliy Katsenelson (22:50):

And that’s probably true, but I would argue that some of that is here to stay. Maybe the inflation that’s driven by supply chains is temporary. But inflation that’s driven by higher wages, I thought it would be temporary in the beginning, but because I thought that was temporary because government was paying people not to work. But even when that ended, we found that the wages kept going higher and higher. The workforce has shrunk. I heard a lot of explanations for that.

Vitaliy Katsenelson (23:19):

Maybe this is just a perfect storm of many different factors like baby boomers retiring. That’s one explanation. The explanation I heard that the pandemic was a wake up call for a lot of people and now, they don’t want to the dead end jobs. I don’t know. Anyway, so there was many other factors. There are many other factors.

Vitaliy Katsenelson (23:38):

So the reason labor is very important, because labor is the largest expense line on almost any company’s income statement. So if you have inflation and wages keep going higher, it’s impossible not to have inflation. That’s point number one.

Vitaliy Katsenelson (23:54):

Point number two, during the pandemic, we basically increased our balance sheet by 40%. The amount of debt US has went up a lot. The problem is debt has already been going up and this is important to understand. In the past, after World War II, US, they had a lot of debt on, on its balance sheet. And after world War II, the debt has been declining. While we were investing in rebuilding the country, while we were building Europe over the last 10 years, our debt has been and growing while economy was growing as well. If you look very closely, you’ll find that a lot of this growth came from us borrowing more money.

Vitaliy Katsenelson (24:32):

In other words, that was part of the reason why the economy was growing. Now, we have 130% debt to GDP which is the highest we ever had and we’re still adding more to that. The US, we are a beneficiary of the fact that US dollar is still reserve currency, but I would argue that over a long time will become… It’s not a binary. It’s not like being a stab in a reserve currency, but if we’re just going to have less and less allocation to us as a reserve currency.

Vitaliy Katsenelson (25:01):

Like you would argue 20 years ago, it was very clear that US dollar should be reserve currency today. If you look at our behavior, I would question somewhat. And not just me, the other invest… It doesn’t matter what I think. It matters what the rest of the world thinks of us.

Vitaliy Katsenelson (25:17):

The reason that’s important is that I think if the US dollar declines, that means we’re going to have higher inflation because the goods we’ll be buying overseas will be more expensive to us. Now, I’m going to give you this macro background. When you are positioning your portfolio for inflation, you want to make sure that your own companies that have price and power. You want to own companies that have high fixed costs and low capital expenditures.

Vitaliy Katsenelson (25:43):

Let me explain what I mean by this. Let’s say you own pipeline companies. Companies that transport natural gas funds. So when you look at these companies, they have very high fixed costs and maintaining pipeline, the cost to maintain pipeline are relatively small. If you have inflation, their fixed costs won’t change very much. However, what is going to happen is that their agreements with their customers are structured in the way that as you have inflation, they’re able to raise prices and therefore the revenues will be going higher while costs will be going higher, but maybe very, very little.

Vitaliy Katsenelson (26:21):

They will actually be in that beneficiary of inflation. This is one example of this. Obviously, you want to buy them when they’re undervalued. What I described to you at first was a quality of the business. But if it’s overvalued, then it’s not a good proposition. Today actually I would argue pipelines in general are still undervalue. So they’re still a good investment today. So if you’re on, plenty of notes.

Vitaliy Katsenelson (26:47):

But anyway, that’s how we think about this. Again, one example it’s going to be different from industry to industry.

Clay Finck (26:53):

Ray Dalio is well known for his all-weather portfolio that utilizes a number of uncorrelated asset classes. Do you believe it is possible to have a well balanced portfolio only holding stocks?

Vitaliy Katsenelson (27:07):

Yes. There’s a caveat. The caveat should be, you have a long term investing time horizon. This is extremely important because if you need money two years from now, you should have be in stocks. And this is where it gets complicated because if you and I talked 20 years ago, I would’ve told you and you are six or seven years old or something, would say, “Well, you probably should have a balanced approach.”

Vitaliy Katsenelson (27:31):

In that case, when I say balance, meaning you should have this much in bonds, this much in equities. At the time, bonds were yielding five or 6%. So equities were returning 11%. So bonds provided you predictability and they did not have volatility of principle. This is important. So as an equity investor, I accept that my stocks could be volatile. If I have a long term time horizon, that’s not a risk.

Vitaliy Katsenelson (28:00):

And so in fact, I would argue and say, it’s the feature, not a bug. But there is an assumption here that I have a long term time horizon. If I have a short term time horizon, then actually that volatility turns into risk because if you need $50,000 to pay for your daughter’s wedding in six months and the stock market declines, well, the loss you have, the stuff that has been temporary becomes permanent.

Vitaliy Katsenelson (28:24):

The problem is and we are kind of in this incredibly… I’m running out of adjectives because we are this insane environment where everything is overvalued. Buying bonds today, especially long term bonds makes zero sense. When I tell clients that come to us and they need money at some point in the near future, look at your portfolio from a barbell approach. Take five or seven years of your expenses and put them into short term bonds or something, very short term, cash-like instruments.

