So this company, which has virtually no competition, has barriers to entry impossible for a new entrant to overcome, and a cash printing machine will be sold for about 12 times free cash flows. Over the past year we’ve seen much lower quality companies being sold for much higher valuations than this.  Most recently, Burlington Northern Santa Fe, which has a significant competitive advantage but has far inferior return on capital and free cash flow generation than IMS, is to be purchased by Mr. Buffett for about 20 times earnings and 30 or more times free cash flows. IMS Health’s management and board have a history of making dumb capital allocation decisions, but this one may go down in history as their dumbest.

We own these shares and will probably hold on to them in the hope that shareholders will refuse this offer.

Vitaliy N. Katsenelson, CFA, is a portfolio manager/director of research at Investment Management Associates in Denver, Colo. He is the author of “Active Value Investing: Making Money in Range-Bound Markets” (Wiley 2007). For more information click here.

 P.S. Here is a PDF of my recommended book list for 2009.

Here is part 2, I hope you enjoy it

Behavioral Investing

The right temperament is crucial in investing. Being a critical thinker and knowing how to value stocks is important, but it is all a waste if your emotions get the better of you. The following books will help you to recognize the shortcomings of your hard-wiring and help you to devise strategies to deal with it.

Psychology of Investing, by John R. Nofsinger, is short and to the point. You’ll become an expert on behavioral investing in about an hour. Well, not quite, but close.

Why Smart People Make Big Money Mistakes And How To Correct Them, by Gary Belsky and Thomas Gilovich. This is a fun and easy read. It also addresses how shortcomings in our wiring impact money decisions, like buying cars and stereos.

Your Money and Your Brain, by Jason Zweig, is another selection. I have to admit that the two books above cover many topics in this book (though this one offers new angles and insights) and are likely to be more exciting reads, but Chapter 10 is what makes this book a must-read: it addresses happiness – yes, happiness. Although, as most of us know, money doesn’t buy happiness (unless you are starving or living on the street), money spent on acquisitions – things – brings a burst of happiness that quickly fades away. Think of your level of happiness when you bought the car of your dreams. Money spent on experiences – being – brings a higher utility of happiness. Recollecting experience brings happiness. I plan to reread this chapter at least a couple of times a year. Zweig also provides a list of things you can do that will make you happy, and none of them require you to spend a penny, which is a big positive in today’s economy.

Reminiscences of a Stock Operator, written in 1923 by Edwin Lefevre, tells from a first-person perspective the fictionalized tale of the early years of the great trader Jesse Livermore. It is rumored that this book was actually written by Jesse Livermore and edited by Lefevre.

Though traders and value investors fish in the same pond – the stock market – and they may even catch the same fish at times, their approaches and analytical timeframes are diametrically different. However, they do share a common element: both are done by humans and thus are impacted by emotions. This book provides a great introspective look inside a trader’s mind and teaches many behavioral and common-sense lessons. Here are some quotes:

Another lesson I learned early is that there is nothing new in Wall Street. There can’t be because speculation is as old as the hills. Whatever happens in the stock market to-day has happened before and will happen again.

and

A man must believe in himself and his judgment if he expects to make a living at this game. That is why I don’t believe in tips. If I buy stocks on Smith’s tip I must sell those same stocks on Smith’s tip.

and

The recognition of our own mistakes should not benefit us any more than the study of our successes. But there is a natural tendency in all men to avoid punishment. When you associate certain mistakes with a licking, you do not hanker for a second dose, and, of course, all stock-market mistakes wound you in two tender spots—your pocketbook and your vanity.

and

One of the most helpful things that anybody can learn is to give up trying to catch the last eighth or the first. These two are the most expensive eighths in the world. They have cost stock traders, in the aggregate, enough millions of dollars to build a concrete highway across the continent.

Another good book about Livermore is called Jesse Livermore, by Richard Smitten. I quoted this book in my book – here is the quote:

After several months of despair, Livermore finally summoned up the courage to analyze his behavior and to isolate what he’d done wrong. He finally had to confront the human side of his personality, his emotions and his feelings. . . . Why had he thrown all his market principles, his trading theories, his hard-earned laws to the wind? His wild behavior had crashed him financially and spiritually. Why had he done it? He finally realized it was his vanity, his ego. . . . The outstanding success of making more than $1 million in one day had shaken him to his foundations. It was not that he could not deal with failure—he had been dealing with failure all his life—what he could not deal with was success.

Economics

Politicians, God rest their souls, always try to appeal to the lowest common denominator. They try to “protect” us from evil doers by insisting on minimum-wage laws or rent controls, or threatening windfall taxes on oil companies. They sound like heroes fighting for the little guy against the evil doers. However, all they are doing is feeding on the economic illiteracy of the Average Joe. This is why the following two books should be required reading in high schools and colleges: Basic Economics by Thomas Sowell and A World of Wealth by Thomas G. Donlan.

You may think Alan Greenspan had a hand in today’s crisis. I know I do. He took interest rates down to incredibly low levels and kept them there for too long, causing the real estate bubble. He also did not think Wall Street needed regulation. But that doesn’t make his book, The Age of Turbulence, any less of an excellent read. It is not written in Fed-speak. It seems that Sir Alan, after he left the Fed, learned how to use English in a very clear and engaging way. This is not just another autobiography, either. The book goes far beyond that. It covers the workings of the Fed, lessons on macroeconomics and history, and perspective on American politics from an insider who served under or worked with the last eight presidents.

Atlas Shrugged by Ayn Rand. This is a novel, not an economics book; however, it accomplishes a lot more than most economics books could ever accomplish. It vividly illustrates what happens to the economy when the invisible hand of capitalism is replaced by the “fair” and “compassionate” hand of socialism: the economy collapses.

Ayn Rand immigrated to the US from Russia in 1927 when she was 22, when her father’s business was seized by the Russian government, ostensibly for the greater good. I left Russia 64 years later, a decade after Rand died, and my family suffered a lot less than hers. However, we (as well as millions of thinking Russians) both saw the ugly consequences of socialism.

In Atlas Shrugged Ayn Rand defines her philosophy: individualism. Individualism is not a politically correct term today (if ever) in our society. One doesn’t make a lot of friends by advertising his selfishness and greed. So call it anti-collectivism, where independence, self-reliance, and individual pursuit of happiness are superior goals, as opposed to collectivism, where pursuit of communal and national goals is often undertaken at the expense of individual liberty.

