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Knowing the Difference Between Value and Price: An Interview With Vitaliy Katsenelson

By Motley Fool Staff - Oct 19, 2015 at 11:04AM

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A top portfolio manager talks about valuing businesses.

The Motley Fool's James Early and Rana Pritanjali recently spoke with Vitaliy Katsenelson, CIO of Investment Management Associates. Vitaliy explained how he helps investors see the difference between a stock's value and its price, as well how he assesses macroeconomic trends when investing. Plus, Vitaliy predicted the next category Apple will disrupt: the automotive industry.



There is no shortage of opinion from investment experts in this world, but one of the few who actually make sense, consistently, is Vitaliy Katsenelson. Vitaliy I've actually known for many years. About 11 years ago, Vitaliy used to write for The Motley Fool. He's since gone on to become the chief investment officer of Investment Management Associates in Denver, Colorado, and Vitaliy is here with us today. So, thank you very much.


It's my pleasure. Thank you.


And I should say "us" is myself, James Early, and Income Investor analyst Rana Pritanjali. The topic of the day we're going to lead off with is a manifesto — Vitaliy's manifesto — pertaining basically to the nonlinearity of investing. And Vitaliy, just off-topic, if there's anybody I can think of who would be a great candidate to write a manifesto, it is you. I don't even have a logical reason to say that, but you just seem like the kind of guy, so I was very pleased to find that you'd actually written this manifesto.


Actually, I have a very logical reason why you think this way, because manifesto sounds very Soviet [crosstalk 00:01:13] manifesto.


You may be from Russia...


That's why you're thinking this way.


...but personality-wise, you are very non-Soviet. I will have to say that as someone who knows you.


That's true. That's true.


These days you talk about, like I said, nonlinearity of investment returns, and one of the quotes you mentioned I like is "any money manager will go through stretches where he looks smarter (or dumber) than he really is, though his IQ hasn't actually changed."

Now Vitaliy, maybe you're looking smart these days, but I'm certainly not. It seems like a lot of macroeconomic factors are driving the markets, and the fundamental factors that investors like you and I tend to base our investing on are sort of being blown around in a storm, or moved around by the waves (whatever analogy you'd like to see). Do you agree with that?


Yes, but I think it's more than that. If you think about overall stocks, they're not cheap, in general. But even cheap stocks over the last two or three months just declined — a lot of them for no reason whatsoever — and got to insane valuations. So the reason I wrote the manifesto is because I wanted to find a way to communicate to my clients. I wanted to set a language and I wanted to set rules that when clients and I talk, they don't just talk about the stock price decline. They separate between the value of the company and the price.

That's very, very important, because what I found is this. I spend an enormous amount of time analyzing a company and, as a value investor, we basically look at companies as [00:02:53] businesses. We study the business, we look 10 to 15 years out, and that's how we value it ... on discounted cash flows.

And so let's say with about $1.50, that with discounted cash flows the business is worth a dollar and today I could buy it for fifty cents. If you think about it, actually that's irrational in the sense that a dollar should not be priced for fifty cents. But let's assume that's the case. Then there's absolutely no reason why that fifty cents could not decline to thirty cents, at first, before it gets to a dollar.

The problem is as an investor, in the short term, the stock price movements, to me, are random. If you were to ask me what Apple stock will do over the next six months, I would have no idea. In fact, my forecast is almost like going to a casino and asking if the roulette is going to stop on the red or the [black].

The same thing with a stock. In the short run, I would have no idea what Apple stock is going to do. In the long run, I have a better idea, because in the short run it's completely, completely random. So in that manifesto, I wanted to set a language. I wanted to set the terms or the rules of engagement between me and my clients, so when we talk about a stock, we'd say, "Well, here's what we think it's worth. It got cheaper, and that's not necessarily a bad thing because we can buy more of it."

The problem is this, and this is another reason for that. I'm going to throw a stock out there just for any reason. Let's say GE stock declined 10%. I know nothing about GE. So to me, the value of GE and the price of GE are going to be kind of the same, because I know nothing about it. So when it declines 10%, I assume the value might have declined because there may be some news that draws the value of GE down, as well (because I have done zero research on GE). But when a stock that I own, where I have done a tremendous amount of research declines, I can separate the difference between the value and the price.

