When listening to Vitaliy Katsenelson talk about today’s markets, be prepared to hear about a bleak outlook. He'll remind you that the U.S. economic recovery is unsustainable, because it relies on government intervention, China is facing an overcapacity bubble and Japan’s population is too old, too indebted and their interest rates are too low.
So, what does Katsenelson, the Chief Investment Officer at value investment firm Investment Management Associates, invest in these days?
Well, in sideway markets. That is, in high quality stocks with a competitive advantages that are insensitive to the health of the global economy. The key is to be “very disciplined and contrary,” he says, “because you are going to be selling when everybody is buying and you will be buying when everybody else is selling.”
In a recent interview with Institutional Investor, Katsenelson explained the strategy behind investing in sideway markets.
Institutional Investor: How do Investors make money today?
Vitaliy Katsenelson: It is going to be more difficult than the last four month made us to believe.
When I talk about sideway markets, I am talking about secular trends that last decades. It not about the next six months, but about decades. In this environment you want to be very disciplined and you have to be contrary, because you are going to be selling when everybody is buying and you will be buying when everybody else is selling.
What is the history behind the sideway markets?
If you look at the last 100 years, every time you had a market boom that lasted 18 years or so, the market that followed was not bear market but it was a sideways market. What I mean by that, is stocks go up and down over a period of time, but really go nowhere. Think about what happened over the last ten years. We had a little bear market, a boom market, a bear market and a another boom market.
So we had a lot of cyclical boom and bear markets inside of this broad sideways trend. The reason this happens is very simple, stocks get overvalued in the end of the cyclical boom market and it takes time for the P/E compression to decline from above average to below average. That P/E compression wipes out all the benefits you get from earnings growth.
Can you give me an example of a typical sideway market stock?
If you look at the stock price of Walmart of the last decade, the stock price is basically where it was ten years ago. The stock price is just flat with a lot of little volatility.
So you look at the stock and think this is a failing company. That is not the case at all. Walmart's earning grew 10 to 12 percent a year over the last decade. I think they almost tripled.
But what happened was in 2009, Walmart stocks were just too expensive. It was traded at 45 times earnings. The price to earnings declined from 45 times earnings to about 12 or 13 times earnings. And therefore all the benefits from earnings growth were completely offset by price to earnings declining. That is why Walmart stock has gotten nowhere.
You've been warning about investing in the Chinese Market. What should investors know?
China has a tremendous overcapacity in many different sectors – such as industrial sector, commercial and residential real estate. Because of the government’s involvement there have been a huge misallocation of resources. The reason why the government did this is because China has a little social safety net and the government wanted to maintain economic growth at any cost. That created the misallocation of resources.
Therefore when the Chinese economy slows down, it is going to have substantial problems. And the Chinese demand for industrial commodities will decline. The Chinese demand for U.S. bonds will decline. It is going to slow the growth of the global economy and impact a lot of countries that have benefited from the Chinese miracle growth, like Australia, Brazil and Canada. They are huge exporters of commodities – they will get hurt when China’s economy slows down.
What would you recommend an investor do to yield high returns?
You want to stay away from companies that are leveraged. You want companies that are insensitive to the health of the global economy. Ironically, those companies are the cheapest asset class today.
If you look at Medtronic – the company that makes medical equipment. The demand for those products will still be there in 3 or 5 years from now. Because as people get older they need more work done on their bodies. So this company has a very good balance sheet and a high return on capital. Over the last ten years, it grew revenues and earnings 14 percent a year and it trades on 10.5 times earnings – ironically the companies that are very geared towards Chinese growth continuing are traded at 16 or 18 times earnings.
I buy companies like Medtronic today, and that is what we are doing in our portfolios. I am buying very defensive companies, very cheap. And that is the right approach for today’s markets.