According to Jennifer Burns, who recently published Ayn Rand’s biography, Rand’s popularity surges during every political cycle, when the merits of our political system are being debated. Winston Churchill said it well: “Capitalism is the worst of all possible economic systems, with the exception of all the others.” I hope we only see the alternative system to capitalism – a compassionate socialism that is often offered to us as an alternative to our dispassionate system – only on the pages of Atlas Shrugged.

Stock Market History

I’ve really enjoyed reading Stocks for the Long Run by Jeremy Siegel, but it took me a while to recognize how dangerous this book is.

It is well-written and provides a very good overview of the performance of different asset classes over last two centuries. But the book needs a different title, maybe something like “Stocks for the Really, Really… Really Long Run.” This way, it would not lure investors into a false sense of security when it comes to stocks. Probably unintentionally, it preaches that stocks (and the stock market as a whole) are always a buy, no matter what valuations are, as they do better than other asset classes in the long –run; and that a 7% real rate of return is a birthright for stock investors, no matter if the stock market is extremely cheap or ridiculously expensive. This is very true if your time horizon is 30 years or you plan to live forever. It is also true if you can tolerate seeing your portfolio go nowhere for a decade or longer. Unfortunately, most of us don’t have this time horizon. We need to send kids to school, pay for weddings, boats, etc. I don’t know anyone who has the patience to see their portfolio of stocks do nothing for decades.

That is why Siegel’s book should only be read with the following antidote: Unexpected Returns, which is a truly terrific book by Ed Easterling. Unlike Siegel, Easterling shows that despite stocks being a great investment for the (really, really) long run, they have periods when their returns are unspectacular. Ed calls these periods bear markets. I call them range-bound markets, which is just a difference in semantics. Those bear (range-bound) markets take place after secular bull markets.

What is the appropriate way to look at risk?

The following two books, Fooled by Randomness and The Black Swan, are by Nassim Taleb. These books address risk and rare events (the Black Swans).

Fooled by Randomness is my favorite nonfiction book, period. I’ve read it at least five times. This book turns the way we are taught to look at risk upside down. Nassim rebels against the current establishment of finance that measures risk with elegant formulas that receive Nobel Prizes but lack common sense.

Any model that solely focuses on past observations and dismisses outcomes that lie outside of what happened in the past is worthless and, more importantly, dangerous. One way of understanding how randomness works is by studying alternative historical paths. This means more than just focusing on what took place in the past – the definite (since it already happened), observed history, but one that beforehand was actually still just one of many possible random outcomes. One should focus on what could have taken place, what alternative paths might have existed. This allows us to think creatively about what could have happened, and with that added insight to then predict and prepare for what might happen in the future.

Let’s take the current crisis: Wall Street and rating agencies dismissed the possibility that housing prices might decline nationwide. This hadn’t happened since World War II – well, then, it wouldn’t happen in the future. Therefore, Wall Street took subprime (risky) mortgages originated in different parts of the country, lumped them together in mortgaged-backed securities, and – voila! – the risk had been diversified away. Junk was turned to gold. Since rating agencies used the same underlying assumption – housing never declines nationwide – they announced to the world that the junk was AAA and should be bought in truckloads – and it was. We know how this story ended.

The Black Swan is a follow-up to Fooled by Randomness. Nassim takes a lot of the concepts discussed in Fooled by Randomness and explains them in greater detail, providing new and unexpected insights. I have to warn you that The Black Swan is not easy. This book has more insights per page than most, but is not a beach read.

In this lecture Nassim covers major concepts described in both books in great detail.

Books for the Soul

What would you do and what would you share with others if you only had months to live? This is the theme of the following two books: Tuesdays with Morrie by Mitch Albom and The Last Lecture by Randy Pausch and Jeffrey Zaslow. In both books terminally ill teachers share their life lessons with readers. Also, Randy Pausch, who sadly passed away last year, gave this great lecture on time management; and here is his last lecture.

Another book I’ll add to this category is The Snowball: Warren Buffett and the Business of Life, by Alice Schroeder. This is an authorized biography of Warren Buffett. I am not sure this is the best book to read if you want to learn to invest like Mr. Buffett, but it gives a very different and interesting view of his life. There are many great lessons we can learn from Mr. Buffett that go far beyond investing, such as about honesty and treasuring one’s reputation. But I thought this book was important for a very different reason, in that it shows that Warren Buffett is not a perfect human being and that we can learn from the maestro, but in a different way: by not repeating his mistakes. He achieved his unparalleled success in his business life at the expense of his personal life, unfortunately.

Especially in today’s environment I find myself wanting to work 24/7 (and I probably do). This is truly a stock picker’s market. I bring my laptop home, read The Wall Street Journal at the dinner table, and my work life starts pushing out my personal life. This book made me realize that no professional success is worth regretting 20 years down the road that you didn’t spend enough time with your kids. Unfortunately, Buffett has that regret.

Vitaliy N. Katsenelson, CFA, is a portfolio manager/director of research at Investment Management Associates in Denver, Colo. He is the author of “Active Value Investing: Making Money in Range-Bound Markets” (Wiley 2007). To receive Vitaliy’s future articles my email, click here.

In crazy times like today, all one could and actually should ask for is sanity. Yes, sanity – a clear mind free of noise to deal with the insanity that is thrust upon us by a volatile and noise-making machine also known as the stock market. We find ourselves glued to the computer screens or CNBC waiting to find out what the Dow’s next tick is going to be. Unfortunately, we are left with only a headache and wasted time. OK, what’s next? Here is my advice: read. Read books that will bring you sanity, the ones that will snap you back into the shell of investor and out of the sorry shell of nervous observer of the daily stock market melodrama. The following books are excellent choices and come with plenty of sanity and sage advice.

Selling

I’ll start with Its When You Sell That Counts, by Donald Cassidy. Selling is usually as popular as candy the day after Halloween. During secular bull markets selling is frowned upon as buy and hold turns into investing religion. And since sell violates the “hold” covenant of that religion, the investor who buys and sells is labeled as a nonbeliever, or even worse, a trader (if you say “trader” fast enough it sounds like “traitor”).

In secular bull markets, on average, sell decisions are not as rewarding as hold decisions, as market valuations are expanding and even second-rate dogs (stocks) start looking like pedigreed cocker spaniels. Every investor is now a “long-term” investor and sell becomes a four-letter word. But being a long-term investor is not about the longevity of your hold decisions, but rather is an attitude. Holding a stock because you bought it is a fallacy; you should only hold a stock if future risk-adjusted return warrants it.

