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320: The Soul of a Value Investor

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Buck: Welcome back to the show, everyone. Today my guest on Wealth Formula podcast. It’s Vitaliy Katsenelson. Vitaliy was born in the USSR, immigrated the United States with his family in 1991. He joined a Denver based value investment firm, IMA, in 1997, ultimately became chief investment officer in 2007 and CEO in 2012. Now Vitaliy is also known as a writer, and he’s written two books on investing, previously Active investing, and The Little Book of Sideways Markets, which we can talk about. And also most recently, a game that’s not necessarily just about investing. It’s called Soul in the Game, which has gotten rave reviews from some very big names, not only in economics but in the arts. Vitaliy, welcome to the show.

Vitaliy: Buck, it’s my pleasure. Thank you. 

Buck: I want to start out because this is an economic macroeconomic, personal finance type show focusing on sort of your specialty, because most of my group, I think, is they’re either into real estate investing or maybe they have some money in the equity markets, but they’re not really actively managing anything. And so there’s a lot of terminology, a lot of lingo that goes in to various types of investing. How do you describe value investing? And I know that you have in your book described it with an analogy with Fiddle iron on the roof. If that’s something you’re willing to do, it may help us less sophisticated individuals. 

Vitaliy: I’ll give you more colorful story about this. So in 2006, in addition to being an analyst, I totally investment class at the University of Colorado. And this was my 6th year teaching class and at this point I stopped preparing for lectures because if I prepare for lectures, I would just not be interested. I would come to lecture, open with the syllabuse and just start talking. So I show up to class one day and it says I have to talk about discount and cash flow analysis. And so I started talking about how discounted cash flow analysis basically is the foundation of investing, not just value investing, any kind of investment. If you’re a real estate investor, that should be foundation of your investment as well. So the analogy I would use was if, let’s say you’re a farmer and you’re about to buy a cow and you need to figure out how much would you pay for a cow, and then you start looking. So what you have to do, you have to identify the cash flows that the cow will generate for you as a farmer. And it’s very simple, right? For the most part, you see, you know, it’s going to produce milk for six or seven years and then it’s going to have a terminal value, which is basically when the cow either you take it to a Butcher or to a Penn Zoo, your choice. And then you start looking at risks. Okay. What are the risks of these cash flows? Well, you could have fertilize the prices going up. That’s the risk. Milk prices may decline. That’s a risk. And you start looking at risk and you start trying to identify what are the worst case cash flows? What are the best case cash flows? What’s the worst case terminal value. What’s the best case terminal value. And that gives you the range of values for account. So this applies actually to any investing. In fact, I would argue that value investing is very similar to real estate investing. Unless you are just buying houses just to sell them a week later or two weeks later, then you’re just looking for greater fuel to buy a house right away. But if you’re buying a house and you look like, let’s say you were going to rent it, right, then you start looking at what’s going to cost you, what cash flows it’s going to generate for you and you start looking. Okay, well, is that return I’m going to get? Return I’m going to get is it going to be greater than my cost of capital? If you look at the kind of basic tenants of value investing, in fact, they are incredibly similar to real estate investing, kind of an intelligent real estate investing. Let’s talk about this first of all, you have a long term time horizon, okay. Which is in real estate, you kind of forced into it because you can’t just buy and sell right away. Okay. Number one. Number two, you analyze stocks, not just pieces of paper, but as businesses, okay. Because what happens in the stock market, this daily liquidity, it’s a bug and a feature at the same time. It’s a bug because it’s a feature because it gives the ability to buy and sell very easily with very low transaction costs, which I’m sure real estate investors would love to have. That. However, it’s a bug because it turns a lot of investors into gamblers. There is more. But the third one I think is very important. You look for margin of safety when you buying a house, which let’s say you’re going to sell in a couple of years. You want to make sure that you buy the price that in the worst case, if the market is not going to be as good or if the economy goes into recession, you’re still going to be able to sell at least break even. So that means when you bought it cheap enough so you have margin of safety. So those are kind of the tenets of value investing. They’re very similar to intelligent real estate investing as well. 

Buck: When you buy stocks in publicly traded markets, again, as somebody who’s not in that space right now, we hear a lot about how the valuations are kind of off the charts. Are you using sort of relative terms to make decisions and stocks right now as a value investor just looking at things and saying, oh, my gosh, there’s really just nothing to buy right now. And I’m just curious on how that works, because, tell me that. 

