In This Episode
With markets continuing their whipsaw movements, it’s hard to know where the dice will fall.
But with the major indices up almost 2% yesterday, there are a lot of tea leaves to go over – and a lot of bargains still to be had.
In a choppy week for markets, Extreme Value editor Dan Ferris joins us again to give his take on what this signals for stocks – and in a week where all sorts of quality companies are trading at discounts, where the biggest opportunities can be found.
He’s joined later by Vitaliy Katsenelson, the CEO and Chief Investment Officer of IMA Individual Portfolio Management. Like Dan, Vitaliy is a seasoned value investor – he’s been doing this for 20 years – and he expands on Dan’s No. 1 stated concern for the today’s markets: liquidity.
A very few companies are well-positioned to ride the liquidity crunch that’s coming – and far more are in for a reckoning.
That’s why Dan urges readers to be cautious on even the company he calls “the greatest business in the world” while Vitaliy points to the one company in the drug distribution center that’s “Amazon-proof.”
1:04: Buck asks Dan what’s top-of-mind for him given this week’s market volatility, and Dan reveals the company he’s watching closely that Porter’s talked about quite a bit even before a wave of new investigations was just announced.
5:17: Now that Disney’s recouped its $4 billion investment in Lucas Films, Buck asks Dan about one of Porter’s most prescient picks – and Dan explains how the company is much more than just a movie and entertainment giant.
8:25: Why has Facebook been getting crushed lately? Dan explains why it’s one of the greatest businesses of all time – yet in times like these, the greatest business in the world STILL won’t save investors.
13:21: Buck asks Dan what election results could do to markets this November. Dan explains why value investing is largely immune to the whims of politicians and parties.
18:30: With China making a major move in the global gold market, Buck asks Dan what a resurgence in gold prices would look like. Dan predicts that this new movement could be, for lack of a better term, like “a change of regime starting.”
22:24: Buck introduces this week’s guest Vitaliy Katsenelson, the CEO and Chief Investment Officer at IMA Individual Portfolio Management. A longtime value investor with more than 20 years of experience, he’s also the author of Active Value Investing and The Little Book of Sideways Markets.
26:30: Vitaliy reveals one of the first things he looks for as a value investor: capital allocators, and why 10-20% ownership of a company is a sweet spot for allocators. “When you make an acquisition, the purchase price came out of your pocket because you own 20% of the business. That’s what we’re looking for in good management.”
32:12: Dan asks Vitaliy about the possibility of low interest rates triggering a deflationary Japan-style period of low growth. “Historically, the way this has been solved is through printing money, through inflation… it’s a rock and a hard place.”
42:36: With health care the fight over pre-existing conditions dominating the midterm elections, Dan asks Vitaliy about the drug distribution company he owns called McKesson. “You made a very interesting point that Amazon will not kill the drug distribution. Why can’t Amazon kill this business?” Vitaliy explains why this drug company “was Amazon before there was Amazon.”
Buck Sexton: Hello, everyone. Welcome to another episode of the Stansberry Investor Hour. I’m nationally-syndicated radio host Buck Sexton. With me, the editor of Extreme Value, Mister Dan Ferris. Dan, great to have you on the podcast, sir.
Dan Ferris: Great to be here, Buck. Really excited.
Buck Sexton: Yeah. You know we’re not with Porter this week but Porter sent us one of the very, very best in the business of finance and advising around all these issues. Dan, can I just get your topline thoughts on this week what are you thinking about? What’s top of mind for you?
Dan Ferris: Well, you know it’s hard not to think about what the market’s done in the past month. But you know we have some specific items that are kind of on my mind lately, and one of them is actually one that Porter has talked about quite a bit, which is General Electric, GE. And you know he’s been bearish on this thing for a long time, and now the news has come out that you know GE has been hit with new investigations into accounting irregularities from the SEC. The SEC is ramping up their investigations, and the justice department has gotten into the act as well. You know possible accounting irregularities related to 22 billion dollars right down in their power division, and the shares are at a nine-year low.
And the thing I worry about this, it’s that this company or portions of it won’t survive because if you look at it the way a banker looks at it, as I look at my Stansberry terminal here, I see a market cap of around 88 billion and book liabilities of around 260 billion and you know net income of negative seven billion over the last five months. At some point here, bankers look at this thing and say, “Wow, this is a problem, we’re not sure what we can do with this.” Now to be fair, the bond market is not worried. All the bonds are trading at 99.8; most of them are trading at 100 or higher, 101. But it’s an ugly situation, and 30 years of lousy culture based solely on making the numbers, you know the Jack Welch legacy. You know he was praised as a hero, and he ruined the company. And now it’s all catching up with him. It’s horrible.