In the money management business my clients hire me for that — to know the difference between the value and price — but they don't know that. They don't know what the stock is worth and therefore when I wrote the manifesto, my point was this. There was asymmetry of information. I know what the business is worth. My clients don't. And it's my job, in our quarterly letter, to communicate to them. To explain what the businesses are worth so when the stock price declines, they are not nervous about it because I explain what the value is.


That's a great answer, and it really underscores the two jobs I think any investment manager has is first getting good returns, but also communicating it and keeping the clients active and participating. And not bailing, which I think is easy for the clients to do in a lot of cases. How do you deal with situations where the macroeconomics actually affect the microeconomics of a company? I'm thinking a company that's exposed to oil prices, for instance.


That one is difficult for me, and I'll be very honest, because we always pay attention to macro, but we pay attention in a slightly different way. I basically say instead of trying to figure out what the employment number is going to be in the next three months, or what interest rates are going to be six months from now, that's kind of noise. That's almost like trying to predict the weather. It may be a lot of fun, but it consumes a lot of your energy and that analysis has a very short shelf life.

Instead, what you should try to focus on, as an investor in general, is on the climate-changing events. So the risk is that interest rates may end up being a lot higher, or that inflation will be much higher, or we may have deflation, or that oil prices will decline. So when you look at these macro risks, that's how we try to pick stocks around it. It doesn't mean we're going to get it right all the time, but we try to identify those risks and then in our stock selection, we try to avoid them.

About oil prices, I'm the worst person to ask about this, because I found that there are some stocks I'm not going to be very rational owning. When a stock has revenues that are tied to a commodity, I find myself extremely irrational when I own them, because I feel like my imagination is extremely rich, and I can see how oil prices could end up staying here for a long, long time. Therefore, a lot of companies that made sense at hundred dollar oil stop making sense at forty dollar oil. And those may be a permanent value kind of [stock], and you might see an erosion in value permanently.


So not weather patterns, but climate change. I like that very much.


Thank you.


Vitaliy, I have a question related to dividend investing. As you see, the low interest rate has pushed yield-seeking investors toward dividend stocks, especially safe and steady dividend stocks, so this has caused a wide gap between the stock price and the intrinsic value of those companies. And this has put an investor in a dilemma — whether you should go for safe and steady stocks, and compromise a bit on valuation, or you should hunt in a ground where you have a riskier stock but it is available at a cheap price. Maybe you can go to Latin American countries, which look like a complete mess right now.


We've gone to some of those. We've paid for it, too.


What is your opinion on that? How do you think about that compromise or think about balance between risk and return?


I think you made a very good point. A lot of investors have been buying dividend stocks just because of the yield, and I think that is incredibly dangerous, because dividends should be part of the analysis. Like it's a part of the equation, but they should never be the equation.

Maybe the analogy would be if you buy a stock that pays a dividend, but the stock is overvalued, it's almost like buying a bond that pays a coupon. It's almost like buying a bond that has a par value of $100 but you're paying, say, $130 for it. Yes, you are going to get this 2-3% coupon, but the price would decline by 30%.

And to be honest, I think this is a byproduct of Federal Reserve policy, and I think it's very dangerous because it shifted a lot of investors to the right of the risk curve. So people who maybe in the past used to own corporate bonds now own dividend stocks, indiscriminately, because the yields there are higher than some corporate bonds. And those stocks scare me. I call it "bond subterfuge," because at some point, they will get will compress significantly and people will lose money.

In addition to that, there is another group of stocks that worries me, and these are (and I'm generalizing when I say this) the master limited partnerships or REITs, or businesses that need to have a lot of debt. Like [with] some businesses the economics make no sense if they don't have debt, and a lot of those businesses also pay high dividends. They've been bought just for the dividends.

I think those businesses will get affected double when interest rates rise, because what's going to happen is their multiples will decline because of what we just discussed (because you could have high interest rates). But more importantly, because they have a lot of debt, their interest expense will go up and the earnings will decline substantially, as well, so those stocks will decline a lot more. So as a warning for your readers, you've got to be very careful. When you own stocks just for dividends, you want to think twice about it.


But the way the market is pricing those safe and steady stocks, the usual investors have reduced their discounting factor in order to make those stocks look like a buy. This is just like an ongoing process — that the stock price is going up and the market's adjusting the price — and it's kind of hard for dividend investors to get out of that spiral.


I do think a lot of people are using very low discount rates now because rates are so low, but I don't think that's going to last over the life of their projection periods and that's probably a problem.