Warren Buffett has been mistakenly promoted (though, I’d argue, demoted) into deity status in this buy-and-hold temple.  Let’s correct this mistake. Warren Buffett became a buy-and-hold investor when his portfolio and positions got big enough, pushing $60 billion, so that selling became a difficult undertaking. In his early career, before “Oracle of Omaha” was his moniker, he was a buy-and-sell investor. Being on the boards of some of his biggest holdings (like Coke and Washington Post) made selling even more difficult.

One doesn’t need the benefit of hindsight to know that at 55 times earnings Coke was tremendously overvalued in 1999. Coke, like the majority of Buffett’s top public holdings (Washington Post, Procter & Gamble, Johnson & Johnson, and many others), did not go anywhere for a decade. I dare you to take a look at his top public holdings and tell me whether he would have done a lot better if he had sold them when they became fully valued (or slightly overvalued). In most cases, that would have been a decade ago.

Emotions assault us from different directions when we face a sell decision: If it is a losing investment, we want to wait to break even. This is the wrong attitude. Our purchase price and sell decision should not be related (the only exception I can think of is tax selling). Or when it comes to selling a winner, we want to sell only at the top. Again this is the wrong attitude: the top is only apparent in hindsight, when it is usually too late.

We should sell the stock when it reaches our price or valuation target, determined at the time of purchase. We (our emotions and false goals to be exact) are our biggest enemy when it comes to investing, and especially selling. Cassidy’s wonderful book has been written to fix this. Its objective is to recalibrate your mind and free you from the imprisonment of past decisions, to break you free from the buy-and-hold state of mind and turn you into a buy-and-sell investor.

OK, this is a bit of a long introduction to this book, but it’s a terrific and a very important work. A proper sell discipline will decide between great or mediocre returns for even the best-crafted buy decisions. Pros may want to skip a few chapters, but it is an important read for everyone, especially in today’s environment.

Think and behave like an investor

The following books should help you to think like an investor, forcing you to think beyond stock tickers and focus on what is under the hood: the businesses and the people who run them. The first one is The Essays of Warren Buffett. It’s a compilation of Warren Buffett’s letters to shareholders from annual reports dating back to the 1970s. Before this book came out (or at least before I was aware of its existence) I had my graduate students at University of Colorado read Buffett’s annual reports, which as you may expect were very repetitious. His wisdom doesn’t vary that much from year to year. This book organizes main concepts and removes annoying redundancy.

Another good book is The Entrepreneurial Investor, written by my friends at West Coast Asset Management. It accomplishes many objectives of Buffett’s essays, plus has plenty of cultural references, humor, and common sense. All of these things make it a fun and enjoyable read. I made this book suggested reading in my graduate investment class.

The Super Analysts by Andrew Leeming is a book I think few people have heard of. The author interviews successful investors (not academics), and they discuss their approach to investing and analysis of common stocks and some specific industries.

You Can Be a Stock Market Genius by Joel Greenblatt is one of those books that should be read more than once. Joel shares very unique approaches about how to find undervalued stocks. On top of being a very good investor, he has a healthy sense of humor. Joel also has written The Little Book That Beats the Market. I plan to read this book with my son when he gets older, as it is a great introduction to investing. At the end of the book Joel offers a “magic formula,” a screen that has beaten the market over a long period of time.

The magic screen is very simple: buy low price-to-earnings stocks that have a high return on capital. Low P/E is an indication of cheapness, while high return on capital is an indication of competitive advantage (at least in the past) and the possibility to grow earnings at high rates. Here is the book’s Web site, which provides a weekly list of stocks that score high on both measures.

The Business of Value Investing by Sham Gad.  Wiley sent me the manuscript to review, and it happened to arrive on my birthday in June.  I opened the manuscript when guests showed up at the door; I set it on the kitchen table.  My niece, a recent graduate from business school, who has little interest in investing, picked it up, and I did not see her for the whole evening.  She loved it! It is hard to make value investing interesting, but Sham did.  I’ve read it too, and thought it was an excellent introductory book to value investing.

Pilgrimage to Warren Buffett’s Omaha by Jeff Matthews.  This is not another biography of Warren Buffett, but rather the most insightful and critical (fair and balanced) analysis of Buffett and Berkshire I’ve ever read.  I also encourage you to read Jeff’s musings on his blog; I’ve been reading it for years. 

The Little Book That Builds Wealth by Pat Dorsey.  Michael Porter wrote Competitive Strategy a few decades ago; quite deservingly it turned into a bible of industry analysis at all business schools and taught in all management programs.  Pat Dorsey took Michael Porter’s concepts and in this very little book applied them directly to investing.  To be honest, if this book had been out when I was teaching my investment class, I’d be using it instead Michael Porter’s (sorry Michael), as it is written for investors.

More Mortgage Meltdown: 6 Ways to Profit in These Bad Times.  This book was written by Whitney Tilson and Glen Tongue, who are excellent investors.  I’ve seen the presentation that is the core of this book, presented by Whitney and Glen, several times; in fact you can download the latest version here.  Investment ideas of how to profit from today’s crisis have already played out for the most part; so this book will not give you fish, but understanding their analytical process will teach you how to fish.

Vitaliy N. Katsenelson, CFA, is a portfolio manager/director of research at Investment Management Associates in Denver, Colo.  He is the author of “Active Value Investing: Making Money in Range-Bound Markets” (Wiley 2007).  To receive Vitaliy’s future articles my email, click here.