Buck Sexton: You know it was about, what, 20 dollars a share a year ago; it’s down now to about, what, around ten. So this stock has lost half its value in the last 12 months.
Dan Ferris: Right. And of course, you know it was much higher than that years ago. I mean it was like one of the ______, right? The longest-running member of the DOW investors and all that; of course it’s out of that now. And the survival, as far as I can tell just from the headline basic numbers, is starting to be really questionable. And you gotta hand it to Porter here who’s kind of head anchor going far on that one.
Buck Sexton: Yeah. If you look at a chart of GE going back to 2009, let me see I think the low was March 13th of 2009, so obviously a financial crisis, all these bad things happening. GE is at $9.62 a share. If you bought it then and held that stock until today, it’s around ten, eleven dollars a share. So ten years you’ve made a dollar to a share maybe.
Dan Ferris: Right. You basically roundtrip in ten years. And the biggest bull market, the longest bull market I should say, in history. So shareholders are obviously headed for the exits here, and they should be sometime ago.
Buck Sexton: Is GE beyond saving as a company?
Dan Ferris: You know the business is there but the liability is so substantial that the real question here for me, Buck, is the destruction of the equity. The real businesses that are real something and do real things, but it’s whether or not the equity would be destroyed is the big. You know after they do this whole you know J thing where they’re looking at whether there’s an effort to conceal the true health of the company, which it’s funny that the market has chimed in [laughs] [Inaudible]. You know once they get through all that, we’ll rush if any [Break in audio] of the equity survive. But [Break in audio].
Buck Sexton: I also wanted to ask you about Disney. So Disney bought Lucas Film six years ago. It has already recouped its four-billion-dollar investment. It seems like a pretty good move.
Dan Ferris: Yeah, well you know it’s funny [Inaudible] were just like praising him to death, because this is another one of his great picks. You know a pure content company and they picked up one of the greatest pieces of content you could have, Lucas Film and they’ve made those movies, and they’ve made four billion, 4.8 billion at the box office with the Star Wars features they’ve done since 2015. And you know they make money off it’s not just films, right. It’s licensing agreements and merchandising tours and clothes and everything you can imagine. And in this age when you’re never sure where you’re gonna be accessing your content from, your spoiling the world’s greatest content as one of the all-time wonderful cash-flushing you know buy it and put it in your 401k and don’t worry about it kind of businesses. And I don't know what the performance is so far in Porter’s newsletter, but if you leave it in there it will be fantastic in five or ten years.
Buck Sexton: So you think Disney now, for folks who are listening, it’s a buy-it-and-forget-it and it’s just gonna keep doing well?
Dan Ferris: You know you can’t – I mean the greatest businesses in the world aren’t necessarily the greatest investments in the world. And honestly, I should know this, I don't know where Porter is, you know whether it’s a buy right now or not. It has seemed a little bit expensive to me, but I think I kind of miss the boat on that one, which is a typical value and honest mistake to make. Things can seem expensive and then the growth fills up and they’re expensive after all. And I think that’s the kind of situation here. If the market continues to fall, which you know it’s still really expensive, of course Disney share price is gonna come off too. But it doesn’t mean you should sell it. It’s still gonna be a fantastic business. And when times are tough people consume all that content because they maybe can’t afford to do other things. But it is a good buy and expect to hold it for a long time kind of business, for sure.
Buck Sexton: Speaking of great businesses, Facebook. You know Porter had said on the podcast a few months back that Facebook is still a great company but we’re entering a period of real volatility here. So the company reported strong earnings, right, but it didn’t do as well as some people thought it would. I mean why did Facebook get crushed? I mean I own some Facebook and it hasn’t been fun recently.
Dan Ferris: No, it hasn’t been fun. And I soured on Facebook starting about September 2017, and I called it the biggest surveillance operation in history. I think I was wrong about that; I think Google is the biggest surveillance operation in history, but Facebook is a close second. And I thought there would be tremendous regulatory and cultural backlash and people deleting it off their phones, and they’re a little more leery nowadays about how these folks are collecting and using their data. And sure enough, I mean I see Facebook was gonna have a problem in September 2017 at the Stansberry conference. And I looked [Inaudible] it until Zuckerberg had to appear before Congress, and you know now they’ve had 50 million user accounts hacked into and they had that horrible moment, that air pocket they hit. I mean they closed at I think 217.50 in late July and after hours. In an instant the thing went to 170 you know from 250. There was no leave, nothing in between; it just hit an air pocket, biggest market-cap loss in history. And I just think that when you get to the longest bull market in history, people think that owning the very best businesses can save them. And I try to make this point over and over again that it absolutely cannot save you. So Porter is right, it’s still a great business, it’s a wonderful business. It’s the most successful thing in human history. Two billion monthly active users is like bigger than you know Catholicism and capitalism and Islam and any other ‘ism you can name. But owning a great business is not going to save you, and I think Facebook is kind of the harbinger.