You're absolutely right. It's almost [like] they're priced as if the sun is going to shine every single day of the year and you're never going to have a rainy day. For the last many years, interest rates were only going down, so it hasn't rained. But at some point it's going to rain. I don't know when, but when it does, it's going to end badly.


Now let's move to Apple. You are a huge fan of Apple — its devices as well as the business. So unlike other device manufacturers, Apple does have a switching cost because of the ecosystem it has created. How will you rate Apple as compared to a traditional dividend aristocrat in terms of visibility of revenue?


So let's separate Vitaliy, the consumer of Apple products and Vitaliy, the investor. When I talk about Apple devices, I'm fairly evangelical about it. I just got iPhone 6s and I've been showing it to everybody, because I'm so excited about the Live Photo feature that it has.

It's more difficult to be an investor in Apple, right now, than it was two years ago, because two years ago... And I'm not trying to brag. Please don't look at it this this way. It's just when Apple was a lot lower, I didn't have to have so much clarity about its future and its future products because the stock was so much cheaper. So today Apple is a more difficult stock than it was in the past, because now the future products will matter a lot more and are more important because the valuation is so much higher.

The concern I have about Apple is that I don't know what the earnings power is right now, and let me explain what I mean. The iPhone sales went up vertically over the last year and it's possible that they have borrowed some of the future sales. So when people look at its earnings power — I forget the number, but everybody looks at nine dollars or ten dollars — I discount it, somewhat, because I think that's now going to be a little bit lower for that reason.

But one characteristic Apple has, that people a lot of times don't realize, is there is a built-in recurrence of revenue. What gave me confidence to buy Apple a while back was I realized that it has a built-in recurrence of revenue. That when you have an Apple iPhone, the next one you're going to have is going to be Apple ... most likely nine out of the last 10 times ... because of the brand, because of the Apple ecosystem, all those things. That kind of gives it recurring revenue annually. Every two years you're going to get a new phone.

As an Apple investor (and as a human being, I guess) I'm very interested in the Apple car and I think Apple will be able to disrupt the automotive industry to the same degree, or even larger, than it disrupted mobile phones.


Wow. Tesla should be scared.


Bold, yeah.


Well, if you look at it, Tesla showed us what an electric car should look like. And I had this ahamoment about electric cars when I went into Tesla's showroom and I saw the power train of Tesla. It looked like a skateboard. It's basically a slab of metal, four wheels, and an engine the size of a watermelon. That's it. It only has 28 moving parts, whereas a normal car has hundreds of thousands of moving parts.

So I realized that if you think about it — and this may be a big claim — but the electric car is not that much different from a cell phone, in the sense that it's a lot more about the software at the end than anything else. So Tesla is really a battery company and a software company.

If you think about Apple, it's a great brand and everything, but it's also a software company and it knows a lot about batteries. So I think because Apple has unlimited resources (it has $150 billion of net cash and it generates about $50 billion a year of cash flows) it can accelerate a lot of things in the electric car industry and it has an incredible competitive advantage if you compare it not to Tesla but to other automakers, because it's never made an internal combustion engine car.

The best example is this. When Apple came out with its iPhone, Nokia should have looked at the iPhone and said, "We get it. We know what the next smartphone should look like." They already had leverage in years. They already knew more about wireless than Apple ever did.

But what they did, instead of coming out with a smartphone, they took the iPhone operating system, tried to add IQ to it, and they failed miserably. Think about General Motors' response to Tesla. They took, I don't know, a Chevy Malibu and added an electric motor to it, and basically that was what became Volt.

Apple doesn't have the history of making internal combustion engine cars, and therefore it doesn't have thousands of engineers doing just that. Therefore it can think outside the box, just like Tesla is doing. So I'm fairly bearish on the auto industry in the long run. Not for the next few years, but in the long run I think Apple is going to make their life miserable.


It's a good point. Companies are like people. We both tend to drag around our emotional baggage and that holds us back. Vitaliy, your points are insightful, as always. Thank you so much for joining us. And guys listening here, if you have time to read just one manifesto this year, please make it Vitaliy's manifesto. I believe you can go to Vitaliy, is that the best website to get it at?


Yes, or just go to

JAMES EARLY: Either way, get this manifesto. Read it. It's short, it's entertaining, and you'll definitely be glad you did. Vitaliy, thank you so much for joining us.


It was my pleasure. Thank you.


Yes, thank you so much for joining us today, Vitaliy. It was a pleasure talking to you today.

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