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Bulkowski's Book Review: Active Value Investing

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Candles Chart
Small Patterns
As of 02/19/2019
  Industrials: 25,891 +8.07 +0.0%
  Transports: 10,618 +49.99 +0.5%
  Utilities: 743 +4.68 +0.6%
  Nasdaq: 7,487 +14.36 +0.2%
  S&P 500: 2,780 +4.16 +0.1%
Tom's Targets    Overview: 02/14/2019
26,000 or 24,600 by 03/01/2019
10,900 or 9,900 by 03/01/2019
755 or 725 by 03/01/2019
7,700 or 7,050 by 03/01/2019
2,825 or 2,650 by 03/01/2019

Written by and copyright © 2005-2019 by Thomas N. Bulkowski. All rights reserved. Disclaimer: You alone are responsible for your investment decisions. See Privacy/Disclaimer for more information. Some pattern names are the registered trademarks of their respective owners.


Active Value Investing: Making Money in Range-Bound Markets, by Vitaliy N. Katsenelson

Active Value Investing: Making Money in Range-Bound Markets, by Vitaliy N. Katsenelson reviewed 3/22/2008 and written by Thomas N. Bulkowski. Copyright (c) 2008 by Thomas N. Bulkowski. All rights reserved.

Katsenelson defines what he means by range-bound markets: "Range-bound markets are the bear markets of price-earnings (P/E) ratios (they decline), whereas bear markets are the bear markets of P/Es and earnings (they both decline)." That is a complicated way of saying that a range-bound market sees lower prices, but a bear market has price dropping faster than earnings.

He shows a chart from 1900 to 2006 and extends the test range back to 1802 and finds only one bear market: the October 1929 to July 1932 drop. He concludes that the 2000 to 2002 drop is part of a range-bound market and not a bear market. There is nothing wrong with this conclusion; it is just a different way of looking at the data.

Katsenelson touches upon foreign securities and other asset classes. About gold, he writes, "Despite its unique properties, gold has not been a good investment. Over the past 100 and 200 years its returns have barely kept up with inflation." Amen to that. A chart shows that the total return from $100 placed in stocks, bonds, gold, and T-bills from 1925 to 2006 shows stocks in first place (valued at $328,450), followed by treasury bonds ($7,169), gold ($3,078), T-bills ($1,929) and the consumer price index (inflation, $1,141). I was toying with diversifying into bonds...forget that idea!

He then discusses the duration of range-bound markets. "The higher the valuations of stocks are at the beginning of the range-bound market, the more likely that the range-bound market will last longer." According to his calculation, the current range bound market began in 2000 and will last to about 2020. Ouch! "Negative emotions that accumulate in the market since the prior bull market are apt to drive stock prices far below their intrinsic value, as has occurred every time in the past century."

He demonstrates the results with a few tables of information from the 1900 to 2005 period using the S&P 500 stocks and concludes, "Lower P/Es lead to higher returns, and higher P/Es lead to lower returns. ...If stocks are bought when the P/E is below average (less than 12), P/E is the investors's best friend... However, if stocks are purchased when the P/E is above average (greater than 16), the P/E turns into a foe, as its compression diminishes returns." In short, growth stocks don't grow as fast as value plays. I still find that surprising, but it is a lesson that other value books discuss.

On page 58, he makes an interesting statement: "Exhibit 3.16...shows that dividends contributed the bulk of the returns to previous range-bound markets. In fact, of the 5.9 percent average total return investors received in the range-bound markets of the twentieth century, 5.3 percent came from dividends; dividends contributed more than 90 percent of total return!" No wonder I've liked electric utility stocks for years now. Last year (2007), the Dow utility average (16.6% rise) was the best performing among the Dow (industrials: 6.4%, transports: 0.2%), Nasdaq (9.8%), and S&P (3.5%).



In part 2 of the book, he discusses his framework for active value investing: Quality, Valuation and Growth (QVG). He devotes a chapter to each. Characteristics of a quality company include strong brands (recognizable names that cost more than other brands), high barriers to entry, regulated monopolies, patents, and a strong management team (one with integrity -- willing to admit mistakes and is honest -- and focus on creation of long-term shareholder value, often as a sacrifice to short-term value). Those characteristics give the company a competitive advantage. "A company that is earning above-average returns on capital (the best kind) will attract new competition," but a history of high return on capital is a sign that a company can maintain that high return.

The competitive advantage will help the quality company prevail whereas those companies with a weak competitive advantage will drop product prices, sacrifice volume, or invest in ways to differentiate from the competition in order to stay competitive.