Buck Sexton: Can we drill down into that a little though? Why is that? I mean you’ve kind of established this principle for people to keep in mind, but it seems counterintuitive that owning a great business, when things get rough, isn’t that the best place to be?
Dan Ferris: Well, it’s a matter of everyone in the world already knowing it. Everybody already knows that this is one of the greatest businesses in the world. In fact, you know a really intelligent person at our conference he said Google and Facebook are the two best businesses in America; I don’t disagree with that at all. I just think at the top of the longest bull market in history you gotta be more careful. You know we saw this with Cisco in March of 2000. The stock was $80.00, and I think today, I haven’t even looked at it recently, I think today it’s still in the forties maybe, so it’s barely made it back to half of where it was at the peak of the DOT com.
Buck Sexton: 45.
Dan Ferris: Yeah, 45. So a little better than half plus dividends, right. And the problem was everybody thought it was an absolute no-brainer. So ten of the top ten mutual funds at the time owned it. ______ was writing saying you can’t not own this stock. Everybody absolutely loved it, and it continued to actually grow and be a good business and gush for cash flow and start paying dividends and everything. And it didn’t matter because absolutely everyone felt that and bought it, and people would get price insensitive. They’ll pay any price on a great business when they’re excited about equities at the top of those long bull episodes. And you know it doesn’t matter how great it is if you paid way too much for it, and that’s really the crux of the issue.
Buck Sexton: So how would you take this framework that you’re laying out for us and apply that thinking to the notion of the melt-up and Steve’s melt-up thesis. Steve’s melt-up thesis is a trade. Steve’s done a lot of work and looked at a lot of data on market history, and he knows how these bull episodes go. And he knows that you get a great opportunity at the end of it to get this huge, fast gain with doubles and triples coming out of the woodwork and stocks that a value guy like me would say are overpriced. So maybe you have a value [Break in audio] portfolio and you have you know a speculative portfolio, but you know we can both be right. Fox News is broadly overvalued. In fact, they’re at their highest valuations in history, and still be a great speculation on a pretty quick, sharp move upward. So those two things they don’t exclude one another.
Buck Sexton: And by the way, what do you think about the way that the market is gonna react to the midterms? Does it react to the midterms? Why has October been a month of somewhat – historically, it’s always kind of volatile in the market, right, but with the midterm looming do you think that affects this? And do you have any feelings on whether the election goes one way or another in terms of control of Congress affects what people are gonna do with their money?
Dan Ferris: That’s a macro kind of pop-down consumeration, and it’s not something that I really think about. Now we all know how people react in the short term. An election can swing equity prices hard one way or the other. And depending on what the candidates might think about a particular industry, particular industries might react. But overall, it kind of mostly does not change the long-term fundamentals and the value, the intrinsic value of thousands of businesses that trade publicly. So yeah, of course you know how these things work. There will be a reaction I expect, maybe not a good one. But in the long term, to me it’s kind of a relatively-meaningless blip really I have to say.
Buck Sexton: And do you think that things are gonna – do you have a sense, a projection, going into 2019 of the overall market, or is there one particular sector, by the way, that you’re either telling people be really careful or get really excited about?
Dan Ferris: So be really careful of almost everything because equities are – you know when we think the S&P 500, two-times sales is exorbitantly expensive of the DOT com bubble I think was three or four times, and we got just a little bit above that earlier this year. And in late August we saw the single-most overvalued moment in equity-market history in the U.S. And of course, you know we saw that end of August and here we are in October is the big correction, substantial low correction here. But none of that is really surprising; none of it would be a surprise going forward to me. As far as stuff to get excited about, gold and gold stocks are historically cheap relative to the broader market. You can measure the DOW in terms of gold ounces, and it was recently above 22 ounces. I haven’t checked in with that lately. But 18, 22 ounces you’re getting into expensive DOW territory and cheap gold territory.
And gold of course got destroyed through early 2016, had a nice popup, but it’s come back down and probably represents a pretty good bet. And of course, I have two of what I think are the very best of gold and overall nonrelated equities in extreme value, not to mention to the public because I don’t think the readers would like it very much with all the money they pay me to tell them this stuff. But I think now is the time to load up on some of that stuff.