Vitaliy Katsenelson (29:01):

And then you can give us your long term… The equity portfolio is going to be there to provide you long term returns. And then there, we can construct a diversified portfolio. And when I say diversified it, let me just clarify this too. This one, the diversification is basically as Warren Buffet will say is like constructing Noah’s arc. When you do this, you end up having a zoo.

Vitaliy Katsenelson (29:26):

That’s not how we do things. We are basically… I want to have companies… If I add something to portfolio, I’m not going to buy just because it’s different from something else I own. It’s great if it’s different from other things I own, but most importantly it has to have a good return profile. What I try to do, we kind of build a matrix and say, “What are the risks that we can identify?”

Vitaliy Katsenelson (29:50):

And we want to make sure that when build portfolio, we have our companies. I don’t want to have the whole portfolio exposed to one risk. That’s how we diversify to make sure they can withstand different risks. [inaudible 00:30:02] What if dollar declines? What if the dollar goes up? What if interest rates go up and down? This kind of thing.

Vitaliy Katsenelson (30:06):

How much exposure do you have to China? This kind of thing. Low or higher commodity prices. That’s how we construct portfolio. I think you can do this. Over the last couple of years, as US market has gone up and it became more and more difficult to find values in the US, we started to buy more and more foreign stocks. Today, I think about one third of our portfolio is actually in foreign stocks.

Clay Finck (30:34):

Now, that you mentioned international stocks, we’re seeing the rise of China as a big player in the global economy. I know that you like to invest internationally. As a value investor, how do you think about China’s rise as a global powerhouse and how might it affect the financial markets?

Vitaliy Katsenelson (30:53):

Yeah. I wrote this very long article on the subject, so I’m going to try to condense a six page articles into six sentences. I’ll see if I can. I think we are… Henry Kissinger said, “We are basically in the beginning of cold war with China, the valley of cold war,” something like that, with China. It’s a different type of cold war that the United States head with Russia. Because at the time, that was ideological. This is a little bit different.

Vitaliy Katsenelson (31:19):

But if you think about that cold war of the ’90s and ’80s, I guess, ’70s as well, you had these two gravitational centers. You had the west and Soviets or Soviet block. And then you had the Western Europe on this side and you had Poland and Slovakia and a bunch of other countries around and China and India on this side. You had the two gravitational poles. This time around you’re going to have something similar, but what’s going to differentiate this polls is going to be the technology.

Vitaliy Katsenelson (31:52):

And this is where it gets weird. China uses technology as a weapon. Over the last 10, 15 years, we had an incredible transition in technology and big data in terms of things. All these things, the data is going to become the new oil and China’s already using data to control the citizens. We are looking at China. We don’t look at them. This is kind of a dictatorial country, not a democracy for sure. It’s rising in power. If it was France or UK or some other European country where it’s democracy and we share similar values with rising to power, we probably would not be as concerned about it, but it’s China.

Vitaliy Katsenelson (32:30):

See the people’s north republic really of China. Therefore, we want to make sure that we are on the different technological platforms. This is why you see… As an example, you see Huawei, one of largest technology companies has been completely stripped out of the Western hemisphere.

Vitaliy Katsenelson (32:54):

What’s going to end up happening? You’re going to have almost like two incompatible technological platforms, the Western platform and the Chinese platform. We know that Western Europe and the US will be the same platform. India is going to be on the US platform. Russia are probably going to join China. By the way, ironically, China and Russia always had a border dispute, et cetera. They always had a very contentious relationship. Now, they’re, “I guess you enemy is my enemy, you are my friend.”

Vitaliy Katsenelson (33:24):

Now, they’re much closer because they even have a joint military exercises. But then what’s become interesting. You don’t know where Middle East is going to end up and some other countries. You have this division and you already start seeing the globalization that we experienced over the last 20 years now been put in reverse. We are looking at Taiwan and seeing that countries at risk have been invaded by China.

Vitaliy Katsenelson (33:52):

Now you have Samsung… Well, no Taiwan Semiconductor, Intel, Samsung and many other countries, their production to United States of semiconductors, because that’s too important for us. The geopolitical situation today is probably the most contentious that we had over the last 30 years, since cold war ended.

Vitaliy Katsenelson (34:13):

One of the ways we are hedging that, which is we have a good chunk of the portfolio allocated to defense companies. Like you and I already talked about high quality means, let’s just think about this for a second. These companies have customer that’s always going to be there, even if it has to print money to be there. Okay, the governments. They going to have… They’re growing the revenues and may accelerate the growth of revenues if God forbid, things get worse.

Vitaliy Katsenelson (34:39):

They have a decent return on capital, great cash flows, great balance sheets. Today, we can actually… They’re not cyclical. It doesn’t matter what happens if we have a recession or not. European governments will continue to spend on defense. And by the way, there’s one misconception in the market that Democrats hate defense and Republicans love it.

