With Vitaliy Katsenelson, Chief Investment Officer at Investment Management Associates and contributor to Institutional Investor Magazine
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The Argument For Why Investing Uncertainty Is Actually A Good Thing
Vitaliy Katsenelson, CIO at Investment Management Associates in Denver, rejoins The Steve Pomeranz Show to talk with Steve about the importance of making “I don’t know” a part of your investment strategy, and how familiarity with your portfolio holdings can make a big difference in terms of tolerating uncertainty. Referring to a recent article by Vitaliy on the subject of not knowing everything that might influence any given investment, Steve wonders whether saying “I don’t know” would be professional suicide for an investment advisor. Vitaliy responds by reconstructing a case he’s made for an “I don’t know” kind of agnosticism about different possible scenarios that might affect portfolio planning. By way of example, he talks about an article he wrote in which he dedicates a page for arguing each side of a debate about whether inflation or deflation was likely to occur in the near future. He says he realized, based on strongly worded emails he received about the piece, that investors and other observers of the economy tended to strongly separate themselves into either inflationary or deflationary camps.
While offering a brief digression on how one might re-position one’s investments for either inflation or deflation—adding gold for inflation or bonds for deflation, etc.—he says the deeper realization he reached is that either camp could be wrong, and there was no good way to be sure which would be more accurate. In any event, the cost of being wrong would be very costly. The end game is not to fatalistically say “forget it, it’s impossible to know what will happen,” but rather to use not knowing as a jumping off point for a thought experiment whose goal is a portfolio adapted to complex circumstances. The best strategy for an “I don’t know” world where either inflation or deflation is possible, Vitaliy reasoned, is to buy stocks that will maintain their value and hopefully their stock prices in either scenario. Vitaliy introduces the metaphor of the “second best hand in poker” to describe investors so convinced that their outlooks are correct that they misjudge the strength of their hand and pay a big price for doing so.
Intrinsic Valuation vs. Short-term Stock Movements
Vitaliy distinguishes the inflationary/deflationary “I don’t know” portfolio from typical portfolio diversification. In this case, it’s about using a methodology to identify companies that can perform well in both inflationary and deflationary macro environments. Unpacking this methodology, he sketches the outlines of how his valuation process works. One important point he makes is that there can be a disconnect between a company’s intrinsic value and its stock price, even with very well known, heavily traded companies. In fact, one of the goals of value investing is to find stocks that are “mispriced.” For buy and hold investors, this means priced too low. He remarks on the paradox that sometimes it’s good for investors when solid companies suffer a stock price decline. The reason for this is that it allows companies to be more aggressive about buying back their own stock, and this bodes well for the financial strength of the company and eventually for its shareholders. He even views these “corrections” in a stock price—if the underlying value of the company hasn’t changed—as a buying opportunity for investors that have just taken the correction on the chin. This is a lesson he shares with his own clients, and he says that once absorbed, it can have a profound effect on their confidence in their portfolios. He adds that he considers it an important part of his job to “close the research gap” between what he knows about the companies he invests in and recommends, and what his clients know. The dividends that result from lessening this gap and having clients understand the logic behind the portfolio are manifold.
Uncertainty And Humility As A Useful Outlook
Steve jokes that he suspected that Vitaliy might be getting frustrated with the market when he started quoting Gandhi and Einstein on humility and uncertainty. Of course, the real reason for the quotes was that they supported Vitaliy’s conviction about the validity of the “I don’t know” approach to investment. For the record, the Gandhi quote was “It is unwise to be too sure of one’s own wisdom and it is healthy to be reminded that the strongest might weaken and the wisest might err.” Einstein took the idea a step further saying “A true genius admits that he or she knows nothing. Smarter and humbler people than me were willing to say ‘I don’t know’ and it’s okay for us mortals to say it, too.” Asked to elaborate on humility, Vitaliy proffers another quote, this time from Charley Munger, Warren Buffett’s right-hand man: “If you’re not confused about a global economy today, you don’t understand it.”
Market Predictions And Media Noise
Steve and Vitaliy wrap up their conversation with a brief exchange about how the media affects or, at least, reports on markets. Both agree that the media has a vested interest in pedaling drama, stoking controversy, and exaggerating market movements in order to string viewers along with the latest news noise. When the market goes down, the media offer all kinds of explanations about what’s driving the selling, and if it’s up they simply abandon those now outdated explanations and swap them out with new ones that “explain” the market’s confidence. In Vitaliy’s opinion, individual stocks go up and down on a short time scale for no discernible reason at all. Of course, that’s not the spin media would put on these random price movements. Steve has the last word, remarking that media exist to sell ad time, and that’s pretty much all you need to know about their priorities.
