An Interview With Vitaliy N. Katsenelson

VITALIY N. KATSENELSON SPENT HIS YOUTH in Murmansk, a city in northwest Russia perhaps best known to Westerners as a setting for The Hunt for Red October.

The Russian navy was a popular career track there. But Katsenelson, now 36, emigrated to the U.S. with his family in 1991, when he was 18. He took a keen interest in finance, earning undergraduate and graduate degrees at the University of Colorado/Denver. Since 1997, he has worked at Investment Management Associates, a Denver money manager with assets of about $60 million.

Katsenelson employs his active-value, or "buy-and-sell," style in overseeing equity portfolios there: He'll happily put money in cash when there aren't enough compelling stocks around. Today, he maintains, the market is range-bound, meaning price/earnings ratios are under attack.

In 2007, Katsenelson published Active Value Investing, a book that outlines his framework for portfolio management and stock-picking. From Dec. 31, 2005, through June 30 of this year, his value strategy has earned an average annual total return of 0.64%, versus a 6.39% decline for the Standard & Poor's 500. Barron's spoke with him last week by phone.

Barron's: Your book stresses the importance of understanding range-bound markets. Why is this critical for investors?

Katsenelson: Over the last 100 years, every time we had a secular bull market it lasted 16, 17 years. But the markets that followed were not bear markets; they were range-bound markets. The only exception was the Great Depression. It is a very important distinction, because you should invest differently in a bear market than you would in a range-bound market. In any range-bound market, you have high starting valuations, which are a byproduct of the secular bull market. If earnings growth becomes negative and stays negative for a long time, you have a bear market. A great example of that is Japan, which has had high valuations and contracting earnings for a long time.

Would an example of a range-bound market be what occurred in the U.S. from 1966 to 1982?

Yes, that's right. The current range-bound market started in the early 2000s. There are two forces working against each other: growing earnings and contracting P/E multiples. The whole idea behind a range-bound market is that P/Es need to get deflated over time.

Range-bound markets are not caused by horrible earnings growth; in fact, earnings growth during range-bound markets is not much different from bull markets. A lot of times people refer to the average P/E as being 15 times earnings, which is true, but markets spend very little time at the average. The average P/E historically has run from above average to below average. It never stopped at the average. It goes from one extreme to the other.

Do you look at the market's rally since March of this year in the context of a range-bound market?

I do. A range-bound market basically goes nowhere for a long time, although it has a lot of cyclical volatility. During the 1966-to-1982 range-bound market, there were five little bull markets and five little bear markets. So the question is, "Where is it today?"

You really need to figure out what the earnings power of the S&P 500 is, but that gets a little tricky. If you look at the 2010 operating-earnings estimate for the S&P 500, it's about $73 a share. But reported-earnings estimates are $46 a share, so there is a big difference.

Why the big discrepancy?

Writeoffs. The true earnings power of the S&P 500 is probably somewhere in the middle. I'm very suspicious of the $73-a-share estimate -- because in 2007, when we had a perfect storm of three or four different bubbles colliding and profit margins at all-time highs, earnings were about $85 a share. I just don't see how, after all that has happened, you could get to $12 below the all-time high for earnings three years later. If you say next year's earnings of the S&P 500 are $50 to $60 a share, the index is trading at 18 to 21 times.

Which is not that cheap.

No, it's not. We are in the middle of a range-bound market that could last 10 years.

Give us an example of how this type of market impacts an individual stock.

Wal-Mart [WMT] is a perfect example. In 2000 it was trading at 45 times earnings, and it earned $1.25 a share. Fast-forward to today, and its earnings have more or less tripled. They grew about 12% a year. At the same time, its P/E contracted from 45 times to about 14 times.

Wal-Mart's stock is back at the same level it was in 2000, despite earnings having almost tripled, because its P/E contracted at a very similar rate. In today's environment, investors should favor absolute-valuation tools, like discounted-cash-flow analysis or breakup analysis, as opposed to relative-valuation analysis -- i.e., Wal-Mart is cheap at a P/E of 14, because it used to trade at 45. Relative valuation is a backward-looking tool, and anchors on valuations that we'll not see again for a long time. That will lead investors into a relative-valuation trap, and lead to overpaying for stocks.