active value investing presentation by vitaliy katsenelson march 2011

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Vitaliy N. Katsenelson, CFA Chief Investment Officer

Investment Management Associates, Inc.

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Active Value Investing Net of Fees performance is after the deduction of management fees, after reinvestment of dividends, interest and other earnings (recorded on accrual basis), and after the deduction of broker fees and commissions. S&P 500 market average includes reinvestment of dividends but are not adjusted for any transaction costs. Past performance is not necessarily indicative of future results and is only one of several factors which should be used in evaluating a professional investment organization.

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We are used to thinking about secular (longer than 5 years) markets in binary terms:

OR

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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

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Dow Jones Industrial Average 100+ Years

The “bear” markets were actually sideways markets

and happened ½ the time

Dow Jones Industrial Average 2000 - 2010

So far markets have gone sideways … hell of a ride, but still sideways

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Secular Bull and Sideways Market Cycles Were Not Caused by:

Economy

Earnings growth

Interest rates

Inflation

Valuation

They Were Caused by:

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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

Earnings Growth +

∆ P/E

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Stock Market Math

∆ Price +

Dividends =

Total Return from Stock(s)

Earnings Growth +

∆ P/E +

Dividends =

Total Return from Stock(s)

OR

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Sources of Return Practical Example:

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Wal-Mart -- A Typical Sideways Market Stock…

2001 - 2010

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Sources of Return: Secular Sideways and Bear Markets (S&P 500)

Sideways Markets: P/E Contraction + Earnings Growth = Low Returns Bear Markets: P/E Contraction + Earnings Decline = Negative Returns

SIDEWAYS MARKETS

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“By the Book” Bear Market – Japan

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Sources of Return: Secular Bull Markets

Bull Markets: P/E Expansion + Earnings Growth = Super Returns

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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.

Today

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ActiveValueInvesting.com Vitaliy N. Katsenelson, CFA

Director of Research

Investment Management Associates, Inc.

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.

Bull, Bear and Sideways Markets Happen

When…

Market Economic Growth Starting Valuation (P/E)

Bull Good (Average) Low

Range-Bound Good (Average) High

Bear Bad High

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In a “perfect” world where humans have no emotions

stock market appreciation = economic growth = earnings growth = 5-6%

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ActiveValueInvesting.com Vitaliy N. Katsenelson, CFA

Director of Research

Investment Management Associates, Inc.

The Effects of Psychology on Market Cycles

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P/E + EPS =

0% + 6% ≈ 6%

“New” average expectations are NOT

met – P/E stopped expanding

End of Bull Market

P/E + EPS = -6% + 6% ≈ 0%

Returns are NOT “new” average, not average, but

below average:

Sideways Market

Interest Rates Move from Good/Bad for

P/Es Reason

Zone 1 Zone 2 GOOD Move to

normalcy

Zone 2 Zone 3 BAD Risk of inflation

Zone 3 Zone 2 GOOD Move to

normalcy

Zone 2 Zone 1 BAD Risk of deflation

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Interest rates and inflation are very important but they take a second seat to market psychology. They ultimately determine the length and the extremes of market cycles.

If interest rates /inflation were higher, secular range-bound may have ended sooner at higher valuation

If interest rates /inflation were not that low, secular bull may have ended sooner at lower valuation

1982

2000

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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 future taxes, higher interest rates (caused by government borrowing), consumer deleveraging – sideways market may last longer than we expect. High inflation will shorten sideways market duration, but final P/E will be lower as well. If nominal earnings growth doesn’t materialize in the future (3,5,10 years), earnings decline – we are set for a secular bear market

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ActiveValueInvesting.com Vitaliy N. Katsenelson, CFA

Director of Research

Investment Management Associates, Inc.

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, sell when fairly valued. Time stocks, not the market: Market timing is very difficult. In the short run emotions are in the driver’s seat. Don’t buy for the sake of being invested. Don’t lose money by making marginal decisions. In the absence of good stocks to buy, be in cash. The opportunity cost of 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 previous range-bound markets. (Warning: dividends are part of the analytical equation, not the equation.) Look overseas -- increases return without increasing risk.

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ActiveValueInvesting.com Vitaliy N. Katsenelson, CFA

Director of Research

Investment Management Associates, Inc.

Bull Markets: Stocks Do Outperform Bonds Hands Down

Throw 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).

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ActiveValueInvesting.com Vitaliy N. Katsenelson, CFA

Director of Research

Investment Management Associates, Inc.

Sideways Markets: Stocks’ Dominance Is Not Significant

Asset allocation is not as important as stock selection.

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ActiveValueInvesting.com Vitaliy N. Katsenelson, CFA

Director of Research

Investment Management Associates, Inc.

Conclusion: Stock Selection Matters A Lot!

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Thank You!

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Investment Management Associates Inc. 7979 E. Tufts Ave, Suit 820, Denver, Co 80237

303.796.8333 / www.imausa.com

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Secular Range-Bound Market Is Comprised of Many Cyclical Markets

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