Disclosure: The opinions expressed are those of the interviewee and not necessarily United Capital. Interviewee is not a representative of United Capital. Investing involves risk and investors should carefully consider their own investment objectives and never rely on any single chart, graph or marketing piece to make decisions. Content provided is intended for informational purposes only, is not a recommendation to buy or sell any securities, and should not be considered tax, legal, investment advice. Please contact your tax, legal, financial professional with questions about your specific needs and circumstances. The information contained herein was obtained from sources believed to be reliable, however their accuracy and completeness cannot be guaranteed. All data are driven from publicly available information and has not been independently verified by United Capital.
Steve Pomeranz: Vitaliy Katsenelson is Chief Investment Officer at Investment Management Associates in Denver, which is a value-oriented investment firm specializing, as I said, in value investments, and he writes extensively for Institutional Investor Magazine and other important publications. He’s been with me on the show a number of times and is a great source and a great investor himself. Welcome back to the show, Vitaliy.
Vitaliy Katsenelson: It’s my pleasure, Steve.
Steve Pomeranz: I know you’re writing all the time. In one of your more recent writings, you wrote about being careful trusting financial pros who are reluctant to say “I don’t know.” These are investments learned from the poker table. “I don’t know.” These three words don’t inspire a lot of confidence and may not get you on CNBC. Give us an idea of the framework in which you’re thinking about what you do know, what you don’t know, and all of that.
Vitaliy Katsenelson: I wrote this article a while back, and in that article— I think on one page I took a view of inflation and on the second page I looked at deflation. I got a number of emails telling me, one guy was saying, “Oh, you’re crazy. There’s no way we can have inflation,” and I got other emails saying, “Oh, you’re crazy. There’s no way we can have deflation.”
One thing I realized, that you have this kind of inflationary and deflationary camps. People who are very certain that you have inflation and deflation. The problem is if you’re concerned about inflation, you’re going to buy gold. If you have inflation, you’re going to make a lot of money, but, God forbid, you have deflation, you’re going to get annihilated. Same thing about deflation. If you think you’re going to have deflation, you’re going to buy treasuries and because of deflation you make a lot of money, but the cost of being wrong is very high because if you have inflation you lose a lot of money.
Steve Pomeranz: Yeah, so let’s just stop for a minute there. I want my audience to understand. Gold will go up if we have inflation because the currency itself is kind of being devalued and, therefore, the price of gold in terms of dollars goes up. If deflation is the case, then owning a long-term bond, which gives you a fixed income stream, that does better because that fixed income stream becomes more valuable. Is that right?
Vitaliy Katsenelson: You’re absolutely right. The point I wanted to make is that when you are very sure … We live in a very difficult environment today when we never had quantitative vision done globally on such a scale, therefore, there’s no playbook. You can’t go to history books and look and say, “When this happened in the past, this is what happens next” because we never had this happen before. Therefore, my concern is people who are very convinced, in one camp or another, may suffer from what’s called in poker “the second-best hand.”
Steve Pomeranz: Second-best hand? Like in poker, you don’t want the second-best hand, right?
Vitaliy Katsenelson: Yes. Because what happens is you have a very, very good hand and you think you’re going to win so you bet a lot and, God forbid, somebody else’s hand is just slightly better than yours. In today’s environment, you basically want to have enough humility to say, “I don’t know.” I think those three words are very important because if you say to them, you try to create a portfolio for an “I don’t know” world where I have no idea if you’re going to have inflation or deflation, and I try to put a portfolio of stocks that would be fine in either environment. I think it’s very important to say, “I don’t know” and then try to have a portfolio that would be fine.
Steve Pomeranz: Well-
Vitaliy Katsenelson: Let me just clarify one thing.
Steve Pomeranz: Sure.
Vitaliy Katsenelson: You may do as well if you just position the portfolio for inflation and you just load up on gold. That portfolio probably would not do as well, you know, if we just have inflation. But the cost of being wrong is very, very important, and I think this is what you need to be very aware of when you put the portfolio together.
Steve Pomeranz: Well, the first thing that comes to my mind when you speak about the “I don’t know” portfolio is that the portfolio that has the hedges, in a sense, or is diversified enough that it may have some gold or something that does well in inflationary environments, maybe treasury in inflation-protected bonds, right? Tips that where the interest rate goes up if interest rates rise, and interest rates generally rise in an inflationary environment. But you also may have some long-term bonds in a portfolio and so on and so forth. Is that how you, as an investment manager, think about the “I don’t know” portfolio? Is it through diversification?