Twitter thoughts (follow me on twitter ):

• STRATFOR series on Russia. Don’t know if it’s Tom Clancy-like fiction or not. But makes an interesting read. Part 1: http://bit.ly/4wbacE
• STRATFOR series on Russia -  “The Kremlin Wars,” part 2: http://bit.ly/1qqvM8     
• Gerald J. Ford made a lot $ buying distressed banks, but cannot find good deals in this market. That says something: http://bit.ly/3eC4eI
• Volcker is right! Banks should have the risk profile of a regulated utility, be broken up, no more too big to fail: http://bit.ly/1ciJP8
• Chinese happy times about to end? http://bit.ly/1j7yao
• Terrific speech by David Einhorn. Must-read! http://scribd.com/doc/21311124
• Germany will not kill nuclear power (if you read between the lines, thx to Russia cutting off gas supplies last year): http://bit.ly/4o26pz   
• Interview with Steve Ballmer of Microsoft (he sounds a bit arrogant). http://bit.ly/2lWdDc   
• Apple MacBook move over, Nokia is coming!  Ok, maybe not, but very nice little netbook by cellphone maker. http://bit.ly/1jPUEb
• Nassim Taleb lecture on his book The Black Swan.  Great overview of the book.  http://bit.ly/2wBXKV
• Jeff Matthews explains the basics of Obama health-care (non) reform: http://bit.ly/18EbcH

In the 1980s, in Soviet Russia, a few times a year, my class walked to a movie theater, where we were shown a documentary.  Attendance was mandatory.  The documentaries were different but the themes were the same: to the accompaniment of patriotic music, we learned about the righteousness of socialism, the greatness of Mother Russia, and the intelligence and foresight of our great leaders.  To demonstrate how good we had it, we were shown images of “decaying” American capitalism.  Of course, capitalism did not get the benefit of patriotic music as we were shown the poverty-stricken homeless, the KKK burning crosses and lynching blacks, and Russia-hating capitalists being poisoned by hamburgers (of course, later I learned this part about hamburgers was not a complete lie).

 Past weekend Americans voluntarily spent a few million dollars to see a documentary by Michael Moore – Capitalism: the Love Story.  But don’t kid yourself, this piece of work is not a documentary, it lacks objectivity and has no intention of seeking the truth, and it is anti-American and anti-capitalist propaganda.  Mr. Moore is a talented propagandist; in Soviet Russia this documentary would have gotten him a medal and elevated him into a state hero. 

 A successful propaganda initiative has to have three elements: (1) to influence attitudes, instead of providing information, (2) to selectively present facts (i.e., lying by omission) to achieve a certain synthesis, and (3) to get an emotional rather than a rational response.

 There is little information in this movie.  Moore spends the bulk of the film going through our country’s trash and presenting it as the main course.  For instance, a corrupt judge sentences innocent teenagers to spend months at a privately owned (i.e., for-profit, nongovernmental) youth-correction facility, while the judge is getting kickbacks from the facility owners.  Moore interviews these poor teenagers, and we feel bad for them, as we should.  We feel angry.  Moore directs this anger towards capitalism (i.e., private enterprise): it is rotten and corrupt.  Of course, the fact that corruption and bribery are the rare exception in the US, not the rule (as in Russia), is never mentioned.

 Really, if you want to make a successful propaganda movie, you must evoke emotion and rightly or wrongly direct it at your subject of hate – in Moore’s case, capitalism. Moore shows families being evicted from their houses, in which some of them have lived for twenty years, and some of them have kids.  Again, we feel bad for these people, we feel their pain, and we want to help.  We are angry.  That’s what Moore wants.  But should we be angry at the bank that has given these people a loan?  Or perhaps we should accept the fact that some people will make bad financial decisions, and they’ll pay a price.  It is the easiest thing to blame a bank, or capitalism – they are not very popular today. 

 But let’s do the impossible, let’s humanize a bank. Let’s say you and I and a few friends put our life savings together and start a bank.  We take deposits and make loans.  Should we “forgive” a loan on a house to a person who overextended, made bad financial choices, or found himself facing hardship and unable to earn his way out of it?  If we do enough of this “forgiving” we’ll go bankrupt, our kids won’t go to college, and we’ll need to ask someone else to “forgive” us for the loans on our houses, credit cards, etc.  I am not even mentioning our depositors losing their money (and the FDIC – the taxpayer – bailing them out) and our employees losing their jobs. 

 So the heartless bank – you and I and a few friends – have to make a choice between sacrificing the well-being of our families for the sake of strangers.  What would you do?  See, this point is too rational and lacks the sensationalism of good propaganda; and thus Mr. Moore, who I am sure thought of it, omitted it. 

 Moore attacks BofA for not resorting to charity and not extending a loan to a factory in Michigan, even after BofA received TARP money.  The same logic I just went through applies to the huge, unpopular BofA.  Should BofA have thrown away money in a loan to the factory, knowing that the factory would not be able to repay it?  Is this not what got us into the present problem in the first place? 

 Banks and Wall Street in general played a role in today’s crisis, but they were just one of many responsible players.  Consumers in pursuit of keeping up with the Joneses overextended themselves (with the exception of cases of outright fraud, no one was forced to buy a bigger house).  Rating agencies were getting paid by the customers they were rating.  The Federal Reserve kept rates at very low levels for too long, politicians pressured lending at any cost, regulators were not regulating – and the list goes on.  Vilifying banks as the only culprit is intellectually dishonest and a very myopic way to look at this complex problem, and Mr. Moore does just that!

 Moore brought a brigade of priests to proclaim: “Capitalism is evil, immoral”; “Jesus doesn’t like the rich”; “the rich will have a hard time getting into heaven.”  Two employees from a factory, talking on camera, made a really important point about capitalism.  They said something along the lines of, “Maybe we should start a cooperative or something, but no, we cannot; we don’t have the money, we are not capitalists.” 

 Ayn Rand said it well in Atlas Shrugged: “But you say that money is made by the strong at the expense of the weak? What strength do you mean? It is not the strength of guns or muscles. Wealth is the product of man’s capacity to think. Then is money made by the man who invents a motor at the expense of those who did not invent it? Is money made by the intelligent at the expense of the fools? By the able at the expense of the incompetent? By the ambitious at the expense of the lazy?”

 Moore neglects to admit that capitalism has brought people out of poverty and socialism sunk them there. He blames rising health-care costs on HMOs, though HMOs are just a pass-through vehicle between payers and service providers.  He accuses capitalism as a system that “allows getting away with paying so little.”

 He offers no alternative to our “broken” capitalism system other than let’s have “democracy.”  This is laughable, as democracy is not a market system, it is a political system.  What he wants is a command-based economy – the Soviet Russia that failed so miserably.  He wants Mr. Mouch from Ayn Rand’s Atlas Shrugged, a mediocre bureaucrat who failed at everything in his life, to be put in charge of Mr. Moore’s version of a “democratic” economy (still not sure what that means).  Mr. Mouch decided how much everyone produced, at what prices goods were sold, and what “fair” wages everyone got paid.  In the end, despite sacrifice after sacrifice, Mr. Mouch’s economy collapses.   Mr. Mouch’s visible “fair” hand fails to accomplish what the invisible “impartial” hand of the free market accomplishes so effortlessly. 

