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ActiveValue

InvestingMaking Money in

Range-Bound Markets

VITALIY N. KATSENELSON

John Wiley & Sons, Inc.

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More Praise forActive Value Investing

Whether a self-styled seat-of-the-pants day trader or the kind ofinvestor who intends to buy and hold forever, youre operating ata distinct disadvantage if you lack the skills to break a companydown into its financial nuts and bolts. Vitaliy Red Katsenelsonis one of the best on the Street at analyzing a business and puttingthat knowledge to work to make money. In Active Value Investing,Red shares the skills and strategies that allow him to cut throughthe noise and build a long-term portfolio of winners. Bull and bearmarkets come and go, but the secrets shared in this book areforever. This book is a must-have guide for any market!

Jeff MackeContributor to Minyanville.com

and CNBCs Fast Money

Vitaliy has done the world a significant favor; he shows, in eruditefashion, that value investing (the one tried and tested investmentapproach) holds in range-bound markets. This should matter forall investors as in a world of low returns, ensuring the avoidanceof permanent loss of capital is paramount. But he doesnt stopthere, Vitaliy manages to go even further and provides you witha working process for evaluating investment in such a world.

James MontierGlobal Equity Strategist, Dresdner Kleinwort

In a world of uncertainty, Vitaliys investing techniques help calmthe storm. James Altucher

Author of Trade Like a Hedge FundFounder of Stockpickr.com

Vitaliy Katsenelson wears two professional hats: As a successfulmoney manager, he has the responsibility to clear out the noiseand center upon what makes a market-beating investment. As aneducator, hes honed his ability to distill complex concepts into theexplainable. With Active Value Investing, hes managed both theclarity of thought and the clarity of investment to bring to you anoutstanding investment resource. Bill Mann

Advisor, Hidden Gems newsletterThe Motley Fool

Vitaliy Katsenelson fcover.tex V3 - 08/22/2007 10:46am Page ii

Active Value Investing provides a laconic vision of how the indi-vidual or institutional investor can successfully navigate a marketthat is neither a bull nor a bear. Unlike most stock market authorswho automatically posit the stock markets prospects as knowingonly one way (up), Katsenelson provides a refreshingly honest and,sometimes, humorous approach to a less defined future.

Douglas A. KassPresident, Seabreeze Partners Management Inc.

Vitaliys passion for value investing and teaching others makesActive Value Investing enjoyable as well as insightful. It is requiredreading for the investment team at Second Curve Capital.

Thomas K. BrownCEO, Second Curve Capital

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ActiveValue

Investing

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Founded in 1807, John Wiley & Sons is the oldest independent publishingcompany in the United States. With offices in North America, Europe,Australia, and Asia, Wiley is globally committed to developing and market-ing print and electronic products and services for our customers professionaland personal knowledge and understanding.

The Wiley Finance series contains books written specifically for financeand investment professionals as well as sophisticated individual investorsand their financial advisors. Book topics range from portfolio managementto e-commerce, risk management, financial engineering, valuation, andfinancial instrument analysis, as well as much more.

For a list of available titles, visit our Web site at www.WileyFinance.com.

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ActiveValue

InvestingMaking Money in

Range-Bound Markets

VITALIY N. KATSENELSON

John Wiley & Sons, Inc.

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Copyright c 2007 by Vitaliy N. Katsenelson. All rights reserved.Published by John Wiley & Sons, Inc., Hoboken, New Jersey.Published simultaneously in Canada.

Wiley Bicentennial logo: Richard J. Pacifico.

No part of this publication may be reproduced, stored in a retrieval system, or transmitted inany form or by any means, electronic, mechanical, photocopying, recording, scanning, orotherwise, except as permitted under Section 107 or 108 of the 1976 United States CopyrightAct, without either the prior written permission of the Publisher, or authorization throughpayment of the appropriate per-copy fee to the Copyright Clearance Center, Inc., 222Rosewood Drive, Danvers, MA 01923, (978) 750-8400, fax (978) 750-4470, or on the Webat www.copyright.com. Requests to the Publisher for permission should be addressed to thePermissions Department, John Wiley & Sons, Inc., 111 River Street, Hoboken, NJ 07030,(201) 748-6011, fax (201) 748-6008, or online at http://www.wiley.com/go/permissions.

Limit of Liability/Disclaimer of Warranty: While the publisher and author have used theirbest efforts in preparing this book, they make no representations or warranties with respect tothe accuracy or completeness of the contents of this book and specifically disclaim any impliedwarranties of merchantability or fitness for a particular purpose. No warranty may be createdor extended by sales representatives or written sales materials. The advice and strategiescontained herein may not be suitable for your situation. You should consult with aprofessional where appropriate. Neither the publisher nor author shall be liable for any loss ofprofit or any other commercial damages, including but not limited to special, incidental,consequential, or other damages.

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Exhibits sourced Ibbotson Associates are from: Stocks, Bonds, Bills and Inflation 2007Classic Edition Yearbook. c 2007 Morningstar. All rights reserved. Used with permission.Copies of the Yearbook may be acquired directly from Morningstar. For more information,please visit global.morningstar.com/SBBIYrBks.

Library of Congress Cataloging-in-Publication Data:

Katsenelson, Vitaliy N.Active value investing : making money in range-bound markets / by Vitaliy N. Katsenelson.

p. cm. (Wiley finance series)Includes bibliographical references.ISBN 978-0-470-05315-7 (cloth)1. Speculation. 2. Investments. I. Title.HG6041.K36 2007332.6dc22

2007013701

Printed in the United States of America.