Vitaliy Katsenelson: Not as much through diversification but through stocks that would do fine in either environment.
Steve Pomeranz: Give me an example.
Vitaliy Katsenelson: Okay, so a company that has a price in power from a single company.
Steve Pomeranz: Okay.
Vitaliy Katsenelson: If you have inflation, they’re going to raise prices. If you have deflation their pricing will not decline. That would be a great example and, at the same time, it would not be levered. Therefore, if you have deflation usually levered companies struggle.
Steve Pomeranz: Levered means?
Vitaliy Katsenelson: Have a lot of debt.
Steve Pomeranz: Debt. Yes, okay.
Vitaliy Katsenelson: At the same time, you basically have a company that would do fine in any environment. We’ll still have a diversified portfolio, but it’s not necessarily … They’re trying to get to a goal, not through as much diversification of owning gold and these treasury bonds, but through securities that would be fine in either environment.
Steve Pomeranz: Well, you also run the risk, when you have a beautiful portfolio like that, of just totally being out of favor for a year or two where the Go-Go stocks or the Netflixes and the Teslas of the world are the only stocks that seem to be doing anything and, as an investment manager, you’re sitting there and you’re looking at the balance sheets and you’re looking at the growth of the book value of these companies, but the stock prices are as frustrating as all-get-out. As a portfolio manager, how do you cope with that?
Vitaliy Katsenelson: Well, I think it’s very important to differentiate between how your stocks are priced versus what they’re worth. In other words, when you look at companies, when you look at stocks, you don’t look at them as just pieces of paper or stocks. You look at them as businesses. When I look at my portfolio and look at the usual stocks, I actually have a fairly good idea of what each company in my portfolio is worth and, therefore, the difference between what it’s worth in the price will a lot of times create an opportunity. If I buy a company and its price declines after I buy it, actually, it may be a good thing.
Let me give you one example: Apple. Apple is buying back an enormous amount of stock today, so when their stock price declines 20%, it means Apple can buy more—if the value of the company hasn’t changed—Apple can buy 20% more shares. In the long run, it actually would benefit, if you are a long-time share investor, it would benefit you if, after you buy the stock, its price declines. It would actually benefit you in the long run.
Steve Pomeranz: Well, I think Apple is a good example because Apple was the hottest stock, really, I think in the world for a while and everybody was talking about that it was going to reach—what was it—a hundred billion dollars?
Vitaliy Katsenelson: A trillion dollars.
Steve Pomeranz: A trillion-dollar evaluation and it never quite got there, but now it’s kind of out of favor because they’re kind of in-between product cycles and they’re still making good money, but people don’t really want to own it anymore. The people that have it are “wondering should I get rid of it?” Of course, you’re going to have the true die-hards who are going to remain faithful and believe in it.
If you bought Apple today, like Berkshire Hathaway was reported to buy a billion-dollars-worth of Apple. And now we know that it wasn’t Warren Buffett, he said it himself, it was one of his guys that did it, but you know they’re going to have to sit on that for a pretty long time, I think, before it gets to a point where they go, “You know what? I’ve received all the value I’m going to get from my initial investment.” That could take five years. Now you’re a portfolio manager and you’ve got clients that you’ve got to cater to all the time and meet with and so on. What do you say to them?
Vitaliy Katsenelson: Actually, Steve, I wrote this article, it’s on the website, it’s called “Manifesto:The Values of Value Investing” and, in the article, basically, it’s an eight-page article, I explain that one of the most important things you and I can do with our clients is to bridge the gap that is created from asymmetry of research. You and I do a huge amount of work on putting investments in clients’ portfolios and our clients don’t because that’s why they hire us. It’s my job to communicate as clearly and as transparently as I possibly can to my clients why we own what we own and what we do. If I bridge the gap—and I cannot just be trivial of this asymmetry of information—then my clients, when things go bad, my clients will be very comfortable with what’s going on because they know what’s going on in their portfolio and the logic behind it.
My clients, when the Apple stock declined, they actually applauded it because, hopefully, I communicated my thoughts about it, and they say “You can always buy more” instead of panicking about it.
Steve Pomeranz: Well, you know there is this idea that investing in individual stocks—while I think it’s kind of becoming more and more out of favor because index funds seem to be taking over the world—but this idea, at least, with individual stocks is that you have a sense for what you own. Whether it’s a Johnson and Johnson, a Procter and Gamble, a Coca-Cola, Disney, you have a sense that there’s a real company underlying and underneath.