Buck Sexton: And China, by the way, according to Zero Hedge, China just took this massive delivery of gold from London and New York, and the takeaway from this piece is that money managers for really the 0.01 of one percent I would wager in China. But they’ve got their high-net people, their high-net clients, getting into physical gold in a pretty serious way. Do you take that as a sign of something?
Dan Ferris: Not necessarily because you know in Asia gold has a different meaning than it does in the west, so they like gold better than we do mostly I think. It has quite a bit of significance in India and China and always has. But you know stay in this business long enough you see everything. I remember when like central banks were selling gold, and now central banks are buying gold. And I remember when it was hard to get high-net-worth investors interested, and now of course these Chinese high-net-worth types are getting into it, which may be a harbinger of other folks getting more interested. But I have to say, my partner and I, a partner who is based in London now, we tried to raise some money a couple years ago because gold stocks were just unbelievably cheap. And we went to friends of his who are huge high-net-worth people who have invested in gold that led us in the past, and they were just not interested. And we keep in touch quite regularly and they’re still just not interested. So maybe this Chinese news is a bit of a harbinger, but I have yet to see it show up elsewhere; I’ll put it that way.
Buck Sexton: How do you expect we would see a big move in gold, and how imminent do you think that could be? What are the indicators that this is coming?
Dan Ferris: Imminent, that’s a good word, isn’t it? It’s different than inevitable, but imminent is tough. I don't know if I’m an imminent guy, you know the timing guy. I just know that from a valuation perspective it’s really attractive. And for me, that means that gold and gold equities have limited downside from here, and that’s the important thing for me. So that means I get to be less worried about the timing and how relatively imminent a big move is. But I will say this, you know we have this action in gold where it was above 1,200 a little bit, then below and above and below. And then it punched up and recently hit about I think 1240, or is it high 1230’s. And you know of course [Inaudible] did great the last couple days here, but that was a sharp, solid move. And I personally hold gold equities, and I had days of great equities that I haven’t seen in a long time with lots of green numbers you know. So that may have been a disruption here. There’s been some disruption, right? The failing stocks are kind of uncoupling where you see Facebook and Google aren’t performing as well as like Apple for example. And then gold is kind of punching up through 1,200. So this could be a big tipping point in this world but you know for lack of a better one where it could be kind of a change of regime starting.
Buck Sexton: By the way, Dan, I don't know what the answer to this is. Sometime when you’re in the interviewer role you ask questions and you know what you’re gonna get. I have absolutely no idea but I want to throw this out there. What do you think about cryptos? Speaking of gold and these alternatives to the equities that everybody is investing in, as a value investor I feel like you must think crypto is the craziest thing ever, but maybe not?
Dan Ferris: You know I do think that it’s extremely interesting, 'cause if you look at the history of bitcoin, it kind of appeared out of the financial crisis. And the creator of bitcoin you know whoever it is or whatever group of people it is behind the name, Satoshi Nakamoto, they are kind of creating an alternative currency. Like they really created a new gold almost. Of course, the gold industry has picked up on this and there are numerous efforts to create kind of a crypto version of gold to where you can trade physical gold with an electronic token, which I think is really, really cool. And that may be the value of this that we would get back to gold-backed currency somehow through all this crypto stuff, and through efforts by like the royal Canadian mint and others to create a way to exchange physical gold via an electronic token. To me, that’s the really exciting part of it. As far as the value of bitcoin, you and I could probably talk about that for an hour and get absolutely nowhere. I have no idea what that thing is worth, but it’s very interesting the history of it and where it’s headed in the gold market especially, very interesting to me.
Buck Sexton: I just know that it’s worth less than it was when I bought it you know ten months ago. [Laughs] That much I know, yeah.
Dan Ferris: [Laughs]
Buck Sexton: So it is what it is.
[Break, Music plays]
Buck Sexton: All right, everybody, our guest this week is Vitaliy Katsenelson. Vitaliy is the CEO and chief investment officer at IMA Individual Portfolio Management. Vitaliy is a long-time value investor with over 20 years of investment experience. He’s the author of two books, Active Value Investing and The Little Book of Sideways Markets. He has appeared on CNBC, Fox Business, BNN, and Yahoo Finance. Forbes Magazine has called him the new Benjamin Graham. Please welcome to the Stansberry Investor Hour Vitaliy Katsenelson. I’m really interested in your investment process, and specifically I want to know three things. The first thing I want to know is how you find new ideas for your portfolio. And the second thing I want to know is, because I know you only like to buy the best businesses, how do you determine if a business is good enough for your portfolio. And the third one is how do you figure out if they’re cheap enough for you to buy?
