Geoff Gannon October 4, 2007

Book Review: Active Value Investing

Review by Geoff Gannon

Vitaliy Katsenelson’s “Active Value Investing” is one of the best investing books published in the last few years. The book is both readable and teachable. It focuses on general principles rather than specific strictures. Although “Active Value Investing” is written in an easily approachable manner, it is structured much like a good textbook ought to be. In this way, Katsenelson’s 282-page book captures much of the spirit of Graham and Dodd’s magnum opus without ever losing sight of our modern day market and the unique challenges it presents.

Katsenelson’s thesis is that the U.S. stock market won’t soon return to its old ways, the ever-rising crescendo of the 1982-2000 bull market on which many of today’s investors were weaned:

For the next dozen years or so the U.S. broad stock markets will be a wild roller-coaster ride. The Dow Jones Industrial Average and the S&P; 500 index will go up and down (and in the process will set all-time highs and multi-year lows), stagnate, and trade in a tight range. They’ll do all that, and at the end of this wild ride, when the excitement subsides and the dust settles, index investors and buy-and-hold stock collectors will find themselves not far from where they started in the first decade of this new century.

With this opening salvo, the reader might well expect the book to devolve into a barrage of unabashed bearishness.

Thankfully, it does not.

Instead the book argues that the bull/bear dichotomy is a false one. True, there are long-term bull markets – but, there are really very few long-term bear markets in the sense in which most people understand the term. Rather, unfavorable long-term market trends tend to be of the “cowardly lion” variety, “whose bursts of occasional bravery lead to stock appreciation, but are ultimately overrun by fear that leads to a subsequent descent“.

That’s the crux of Katsenelson’s book – and quite a crux it is. He has the data to support it – and anyone who has spent any time looking at long-term market trends knows that it doesn’t take much to demolish the bull/bear dichotomy which seems to fascinate Wall Street (and infect its literary output). Terms which may make a good deal of sense in the short-term are used as if they applied to long-term trends, when almost all of market history shows they don’t.

I’m sure it’s more fun to be unabashedly bearish – especially when writing a book – than it is to be realistic. But, the facts are the facts – and the facts say that the word “bear” doesn’t really belong in our long-term market vocabulary.

Katsenelson provides a great service when he demolishes the bull/bear dichotomy and shows his readers the truth – the boring, honest truth – that in the long-run, sometimes markets go up and sometimes markets go sideways; sometimes P/E ratios expand and sometimes P/E ratios contract. These trends can last a long time. It’s easy for investors to become so accustomed to the market they knew that they can no longer see the market they are being asked to invest in with the honest eyes of an unconditioned mind.

Katsenelson demolishes myths, opens eyes, and then instills the basic tenets of value investing. While this process may sound abstract, the text itself is not. Katsenelson combines concrete data with abstract principles to illustrate important points like P/E expansion and contraction – and what that means for the buyers of high and low P/E stocks respectively:

…I wanted to see what would happen to the average P/E of each quintile if I bought each quintile in the beginning of the range-bound market (January 1966) and sold it at the end in December 1982…The highest-P/E quintile exhibited a P/E compression of 50.3 percent. The P/E of the average stock dropped from 29.3 in 1966 to 14.6 in 1982. That portfolio generated a total annual return of 8.6 percent. The lowest-P/E quintile to my surprise had a P/E expansion of 34.8 percent. Yes, you read it right. The P/E of the average stock in my lowest-P/E quintile actually went up from 11.8 to 15.8 throughout the range-bound market. That portfolio produced a nice bull market-like total annual return of 14.16 percent…

This book will teach you about our markets and their past. More importantly, it will teach you how to invest with an eye towards value at a time when a sound value orientation can do the most good.

This is an excellent book. I highly recommend it.

Active Value Investing: Making Money in Range-Bound Markets