He then discusses the balance sheet and writes, "To gauge a company's true indebtedness and the risk that comes with it, you should utilize debt and interest coverage ratios in relation to net income; earnings before interest, taxes, depreciation, and amortization (EBITDA); operating cash flows; and/or free cash flows. These ratios tell a more accurate story about the balance sheet (debt) risk and are not distorted by share buybacks. Here are some examples of these ratios: debt/EBITDA; debt/operating cash flows; EBITDA/interest expense; operating cash flows/interest expense."

Pension plans and leases are off-balance sheet bombs waiting to explode. A company that assumes a high rate of return on its plan assets may mean the company uses aggressive accounting. Companies with stellar balance sheets are takeover bait.



Growth is composed of two parts: earnings and dividends. Revenue growth drives earnings. If revenue is rising faster than costs, net margin will expand and net income growth will exceed revenue growth. Revenue growth can come from selling more products both domestically and internationally, raising prices, or lowering prices that creates higher demand and lowers costs.

As part of the revenue discussion, he says that stock buybacks are great ways for a company to boost shareholder value providing it is done at a cheap price. Using debt to finance a stock buyback is less attractive than using free cash flow to pay for it.

Companies that pay a large dividend tend to have stocks that drop less. When the price drops, the dividend rate increases, attracting more shareholders looking for income. That buying demand supports the stock. Katsenelson writes that "A study conducted by Cliff Asness and Robert Arnott called 'Surprise! Higher Dividends = Higher Earnings Growth, ' published in the Financial Analysts Journal, showed that companies that had a higher dividend payout actually grew earnings faster." They showed that when the company retained earnings instead of paying them out, they had a tendency to invest poorly by buying other companies at prices too high or that were not a good fit to begin with. "Cash that has not been paid out is often squandered by management," he writes.



Ratios such as price to earnings, price to cash flow, price to sales, price to dividends, and price to book are good ways to screen for stocks, according to Katsenelson. One of the startling statements in the book is that the PEG ratio is flawed because it "assumes a linear relationship between P/E and earnings growth. ...Higher growth of earnings usually comes at higher risk; thus the relationship between P/E and a company's growth rate is far from being linear, and the PEG ratio doesn't address this issue. In addition, the traditional PEG ratio is focused solely on earnings and ignores dividends. On top of all that, it assumes that a company that is not growing earnings is worthless (P/E divided by 0 percent growth = 0 value)."

The author examined the range-bound market from 1966 to 1982 and found:

  • "The high-valuation stocks performed worst in terms of change of the P/E from the market's P/E contraction.
  • Lowest-P/E stocks consistently outperformed highest-P/E stocks, in many cases by a margin of 2:1.
  • Lower-valuation stocks consistently dominated higher-valuation stocks, producing much better returns than their higher-valuation comrades. They suffered lower P/E decline at the time of P/E compression. They also achieved higher P/E expansion at the time of P/E expansion."

Concerning the three QVG elements, he assessed whether or not you can use one or two of the elements instead of all three. In the chapter's conclusion he says that "As a general rule, you should not compromise on more than one Quality, Valuation, or Growth dimension, as it introduces too much risk and/or subpar returns (to say the least) into the mix. Each of the Quality, Valuation, and Growth dimensions is an important source of value creation." In other words, if you can't find a good quality company with good growth at a low price, then keep looking.


Active Value Investing

Katsenelson discusses active trading using the value approach. He says, "Anybody who invests in stocks should expect to commit capital for five years or longer." That is not the same as holding a stock for five years, but it emphasizes the long-term approach needed. He explains what he means by active value investing when he writes, "In the range-bound market you should employ an active buy- and-sell strategy: buying stocks when they are undervalued and selling them when they are about to be fully valued (as opposed to waiting until they become overvalued)."

He further explains the method: "For every company you find worthy of owning (high quality and growth marks), set the optimal price or valuation levels at which it transforms into a good stock. First, determine the fair value of the company using the combination of relative-and absolute-valuation tools discussed in the Valuation chapter. Then, settle on the required margin of safety (the discount to the fair value) that will lead to the buy P/E. And finally (the hardest part), sit and patiently wait for the stock to come down to the predetermined target valuation level and/or price.

When deciding when to sell, he offers an invaluable tip in the form of a question: "If a new person were to manage [your] portfolio, what would he/she do?"

-- Thomas Bulkowski


See Also

Written by and copyright © 2005-2019 by Thomas N. Bulkowski. All rights reserved. Disclaimer: You alone are responsible for your investment decisions. See Privacy/Disclaimer for more information. Some pattern names are the registered trademarks of their respective owners. Your momma is so fat that her driver's license says, "Picture continued on other side."