Vitaliy Katsenelson: When you’re looking for ideas, we try to have – it’s kind of interesting. [Laughs] We try to pull randomness into process, and let me explain what I mean by this. You know we try to look – I run screens. I read postings on the ______ investor club where I’m a member. I look at fortune apps of money managers I respect. As you know, I have a huge network of other value investors, and you're one of them, that I talk to on a semi-regular basis. And it’s a semi-random process because it’s not like ideas come to me you know every six-and-a-half weeks. The ideas come to me on a very sporadic basis. Most of the time they lie outside of my core competence, so I look at them and if there’s a business I don’t understand, which happens quite often, I say okay, just note it and move to something else. So it’s a semi-random process but you just have to be open to new ideas.
Buck Sexton: Random, that’s a good way to put it.
Vitaliy Katsenelson: Yeah. So to answer your second question, what is quality? So we actually systematize quality. So when we do research, our research is very qualitative but there’s some quantitative elements as well. So what quality means to us, three general things. Number one, it’s a good business. It’s a great balance sheet and it’s a great management. So what does high-quality business mean to us? It basically means three things. So it’s a high-quality business. It’s a great balance sheet, and it’s great management. Great business means you know a company has a competitive advantage, usually has a high recurrence of revenues. Companies that have high recurrence of revenues usually their cash flows are a lot more stable. If a company has a significant amount, usually it has high-return capital. They’re looking for tailwinds, not headwinds, of growth for the company.
And so those are kind of the basic things that will determine kind of a great business. And then balance sheets for the most part are very conservative. So we’re looking for companies that don’t have a lot of debt. Most companies in our portfolios probably have a net-cash position.
And then the last point, which is as I get older and have been doing investment for over 20 years, I start to appreciate the human element in investing. And management becomes paramount for us. So when you look at management, you’re really looking for two things. You want to own businesses that are run by people who do a great job running the business, but we also look for great capital allocators. And when you look for great capital allocators, one thing we like to find is somebody who owns a big chunk of the business. When you own, individual, ten or twenty, fifteen percent of the company and you make an acquisition, now you’re spending your own money. You’re not just a hired hand. You’re actually 20 percent of the purchase price came from your pocket because you owned 20 percent of the business. So that’s something we want to find. That’s what we’re looking for in good management.
And the last question you asked me is how do you value them. So we basically value a company – we kind of approach this as if you’re buying the whole business. We ask ourselves how much the business is worth, and this is where it becomes an art, not a science. This is where we say – you know we approach it from different perspectives. We look from a discounted cash-flow analysis. We look at historical valuations. We look at if it’s – we may be looking at the value, you know how much we’re paying per customer. There’s no just one answer; it’s gonna depend on the business. But at the end of the day, we just try to figure out how much the business is worth if we were to buy the whole thing.
Buck Sexton: Yeah. So I would really call you like kind of to me you sound like Warren Buffett. I mean high-quality businesses, you know competitive modes, high-recurring revenues, great balance sheets, great management with ownership. You sound a lot like Warren Buffett to me, which I think is a good thing.
Vitaliy Katsenelson: Well, there are a couple differences between us. You know he has much better track records and has a lot more money. [Laughs] But at the same time, yeah I could go into ______ Hathaway year after year. So yes, Warren Buffett and I go kind of to the same church of value investing. Yeah.
Buck Sexton: That’s a good way to put it, same church. So using your process, and I read everything you write and if people want to read your writings they can find it at contrarianedge.com, right?
Vitaliy Katsenelson: Yeah.
Buck Sexton: Okay. So I know one piece that you’ve out recently kind of echoes some things that I’ve been saying. And you said that the average stock today is overvalued somewhere between tremendously and enormously. So you’re having trouble finding new ideas that are cheap enough, correct?
Vitaliy Katsenelson: Yes. So I wrote this article, and when I was writing this, I was actually writing a letter to clients. And for a long, long time I was telling our clients that’s a hard time finding companies that meet our criteria, that is high quality and very cheap. And I keep saying that, and then I figured instead of me just saying it let’s look at the market from 30,000 feet. And so I looked at the stock market valuation going back 100 years and how does today’s valuation compare to historical valuation. And if you look at price-to-earnings basis, we are about 130 percent above average valuation. If you look at the revenue to GDP, if you look at the market cap to GDP, then that’s basically it’s a market cap to revenue basically I think for the whole economy. Again, we are at the second-highest valuation ever, and the only time it was higher was in 1999. And if you look at the ______ ratio, which is basically if you look at the market cap divided by the book value, again, we are the second-highest valuation ever. So the market is incredibly, incredibly expensive.