Vitaliy Katsenelson (35:02):

What we found, if you look at data, it’s really has nothing to do who is in the White House, it has to do with geopolitics. The defense spending has everything to do… Is not really… We have Biden in the White House who is Democrat and defense spending bill, higher this year than it was last year. Seeing what you’re seeing with our relationship is China and Russia, I don’t think our defense bill is going to decline. What’s actually more interesting, we own a lot of European defense companies because Europe over the years has underspent in defense because they were basically kind of free-riding on the US.

Vitaliy Katsenelson (35:36):

And now the look at United States and especially after what happened in Afghanistan and they say, “Maybe we should be able to defend ourselves.” So I think spending in Europe is going up. UK increased the budget by 10% for last year. We own US and European companies, defense companies. We can buy them at very, very cheap especially considered not just in a relative basis, an absolute basis. I think they’re very attractive. Some of them even pay very nice dividends. That’s how we deal with… There was a China issue and it’s a hedge at the same time and cheap companies at the same time.

Clay Finck (36:13):

Now, you wrote the book, The Little Book of Sideways Markets. And do you point out that history shows that a sideways market typically occurs after a secular bull market. With the role that the federal reserve plays in the financial markets, do you still anticipate valuations to normalize?

Vitaliy Katsenelson (36:30):

Yes. When I wrote the book, what I did not anticipate it, interest rates declining to basically zero not negative. That decline added a lot of fuel to valuations and they might have went up much higher than I expected them to. So I would argue I was wrong on that. Again, if I knew that interest rates would be this low, I probably would’ve written a different book.

Vitaliy Katsenelson (36:53):

However, now that valuations are so high and interest rates are so low and we have signs that inflation is here to stay, if interest rates continue to go up, it’s going to be very difficult for the valuations to stay this high. A lot of companies could trade it in [inaudible 00:37:09] because discount rate was so low and now, discount rate is higher. But what if interest rates don’t go up?

Vitaliy Katsenelson (37:16):

If they don’t go up, they may have a different issue. You may actually have a very unpleasant recession or just economic stagnation like what happened in Japan. What’s important about what happened in Japan, valuations get very high, interest rates declined, but stock prices still collapse.

Vitaliy Katsenelson (37:35):

Japan was a kind of a nuclear winter of a stock market for 20 years until recently. I think from this perspective, I think the value has a much greater tailwind than it ever had over the last 10 years. If you were a value investor, you needed to have a great emotional support from your family. I think that’s about to change. But yes, I think the price to earnings are most likely to decline.

Vitaliy Katsenelson (37:57):

In fact, if you carefully think about our conversation today, a lot of things is really just about inverting. The things that helped us in the past, those things will hurt us in the future. Like price to earnings. When they go up, it’s a loan, it’s not a gift. We have to pay it back. When you borrow money, it’s literally a loan. It’s not a gift. There’s going to be a lot of mean reversion, a lot of pain back for the excesses of 10 years.

Vitaliy Katsenelson (38:25):

In other words, my Little Book of Sideways Markets is more relevant today than even when I wrote it 10 years ago. 11 years ago.

Clay Finck (38:33):

Yeah. It makes sense to me. Vitaliy, thank you so much for taking the time to chat with me and share your knowledge with our audience today. Before we close out the episode, can you share with the audience where they can go to get connected with you and learn more about your books?

Vitaliy Katsenelson (38:49):

I’ll give you two places. I guess if you listen to this podcast, you’re more likely to be listening, not a reader. We have this Lazy Man’s Podcast, which is not as great as your podcast, but it’s basically my articles read to you by somebody who’s not me, does not have this beautiful Texas accent as I have.

Vitaliy Katsenelson (39:06):

You can find it on investor.fm or just look for Intellectual Investor Podcast. And then you can read my articles on contrarianedge.com, E-D-G-E, contrarianedge.com. And there you can subscribe to get my articles by email because when you subscribe to get them by email, you also get my father’s artwork. I discuss classical music and other things in this article. So I would argue subscribing to my articles is probably better. And it’s still free, so it doesn’t matter. But anyway, yeah.

Clay Finck (39:38):

Got it. I’ll be sure to link both those in the show notes. Vitaliy, thank you so much.

Vitaliy Katsenelson (39:42):

Thank you so much. It’s been a pleasure. Great questions.

Clay Finck (39:46):

All right, everybody, I hope you enjoyed today’s episode. Please go ahead and follow us on your favorite podcast app so you can get these episodes delivered automatically. And if you haven’t already done. So be sure to check out our website, theinvestorspodcast.com. There, you’ll find all of our episodes, some educational resources we have, as well as some tools you can use as an investor. With that, we’ll see you again next time.

Outro (40:09):

Thank you for listening to TIP. Make sure to subscribe to We Study Billionaires by The Investor’s Podcast Network. Every Wednesday, we teach you about Bitcoin. And every Saturday, we study billionaires and the financial markets. To access our show notes, transcripts or courses, go to theinvestorspodcast.com. This show is for entertainment purposes only. Before making any decision, consult a professional. This show is copyrighted by The Investor’s Podcast Network. A written commission must be granted before syndication or rebroadcasting.


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  • Robert and Clay’s tool for picking stock winners and managing our portfolios: TIP Finance.
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