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DeMarche
The Five Key Sourcesof Stock Returns
Bob DuwaDeMarche Associates, Inc.
CFA NebraskaFebruary 18, 2009
2 DeMarche
The Five Key Sourcesof Stock Returns
• Key Factor Groups
• DeMarche Phase Analysis
• Market Outlook
3 DeMarche
Key Factor Groups
4 DeMarche
Forces Affecting Stock Return
The Economy
MarketBehavior
IndustryOutlook
StockPrice
Company Characteristics and Issues
5 DeMarche
Five Factor Groups
Investment Style FactorsDividend yield, book to price, earning yield
Firm FactorsEPS growth, ROE, asset turnover, profit margin, debt level
Industry FactorsCompetition, regulation
Liquidity FactorsTrading volume and change in volume, share price, cap size
Momentum FactorsShort, intermediate and long-term price history
6 DeMarche
Key Factor GroupsProviding Highest Sources of Alpha
Valuation
Risk
Growth
Industry
Momentum
Liquidity
“Style”
7 DeMarche
DeMarche Style Factors – Growth/Value
HighDeMarche Growth RatingLow
HighRelative Price StrengthLow
HighEarnings GrowthLow
HighAsset GrowthLow
HighDividend GrowthLow
LowCash Flow YieldHigh
LowDividend YieldHigh
LowSales-to-PriceHigh
LowBook-to-PriceHigh
Growth StocksFactorValue Stocks
HighDeMarche Growth RatingLow
HighRelative Price StrengthLow
HighEarnings GrowthLow
HighAsset GrowthLow
HighDividend GrowthLow
LowCash Flow YieldHigh
LowDividend YieldHigh
LowSales-to-PriceHigh
LowBook-to-PriceHigh
Growth StocksFactorValue Stocks
VALUE TO GROWTH SPECTRUM
8 DeMarche
DeMarche Growth vs. DeMarche Value
-30.0
-20.0
-10.0
0.0
10.0
20.0
30.0
Dec
-84
Dec
-85
Dec
-86
Dec
-87
Dec
-88
Dec
-89
Dec
-90
Dec
-91
Dec
-92
Dec
-93
Dec
-94
Dec
-95
Dec
-96
Dec
-97
Dec
-98
Dec
-99
Dec
-00
Dec
-01
Dec
-02
Dec
-03
Dec
-04
Dec
-05
Dec
-06
Dec
-07
Dec
-08
Moving One-Year Returns
Percent Spread
Value Outperforms
Growth Outperforms
Style Leadership – Growth/Value
9 DeMarche
11.03
15.8613.9
19.68
11.95
0.00
2.00
4.00
6.00
8.00
10.00
12.00
14.00
16.00
18.00
20.00Large CapGrowth
Large CapValue
Small CapGrowth
Small CapValue
S&P 500
Large Cap Gr Large Cap Val Small Cap Gr Small Cap Val S&P 500
FAMA Style Indexes1928-2007 Annualized Returns
10 DeMarche
DeMarche Style Factors - Quality
AGGRESSIVE TO DEFENSIVE SPECTRUM
HighProfit MarginLow
HighDividend YieldLow
HighCash Flow YieldLow
HighEconomic ReturnLow
HighPayout RatioLow
HighMarket Cap SizeLow
LowNon-Market RiskHigh
LowEarnings VariabilityHigh
LowMarket RiskHigh
LowShare TurnoverHigh
LowTrading RangeHigh
Defensive StocksFactorAggressive Stocks
HighProfit MarginLow
HighDividend YieldLow
HighCash Flow YieldLow
HighEconomic ReturnLow
HighPayout RatioLow
HighMarket Cap SizeLow
LowNon-Market RiskHigh
LowEarnings VariabilityHigh
LowMarket RiskHigh
LowShare TurnoverHigh
LowTrading RangeHigh
Defensive StocksFactorAggressive Stocks
11 DeMarche
Style Leadership - QualityDeMarche Aggressive vs. DeMarche Defensive
-40.0
-30.0
-20.0
-10.0
0.0
10.0
20.0
30.0
40.0
50.0
60.0
Dec
-84
Dec
-85
Dec
-86
Dec
-87
Dec
-88
Dec
-89
Dec
-90
Dec
-91