So what makes things even more complicated – so the stocks are expensive, and I would argue the global economy is on fairly shaky ground, because think about it. We are – actually the U.S. economy is growing; it’s now growing like almost five percent. But it’s growing while the interest rates are still at an incredibly-low level, and our debt has doubled over the last ten years. And while our debt has doubled, our interest expense for the country has remained the same because interest rates are so low. And you know the question becomes will we continue to grow, not just the U.S. but the global economy, if interest rates are higher. And I don't know when they would go up, but there is a high probability that they will go up, because we are running this year I think a trillion-dollar budget deficit and our debt is very high.
So at some point a value investor will say, “Well, we are not gonna be willing to lend to the U.S. government at three percent,” and whatever are the numbers, four or five or six percent. And also what makes it interesting, if you think about it for a second, if interest rates go up, that actually is inflationary and deflation at the same time, because if interest rates go up, what happens is the amount of money government has to spend on interest payments goes up as well, which creates a larger hole in the budget deficits. That means governments are gonna have to print more money, which is inflationary and it’s a self-fulfilling cycle.
Buck Sexton: Right. And you also you made another point and kind of put another twist on it. Even if interest rates remain low, then this is probably a sign that we’re in sort of a deflationary Japan-type area where we don’t really want to – you don’t want your economy to be doing that either. So it’s really between a rock and a hard place from the top down.
Vitaliy Katsenelson: Yeah.
Buck Sexton: Yeah. And of course historically, the way that this has been solved is through inflation, right, just by printing money, which that’s not good either. It’s really a difficult situation. Who knows how it will all work out? So I wanna talk about so here’s the situation. You told us your process. You’re having trouble finding ideas. Stocks are overvalued, and you’ve done something this year that you’ve never done before, which is to buy put options. And I just want to know like how did you come upon this. How did you decide to do this all of a sudden after never doing it before?
Vitaliy Katsenelson: Well, so the last year-and-a-half I was actually on the pursuit of trying to become more creative in general. And in fact, I’m working on a book that’s kind of trying to address this, how does a value investor become more creative. And one thing I realize, so I’ve kind of been more open to new ideas. And when I started thinking about the volatility and how volatility became, as an asset itself, became very, very cheap. So as a value investor, you’re kind of attracted to cheap assets. And let me run this analogy by you, and that’s kind of the analogy I used in the article, because once I started to think about it this way, it became so clear. Just think about it this way. If you live on the coast of Florida and the hurricane hits Florida every five years, so probability on any given year the hurricane will impact Florida is about 20 percent.
So in other words, let’s say the probability remains the same every single year; it’s 20 percent. However, right after a hurricane, because of the recency, people will start to believe that hurricanes happen more often, and therefore insurance will be priced not on a 20-percent probability but on 30- or 40-percent probability. So insurance becomes more expensive right after a hurricane. On the flip side of it, if you haven’t had a hurricane for ten years and people start thinking you know hurricanes don’t really happen that often, the same hurricane will be priced not at 20 percent but at ten percent. So in reality, if you could, you want to buy hurricane insurance when nobody expects a hurricane, and it’s not a good bargain right after a hurricane, so even though the probability that you’re gonna have a hurricane next year is still the same, 20 percent.
Now if you apply this to a stock market, volatility to some degree is the price of insurance. But there is a very distinct difference between a stock market and hurricanes, and this is very, very important. If you had a hurricane last year, the chances that you're gonna have a hurricane this year are actually the same. It makes no difference because the hurricane of 2018 does not know the hurricane of 2017, because it’s like flipping a coin. They are independent events; one is not related to another.
Buck Sexton: Got it.
Vitaliy Katsenelson: However, the stock market is a very different animal. The longer you don’t have a stock market decline, the more likely that you’re gonna have another decline. And the reason for that, because especially today when a lot of the stock-market appreciation has happened not because of earnings growth but because of price-to-earnings expansion. Price-to-earnings expansion is basically like a pendulum that goes from one extreme to another. And the longer you did not have a correction, the more likely that you’re gonna have another correction and it’s gonna be more violent. So it’s almost like I think of it as a rubber-band being pulled. So when I look at the volatility early this year and I see so it’s very, very cheap and the probability that we’re gonna have a correction and it’s gonna be a significant correction actually increased. So now it became even more attractive to me. So that’s why when we’re buying put options in the market, we are buying another valued asset, like doubling the valued asset basically.
