Sideways Markets

Vitaliy N. Katsenelson, CFA

Chief Investment Officer

Investment Management Associates, Inc.

 Economy
Vitaliy N. Katsenelson, CFA
Chief Investment Officer

Investment Management Associates, Inc.

Interest rates are at an all-time low, debt has skyrocket globally, and for
all our effort (we have consumed a lot of Red Bull) our economy is
barely producing 2% real growth.
 How to Stay Rational
in an Irrational World
Vitaliy N. Katsenelson, CFA
Chief Investment Officer

Investment Management Associates, Inc.

 How to Do Okay
Vitaliy N. Katsenelson, CFA
Chief Investment Officer

Investment Management Associates, Inc.

Six Commandments
1. A stock is fractional ownership of a business
2. Long-term time horizon
3. Mr. Market is there to serve us.
4. Margin of safety
5. Risk is permanent loss of capital
6. In the long run stocks revert to their fair value.
1. A stock is partial ownership of a business
Would we want to own this business if the stock market was closed
for 10 years?
(Thank you Warren Buffett)
2. Time horizon analytical / holding long-term time horizon
A long-term time horizon is extremely important for value investors for
several reasons:
It is impossible predict how a stock will be priced in the short run.
Having a longer time horizon than the rest of Wall Street is a very important
competitive advantage.

How do we embed a long-term time horizon into our process?

Look at earnings and cash flows at least three (often five) years out.
Use discounted cash flow
3. The market is there to serve you, not the other way
around
Stock fluctuations should be looked upon as a feature of the stock market, but only
if you know what the asset is worth!

Make Mr. Market serve us and do not become its slave.

What we do in a scenario:
Stock A is worth $1, but price falls from 50 cents to 30 cents

Thats a blessing for several reasons:

Company A now can buy back a lot more of its stock at lower prices.
We can add to our position after all, its 40% cheaper!

Here is the key: Make sure that what you thought was worth $1 is still worth $1 !
3. The market is there to serve you, not the other way
around
Everyone has a plan 'till they get punched in the
mouth.
Mike Tyson
3. The market is there to serve you, not the other way
around
How do you remain rational when Mr. Market has just punched you in
the mouth by repricing your $1 stock from 50 cents to 30 cents?

Maybe Mr. Market is right and the fair value was never really $1 but
only 40 cents?
3. The market is there to serve you, not the other way
around

You want to remain rational by maximizing your Total IQ!

Total IQ = IQ x EQ
(where EQ <=1)
3. The market is there to serve you, not the other way
around
IQ our intellectual capacity to analyze problems will vary with the
problem in front of us.

We buy stocks that fall within our sphere of competence.

We tend to stick with ones where our IQ is the highest.

3. The market is there to serve you, not the other way
around
EQ

If investing were an exact science, our emotional quotient (EQ) would

be irrelevant.
Investing is not a science and we are humans
We have plenty of emotions, and thus EQ is a very important part of this
equation.
 3. The market is there to serve you, not the other way
around
EQ, Myself as a Patient:
Problem 1: Distortion of probabilities
Even if my intellectual capacity to analyze a problem is not impacted
My brain may be solving a distorted problem.

Problem 2:
My EQ is not constant
My ability to process information effectively declines under stress.
The Consequence:
I either lose the big picture or overlook important details.

BUT: The higher my EQ is with regard to a particular company, the more likely
my Total IQ will not degrade when things go wrong.
 3. The market is there to serve you, not the other way
around.
How do we increase our Total IQ?
a) We increase it by subtraction:
Shrinking our universe to stocks within both our IQ and EQ zones.
We are very careful about stocks when our IQ or EQ is low
Example:
Our IQ is low for a non-revenue-generating, single-future-product biotech
company.
We have zero analytical insights into this business!
In investing we only need 20-30 stocks
We get to choose which problems we want to tackle.
We usually like easy problems.
 3. The market is there to serve you, not the other way
around
b) Find areas where your EQ is highest.

Our EQ is much higher with higher-quality companies.

For every company in our portfolio or on our watch list, we quantify quality.
If you dont quantify quality it is very easy to lower your standards.

Quality for us is a filter:

If a company doesnt pass its quality test, it is dead to us!
 3. The market is there to serve you, not the other way
around
Quality Attributes:
(1) Competitive advantage
(2) Balance sheet
(3) Recurrence of revenues
(4) Management

Maximizing both our IQ and EQ for individual stocks will maximize the
Total IQ of the portfolio.
If we get punched in the mouth we are able to rationally reanalyze:
Buy more, do nothing, or sell
 3. The market is there to serve you, not the other way
around
We cautiously guard our EQ!
Its a mistake to let the outside world in unchecked to your daily work life.

We spend little time watching business TV during the day

Its incredibly toxic to your time horizon.
Its incredibly toxic to your Investor mentality.
 3. The market is there to serve you, not the other way
around

You need to have clients who allow you to maintain your EQ. Otherwise,
following the Six Commandments is practically impossible.
 3. The market is there to serve you, not the other way
around.
On January 25th, 2013 at 3:55 pm
I get this email from a client:
3. The market is there to serve you, not the other way
around.

Initial Buy

Buy More
4. Margin of Safety
Leave room in your buy price for being wrong.
Margin of safety is a function of two dimensions:
A companys quality
Its growth

We quantify both a companys quality and growth.

Thus margin of safety is deeply embedded in our valuation operating system.
5. Risk Permanent Loss of Capital
Methodically focus on what the company is worth.
Total IQ is maximized!
Fluctuations are just noise.

Volatility becomes our friend

We can rationally take advantage of it!
6. In the long run stocks revert to their fair value

Long run is the key term.

The value of any asset is the present value of its cash flows.
Our discounting does not use 3% or 6% rates.
That assumes too much that interest rates will stay at this insanely low level
forever.
We assume that interest rates will revert to a higher equilibrium.
Thus we us at least a 10% rate.
Reversion to fair value is not a pie in the sky concept!
If a stock is significantly undervalued for a long time, share repurchases will
take the company private!
A Game of Chess
Chess is a game of small advantages.
Everyone starts equal: same number of pieces, same positions
BUT Every move has an impact.
Every move accumulates towards victory.
Investing is not that much different.
The key to doing okay (succeeding) in this irrational world:
Actively ingrain each one of the Six Commandments.
Improve your investment process just a little each day doing okay
will follow.
$240

$140