 Mr. Moore’s propaganda flick ends with pictures of the aftermath of hurricane Katrina.  The images are powerful, full of emotion, and again in his final misdirection Moore manages to blame it on capitalism.

 Vitaliy N. Katsenelson, CFA, is a portfolio manager/director of research at Investment Management Associates in Denver, Colo.  He is the author of “Active Value Investing: Making Money in Range-Bound Markets” (Wiley 2007).  To receive Vitaliy’s future articles my email, click here.

 China is the obvious culprit as it’s the largest holder of our fine Treasury obligations.  If China’s exports to the US don’t recover to the pre-Great Recession level then, considering its large overcapacity and bad-debt problems, it may quite suddenly find itself unable to buy as many of our bonds/bills. Or even worse, it may start selling them. But this scenario is one I’ve discussed in the past more than once.

Then you start looking down the list of who’s who in the ownership of our government debt, and you find Japan only slightly behind China. Japanese interest rates were circling around zero, but they still failed to stimulate the economy that’s been in a recession for as long as I can remember. The Japanese savings rate was very high, and thus, as government debt ballooned over the last two decades, it was happily absorbed by consumers who were net savers – they had extra funds to invest. However, Japan has one of the oldest populations in the developed world. As people get older they save less; thus the savings rate has been on a decline in Japan. (The fact that their exports fell 36% did not help their savings rate, either. To save you need income).

The appetite for Japanese bonds will decline in tandem with their savings rate. The Japanese government (and corporations) will have to start offering higher yields to entice interest in its bonds. Interest rates in Japan will rise,  and this of course will put a significant interest-servicing burden on the already highly leveraged Japanese government. But more importantly  (at least from our selfish US perch), Japan will finally become a formidable competitor for borrowing. Our borrowing costs will rise. In addition, Japan may also start buying less  or selling US debt, not by choice but out of necessity, putting additional pressure on US interest rates.

Not to appear as an “on the other hand” economist (I’m not one), but the counterargument to this is, the US consumer may become a net saver and will be able to offset (at least some of the) declining demand from our friends across the Pacific.

P.S. I was interviewed in last week’s Barron’s (you can read full interview on SmartMoney).

Vitaliy N. Katsenelson, CFA, is a portfolio manager/director of research at Investment Management Associates in Denver, Colo.  He is the author of “Active Value Investing: Making Money in Range-Bound Markets” (Wiley 2007).  To receive Vitaliy’s future articles my email, click here.

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.

read complete article on SmartMoney site - NO subscription required   or  read complete article on Barron’s site  - requires subscription

Gold gets dug out of the ground in Africa, or someplace. Then we melt it down, dig another hole, bury it again and pay people to stand around guarding it. It has no utility. Anyone watching from Mars would be scratching their head.
- Warren Buffett

The reasons why one should sell the cat, pawn the mother-in-law, and use the proceeds to buy gold are well known: the Fed is printing money faster than you can read this, which will result in inflation; the government is borrowing like a drunken monkey, so the dollar will be devalued; this will debase all currencies, so the only thing that will save you is the shiny metal.

However, here are some arguments why one should think twice before jumping in bed with gold bugs, or at least remain sober while determining gold’s weight in the portfolio . 

1. For investors (not speculators) it is very hard to own gold, because you cannot attach a logical value to it. Unlike stocks or bonds, gold has no cash flow and has a negative cost of carry  – it costs you money to hold it.  It is only worth what people perceive it to be worth right now.  The argument I commonly hear is, “What about all those Enrons, Lehmans, Citigroups, etc. that either went bankrupt or got near it?  What was the value of those?”  If the lesson learned is not to own stocks but to own gold, it is the wrong lesson.  The lesson should be: own companies you can analyze (the aforementioned companies were unanalyzable) and diversify – don’t put your all net worth into one stock. 
2. The gold ETF SPDR Gold Shares (GLD) is the seventh largest holder of physical gold in the world.  If its holders decide to sell (or are forced to sell; think of hedge-fund liquidations), who will they sell it to?  This is extremely important, as the presence of GLD changes the dynamics of the gold price, both to the upside and downside.  If gold keeps climbing, the ease of buying will drive gold prices higher than in GLD’s absence.  In the event of a significant sell-off, there are not enough natural buyers of physical gold. It is a bit like a roach motel – easy to get in, hard to get out.
3. In the past, gold had a monopoly on the inflation and fear trade. Not anymore.  Now you have competition from Treasury Inflation-Protected Securities (TIPS), currency ETFs, short US Treasury ETFs, government guaranteed/insured FDIC checking accounts, etc.  TIPS suffer from the flaw of the CPI being measured and reported by the US government, which has an inherent bias to understate inflation; returns of commodity ETFs are skewed by price differentials between financial derivatives and spot prices of underlying commodities; returns of leveraged ETFs diverge significantly over the intermediate and long run from the underlying index; FDIC reserves are being depleted with the every-Friday-night bank bailout (but believe you me, the US government will not let FDIC go bankrupt, even if it means it has to raise taxes and impose draconian fees on the banking sector).   

   The bottom line here is this: none of these investment vehicles are perfect, in fact many have significant flaws; but despite their flaws they attract money away from gold, thus undermining gold’s monopoly on the fear/inflation/currency debasement trade.  (I’ve discussed it in greater detail in my book).

4. If, because of points 2 or 3 above, gold fails to perform as expected, the perception  of what gold is worth may change dramatically. 
5. Inflation is a possible but not a guaranteed outcome of what is taking place in the economy today.  Deflation or a muddle-through economy with very low nominal growth are possible and probable outcomes.  We are seeing signs that point away from inflation: the money supply declined at a 12% annualized rate over the past four weeks, according to David Rosenberg of Gluskin Sheff.  

   Though gold bugs argue that gold will perform well in either an inflationary or deflationary scenario, history doesn’t support that conclusion. Gold has done well in inflationary environments but not during deflation or low nominal economic growth.  In the 1970s, when inflation in the US was raging, gold performed better than any other asset class (though remember, at the time gold had no competition in the inflation trade, no TIPS, or ETFs that long other commodities, short US Treasuries etc..).  However, one had to know exactly when to get on and off the gold bus.  If gold was bought after considerable appreciation, that investment/speculation resulted in losses.  Gold has more than doubled in price since 2005, but has it already priced in future inflation?  I have no idea; you cannot value it.