Buck Sexton: That’s very, very interesting. It’s basically you’re valuing insurance and you found insurance cheap so you bought it. You know you did another thing though that you wrote about as well, which struck me as a defense maneuver as well, which was that you sold short-term bond ETFs and you bought U.S. Treasury bills. Why did you do that?
Vitaliy Katsenelson: And I’ll be honest, I’m not sure if I’m just being too paranoid about that move, but you know what, there was no cost in that paranoia. So we today – so let me describe what we do here. The way we manage money is very different than from other money managers. Each portfolio is managed individually. The reason it’s important, because clients that came to us three years ago are maybe 70 percent invested, but a client that would come today would be 25 percent invested. The reason it’s important is that we have a lot of cash, and that cash is earning absolutely nothing. So we were using short-term bond-bullet ETFs. And what it means is basically – imagine you own a bond fund that the bond matures in say 2019 and the bond fund itself matures in 2018. Okay. And we use that to be care substitute. That’s how we can pick up some yield, you know defensive yield. But I was at a conference that you attended too at Value Israel, and a friend of ours, Adam Schwartz, made a presentation about short-term bond. He was talking about something else. He was talking about how the junk bond ETFs they have a flow in them. There are many problems, but many of the problems he was talking about there was a mismatch in liquidity basically. In that the holders of those junk bonds –
Buck Sexton: I loved it, yeah. Go ahead; I’m sorry.
Vitaliy Katsenelson: Yeah, yeah. Between the liquidity of the bonds and the ETF itself. And this made me think about the ETFs that we owned that were not junk; they were not junk. The stuff we own is very high quality, but they still suffer from the same flaw. And here is the problem. So if you are looking for yield and in the past you may be buying individual bonds, but individual bonds are not that liquid. So what happens when you buy an ETF, ETFs are very, very liquid, so ETF turns around, goes out and buys bonds. Now let’s say we have some kind of market dislocation and people start dumping those ETFs very rapidly. And suddenly you may discover that liquidity that’s demanded from those bonds will be much greater than the actual liquidity. And so what may happen is that the prices that would be – so you may have a price dislocation.
Buck Sexton: Right.
Vitaliy Katsenelson: So what we did, we saw the short-term bond ETFs and instead they were treasuries. And when we did this, we realized actually that you are getting similar prices on treasuries, six, seven, one-year treasuries than we are getting in those ETFs as well. So basically, the paranoia did not cost me anything. And the reason it’s important is because when you have 70 percent of your portfolio in the ETFs and let’s say there was dislocation in the market, I would not be able to sell them at a good price when I need it the most because when the stocks are on sale. So that was a huge risk for us. It’s a very low probability risk, but I thought it was worth for us to switch.
Buck Sexton: Yeah. So I’ve heard common concerns about liquidity in that same grain. Listen, we don’t have a whole lot of time left but I do want to touch on something that you had written about as well. Now you guys own a drug distribution company, a prescription drug distribution company called McKesson. And you made a very interesting point, and it’s just this one point I’m interested in today, that you think Amazon will not kill the drug distribution business. Why don’t you think Amazon, they killed many other businesses, why won’t they kill this one?
Vitaliy Katsenelson: Well, I think the company CEO made a great point. He said they were Amazon before Amazon was Amazon. So when Amazon went and killed Barnes & Noble and they hurt Best Buy, etcetera, they had a structural competitive advantage against them. When it comes to drug distributors, that advantage is not there. McKesson is a distributor, so it owns ten or fifteen warehouses just like Amazon does. And it’s sole focus is on distributing drugs. So it had sales in 2017 of roughly 200 billion dollars. It has enormous bargaining power. And there is one anecdote that really spoke of McKesson’s bargain power. Walmart, which is the fourth-largest pharmacy in the United States and has about 25 billion dollars of sales in pharmaceuticals, became McKesson’s client because they could not get as good of prices on drugs when they were buying it directly from manufacturers as they could get when they buy it through McKesson. So that was one of the points.
Another point was that distributing drugs is a very difficult endeavor, because some of the drugs have to be refrigerated. You also distributed opioids, which all distributors got in trouble doing that. So it’s an incredibly specialized business and it’s an incredibly low-margin business. So there are so many more low-hanging fruit for Amazon to go after than to go after an industry where Amazon is competitively disadvantaged.
Buck Sexton: Yeah, that’s a great point. There are a lot less-complicated things for them to go after. Listen, we’re just about out of time so I have one final question for you Vitaliy. Vitaliy Katsenelson, do you eat dessert?
Vitaliy Katsenelson: I don’t. I gave up on sugar – well not sugar but basically I gave up on desserts actually a year ago.