Vitaliy: So there are two questions in this actually. One is do I use relative valuation tools or absolute valuation tools? And the second question is the market in this very expensive market, can I still find individual stocks? So I’d argue and actually in my books, both in active value investment, in a little book of sad markets. I discussed this in the environment we’re in today, relative valuation tools are very dangerous because relative valuation tools are basically tied. The value of the you’re basically saying this asset is cheap because it used to trade at higher valuation and now trade at low valuation. Therefore it’s cheap. The problem is when the value of the past was set by low interest rates, this value may not be the same. That value may not be the same when interest rates are higher. So you want to buy an asset. When we value assets, you want to value them on what is it worth in a semi normalized interest rate environment. So that’s therefore you start switching to be spending very little time. I glanced what it used to trade in the past, but to me, that’s very weak in itself. It has very little information. Mostly we spend a lot of time looking at what is it as it’s worth in absolute sense, and then we want to buy it at the discount to what it’s worth. So that’s it right now. 

Buck: What is that to do right now? That must be quite difficult to do right now, though, to buy things at a discount. 

Vitaliy: Think about this. There’s space. I don’t know. There are three or 5000 stocks globally at another 10,000. I’m kind of generalizing. So in my portfolio, I only need 30. So therefore and this is like to ask a second question. I think overall, the US markets are very expensive, even despite ever since declined. Like, European markets are not as expensive and European markets are less expensive. So we look globally and trying to put portfolio, 30 stocks that still have marginal safety. So we have about 60% investment. If you look at our full about 60% in the United States, 30, 40% European stocks. But again, just like, think about it. If you need to buy a house, you’re a real estate investor. And let’s say you can buy a house anywhere in the United States. I’m sure there are markets like in Florida and California that’s probably extremely overvalued. But I’m sure there are markets, I don’t know, in the Twin Falls, Idaho, nobody cares about them. And you can buy a house. You can find a house that trades at $0.60 an hour. Okay. So you just have to be very diligent and very patient. 

Buck: Got it. Let’s shift a little bit over to the new book because it sounds like it’s getting a lot of really great reviews. The book itself is called Soul in the Game, The Art of a Meaningful Life. Why did you write this book? 

Vitaliy: That’s a great question. So I almost have to give you kind of a background. How I started writing. So I started writing Southern Ford. The Street.com was looking for financial writers. And I found myself where I wanted to give it a try. So I started writing for the studio.com, and I fell in love with writing. I discovered that this is something I really like doing. And for a long time I just wrote about investing. And if you think I had all the reasons to do this because I had a graduate degree in finance, I had a CFA, and that was my day job. But I would write this article. So I started with three. Threes.com. They don’t write for Market Watch. I would write for Institutional Investor. I wrote for Financial Times and other publications. And I would take these articles and send it to my friends. And first, my list was literally 20 people. In the beginning of the article, I would start talking about my personal life, and I would just have a few paragraphs. Over time, my articles, these emails turned where I spend a lot more time talking about my personal life. And my reader base expanded from 20 people to 100,000 people. And I started to get emails from readers saying Italy. I actually came to reading your articles because of your investment insights, but I’m staying because of what I learned about life from your life articles. And so I’ve been writing for almost 18 years. And over the years, I write a lot of articles about life. And my readers encouraged me to turn them into a book. And I always resisted that because I’m a money manager who’s supposed to be writing about investing. And this then in August 2020, in addition to love for investing and love and writing about life, I love classical music. And I write a lot about classical music. So I was writing this article about Chekovsky. And Chekovsky wrote this six Ted for Violence, which is basically Peace composed for strings. And I read Memoirs of Shikovsky, where he struggled writing this piece. And I realized that the struggles to costly experience composing it are very similar to any writer goes through when he writes. This is like it’s universal because it’s a creative activity. And any creative activity has a lot of there is a lot of doubt, a lot of frustration. So I wrote this article basically saying, this is what I go through as a writer when I write. And when I finished writing, I realized that’s my struggles are very similar to what other people face as well when they write. And then I look back and I realized over the years there were so many articles that if I actually can put them together, I can enter them into a book that would help people. My initial reason for me why I started writing the book was very idealistic. I just really want to help people. So I put my essays together, and I was going to self publish them. Self publish them. I got an email from Herriman House, which is a British publisher who I talked to a couple of years before about writing an investment book. They asked me how’s that book going? And I said, Well, I don’t have that book that I was going to write, but I have this new book idea. I send them a collection of my essays. And to my surprise, they said, let’s publish it. So now I was a bit shocked because I started to question their sanity. So I went to a few of my friends. I went to Morgan Hussell, and I went to another friend who published a book with them, Laurence Cunningham. And I said, what do you think of this publisher? They said, they’re great. Anyway, this is how this book came about. And this book is basically has six sections. Five sections. I talk about is beginning autobiographical. Then I talk about my self improvement journey. Then I talk about Stoic philosophy. Then I talk about creativity. And then I talk about classical music composers from Jacobski to Japan. And then I kind of, to my surprise, I take all these concepts and some of them bring them all together. That how to actually have a meaningful life, having all this in your life, creating creativity, some improvement, all those things. 