Though gold bugs make it sound as such, gold is not the only and not the best alternative if the worst fears come to pass.  The best way to deal with the risks of dollar devaluation and high inflation – with a much lower cost to being wrong – is, instead, to own stocks of companies that have pricing power of their product. When inflation hits, they will be able to raise prices and thus maintain their profitability.  Also, companies that generate a large portion of their sales from outside the US will benefit from the declining dollar. 

Gold bugs look at gold as a currency, but it is not one and unlikely to be one in our lifetime. Here is why: there is not enough of it around, so even if world government were to adopt a fractional system (currency in circulation as a multiple of gold reserves), they will never go for it, because central banks and governments will never give up their monetary tools – inflation is a very addictive tool to fight growing monetary obligations.  

There is a wild card in the price of gold, though: China (John Burbank made that argument at the Value Investor Congress in Pasadena). If it decides to switch partially from owning US Treasuries to owning gold, the price of gold will skyrocket.

Vitaliy N. Katsenelson, CFA, is a portfolio manager/director of research at Investment Management Associates in Denver, Colo.  He is the author of “Active Value Investing: Making Money in Range-Bound Markets” (Wiley 2007).  To receive Vitaliy’s future articles my email, click here.

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It’s almost impossible to value big financial institutions like Citigroup (C), Bank of America (BAC), or Goldman Sachs (GS) — they’re a lot like hot dogs — you don’t really know what’s inside of them; for the most part, they’re leveraged hedge funds.

They may appear to be cheap on a price-to-book basis, but the book is an illusive concept when it comes to financial stocks, especially when leverage, a deteriorating economy, and accounting assumptions may transform the book into a pamphlet in a New York second.

There are very few financial companies that one can actually analyze and thus value — American Express (AXP) is one of them, and I believe it’s a great proxy for other financial stocks. American Express’s financials are transparent, thus you can make some fairly reasonable assumptions of its normalized credit losses (net write-offs), borrowing costs, fixed costs, etc… and come up with a ballpark earnings power.

In 2007, American Express earned $3.26, however, at the time, its net write-offs of its credit-card portfolio were hovering at an all-time low of 3.3%.

American Express was benefiting from the temporary impact of a new bankruptcy law passed in 2005 (people rushed to file for bankruptcy before the stricter law went into effect, which lead to lower bankruptcy filings in 2006 and 2007), in addition to easy access of credit through home equity loans, low unemployment, and expanding economy.

The 3.3% net write-offs are not coming back anytime soon, so $3.26 of earnings (which implies a price-to-earnings ratio of 10 at today’s price) is a number we can dream and fantasize about, but won’t see for a long, long time.

Fast-forward to today: American Express’s losses almost tripled, approaching 10% (though this number is a bit exaggerated by American Express proactively cutting available credit to its customers). Wall Street expects the company to earn $1 per share in 2009. However, similar to $3.26 earnings per share, this number is not really meaningful either – bad times, as good times, will not persist forever.

To figure out American Express’s normalized earnings power, you need to make an assumption of its normalized net write-offs, among other assumptions (borrowing costs, new level of fixed costs, size of the portfolio, growth of discount fees, etc…) with which I’ll not bore you here.

Though American Express’ credit card portfolio losses may go even higher in the short run, in the long run they’ll decline toward their historical average of 4.5% to 5.5%. In this case, the company’s earnings will be somewhere between $1.9 to $2.3, thus creating a price-to-earnings ratio of 14 to 17 times, turning American Express into a fairly valued stock. (If the “new” norm for net write-off will settle at a higher number, my earnings estimates are off. FYI: 0.5% of higher write-offs reduces earnings power by about 20 cents a share).

Today’s American Express price reflects a return to a normal environment – to which we have not returned yet – and the road to that goal may be longer than we expect and bumpier than we’d like (unemployment – the most important factor driving credit card defaults – is still rising).

But even if American Express has earned its normalized earnings today, the stock would be fairly valued at best. What’s the upside? The same is true for many other financial stocks.

Vitaliy N. Katsenelson, CFA, is a portfolio manager/director of research at Investment Management Associates in Denver, Colo.  He is the author of “Active Value Investing: Making Money in Range-Bound Markets” (Wiley 2007).  To receive Vitaliy’s future articles my email, click here.

-Mark Twain

 September 1st is a very strange day for me.  In Russia the school year across the whole country started on September 1st.  I vividly remember myself as a child on that day throughout my childhood.  The sun always shined brighter that day, the cleanliness of my uniform was at the year’s high, it was custom to bring flowers to teachers on that day thus the school smelled like a botanic garden.  Every year I promised myself that I’d be more serious, to smile less and make fewer jokes.  Teachers did not like my smile or my jokes, always called me a class clown.  Every year I failed at these goals.  Thank God!   

 This introduction has absolutely nothing to do with what I am about to discuss except that today is September 1st, the beginning of September and historically has been the worst month of the year for investors.  After I looked at the data from 1900 to 2008, it is safe to conclude that September historically was the worst month for investors, period.  Stocks average and median returns were -1.16% and -0.56%, respectively.  Far worse than any other months.   In fact with the exception of June where median returns were down 3 basis points, no other month of the year had negative median returns than September.  In 63 out of 108 years September brought negative returns to investors, greater than any other month.

 It gets worse, when returns in August were greater than 2% average and median returns in September were -2.29% and -1.44%, respectively.   I’ll be honest I have no idea why this happened or what this September has in store for us.  Maybe investors don’t like the end of summer and the first months of fall.  Maybe if some of your stocks a hovering close to fair value you sell now?  Or maybe if you were looking to buy a stock you wait a little?  

Vitaliy N. Katsenelson, CFA, is a portfolio manager/director of research at Investment Management Associates in Denver, Colo.  He is the author of “Active Value Investing: Making Money in Range-Bound Markets” (Wiley 2007).  To receive Vitaliy’s future articles my email, click here.

Guangshen Railway announced its results a few days ago for the first six months of 2009: “tonnage of freight transported by the Company amounted to 26.5406 million tonnes (2008 interim: 34.5508 million tonnes).” – a decline of 23%.

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What do we take out of this?  The Chinese ascent over last decade has lowered the degree of separation between China and the global economy.  What happens in China doesn’t stay in China (not anymore); it spills over to the rest of the world. 

Today, Chinese economic growth is the force pushing the global economy. The quality of this growth, however, is low as it is predicated on massive (forced) lending and thus unsustainable.  As Chinese growth slows, China will turn from a wind into sails of global economy to its anchor.  The impact will be felt in many, often unsuspected places. 

