A note before I begin. When I do book reviews at this website, I have read the whole thing, even if I might skim some sections. In this case, I read all of it without skimming. It is a very good book on value investing. His objective is to teach you how to make money in range bound markets. Now I hadn’t thought of value investing in that way before, but it makes sense to me. If the average dollar invested in the stock market isn’t going anywhere, how can you make money? It was easy from 1982 to 2000, but what about relatively stale periods like the last seven years? During periods like that, security selection is paramount, as is willingness to adjust your portfolio to accommodate new cheap areas of the market.

He has a three part system for stock evaluation — Quality, Valuation, and Growth. He spends most of his effort on valuation, and provides the reader with a detailed and disciplined way of coming up with what P/E a stock deserves. I am not going to adopt it for myself; I already have my own methods, but someone looking for a rigorous way to value public companies could do worse than the author’s methods. (Note: this is not a full endorsement of his valuation methodology. I’d have to do a lot more work to get there. It’s credible and reasonable; it looks fair, but requires the user to make relative judgments about the character of the company being analyzed.) The methods require thought and work, but none of the formulas require anything more than grade school math, unless you want to try discounted cash flow analysis.

Other key concepts get covered in the book as well: margin of safety (and how to calculate it), buy discipline, sell discipline, contrarianism, and diversification (not too little, not too much). The idea is to not lose much when an idea goes wrong, and make money when the price of an undervalued stock returns to fair value, and sometimes overshoots it. His view on risk is similar to mine: don’t overdiversify, buy quality companies trading at a discount, sell them when they are fairly valued, or when the deteriorating fundamentals no longer justify the price. His view on international investing is similar to mine: go anywhere, but be aware of the risks.

On the whole, I found his methods to be similar to mine. Here are the differences:

1. His portfolio is more concentrated than mine. 20 stocks vs 35.
2. I have a more explicit rebalancing strategy.
3. He focuses more on growth than I do… maybe I could learn something there.
4. I spend more time on industry selection and pricing power.
5. I don’t use P/E as my primary metric.
6. I spend more time looking for ideas that are better than my current portfolio, and doing explicit swap transactions to keep my portfolio focused on value.
7. I may be wrong here, but I think I spend more time on accounting and free cash flow issues.

That said, I like Vitaliy Katsenelson’s processes and can heartily recommend this book to my readers. His book is a fine addition to the world of value investing. If you want to buy it, you may do so below. Full disclosure: I get a small cut of the proceeds from Amazon if you use the link below.

Oh, and here is the book’s website.

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About a month ago, when the financial markets were more skittish, I saw a series of four articles on more interest in distressed debt investing (One, Two, Three, Four).  In this market, it didn’t surprise me much because we have too many smart people with too much money to invest.  It reminds me a bit of a RealMoney CC post that I made a year and a half ago:

		David Merkel
		Make the Money Sweat, Man! We Got Retirements to Fund, and Little Time to do it!
		3/28/2006 10:23 AM EST

What prompts this post was a bit of research from the estimable Richard Bernstein of Merrill Lynch, where he showed how correlations of returns in risky asset classes have risen over the past six years. (Get your hands on this one if you can.) Commodities, International Stocks, Hedge Funds, and Small Cap Stocks have become more correlated with US Large Cap Stocks over the past five years. With the exception of commodities, the 5-year correlations are over 90%. I would add in other asset classes as well: credit default, emerging markets, junk bonds, low-quality stocks, the toxic waste of Asset- and Mortgage-backed securities, and private equity. Also, all sectors inside the S&P 500 have become more correlated to the S&P 500, with the exception of consumer staples. In my opinion, this is due to the flood of liquidity seeking high stable returns, which is in turn driven partially by the need to fund the retirements of the baby boomers, and by modern portfolio theory with its mistaken view of risk as variability, rather than probability of loss, and the likely severity thereof. Also, the asset allocators use “brain dead” models that for the most part view the past as prologue, and for the most part project future returns as “the present, but not so much.” Works fine in the middle of a liquidity wave, but lousy at the turning points.

Taking risk to get stable returns is a crowded trade. Asset-specific risk may be lower today in a Modern Portfolio Theory sense. Return variability is low; implied volatilities are for the most part low. But in my opinion, the lack of volatility is hiding an increase in systemic risk. When risky assets have a bad time, they may behave badly as a group.

The only uncorrelated classes at present are cash and bonds (the higher quality the better). If you want diversification in this market, remember fixed income and cash. Oh, and as an aside, think of Municipal bonds, because they are the only fixed income asset class that the flood of foreign liquidity hasn’t touched.

Don’t make aggressive moves rapidly, but my advice is to position your portfolios more conservatively within your risk tolerance.

Position: none

We are still on the side of the demographic wave where net saving/investing is taking place, and that forces pension plan sponsors to find high-return areas to place additional monies.  Away from that, the current account deficit has to be recycled, and they aren’t buying US goods and services in size yet.  That’s why there will be vultures aplenty, outside of lower quality mortgages.  Even the debt market for new LBO debt is slowly perking up.  The banks pinned with the loan commitments may be able to get away with mere 5% losses.  Away from that, investment grade and junk grade corporate bonds are looking better as well.

Now, don’t take this as an “all clear.”  There are still significant problems to be digested, particularly in the residential real estate and mortgage markets.  CDOs still offer a bevy of credit issues.  There will be continued difficulties, and I don’t expect big returns.  But with so many willing to take risk at this point, I can’t see a big drop-off until they get whacked by worsening credit conditions.

There are times when I feel “in sync” with the markets, and times when I don’t.  Example: for the four months from June 2002 to September 2002, my broad market portfolio lost 32.5% of its value.  Needless to say, I questioned my sanity while BBB bonds traded at 400 basis points over Treasuries.  (Yes, I had those to worry about also, I was managing several billion in corporate and other bonds at the time.)

So what did I do? I kept doing what I always do.  If I found a trade that improved the fundamentals of the portfolio, I did it.  I kept following my discipline, even though it hurt.  In late September, I scraped together my spare cash and invested it into the portfolio. On October 7th, we hit bottom for both the equity and credit markets.  (After the European financial regulators were done making their financial companies sell US stocks, in order to preserve their solvency.)   Over the next 15 months, I had my best period of outperformance ever.  Including the four-month drawdown (worst in my life), the full nineteen month period gave me a 26% return, which was pretty good for that time period.

In general, the time to give up on a strategy is not when it is hitting you hard and negative.  Instead, look for the fundamental reasons why your strategy isn’t working, and ask how long lasting those factors are, and whether/when they might reverse.  If after that analysis, you realize that the factors are long lasting, and unlikely to reverse anytime soon, then change.  But if they are likely to be transitory, it is time to maintain the discipline and press on.  It will not feel good at the time to do so, but it will likely pay off.  I experienced this while doing small cap value in the 90s, managing corporate bonds 2001-2003, and with my broad market equity strategy 2000-2007.  Things always hurt the worst near bottom turning points, and vice-versa in top formation.

The third quarter did not work so well for me.  Part of it was value investing being out of style.  With all of the new growth investors over at RealMoney, it is interesting to hear them perk up and crow a bit.  They’ve suffered enough over the past seven years.  But as for me, my sector rotation discipline covers some of that, while staying in a value framework.  In the last few weeks, I might be seeing a turn in my relative performance.  At least, it feels that way.  Ideas are working for the reasons that I would expect.  So, I am guardedly optimistic on relative performance.  But what would you expect?  I’ve been through worse, and bounced back, so I keep doing what I do.