Buck: There was one, I guess, during this process you discovered or you really got into Stoicism talk a little bit. What exactly is Stoicism? What about it attracted you. And ultimately, how is it all relate to your personal and business life? 

Vitaliy: Now, I’ve heard a lot of stoic philosophy over the years, and I’ve seen quotes by bacterias or Seneca, Marxarillus, and they always sounded very intelligent and very smart. And then there was this one concept I read that completely blew me away. And that’s really in fact, I was almost done with the book, and I stopped writing the book. I emailed my publisher. I said, I really want to write about Stoics. So let’s passport deadline indefinitely until I finish writing about Stoics. So pictures. Let me talk about Stoic philosophy. Basically, it’s ancient philosophy that’s about 2000 years old. And that was started by Xeno. Zeno was a very wealthy trader. Trader who basically lost his ship in the shipwreck. So he went from being very wealthy to very poor overnight. And he started this philosophy in Athens in a place. I can never say the name of the place, but basically it’s called Archoa. And that’s how philosophy came about. He was the founder, but we know a lot less about him, but we know about his followers, which is basically Petitus, who was a slave, Seneca, who was one of the richest people in Rome. He was an advisor to emperors. He was a Senator, he was a playwright. And then we have Mark. Sorrellis who was the Emperor of Rome? So those are basically the founders of Soy philosophy, or at least the writings of their writings are the ones that survive to this day. Okay, so Pectoris was a slave, and he had this concept called dichotomy of control. And that’s really what attracted me to Stoicism. And he basically says there are things that are up to us, and there are things that aren’t. And the things that are up to us is what we do, what we can do. Everything else is external. So in your life, let’s say you’re studying for an exam. What you can control is how much you study, how well you study, how much you prepare for the exam. Okay? You can control your effort of that. The results you get, you have zero control over that. Okay? So you have control in preparation. You can try to the best when you show up. I remember I took a CFA exam. I had some control over how well I slept before the exam. At least I could put in an effort to have a good sleep. Okay. I could bring two calculators to the exam, but I had zero control if they’re going to be air conditioning in the room or not, if there will be noise in the room or not. All those things work. External. External applies to everything we do. When you people are root to you, there’s nothing you can do about that. That’s external behavior, what you have control over how that impacts you and how you respond. That’s an example of the philosophy and it’s much richer than it’s a very rich philosophy. 

Buck: Tell me, though, that there was something specifically that seemed to have some philosophical piece that really resonated with you. What was that? 

Vitaliy: I realized the Stoic philosophy could provide me, could reduce the volatility of the negative emotions in my life. Right. If I start looking at things that this is under my control, this is not under my control. So this is very quick story. I just came back from New York and my daughter and I took my son to birthright trip to Israel. So we had to drop him off in New York, spent two days there, and then she would go to Israel. I bought tickets for a plane, and so our plane was supposed to land in New York at 05:00. At 08:00, we bought very expensive tickets to go Metropolitan Opera. The plane landed on time, but then it ended up sitting on tarmac for 2 hours because of thunderstorms, all the gates were closed, so we could not get off the plane. So if I’m late to the opera, we’ll lose a lot of money. So at this point, I could either start freaking out and get nervous, et cetera, or I could basically say there’s absolutely nothing I can do about this. I could worry about this. I could get frustrated. I could yell at the flight attendant, it’s not going to make a difference. Or I can just basically accept the fact that’s not up to me. And all I can do is just try to do the best job I can get to that front time. If I can make it, I’ll make it. If not, well, there’s absolutely either a worry or not. The outcome is still going to be the same. That would be an example of that, because the only thing I could control is my behavior or how we interpret what happened to me. And at the end of the day, we actually ended up not making to the opera, but opera was kind enough to refund us the money, actually, which was a nice surprise. But again, that’s an example of my behavior where it just reduced, reduced kind of the volatility of my blood pressure. 