Dec
-92
Dec
-93
Dec
-94
Dec
-95
Dec
-96
Dec
-97
Dec
-98
Dec
-99
Dec
-00
Dec
-01
Dec
-02
Dec
-03
Dec
-04
Dec
-05
Dec
-06
Dec
-07
Dec
-08
Percent Spread
Moving One-Year Returns
Aggressive Outperforms
Defensive Outperforms
12 DeMarche
Firm Factors
Profitability (ROE)
EPS Growth
Dividend Growth
Asset Turnover
Profit Margin
Debt Level
13 DeMarche
D9
87
65
43
2A
G9
87
65
43
2V
0
10
20
30
40
50
60
70T
ota
l C
om
pa
ny
Co
un
t
Defensive - Aggressive Value - Growth
Topography of the MarketCompany Count vs. Growth / Value and Aggressive / Defensive
D9
87
65
43
2A
G9
87
65
43
2V
D9
87
65
43
2A
G9
87
65
43
2V
0
10
20
30
40
50
60
70T
ota
l C
om
pa
ny
Co
un
t
Defensive - Aggressive Value - Growth
Topography of the MarketCompany Count vs. Growth / Value and Aggressive / Defensive
14 DeMarche
D9
87
65
43
2A
G9
87
65
43
2V
0%
2%
4%
6%
8%
10%
12%
Pe
rce
nt
of
To
tal
Ma
rke
t C
ap
Defensive - Aggressive Value - Growth
Topography of the MarketMarket Cap vs. Growth / Value and Aggressive / Defensive
D9
87
65
43
2A
G9
87
65
43
2V
0%
2%
4%
6%
8%
10%
12%
Pe
rce
nt
of
To
tal
Ma
rke
t C
ap
Defensive - Aggressive Value - Growth
Topography of the MarketMarket Cap vs. Growth / Value and Aggressive / Defensive
15 DeMarche
Valuation Basis PointsFormulas R-squared per Ventile
Price to Book 80% 34Price to Cash Flow 73% 35Earnings to Price 33% 23Earnings Surprise & Revisions 3% 4CAPM 5% -5
Source: DeMarche Associates, 1978 - 2001
One-Year Return Predictability of Various Valuation Formulas
16 DeMarche
Basis PointsMetrics R-squared per Ventile
Asset Utilization (Turns) 48% 27Free Cash Flow Return on Investment 41% 21ROE 40% 11EVA 32% 13Cash Flow Return on Investment 12% 7ROA 0% 2
Source: DeMarche Associates, 1978 - 2001
One-Year Return Predictability of Various Metrics
17 DeMarche
Lakonishok Study (1951 - 1998)
Percentage of Firms with ABOVE-MEDIANGrowth in Operating Income for Number of Years
50.0
25.6
13.0
6.83.6
2.0 1.2 0.7 0.5 0.30
10
20
30
40
50
60
1 2 3 4 5 6 7 8 9 10
Years
Predictability? Companies Change!
18 DeMarche
DeMarche Study (1972-2001) (Lakonishok Method)
Percentage of Firms with ABOVE-MEDIANGrowth in Stock Returns for Number of Years
50.0
27.8
15.0
8.74.9
2.8 1.6 0.9 0.5 0.30
10
20
30
40
50
60
1 2 3 4 5 6 7 8 9 10
Years
50.0
27.8
15.0
8.74.9
2.8 1.6 0.9 0.5 0.30
10
20
30
40
50
60
1 2 3 4 5 6 7 8 9 10
Years
Predictability? Companies Change!
19 DeMarche
• Focus time on holdings with worst expected return potential to avoid “bombs”
• Identify sell signals
• Quantify basis for shifts in industry bets
• Add value in tilt decisions on growth/value or aggressive/defensive spectrum
Benefits for Portfolio Managers
20 DeMarche
Benefits for Clients & Consultants
• Better understanding of investment process
• Improve communication between client, manager, and consultant
21 DeMarche
DeMarche Phase Analysis
22 DeMarche
Probability Distribution ofThree-Year S&P 500 Returns
1929 – December 31, 2008
Return
Pro
babi
lity
-1 Std. Dev. +2 Std. Dev.+1 Std. Dev.-2 Std. Dev.