It will tank the commodity markets, commodity producers and commodity exporting nations.  Let’s take oil, for instance.  As incremental demand from China collapses, oil prices will follow, taking the Russian economy with it, as Russia is for the most part a one-trick-petrochemical-pony.  According to GavKal Research China accounts for 15% of Brazil’s exports (up from 1.5% a decade ago), significantly impacting the economy of that South American nation..

Demand for industrial goods will fall off the cliff.  China consumed a lot of those goods - $550 billion worth annually (also according to GaveKal Research).  So if Caterpillar expects to sell more of its yellow earthmovers to China, it will have put that thought on hold for awhile.  (Side note: CAT’s CEO expects CAT’s earnings “$8 to $10 per share within five years if the world economy recovers”.  Let me put it into a proper context: in 2007-2008 circa when its margins and sales were at all time high, double their historical average, CAT earned about $5.50 a share.  Good luck!)

Finally, Chinese appetite for our fine currency will diminish, driving the dollar lower against the renminbi and boosting our interest rates higher. No more 5% mortgages and 6% car loans.

Identifying bubbles is a lot easier than timing them.  An astute observer could have seen the Japanese bubble developing in 1986, 1987 and 1988, but he would have been “wrong” until 1989.  Now sprinkle on top of this the Chinese government’s willingness to do anything in its power to postpone the bursting of the bubble and the complexity of timing increases exponentially. 

Those of you who are familiar with my writing on this subject may rightfully accuse me of beating a dead horse – or in this case a dead dragon.  But I firmly believe that those who invest in China or ignore the consequence of very likely Chinese economic malaise do so at great peril.

Vitaliy N. Katsenelson, CFA, is a portfolio manager/director of research at Investment Management Associates in Denver, Colo., and he teaches a graduate investment class at the University of Colorado at Denver. He is the author of “Active Value Investing: Making Money in Range-Bound Markets” (Wiley 2007).  To receive Vitaliy’s future articles my email, click here .

Let me demonstrate it by this analogy:  Let’s rewind 20 years.  It is 1989 and I am writing that the Japanese economy is on the verge of severe decline.  I’m facing a lot of skepticism.  Most people are calling me crazy and throwing heavy objects at me.  After all, the Japanese are on top of the world.  Their economy has been a consistent grower for decades, with a rate of growth that trumps that of the US and Europe.  Japan has the manufacturing thing nailed – they are simply better and more efficient at it than us.  Magazines and newspapers swarm with stories about Japan, how hard working they are, how unique their culture is (we of course, feel inferior, as lazy Americans).  Japanese exports significantly exceed their imports, generating huge capital-account surpluses – they are swimming in dollars and buying up America. Every other restaurant in Hawaii serves sushi and menus are in English and Japanese (not Spanish).  I may be exaggerating with the last part, a little, but not much. 

So, in 1989, who am I to poke holes in Japanese grandness and predict their malaise.  Japan could do no wrong.  Of course, we know how that story played out: a bust of a major banking/real estate bubble, a contracting economy for almost two decades, accompanied by deflation, ballooning debt, etc. 

 Fast-forward, and China today is where Japan was in the late ’80s, except with the greater political instability that comes with a semi-controlled economy and the lack of a social safety net (read: jobless, hungry people don’t write angry letters, they riot). 

 Since China can do nothing wrong, everything I write about it is met with skepticism.  Today China projects to the world a similar image as Japan did in the 1980s.  My personal favorite is the incredible spectacle of the Chinese Summer Olympics opening ceremony: the elegant, wonderfully choreographed performance by fifteen thousand people, the marvels of modern technology (the 500-foot LCD screen comes to mind here), the virtually unlimited budget of the Chinese government, and seven years of preparation created a spectacular event that will be hard for any nation to follow.  (I feel bad for Russia and England, who will be putting on their Olympic spectacles next). 

Lately, the Chinese economy has been impressing us with its growth: it was growing when the rest of the world was contracting, fast.  But Chinese economic structure is not is not superior to the West’s; the Chinese can just cook GDP numbers better and control their economy more effectively through forced lending and spending. 

However, these short-term advantages come with long-term consequences – there will be a steep price to pay for them; there always is.  I’ve written a lot about this (here and here).  Instead I’ll quote James Grant, the publisher of Grant’s Interest Rate Observer.  Jim is providing the latest issue of his newsletter free, and I encourage you to download it and read his article on China – it is excellent! (Full disclosure: I’ve never met James and have not been recruited to plug his newsletter). 

Here are a few quotes from his article – many things you’ve heard from me before, but he finds a way to say them better:

“In the 1930s, Western intellectuals persuaded themselves that the Soviet economic model was depression-proof.  Today, not a few investors marvel at the vigor of the modified communist economic model of the People’s Republic. 

“A superb primer on the risks of China’s go-for-broke lending drive was published by Fitch Ratings on May 20. Is it not passing strange, the agency asks, that Chinese lending is accelerating even as Chinese corporate profits are shrinking? ‘Ordinarily, falling corporate earnings are met with tightened lending, but in China, precisely the reverse is evident. . . .’ You would expect—and Fitch does anticipate—that the borrowers of these trillions of renminbi are not so profitable as they were in the boom, and some will therefore struggle to service their debts.”

 I think this chart, also excerpted from Grant’s Interest Rate Observer, tells the full story of the quality of China’s latest growth and its lending habits (lending has doubled over a span of a few quarters!):

 “The Shanghai A-share market jumped by 65% in the first half, to a level that fixes its value at 31 times trailing net income, up from 12.8 times at the October lows. Chinese M-2 was 25.7% larger in May than it was a year before.

 “Examining, first, the track of Chinese bank lending and, second, the trend in Chinese nonperforming loans, the seasoned reader will remember …  Drexel Burnham Lambert. In the mid-to-late 1980s, the American junk bond market combined breakneck growth with muted default rates. The secret, fully revealed during the subsequent bear market, was that the default rates were a direct product of the issuance rates. Borrowers didn’t default because of—to adapt the Fitch formulation to that earlier time—the ‘pervasive rolling over and maturity extension of bonds as they fell due.’  Drexel failed when the junk market did.

 “It’s no small thing that China is especially enamored of the shot-and-a-beer-for-breakfast approach. Nothing about China is small or insignificant nowadays, since the Chinese economy is actually growing. It might, indeed, account for 74% of worldwide GDP growth in the three years to 2010,  the International Monetary Fund estimates.” 

