As you may have noticed, there is a new value investing book out. It’s called Active Value Investing: Making Money in Range-Bound Markets by Vitaliy N. Katsenelson. In the spirit of full disclosure, I want to mention that Vitaliy is sponsoring this month’s contest at Value Investing News, where we are giving away three free signed copies of his book. Acknowledging this potential bias, I’ve tried to be extra critical in my review of this book.
Who is Vitaliy Katsenelson?
Vitaliy is a CFA charter holder and a portfolio manager with Investment Management Associates. (You can review IMA’s performance record here.) He has been involved with the investment industry since 1994. Vitaliy is also a fellow value investing blogger at the site, Vitaliy’s Contrarian Edge. I give authors more credibility when they are willing to expose themselves to public comments and debate by having a blog.
In addition to his portfolio management work and writing, Vitaliy also teaches at the University of Colorado at Denver. He teaches an interesting sounding class called Practical Equity Analysis and Portfolio Management. You can tell that Vitaliy has teaching experience from his clear writing style and good use of examples in Active Value Investing.
Vitaliy’s life is another example of the American dream come true. He grew up in the Russian city of Murmansk during the Cold War, overcame his bias against the United States, immigrated with his family to the U.S., earned bachelor’s and master’s degrees from the University of Colorado at Denver, and now has a successful financial career. It is a very impressive story that I’m sure gives Vitaliy a unique perspective on life. I enjoyed reading Vitaliy’s story in the Acknowledgements section of Active Value Investing. It’s at the last few pages of the book, so be sure not to miss it.
Why you should read this book?
First off, Vitaliy is keenly aware of the audience for his book. Value investors are a skeptical lot, and Vitaliy immediately sets about mentally disarming this tough audience. I chuckled when I read the imagined Q&A session with the “Skeptical Reader”. I was more than willing to step into the role of the skeptical reader. The Q&A session did a good job of answering my questions about what is active investing, what is a range-bound market, and what I can do to address this market challenge. After this short section, I was motivated to read more.
Are we in a “range-bound” market?
Part I of Active Value Investing examines whether we are in a “range-bound” market. Vitaliy starts this section with a warning, “Fasten your seat belts and lower your expectations,” and sure enough my expectations did drop a bit. Not to worry though, my expectations rose again after page 72 of this 282 page book and it definitely became a worthwile read.
The first 72 pages of the book takes you through a detailed statistical history of the market to support Vitaliy’s thesis that we are in a range bound market. Like many other recent pieces on historical market performance, this part of the book relies heavily on Yale University professor, Robert Shiller’s data. I must admit that I’m not much of a fan of historical market analysis and I’ve seen similar research elsewhere, so it was hard for this section to keep my interest. However, the paragraphs on the Japanese bear market (pg. 27-29) did pique my interest, and this discussion helped explain the difference to me between bear and range-bound markets.
Even though I struggled a bit to get through this part of the book, I definitely came away believing that there is a lot of evidence to support the possibility that we are in a range-bound market. My problem might have been that I was convinced too quickly. If you are anything like me, I recommend that you skim through this Part I of Active Value Investing once you are convinced that we are in a range-bound market.
How do I become an active value investor?
Part II of Active Value Investing was much more to my liking. It sets out to teach you how to be an “active” value investor. Vitaliy does this by detailing his quality, valuation, and growth framework. I found this to be an excellent approach to analyzing stocks.
In Chapter 5 on quality, I was especially excited to see a section on competitive advantage. I found it interesting that Vitaliy focuses on the importance of sustainable competitive advantage similar to the way I do, and uses the same term for it that I use. I know that Buffett uses the term “durable competitive advantage”, and I’ve seen a few other variations elsewhere, but I prefer focusing on “sustainable” competitive advantage. To further illustrate what sustainable competitive advantage is, Vitaliy provides a great discussion on brands using several good examples to make his point. I had a similar discussion on brands back in October of 2005 in a post about brands versus franchises.
I also found the discussion on debt to be very enlightening. Vitaliy notes how stock buybacks distort the apprearance of the balance sheet and can result in debt-to-asset or debt-to-equity ratios that are misleading. I had never thought about this issue before, and I have been primarily using debt-to-equity ratios in my analysis, so I found this discussion to be extremely valuable. Instead of using the debt-to-equity ratio, Active Value Investing recommends we utilize the debt/EBITDA, debt/operating cash flows, EBITDA/interest expense, and operating cash flows/interest expense. I’ll be definitely relying on some of these other ratios a bit more in the future. Vitaliy followed up this discussion on debt with an illustrative case study of Colgate-Palmolive’s capital structure. This is one of the strong points of Active Value Investing, the book includes many good examples to help the reader understand what a concept really means. Vitaliy fully explains how sustainable competitive advantage, high-quality management, predictable earnings, significant free cash flows, strong balance sheet, and high returns on capital are some of the main elements that help determine quality.
Growth is also an important element of active value investing. Vitaliy uses a flipped growth pyramid to explain the drivers of growth. He lays out the primary strategies companies use to grow revenue and then goes on to talk about growth from margin improvements from operating efficiency, economies of scale, and stock buybacks. Vitaliy includes a good case study of Westwood One’s share buyback, which illustrates how share buybacks can destroy shareholder value if done improperly. This section on growth concludes with the topic of dividends and their relative importance in a range-bound market.
Valuation is at the hear of active value investing. Vitaliy does an excellent job explaining the concept of discounted cash flow analysis using the story of Tevye the Milkman. Tevye’s cow, Golde, and her various cash flows are cleverly illustrated. I know I will be using this graphic in the future when I’m asked to explain discounted cash flow analysis. One unique concept introduced, was the absolute P/E model. The absolute P/E valuation method uses a schedule of expected EPS growth rates and, dividend yields to adjust a base P/E value level. This multifactor P/E model seems practical but relatively untested in my mind. I’d be interested in talking to Vitaliy in ten years to see if he still uses it. Regardless, it still might be interesting to compare the results you get with more traditional discounted cash flow models with this absolute P/E method of valuation to see how close your results come out.
I highly recommend that you read Chapter 12: Sell Process – Make Darwin Proud, if you read anything in this book. This chapter was a wake-up call to me. I don’t have a really good sell process and the one Vitaliy presents is very logical and seems to be the key to acheiving good investment performance in a range-bound market. Vitaliy recommends setting a P/E target level right away to determine when to sell a stock. He even suggests using a stop-loss strategy after a stock reaches its fair valuation. I’ve started using this particular strategy.
Finally, I also recommend reading chapter 13 on risk. If you are new to the topic of risk and randomness, this chapter will be a great introduction for you on the topic. He breaks the concept of randomness into two components: the level of uncertainty and the significance of impact. I am a big fan of Steve Irwin, the Crocodile Hunter, and I think Vitaliy did a great job discussing the role of randomness on Steve Irwin’s life.
In summary, I think there is a lot of substance to Active Value Investing. The first few chapters might turn off some (market history buffs might love it), but the second half of the book is a real gem. If you are new to the concept of value investing, you will learn a tremendous amount from the clear and instructive writing. Even if you are a seasoned value investor, you will find several unique concepts and new ways of looking at value investing.