February 8th, 2013
Vitaliy Katsenelson’s Active Value Investing is really two books in one. The the first part of the book deals with long-term trends in the stock market. Katsenelson lays out in significant detail his case that the US stock market entered into a range-bound market following the bursting of the tech bubble. The second part of the book highlights in great detail his investment process for selecting stocks, which he describes as an active value investing methodology.
The book is different from other books on value investing as it deals with broader stock market trends vs. solely focusing on the valuation of individual equities. Katsenelson makes the case that range-bound markets represent periods of time where investors must suffer poor returns due to the above average returns enjoyed during the prior bull market cycle. Essentially, the above average returns enjoyed during the bull market are due primarily to the over-valuation of equities based on rising P/E multiples. Long-term returns in the stock market are largely a function of the starting P/E level. Range-bound markets are caused when P/E levels decline from extremely high levels to a more normalized level. After reading the book, it’s clear that US stock market has been in a range-bound market since 2000. The most interesting point that Katsenelson highlights in the first half of the book is that underlying economic growth is not significantly different during secular bull markets and range-bound markets. Growth in corporate earnings is surprisingly stable over long-period of times. Thus, the main cause of the divergence in equity returns between a bull market and range-bound market is due primarily to changes in valuation levels as measured by P/E.
After making a highly plausible case for the US market being in a range-bound market, Katsenelson discusses in great detail how to invest in range-bound markets. The second-half of the book resembles other books on value investing and highlights Katsenelson’s QVG (Quality, Value and Growth) investment framework. Additionally, Active Value Investing is one of the first books on value investing that explicitly deals with factoring growth into the valuation of a stock. Almost all the traditional value investing books that I’ve read always focus on net asset value as the starting point for any valuation analysis. Active Value Investing focuses on identifying high quality companies and determining the appropriate intrinsic value for their share price. Katsenelson’s investment methodology in many respects is similar to Warren Buffett’s belief in buying high quality companies at reasonable valuation levels. Rather than focusing on how much a company is worth in receivership, the QVG framework is helpful in determining the valuation of businesses with durable competitive advantages and strong growth prospects.
The Quality component of the framework deals primarily with identifying companies with durable competitive advantages, strong balance sheets, stable earnings and strong management. Katsenelson’s focus on finding companies with high quality management teams is also a departure from traditional value investing tenets. Warren Buffett has made it abundantly clear in his writings that the horse is more important than the jockey in terms of the investing world. Implying that a company’s competitive positioning is more important than the management team running the company. The final point that Katsenelson makes is that high returns on capital are the best single indicator that a company has a sustainable competitive advantage. Range-bound markets are brutal for individual equity returns. By investing in companies that are high quality the continual pressure of a declining P/E ratio will hopefully be offset by improving earnings.
The growth aspect of the QVG framework, primarily deals with how companies achieve both growth in earnings and dividends. The book highlights the traditional methods for achieving increased earnings such as revenue growth and improving profit margins. The entire growth section is relatively straightforward and there is nothing new that an experienced value investor would pick-up. Regardless, I think the most important point highlighted in the growth section of the book is the importance of not simply extrapolating historical growth rates into the future. If a company has grown earnings through margin improvements, this source of growth is ultimately finite.
In my view, the valuation section of the book was well worth the purchase price of the book alone. Katsenelson provides a detailed explanation of the distinction between absolute valuation vs relative valuation. Novice investors typically fail to distinguish between the two. An absolute valuation model such as a DCF analysis provides a valuation yardstick that is independent of what other stocks are trading at. A relative valuation tool such as the P/E metric compares a company’s valuation with that of other companies. In the case of relative valuation a company could still be considered cheap at a high absolute P/E multiple if its peers were trading at even higher multiples. I think the most interesting concept that Katsenelson highlights in the valuation section is the idea of an absolute P/E valuation model. Essentially a fair value P/E can be derived for a stock based on earnings growth, dividend yield, business risk, financial risk and earnings visibility. The benefit of this approach is that an investor can obtain an independent valuation of a stock without having to rely on overall market valuation levels. By using an absolute P/E model an investor can decrease the likelihood of buying a stock near the top of a range-bound market.
Most books on value investing discuss how to value equities but don’t really delve into the detail of how to manage a portfolio of equities. Active Value Investing not only provides a valuation methodology but also highlights the criteria an investor should use for both buying and selling. Maintaining a sell discipline in range-bound markets is of paramount importance as gains made by the market are not likely to be sustainable.
I think one area of improvement would have been the inclusion of a comprehensive case study on a stock valuation. Essentially, it would have been interesting to see a step by step example beginning with the screening process and ending with the QVG analysis for a single stock. There were clearly a number of real life examples provided in the book, but there wasn’t a single comprehensive case study. Additionally, I would have liked to see more information on the screening criteria that Katsenelson uses to identify undervalued stocks and more information on particular sectors that he finds attractive from a structural viewpoint.
Overall, I think the book should be read by both novice and experienced investors. Most value investors don’t worry about where the market is headed and simply focus on the valuation of individual equities. Unfortunately, investors can no longer ignore the impact of being in a range-bound market. Katsenelson has provided a guide book on how to defend your portfolio in a range-bound market, while waiting for the next bull-market to begin. Additionally, I think you could literally learn to manage an entire portfolio from reading this one book. I think the book is well worth the purchase price and belongs in every value investor’s library.