When you invest in an index fund it’s a number that’s bouncing up every day and down every day, and you don’t really have a sense that you’ve got like 500 terrific companies in there. I would say for the index fund investors, you know, go on to some website like Yahoo, open up that can or zip open the bag and look what’s inside it because that will help you maintain your courage in those periods of time when you see this S&P 500 go down. I think you’re saying the same thing, right?
Vitaliy Katsenelson: Yeah, the problem is that it’s almost like a hot dog. You don’t really know what’s inside of it.
Steve Pomeranz: (Laughs). Well, that could be a good thing, I’m not sure.
Vitaliy Katsenelson: Yeah (laughs). That’s true. You’re absolutely right, and I think this is why when clients open their statement and they see stocks in their portfolio, they can relate to them. They can relate to Apple, to Johnson and Johnson, to whatever. I think there’s something to that, as well. I agree.
Steve Pomeranz: My guest is Vitaliy Katsenelson. He is Chief Investment Officer of Investment Management Associates located in Denver and he is referred to as a value shop. He is looking at companies and their intrinsic value, trying to forecast what would be a fair value and what would be undervalued and then make appropriate decisions. He’s looking at balance sheets, he’s looking at the companies themselves.
You know, I knew that you were getting a little bit frustrated because you’re quoting Gandhi and Einstein (laughs), and, as you said, when you have to get to the point where you’re quoting those two guys, things are getting a little desperate. Allow me to read what you wrote here. You’re talking that investing in the current environment requires a lot of humility and that Gandhi said, “It is unwise to be too sure of one’s own wisdom and it is healthy to be reminded that the strongest might weaken and the wisest might err.” Einstein took the idea a step further saying, quote, “A true genius admits that he or she knows nothing. Smarter and humbler people than me were willing to say ‘I don’t know’ and it’s okay for us mortals to say it, too.”
I mean, if Einstein is saying he doesn’t know anything, and he’s basically been the person I can point to that’s changed the world the most, and Gandhi with his wisdom, I think we should all take a little bit from that, and I guess when you’re investing you sure as heck don’t know what’s going to happen in the future. Even sometimes, getting back to your poker analogy, Vitaliy, sometimes the best player can’t even get a break. The really good players will look at the probabilities of their hand and the success of their hand and they’ll bet on strong probabilities when they have the strongest probability of success, they’ll bet large. I think that’s what Buffett does, if you would agree. You know, he sits around, he waits, he watches a lot of hands go by, but when he sees the one that is so-called ‘the fat pitch’, as he puts it, he swings hard. Even someone at the table by random chance could still have a better hand. So, final words for you about humility. Take us there.
Vitaliy Katsenelson: I’m going to quote Charlie Munger, Warren Buffett’s partner at Berkshire Hathaway. He said that “If you’re not confused about a global economy today, you don’t understand it.” I can’t say it better than that.
Steve Pomeranz: (laughs) Yeah, it is impossible.
Vitaliy Katsenelson: This is a brilliant person who basically says, “I don’t know.”
Steve Pomeranz: You know the other manifestation that I’ve realized in the last year is that there’s always something to worry about and somehow these ideas bubble up in the media and they catch our attention through the headlines. You know, whether it’s the European Union that was an issue or the fiscal cliff, and those issues go away, they disappear, but then they are replaced with new issues. We always have this litany of issues and worries that bubble up and, in a way, it feels so manufactured to me. Do you have any ideas on that?
Vitaliy Katsenelson: Well, I think what happens a lot of times, the news media tries to explain movements in stock markets by some kind. The market is going down and they’re saying the market is worried about this, this, and this. Market is going up, and they’re just changing their focus from negatives to positives. So, in reality, in the short run, stocks go up and down, but the price movements are random. But if I own CNBC or CNN, I would be doing the same thing because if I didn’t, you’re probably not going to watch this channel much longer. I mean, you have to do this, but you as an investor need to be aware that this is just noise.
Steve Pomeranz: Yeah, fundamentally, the commercial media is out there, as I always say, to sell soap. I mean, nobody gets to be at the desk of CNBC and get whatever salaries they’re paid and have that major production unless they’re bringing in advertising revenues, period. They have to make sure that they keep your eyeballs glued to the set.
My guest is Vitaliy Katsenelson, Chief Investment Officer of Investment Management Associates in Denver, Colorado. Vitaliy, thanks for taking the time to join us.
Vitaliy Katsenelson: It’s my pleasure, thanks, Steve.
Steve Pomeranz: All right, my friend, thank you very much.