Buck Sexton: You’d written about it and you said that you know just saying to yourself, “I don’t eat dessert anymore,” has been a very powerful transformation for you, hasn’t it?
Vitaliy Katsenelson: Yes, it has. And let me tell you my shortcut. As you said, I told myself I don’t eat dessert, and I call it a half-binary decision. And what I mean by this, if you eat dessert sometimes, let’s say once a month, then every single time dessert is offered to you you have to make a decision. And every time you have to make a decision, it consumes energy, right? So if you are tired that late in the day and you don’t have this energy, then this is when you give in. If you say to yourself, “I don’t eat dessert,” then every time dessert is offered to you or you see dessert, it’s not a decision because you just say, “I don’t eat desserts.” And that was my shortcut to doing this. And by the way, I quit eating carbs the same way.
Buck Sexton: That is brilliant, that is brilliant. And it kind of reflects the thoughtful approach I think that you have to everything you do. I think you’re one of the smartest guys I know, and I think you’re one of the best investors I’ve ever met. And I’m really grateful to have you as a friend, and I’m grateful that you could make it onto the program today. Thanks, really.
Vitaliy Katsenelson: Well, you are very kind. And I’m a big fan of your writing as well, so it’s mutual, so.
Buck Sexton: Yeah. All right, mutual admiration society I guess. Thanks a lot, Vitaliy, and we’ll talk to you soon.
Vitaliy Katsenelson: Absolutely. Thank you very much.
Male: All right, lots of financial wisdom on this week’s episode of The Investor Hour. Let’s get to the mail bag. Email number one: Hey guys, first off, love the show. My question is how low does GE go? Does it go all the way to bankruptcy? Keep up the great work. Paul.
Buck Sexton: Okay, Paul B, thank you for the question and for the compliment on the great work. How low does GE go? I will tell you this: I don't know, but for the first time now I am starting to think that there could be permanent equity destruction to part of this. It has to break up and I don't know if GE itself goes to zero; I kind of doubt that. And the reason I doubt it right now is 'cause they’ve had tons of bad news. We know the liabilities are enormous, and yet the bond market is just completely not concerned at all with just about all the bonds I can find outstanding trading at par or within just a whisker of par. So at this point I would say no, it doesn’t go all the way to bankruptcy. But for me, it’s such a giant complex thing, and now that they’re being investigated for concealing the health of the company, we really don’t know, do we? So that’s my answer, Paul. Thanks for the question.
Male: Email number two. Buck, great watching you on the webinar with Dr. Sjuggerud. I have to say your imitation of Bernie Sanders was awesome; you have to do that more often.
Buck Sexton: All the best, Mosha. Mosha, anything for you, baby. You know we’re gonna have free school, free healthcare. It’s gonna be all free. No one’s gonna pay for anything. It’s gonna be the millionaires and the billionaires are gonna pay, and you’re not gonna pay anything unless you’re a billionaire in which case you’re terrible. So yeah, there you go, there’s a little bit of Bernie for you.
Male: Email number three in the mailbag. This is from Debbie. Gentlemen, your stocks that you hold for a number of years and have 100, 200, 300 percent on high returns, when would you suggest to sell? Paid-in-full member, Debbie.
Buck Sexton: Debbie D., thank you for your question. You know we can’t really give individual advice, so I’m gonna just frame this very generally. First of all, look, if you have a stock that’s up 300 percent and you’ve been holding for years, bravo, good for you. You have a very good problem on your hands. And really it’s kind of like our guest Vitaliy Katsenelson was talking about today, you gotta take these things on an individual basis when you’re valuing the companies, on an individual basis when you’re buying them and when you’re holding them and when you’re selling them. So it’s really kind of an impossible question to answer in the generic, but I will guide you to you know the health of the company. You have to have an opinion about the health of the company today and what you think the health of the business will be two, three, five, ten years out. And you start from there and decide whether or not you want to continue compounding or whether or not you want to take gains off the table. And there are other personal things that I can’t even address like how old are you, how much money do you have, you know what do you need to do. You see, the question it’s much broader than what do I do with just this one stock. And I hope that helps you.
Male: All right, that concludes another fantastic episode of the Stansberry Investor Hour. Be sure to check out our recently-revamped website where you can listen to all our episodes, see show transcripts, we get a lot of emails about that one, and where you can enter your email to make sure you get all the latest updates. Just go to the same address, investorhour.com. That’s investorhour.com. That’s it for this week. Love us or hate us, just don’t ignore us. Thanks for listening. Talk to you next week.