 Finally, the most important part:

 “Since 2005, China has generated 73% of the global growth in oil consumption and 77% of the global growth in coal consumption.” [emphasis are mine]

 Need I say more?

Vitaliy N. Katsenelson, CFA, is a portfolio manager/director of research at Investment Management Associates in Denver, Colo., and he teaches a graduate investment class at the University of Colorado at Denver. He is the author of “Active Value Investing: Making Money in Range-Bound Markets” (Wiley 2007).  To receive Vitaliy’s future articles my email, click here.

 Given my usual warning, I don’t want to discuss politics in my writings for two reasons: it bores me to death and I’ll upset 55% of my readers. But an investor cannot ignore politics especially today. What happens in Washington doesn’t stay in Washington.

In his healthcare proposal President Obama is using a tactic described in behavioral finance as anchoring. Here’s a real life example from my married life. Let’s say I buy an expensive toy (usually a geeky one like an electronic gadget) for $300. My wife will ask me how much it is, and I’ll respond with $600. With a stunned look on her face, her reaction is typically “You paid $600 for this?” I then come back with, “What would you say if it was $300?”

Her answer is usually something like “Ok, that would be a good price,” and I’ll finally admit I lied and that it is $300. She’s not upset with me anymore and everyone wins. I anchored her at the higher price ($600) and then the lower ($300) now seems like a bargain. 

Mr. President is doing the same thing. He asked in his healthcare bill a lot more than he knows he could possibly receive. So anytime he is giving up something, like insurance companies’ right to exist, he is “compromising” and republicans and taxpayers claim a small victory. This is important. The President knows he won’t receive everything he asked for. He knows that the public option (a government insurance competitor - an Oxymoron if ask me) was a “no go” from very beginning. And thus he’ll “compromise” it away with cooperatives.

As dust around the healthcare bill begins to settle, we are seeing hints that health insurance companies will not be euthanized and in the worst case, they may have to compete with cooperatives. Let me tell you this. As a guy who spent half of his life in Russia and has seen cooperatives, this is an antonym to competition. I have yet to meet a person who adores his HMO, but for-profit HMOs are a better evil and more importantly, more efficient than not-for-profit cooperatives. I am buying HMO stocks.

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After I wrote the last note about China’s creative calculation of its GDP, a friend wrote: “So what?  Who cares what is going on in China?”  If the Chinese economy was the size of the Vietnamese economy, and it was not responsible for more than 2/3 of our trade deficit and didn’t hold $2.2 trillion in foreign reserves (about half of which is in US dollars), I’d be spending a lot less time thinking and writing about it.  However, what happens in China in the near future will have a significant impact on the world, and more importantly our own economy: it will impact interest rates, the dollar, commodities, and demand for industrial goods; and there will be geopolitical consequences.  China matters a lot!  

Another friend said: “You pick on the wrong governments.  First Russia, now China.  They’ll have you killed.”  Though it makes a cute joke, there is some sense of truth in her comment.  Anyway, call it bravery, call it stupidity, here is my [fixed link] latest article in Sunday’s New York Post (also included below), explaining why the Chinese economy should not make us feel inadequate and explaining the consequences of what is taking place in China on the US stocks.  Here is my interview with BNN TV (the Canadian version of CNBC) on the same topic (my wife thinks my hands need to be tied to a chair when I talk on TV, and though she has a valid point, I cannot talk without my hands).   

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I hope you enjoy this and more importantly find it beneficial.  You are welcome to share it with your friends (and enemies). 

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Avi Presentation

China’s growth an accounting miracle

Now we are learning how China has achieved its “miracle growth.” The country showed positive GDP growth while its electricity consumption declined in the beginning of 2009 – creative accounting that makes Enron’s accountants appear as dilettantes. A paper published by John Makin at American Enterprise Institute explains it well:

“Once China had announced its 8 percent growth target, it began to disburse funds directed at a sharp increase in public works spending. It is important to understand that the disbursal of funds is recorded as GDP growth. So the government can easily control the pace of growth by the pace at which it releases funds that have already been allocated in the stimulus package to the creation of higher production or growth numbers. Funds disbursed for fixed-asset investment by state-owned enterprises or provincial governments are counted as having been spent when they are disbursed. In fact, the funds go out to the state-owned enterprises and provincial governments and may be held until actual projects are identified and undertaken.” (Emphasis is mine.)

But wait, it gets worse:

“…Ambitious planners count shipments [consumer products] as retail sales while end-use demand may be absent. In such cases, the “sales” are made to happen by virtually giving away the products that have already been produced and counted as GDP growth.”

I am not convinced if China will have inflation in the long-run. It appears that deflation is a more likely scenario as China is ridden with overcapacity – the country was geared for much higher global growth. I can, however, see inflation erupting in a very short timeframe as money has been thrown at the consumer/companies, and we are seeing this in the stock market and real estate. But in the long run, inflation appears an unlikely outcome: overcapacity and slower demand from the US and Europe will force Chinese producers to cut prices to increase utilization and stimulate demand.

Lately, we’ve started hearing whispers of the Chinese renminbi contending for the status of the world’s reserve currency. On the surface it more or less makes sense. The US is struggling and Europe has structural problems. John Mauldin correctly put it, “EU was designed for prosperity not for adversity.” It will be hard for the EU experiment to survive in the long run. But that’s a topic for a different discussion.

China on the other hand is chugging along. I heard (though not confirmed) the Chinese stock market now has a greater market capitalization than Japan’s. Though the Chinese economy has the size of a global currency contender, it lacks one not-so-little element that the global economy will require for renminbi to become the world’s currency – political stability. We forget that China is still not a democracy. I am not sure what to call the political system of the People’s Republic of China but I don’t think it’s the “people’s” nor is it a “republic.” The rule of law is a nascent concept in China. Something is only legal if the government thinks it is legal.

And finally, I’m sure China doesn’t want the renminbi to be the world’s currency as it would drive up the value – a suicide for an export-based economy.

Vitaliy N. Katsenelson, CFA, is director of research at Investment Management Associates in Denver, Colo., and the author of Active Value Investing: Making Money in Range-Bound Markets.

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P.S. I highly recommend you read Peter Drucker’s paper called Managing Oneself – it is terrific. I’ve read it the first time about six years ago, had a huge impact on my life.  Also, a friend forwarded a very interesting article by Anatole Kaletske (I’ve never heard of him until today), he makes a very interesting case that European Central Bank has outdone even our mighty Fed in quantitative easing.