Active Value Investing by Vitaliy Katsenelson March-2011


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Active Value Investing by Vitaliy Katsenelson March-2011

  1. 1. Vitaliy N. Katsenelson, CFA Chief Investment OfficerInvestment Management Associates, Inc. 1
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  3. 3. Active Value Investing Net of Fees performance is afterthe deduction of management fees, after reinvestmentof dividends, interest and other earnings (recorded onaccrual basis), and after the deduction of broker feesand commissions.S&P 500 market average includes reinvestment ofdividends but are not adjusted for any transactioncosts.Past performance is not necessarily indicative offuture results and is only one of several factors whichshould be used in evaluating a professionalinvestment organization. 4
  4. 4. We are used to thinking about secular (longer than 5 years) markets in binary terms: OR 5
  5. 5. There is another type of long-term market – Cowardly Lion or Sideways “bursts of occasional bravery lead to stock appreciation, but are ultimately overrun by fear that leads to a subsequent descent” – Active Value Investing: Making Money in Range-Bound Markets 6
  6. 6. Dow Jones Industrial Average 100+ YearsThe “bear” markets were actually sideways markets and happened ½ the time 7
  7. 7. Dow Jones Industrial Average 2000 - 2010So far markets have gone sideways … hell of a ride, but still sideways 8
  8. 8. Secular Bull and Sideways Market Cycles Were Not Caused by:  Economy  Earnings growth  Interest rates  InflationThey Were Caused by:  Valuation 9
  9. 9. As Long As: Inflation Remained Reasonable / Deflation Was Absent / GDP And Earnings Growth Remained Positive – Market Was Either Bull Or Sideways.Note: Real GDP growth was extremely stable throughout all secular markets 10
  10. 10. Stock Market Math Earnings Growth ∆ Price + + ∆ P/E Dividends =Total Return from Stock(s) OR Earnings Growth + ∆ P/E + Dividends = Total Return from Stock(s) 11
  11. 11. Sources of ReturnPractical Example: 12
  12. 12. Wal-Mart -- A Typical Sideways Market Stock… 2001 - 2010 13
  13. 13. Sources of Return: Secular Sideways and Bear Markets (S&P 500) SIDEWAYS MARKETS Sideways Markets: P/E Contraction + Earnings Growth = Low Returns Bear Markets: P/E Contraction + Earnings Decline = Negative Returns 14
  14. 14. “By the Book” Bear Market – Japan 15
  15. 15. Sources of Return: Secular Bull MarketsBull Markets: P/E Expansion + Earnings Growth = Super Returns 16
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  18. 18. Bull Markets Start at Below-Average and End At Above-Average Valuations.Range-Bound Markets Start at Above-Average and End at Below-Average Valuations. 19
  19. 19. Bull, Bear and Sideways Markets Happen When…Market Economic Growth Starting Valuation (P/E)Bull Good (Average) LowRange-Bound Good (Average) HighBear Bad High 20
  20. 20. In a “perfect” world where humans have no emotionsstock market appreciation = economic growth = earnings growth = 5-6% 21
  21. 21. The Effects of Psychology on Market Cycles End of Bull Market “New” average expectations are NOT met – P/E stopped expanding P/E + EPS = Sideways Market 0% + 6% ≈ 6% Returns are NOT “new” average, not average, but below average: P/E + EPS = -6% + 6% ≈ 0% 22
  22. 22. Interest rates and inflation are very important but they take a second seat to marketpsychology. They ultimately determine the length and the extremes of market cycles. Good/Bad for Interest Rates Move from Reason P/Es Move to Zone 1 Zone 2 GOOD normalcy Zone 2 Zone 3 BAD Risk of inflation 1982 Move to Zone 3 Zone 2 GOOD normalcy If interest rates /inflation were higher, secular Zone 2 Zone 1 BAD Risk of deflation range-bound may have ended sooner at higher valuation 2000 If interest rates /inflation were not that low, secular bull may have ended sooner at lower valuation 23
  23. 23. Still in the Sideways Market? Valuations are still high (above average). Valuations need to stay below average for a while (see next slide). Real earnings growth will be lower in the future due to higher futuretaxes, higher interest rates (caused by government borrowing), consumerdeleveraging – sideways market may last longer than we expect. High inflation will shorten sideways market duration, but final P/Ewill be lower as well. If nominal earnings growth doesn’t materialize in the future (3,5,10years), earnings decline – we are set for a secular bear market 24
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  25. 25. Brief Summary of Strategy and Analysis for Today’s Environment Be a buy and sell investor. Buy and hold is in a coma (see next chart) . Time(price) stocks through a strict buy and sell process. Buy when undervalued, sellwhen fairly valued. Time stocks, not the market: Market timing is very difficult. In the short runemotions are in the driver’s seat. Don’t buy for the sake of being invested. Don’t lose money by making marginaldecisions. In the absence of good stocks to buy, be in cash. The opportunity costof cash is not as high as in a secular bull market. Increase your margin of safety: Fewer (better) stocks will be in your portfolio. Favor dividend-paying stocks. Dividends were 95% of the return in previousrange-bound markets. (Warning: dividends are part of the analytical equation, notthe equation.) Look overseas -- increases return without increasing risk. 26
  26. 26. Bull Markets: Stocks Do Outperform Bonds Hands DownThrow money at stocks, and you’ll do much better than in bonds or cash. In general, the fewer decisions you make the better off you are (buy and forget). 27
  27. 27. Sideways Markets: Stocks’ Dominance Is Not Significant Asset allocation is not as important as stock selection. 28
  28. 28. Conclusion: Stock Selection Matters A Lot! 29
  29. 29. Thank You!To signup for complimentary articles via email visit Investment Management Associates Inc. 7979 E. Tufts Ave, Suit 820, Denver, Co 80237 303.796.8333 / 30
  30. 30. Secular Range-Bound Market Is Comprised of Many Cyclical Markets 31
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