Buck: That’s funny. I feel like that’s been sort of my philosophy the last couple of years. And I thought it was just because I was getting old, but maybe I’m an underlying Stoic and I didn’t realize. 

Vitaliy: Yeah, but you know what’s interesting about Stoic philosophy? You read this, you read this, and it’s been written 2000 years ago, and it sounds like it could be written yesterday. Right. Because humans really don’t change. We have new fancier tools, but at the end, emotions.

Buck: Too much change. Absolutely. Speaking of emotions, the last time we tried to connect it was right at the beginning of the Russian invasion of Ukraine. And I know that affected you very much. And I’m curious if you can kind of give us a little bit of what that experience was like and related to some of the philosophies that you’ve been talking about. 

Vitaliy: Yeah. Well, I think that’s where I failed. My stoicism hasn’t failed completely. Yeah, right. No, actually, it’s kind of funny. You and I were going to meet. It was scheduled weeks before the invasion. And I remember I look at my calendar and I have a podcast scheduled. Podcast scheduled. And I show up to the podcast and you start asking me questions about investing. And I realized that my brain was so I was so overwhelmed with what’s going on in Ukraine, talking about investing felt so irrelevant. Sure. At the time. So I was born in Russia, and I left Russia in 1991 when I was 18 years old. So what’s important to understand is, for Russians, World War II was an incredibly dramatic experience. 20 million Soviet Union citizens died during that war. It’s important to say Soviet Union, not just Russians, but Ukrainians, belongs, et cetera. May 9, which is the victory day, is the day that is the World War Two ended almost 70 something years ago. That day is to celebrate it today as if it was just happened a few years ago. The reason it’s important is that because I grew up hating Nazis, I grew up hating Nazis because they came to my country. They killed millions of people, and it was an unprovoked attack. Right. I look at what Russia I looked at Russian behavior towards Ukraine, and I realized the Russian behavior is no different from Nazis. And to me, it was shocking. I was just in complete shock because Ukraine did absolutely nothing to Russians. And then what was interesting, as I wish the war developed. Then I suddenly started to see that Ukraine could actually win this war. And before the war, there was kind of this assumption that Russia had this huge army, well trained army, et cetera. And what we saw that the army is not well trained. The strategy is very flawed. One thing I learned that they had five different generals conduct five different parts of the army. And with very little communication between each other, we start seeing that the tanks are like their supply lines were not very good. They would just leave tanks in the middle of the road because they were out of gas. And the most importantly is that Ukrainians fought because Ukrainians fought as if the country was invaded by Nazis. Sure. And what we discovered that when Putin basically said three things before the war that did not exist but exist today. Number one, he was saying that NATO was the Antarctic Alliance that wanted to fight Russia. In reality, that was not true because NATO was basically chaotic organization that didn’t have a purpose because it didn’t have an enemy. So Europeans did not feel like they want to spend a lot of money on the military because there was no purpose for that. Well, today native is a very different organization. 

Buck: Well, then all the Finns and the Swedes and everybody who is neutral all of a sudden feels like there’s an enemy that they need protection against. Right. So that’s the paradox. 

Vitaliy: No, that’s exactly right. I think that’s exactly right. Number two, I would argue and I can’t prove this, but I probably write about this. If Russia did this invasion in 2014, it probably would have turned out the way Putin expected it to happen in 2022 because of the time. Two things. First of all, Ukraine did not almost have a very small army, number one. And number two, Ukrainian identity as a nation did not really exist. It was still kind of looking for Russian Ukraine identity. But after 2014 invasion, after Russia took Crimea from Ukraine, after the war in the Dunbar, and that actually created Ukrainian identity. And we can see this very clearly because Harkov city right next to Russian border, which is probably 60 65%, you would call Russians. The Russians in the city looked themselves as Ukrainians fighting against Russian Army. Putin basically has created the Ukrainian identity that did not exist to that extended list before the war. Number three, for a long time was talking about fifth column in Russia, where there is a lot of Slipper cells, et cetera, that kind of enemy of the States are there. And I don’t know if it’s true, if it was true or not, but we didn’t see that. We didn’t see any actions by the fifth column. But now we see there are explosions happening all over Russia, like there was an airport very far in Siberia that was blown up. It seems like it’s Russians going to be rebelling little by little against kind of the government. So anyway, this is where we are today. But I’m still shocked that there is a war happening between Russia and Ukrainians, because when I was growing up in Russia, what’s important to understand is that there was very little difference between ethnically between Russians and Ukrainians or the Russians for this matter, because if you see Russian or Ukrainian on the street, you would not know the difference. And in fact, it’s probably as close as you get to civil war because, yes, they share the same culture. The Russians Ukrainians have a very similar culture. Probably almost every single Ukrainian speaks Russian. So I just could not imagine this were happening. 