10.83%
35.10%
22.96%
-13.45%
-1.31%
S&P 6/30/03-11.21%
S&P 6/30/99 29.10%
S&P 6/30/05 8.37%
S&P 6/30/00 19.67%
S&P 12/31/08-8.36%
23 DeMarche
Phase I 55.5% Early Bull Phase II 19.0% Bull Phase III 3.5% Late Bull/Early Bear Phase IV -19.6% Bear Total Period …………………………………………………… 10.8%
Market Phase Stock Prices Corporate Earnings
S&P 500 Annualized
Return
Market Phase Analysis (01/01/63 to 06/30/05)
Market Phase Analysis1/1/63 to 12/31/08
54.8%
19.2%
-15.4%
9.4%
24 DeMarche
Drivers of Stock Price – Bull MarketOne-Year Return Predictability of Various Metrics
Basis PointsMetrics R-Squared per VentileROE 31% 13Asset Utilization 27% 17Free Cash Flow Return on Investment 20% 12
EVASM 9% 8ROA 0% - 1
Source: DeMarche Associates, 1978-2001
25 DeMarche
Drivers of Stock Price – Bear Market
One-Year Return Predictability of Various Metrics
Basis PointsMetrics R-Squared per VentileAsset Utilization 41% 73Free Cash Flow Return on Investment 32% 65
EVASM 27% 39ROA 4% 13ROE 0% 0
Source: DeMarche Associates, 1978-2001
26 DeMarche
Style Leadership by DeMarche Market Phase
Style Leadership
Phase I Small Cap Growth
Phase II Large Cap Growth
Phase III Small Cap Value
Phase IV Large Cap Value
27 DeMarche
Benefits for Clients & Consultants
• Better understanding of manager returns and periods of expected bad performance
• Tactical Restructuring
28 DeMarche
DeMarche Market Outlook
29 DeMarche
Discretionary Management Services, LLCForecast 2009
Jan 1 - Dow 8776 Dec 31 - ???
--- --- Back to 8776 ?
1st Quarter - Test 7450 low
If broken, seeks support below 7000
By Labor Day - Dow tries to break 10,000
1st Quarter 2nd Quarter 3rd Quarter 4th Quarter
30 DeMarche
3-Yr. Equity Returns?Projected 3-Year Stock Returns Using Bogle Model (Values in Table)
Based on Various Earnings Growth Rates and Ending P/Es(Annualized Values in Table)
As of 12/31/2008
Model Inputs: S&P 500Beginning Yield 3.0%Beginning P/E 19.6
Ending P/EScenarios: 12.0 14.0 16.0 18.0 20.0 22.0
6.0% -6.1 -1.6 2.5 6.2 9.7 13.0Earnings 3.0% -9.1 -4.6 -0.5 3.2 6.7 10.0Growth 0.0% -12.1 -7.6 -3.5 0.2 3.7 7.0Rate -3.0% -15.1 -10.6 -6.5 -2.8 0.7 4.0
-6.0% -18.1 -13.6 -9.5 -5.8 -2.3 1.0
Price/Earnings ratio represents the month-end index closing price divided by 12-months quarterly as reported diluted earnings per share (GAAP EPS). As of 12/31/08, nine months of actual reported earnings and three months of estimated earnings were used.Averages Since 1936: P/E 15.8 12 Mo. Earnings Growth Rate 7.3%
31 DeMarche
3-Yr. Fixed Income Returns?Projected 3-Year Bond Returns (Values in Table)
Based on Various Changes in Yields(Annualized Values in Table)
As of 12/31/2008
Barclay's Sector IndexesModel Inputs: Interm. Gov't US Credit High Yield
Beginning Yield 1.5 6.8 19.5
Beginning Duration 3.6 6.0 4.1
Scenarios: Interm. Gov't US Credit High Yield+200 -1.0 2.6 16.7
Net Basis Point +100 0.3 4.7 18.1Change in +0 1.5 6.8 19.5
Yield -100 2.6 8.8 20.9-200 N/A 10.7 22.2
Projected bond returns shown above make no assumption about potential default or recovery rates.
32 DeMarche
Man is not a rational being, man is an animal
that rationalizes!
Source Unknown
33 DeMarche
DeMarche Associates913-384-4994
www.demarche.com
www.dms-demarche.com
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