10 9 8 7 6 5 4 3 2 1

www.wiley.com

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For my parents:My father Naum and in memory of my mom Irene

Thank you for always believing in me

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Contents

Preface xiii

PART ONEWhat the Future Holds

CHAPTER 1Introduction: Range-Bound Markets Happen 3

Fasten Your Seat Belts and Lower Your Expectations 3Lets Identify the Animal 4Secular versus Cyclical 4Distinction between Secular Bull, Bear, and

Range-Bound Markets 6Is 100 Years Long Enough? 7Stocks Carried the Torch in the Long-Run Marathon 8International Stocks Were Bright Lights, Too 10Will Gold Shine Again? 11Golds Recently Emerged Competition 13The Deception of the Long Run (Marathon) 14Range-Bound Markets Erode Bull Market Returns 15The Long Run for Us May Be Shorter Than

We Think 17

CHAPTER 2Emotions of Secular Bull, Bear, and Range-Bound Markets 23

Bull Market Euphoria 23Bear Market Doldrums 25What Does a Secular Range-Bound Market

Feel Like? 29Volatility of Bull and Range-Bound Markets 31

vii

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viii CONTENTS

CHAPTER 3Stock Market Math 37

Sources of Capital Appreciation: Earnings Growth 38Sources of Capital Appreciation: Price to Earnings 48Sources of Dividend Yield 57Why Range-Bound Markets Follow Bull Markets 61It Is Not Over Until It Is Over 62

CHAPTER 4Bonds: A Viable Alternative? 67

Why Not Bonds? 67Asset Allocation Role Is Diminished

in Range-Bound Markets 69

PART TWOActive Value Investing

ANALYTICSIntroduction to Analytics: The Quality, Valuation,and Growth Framework 77

CHAPTER 5The QQuality 79

Competitive Advantage 79Management 82Predictable Earnings 89Strong Balance Sheet 91Significance of Free Cash Flows 95High Return on Capital 102Conclusion 102

CHAPTER 6The GGrowth 103

Sources of Growth: Earnings Growth and Dividends 103Past Has Passed 111Future Engines of Growth 112Dividends 114Growth MattersA Lot! 117

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Contents ix

CHAPTER 7The VValuation 119

Tevye the Milkmans Approach to Valuation 119Review of Relative Valuation Tools 128Absolute Valuation ToolsDiscounted Cash Flow Analysis 132Relative versus Absolute Tools 134Absolute Models Overview 136The False Precision of Math 137Absolute P/E Model 139Discount Rate Model 148Margin of Safety Model 151The Marriage of Absolute P/E and Margin of Safety 155Bring Out the Toolbox 155The P/E Compression and How to Deal with It 157

CHAPTER 8Lets Put It All Together 165

The Added Clarity 165One Out of Three Is Not Enough 165Two Out of Three Is Better, But Is It Enough? 167Conclusion 174

STRATEGYIntroduction to Strategy: The Value of Processand Discipline 177

CHAPTER 9Buy ProcessFine-Tuning 179

The Value of the Process and Discipline 179Think Long-Term, Act Short-Term 181Meet Your New Best FriendVolatility 182Time Stocks, Not the Market 183Cash Is King 185Be Ready to Strike When the Time Comes 186

CHAPTER 10Buy ProcessContrarian Investing 187

Contrarian Is the Name of the Game 187You Dont Have to Own It 189Be a Myth Buster 190Quantify Everything and Be a Contrarian Headline Investor 191

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x CONTENTS

Time Arbitrage 192Finding New Ideas 193Do In-Depth Primary (Your Own) Research and

Document It 200

CHAPTER 11Buy ProcessInternational Investing 201

The World Has Flattened: Hola, Bonjour, Guten Tag,Buon Giorno to the Rest of the World 201

Same Difference 202Location of Corporate Headquarters Abroad May Not

Constitute a Foreign Company 203You Are Exposed to More Foreign Political Risk Than

You Realize 204What About the United States? 205Pick Your Comfort Zone and Go from There 206Dont Confuse a Fast-Growing Economy

and a Good Investment 207Currency Risk 207How Much Is Too Much? 208Conclusion 209

CHAPTER 12Sell ProcessMake Darwin Proud 211

Selling When Stock Price Has Gone Up 212Selling When Fundamentals Have Deteriorated 215Conclusion 221

RISK AND DIVERSIFICATIONIntroduction to Risk and Diversification 225

CHAPTER 13A Different View of Risk 227

What Is Risk? 227Properties of Randomness 228The Crocodile Hunter, Randomness, and Investing 229Understand the Linkage Between and Inside

QVG Dimensions 234

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Contents xi

Identify Impact of Randomness on Value Creators 235The Cost of Being Wrong 238Conclusion 239

CHAPTER 14A Different View of Diversification 241

Dont Bet the Farm! 242Too Many Eggs or Too Many Baskets 243Mental Accounting and Diversification 244Mental Accounting and Randomness in a Stock Portfolio 246Randomness Could Be Your Friend 248

CHAPTER 15Conclusion and Implication 251

I Could Be Wrong, But I Doubt It 251Bull Markets 252Bear and Range-Bound Markets 253Bonds? 255No, I Am Not Wrong 256

AppendixYears to Bull Market 257

Acknowledgments 267

Notes 273

Index 275