Buck: Right. Going full circle, I guess. Tell me how this conflict, how it all feeds into what you do in your day job. 

Vitaliy: There’s a saying we worry macro and we invest micro. So as an investor, I have to be aware of what’s going on in the world, in the global economy. Right. And then I have to take this. And when I make decisions on individual companies, I want to make sure the companies invest in are going to survive anything the global economy throws it down. Sure. Right. So even before this conflict. We were struggling from inflation. Right. And we had some of it was kind of short term inflation from supply chains. Some of it was a longer term inflation that you can argue was caused by labor markets. Interest rates were already going up before this, which is very inflationary, because when interest rates go up, the cost of everything that has to be finance rises. So that’s inflationary. Well, the war in Ukraine added more to this worry because now you have fertilizer prices are going up, doubling and tripling. So think about this. So basically, two major fertilizers are nitrogen based and potash based. Russia and Belarusia are the second and third largest exporters of potash, which is used for fertilizers, and nitrogen, which is another fertilizer, is based on natural gas. So natural gas prices have doubled because of the war. So because, remember, Russia is one of the largest producers of oil and natural gas. So it’s produced about, I forget, 11 million barrels a day out of about 100 million barrels a day consumption globally, about 10%. So as the west place sanctions on Russian oil and over time, we reduce consumption of Russian natural gas. That means oil prices will stay at elevated level and so will natural gas prices. The higher fertilizer prices means that we’re going to have higher calorie prices, any calories that meat, milk, corn, etcetera. Globally. And that’s going to impact what we find is that the food prices impact richer countries less than impact poor countries. So I’ll give an example. In Ukraine, about maybe 40% of discretionary income goes to pay for food. In United States, that number is close to 8%, down from 17% to 30, 40 years ago. So as I look at the portfolio construction, we are basically on companies that are delinquent to the health of the economy. So in other words, we own a lot of companies that are a lot of defense companies. We own them before the pandemic, before the war. And we added more to them when the war started. We own companies pipelines or companies that health is basically it doesn’t matter what’s happening to the consumer, what’s happening to the economy. The demand for their products is not going to change. And also, since we are facing inflation environment. You want to own companies that have pricing power. 

Buck: Interesting stuff. We can talk forever here, Vitaliy. You have such a breadth of knowledge and interests, but I want to make sure we let you get back to other things in life here. So the book again, the most recent book, which is getting it’s got incredible reviews from people like Nassim Talib, General Stanley McChrystal. Congratulations on that. And I’m excited to get a chance to read it. It’s called Solo in the Game, The Art of a Meaningful Life, and that’s not out yet. Is that right? 

Vitaliy: Yeah, it’s going to be on June 22. 

Buck: Yeah. And if there’s an interest in pre ordering that, how do you do that? 

Vitaliy: Well, you can do it on Amazon. However, if you go to salinggame. Net, you preorder the book on Amazon, go to soulinthegame.net and email your receipt. We will send you three chapters from the book so you can start reading today and four bonus chapters that are written after the book was published. So it’s soulinthegame.net. 

Buck: Got it. And then if people want to learn more about you on the business side, how can they do that? 

Vitaliy: I would suggest they subscribe to my articles first on contrarianedge.com contrarianedge.com or listen to my podcast on Investor.Fm. And then after that if they can reach out to us, they can, but I would suffer my articles first. 

Buck: Sounds good. Vitaliy, thank you so much for being on Wealth Formula Podcast. Love to have you on again at some time in the future. 

Vitaliy: Buck, thank you so much for a lot of fun. Thank you. 

Buck: We’ll be right back.